What Is Should Costing and Why Is It Important?
Learn how 'should costing' analyzes the true, optimal cost of goods and services, empowering smarter business decisions and cost efficiency.
Should costing is a strategic cost management technique that helps organizations determine the theoretical cost of a product or service. This method focuses on what a product or service should cost, rather than simply accepting what it does cost. Its purpose is to provide a benchmark for strategic planning and cost optimization. By understanding the underlying cost drivers, businesses can make more informed decisions about pricing, sourcing, and operational efficiency.
Understanding Should Costing
Should costing involves a “clean sheet” approach, building costs from scratch based on efficient operations and ideal conditions, unlike traditional cost accounting which relies on historical data. The core philosophy is to analyze every component and process to identify the cost under optimal circumstances.
This analytical approach helps identify specific cost drivers and potential areas for efficiency improvements. It aims to establish an optimal or target cost by breaking down a product or service into its fundamental elements. This detailed analysis provides a robust estimate, preventing reliance solely on supplier quotes or past spending patterns.
Elements of a Should Cost Model
A should cost model dissects a product or service into its fundamental building blocks to estimate cost. Direct material costs are a primary component, considering not only raw material prices but also expected scrap rates and material yields.
Direct labor costs are also analyzed, encompassing hourly labor rates, the efficiency of the workforce, and the precise time required for each production step. Manufacturing overhead includes both variable costs, such as utilities tied to production volume, and fixed costs like depreciation of machinery or indirect labor. Non-manufacturing costs, such as research and development, selling, general, and administrative (SG&A) overhead, and transportation, are also included. Finally, a reasonable profit margin for the supplier or internal department is typically incorporated to arrive at a fair “should cost” that reflects a sustainable business model.
The Should Costing Process
The should costing process typically begins with clearly defining the scope of the analysis, specifying the product, service, or component to be evaluated. Following scope definition, extensive data collection is performed, gathering detailed technical specifications, process flow diagrams, bills of materials, and relevant market data. This data is crucial for populating the cost model with accurate inputs related to materials, labor, and overhead.
Next, a cost model is developed, often utilizing engineering estimates, industry benchmarks, and granular cost breakdowns for each identified element. This involves calculating the cost of each part, process, and operation under efficient conditions. The developed model then undergoes analysis and validation, where the estimated “should cost” is compared against actual or quoted costs to identify discrepancies and underlying cost drivers. Finally, the findings are compiled into reports and presented to stakeholders, providing actionable recommendations for cost reduction and negotiation strategies.
When Should Costing is Used
Should costing is a valuable tool applied in various strategic scenarios to gain a competitive advantage and optimize expenditures. It provides significant leverage in supplier negotiations by establishing an independent, fact-based understanding of a fair price. This allows organizations to challenge inflated quotes and secure more favorable terms.
During new product development, should costing helps in setting target costs early in the design phase, ensuring that the product can be manufactured profitably and remains competitive in the market. It is also useful in internal cost reduction initiatives, as it identifies inefficiencies within a company’s own operations. This allows for targeted improvements and process optimization. Should costing supports strategic sourcing decisions by enabling a thorough evaluation of different options, such as whether to “make” a component internally or “buy” it from an external supplier. The analysis also serves as a benchmarking tool, allowing companies to compare their internal costs against industry best practices and identify areas for performance improvement.