What Is Should-Cost Modeling and How to Build One

Should-cost modeling is a strategic financial practice that helps businesses understand the true underlying cost of a product or service. It involves dissecting all expenses associated with design, manufacturing, and delivery to arrive at an objective cost estimate. This approach aims to determine what a product or service should cost, rather than simply accepting a quoted price from a supplier.

The fundamental purpose of should-cost modeling is to empower informed decision-making, particularly within procurement and supply chain management. By establishing an internal benchmark for fair pricing, companies can negotiate more effectively with suppliers and identify opportunities for cost optimization. This detailed understanding of cost drivers provides a significant advantage in achieving better value and fostering more transparent relationships in the supply chain.

Key Elements of a Should-Cost Model

A comprehensive should-cost model breaks down all individual cost components that contribute to the final price of a product or service. Understanding each element is foundational to accurately estimating what an item should cost under efficient conditions, providing a granular view of expenditures.

Direct materials are raw inputs that become part of the finished product. Their cost is determined by market price, quantity required, and waste generated. For example, apparel manufacturing includes fabric, thread, buttons, and zippers. Logistical expenses like freight and handling are also considered.

Direct labor includes wages and benefits paid to employees directly involved in converting raw materials into finished goods. This encompasses hourly rates, overtime, and associated payroll taxes. Efficiency rates and time spent on specific tasks are also factored into these costs.

Manufacturing overhead comprises all indirect production costs not classified as direct materials or labor. Examples include indirect labor, utility costs, machinery depreciation, and factory rent. These costs are typically allocated to products using a predetermined rate, often based on direct labor or machine hours.

Selling, General, and Administrative (SG&A) expenses cover non-manufacturing costs related to selling products and managing the business. This includes sales commissions, marketing, administrative salaries, and office supplies. While not directly tied to production, these expenses are part of the overall cost structure a fair price should cover.

Profit margin is incorporated to ensure the supplier earns a reasonable return. This margin varies significantly by industry, product complexity, and market conditions, generally falling within a range that sustains business operations and allows for future growth. Typical margins range from 5% for high-volume goods to 20% or more for specialized items.

Tooling and capital costs are considered for new products or custom components. These are often one-time or amortized costs for specialized equipment, molds, or fixtures necessary for production. They are a legitimate part of the overall investment that needs to be recovered through pricing.

Building a Should-Cost Model

Constructing a should-cost model involves a structured process of data collection and analytical techniques. The accuracy of the model depends heavily on the quality and detail of the information gathered, ensuring a robust and defensible cost estimate.

Data collection is the initial step, requiring various information sources. Internal records like historical costs and engineering specifications provide insights into past production. External sources include market benchmarks, industry reports on labor rates, and public financial data. Expert interviews also offer valuable qualitative data.

Several analysis techniques are employed to estimate costs for each component.

Bottom-up costing breaks down a product or service into its smallest parts, estimating the cost of each component and process. This involves calculating raw material amounts, machine time, and labor hours for every operation.

Parametric estimating uses historical data and statistical relationships to forecast costs based on key parameters. For example, knowing the cost per pound of metal allows estimating material cost for a new product based on its total weight.

Activity-Based Costing (ABC) allocates overhead costs more precisely by identifying the specific activities that consume resources and then assigning costs based on the consumption of those activities.

Benchmarking involves comparing estimated costs against industry best practices or the costs of similar products from competitors to identify discrepancies and potential areas for improvement.

Model construction compiles analyzed data and estimated costs into a coherent structure, often using spreadsheets or specialized software. The goal is to aggregate all direct materials, direct labor, manufacturing overhead, SG&A, and a reasonable profit margin to arrive at the total “should-cost” figure. The model should be dynamic, allowing for adjustments based on changing market conditions or design modifications.

Applying Should-Cost Analysis

Once a should-cost model is built and the objective cost determined, the analysis becomes a powerful tool for various business applications. It transforms raw data into strategic intelligence, driving actionable decisions and improving financial outcomes.

The “should-cost” provides a strong basis for negotiation with suppliers. Companies use this detailed cost breakdown to engage in fact-based discussions, challenge unreasonable bids, and identify areas for cost reduction. This transparency fosters collaborative relationships by focusing on true manufacturing costs.

Should-cost analysis also aids in supplier selection. By understanding what a product or service should cost, businesses can objectively evaluate and compare potential suppliers, ensuring they receive fair value. This moves beyond simply accepting the lowest bid, focusing on suppliers who can meet the target cost efficiently.

Internally, companies leverage should-cost insights to identify inefficiencies within their manufacturing or service delivery processes. Comparing actual costs to the “should-cost” benchmark pinpoints areas for operational improvements, waste reduction, or process optimization, leading to significant internal cost savings.

The model also informs make-or-buy decisions, determining whether it is more cost-effective to produce a component internally or outsource it. A thorough should-cost analysis provides the financial data needed for this strategic choice, impacting resource allocation and supply chain structure.

Should-cost analysis supports strategic sourcing initiatives. It enables businesses to identify opportunities for value engineering, redesigning products to reduce costs while maintaining functionality. It also helps explore alternative material sourcing options for cost efficiencies without compromising quality.