Should Cost Modelling

Should Cost Modelling

Should Cost Modelling is a Valuable Tool – So, What Should PPE Cost?

As a weapon in the armoury of Procurement professionals, Should Cost Modelling is definitely under-used. As Procurement teams seek to become more agile it’s important that the traditional reliance on Strategic Sourcing and Tenders is tempered with some other tools. Should Cost Modelling (“SCM”) enables acceleration of award decisions and value assurance activities.

What is Should Cost Modelling?

Emerging from the product development and engineering fields, Should Cost Modelling (“SCM”), supports Procurement in breaking-down a product or service into its component parts, establishing what these components cost, then building a model that indicates what the overall product or service ‘should cost’.

SCM was most applicable historically in manufacturing, where automotive or defence sub-assemblies can be broken down into their component parts and individually costed. Today, its use can be widened to encompass almost any bought in good or service. If there is a tangible input (e.g. materials, labour, buildings, platforms) then it is possible to apply the principles. Albeit – as with a plasterer’s trowel – in the hands of someone without the experience and expertise in handling financial information, understanding production etc. it can be dangerous. We know that in many cases markets drive prices however, SCM allows us to know what a ‘baseline’ price should be. Which is what we are about to demonstrate below.

How to Apply Should Cost Modelling?

In the interests of being topical we’re using PPE, specifically the example of a Lab Coat. We recognise that pricing at the time of writing (May 2020) is being fully driven by market demand, giving rise to excess profits to suppliers however, we’ve used it as the basis of an example to help readers understand how to apply the principles.

Composition of a Lab Coat?

There are seven elements of the composition of a Lab Coat:

  • Base Fabric: The journey from the cotton fields to the fabric used to make a Lab Coat is well established.  The yarns start off in the field where through manual or automated picking the raw cotton is harvested before being packed into bales and shipped to a processing plant to be spun into yarn.  This happens all over the world but generally in low cost countries.  Depending upon their intended use the yarns are treated, classified and eventually woven into rolls of fabric. In our example the fabric is a blend of polyester threads and cotton (35%/ 65%.) The fabric is woven to a weight per square metre.  The weight of the fabric in the illustration is 210GSM woven in a ‘twill’ finish.  The rolls are stored and then shipped to garment manufacturers. 
  • Trim is the felt to add weight and shape to structures in the coats such as the collar and cuffs plus thread, tape, buttons and fastenings, all of which have different levels of quality associated with them depending upon specification.
  • Packaging is cardboard, plastic and perhaps wire hangers. 
  • Labour cost: The production process is heavily manual, using approximately 45 minutes of labour per unit. We’ve assumed the seamstress is based in Hanoi, Vietnam, on minimum wage. Cutting uses mechanical cutters but the machines usually require a large manual element to load the fabric, set the machine and oversee the process.  The different elements of the coat are sent to specialist sewing operatives who sit at sewing machines and usually work on a piece rate basis.  The part assemblies are then brought together in a final assembly process, again by a sewing operative to complete the coat.
  • Factory overhead including profit: From experience and deductive reasoning from publicly available financial reports we assess the level of overheads and profit.
  • Shipping to EU: Shipping costs per full container are widely published.  Large users, with some market expertise and power will gain efficiencies.
  • In-Country Marketing, Storage & Distribution (including Profit): These costs include receipt, storage, picking, packing, sales and customer services etc.  The distribution cost is the cost of getting it from the distributor to the retailer. 

What is the Should Cost?

ComponentPrice per unit (£)
Base Fabric: In our illustration 1.85 square metres of fabric are used to make a coat. This shape is cut as efficiently from the rolls of fabric as possible to minimise the off cuts or waste (which is usually sold on into cushion stuffing or similar processes). Cost per meter is approximately £1.05 for bulk purchase of the 210GSM polycotton mix (Source: various google websites, e.g. made-in-china.com) [1.85sqm x £1.05] = £1.94
Trim: All the individual items could be sourced and assessed for cost. From experience, we’ve assumed total cost of £0.85 for all the trim elements.£0.85
Labour: In Hanoi, Vietnam the minimum wage is 4,420,000 VND per month (approx. £6.20 per day) (Source: wageindicator.org). Cycle time to make a lab coat is approximately 45 mins[45 mins x hour rate £0.77] = £0.57
Packaging:  Again, with detailed research, a hangar could be found to cost £0.03 and the cardboard and plastic protective layer £0.17£0.2
Cost of Goods Sub-total£3.56
Factory Overhead including Profit: based on 40% mark-up£1.42
Ex-factory Sub-total£4.98
Shipping to UK: Assuming one containerload at £4,000 including all freight costs for 12,000 units[£4,000 for12,000 units] = £0.33
Sub-total Landed cost£5.31
UK Marketing & Distribution: This is a function of the volume ordered; assume uplift 25% of Landed Cost£1.37
Should Cost Model Total£6.68

£6.68 ….. So What?

The key benefit of Should Cost modelling is that, if done well, it provides a perfect entry point into negotiations with the retailer in the UK.  It gives the buyer a level of confidence to either dispense with competitions entirely and rely on negotiating the retail margin or to run a competition, if required by policy or regulations, and to focus the competition specifically on the retail margin and associated service levels. This approach will increase speed to market and reduce the costs of administrating an RFP process.

Using Should Cost Modelling for Sensitivity Analysis

Obviously, costs are variable and, in this example, will be affected by factors ranging from weather conditions affecting the harvest, through to oil price for shipping, pandemic which affects cotton picking labour and accidents which affect capacity or supply.  So, a further use of the Model is to flex it to show the impact of a rise of fall in component costs and what that does to overall cost.

Artificial Intelligence (AI) Should Cost Modelling?

Historically, SCM was time-consuming. It requires access to multiple and frequently changing datasets on material/ commodity prices, labour rates and other components. However, with the emergence of data mining and Artificial Intelligence it is now possible to scrape and interpret this information into pre-built cost models with limited effort. 

SCM is now being applied in services, scraping job boards in individual countries and real estate information to assess labour cost per hour and square foot property costs.

The future means that with some confidence, buyers will be more informed on what a service should cost, and therefore in most cases what it WILL cost, following a negotiation. And in some cases, this will replace the traditional Tender process providing stakeholders with the confidence that they are paying fairly for a service.

This article has been co-authored by Jonny Michael & Malcolm Smith from JMCL and guest contributor Graham Copeland of 2 Sides of a coin. If you would like any more information on effective Should Cost Modelling and how JMCL experience and expertise will help you please contact Jonny Michael, CEO of JMCL Consulting:

E: j.michael@jmclconsulting.com

M: +44 (0) 7831390161