Should-cost modelling: understanding what it costs your supplier to make what you buy

Most businesses can say exactly what their main suppliers charge. Far fewer can say, even roughly, what it costs those suppliers to make and deliver what they sell. The gap between those two numbers is someone’s margin. The useful questions are what that margin pays for, whether it is justified and whether it will still be there in a few years.

Purchasing is often organised around the price: an annual negotiation, a target saving, a comparison with last year. That measures negotiating results, not why the price is what it is. Yet only the second kind of knowledge tells a business what to do next: negotiate harder, change the specification, find a second supplier, change how it orders, or leave the arrangement alone.

This article explains should-cost modelling, an independent estimate of what an item should cost to make and deliver efficiently, built from its materials, processing, finishing, logistics and other components. It covers why it matters, what supplier margin actually pays for, how to build a simple model, how to interpret what is left over and how to use the result in conversations with suppliers.

Why it matters

For many product businesses, most of the cost of goods is bought rather than made. Design, assembly and service happen inside, but materials, components and subcontracted processes make up much of the unit cost. That means the business has the least information about the largest part of its own costs.

Several forces make that gap expensive:

• Input costs move: materials, energy, freight and exchange rates change, and price increases often pass through to buyers faster than decreases.
• Supply markets change quietly: consolidation among suppliers, or their suppliers, can reduce competition without the buyer noticing.
• Information is lopsided: a significant supplier sees your volumes, urgency and changes, and understands your situation better than you understand theirs.

A should-cost model narrows that gap. It does not need to be precise. Its job is to turn the next conversation with a supplier into a comparison of estimates rather than a request for a discount.

Margin is not automatically waste

It is tempting to see every dollar of supplier margin as money lost. But margin usually pays for something:

• Risk: the supplier carries the risk of idle equipment, scrap and price changes.
• Inventory: the supplier may hold stock, funding it from its own capital.
• Aggregation: the supplier spreads equipment and expertise across many customers, achieving scale you may not have.
• Tooling and capital: investment in machines and tooling must be recovered.
• Capability: specialised skills, certifications or know-how.
• Warranty and quality: the supplier stands behind its work.

If you remove a supplier or bring work in-house, you inherit these functions along with the margin, usually without the supplier’s scale. The make-or-buy decision is covered in make or buy: choosing between in-house manufacturing and outsourcing.

Defensible and informational margin

A helpful distinction is between two kinds of margin.

Defensible margin rests on something real: a scarce input, a licence or accreditation, specialised capability, significant capital, switching costs or risk the supplier genuinely carries. Challenging it usually means a major change, such as developing a new supplier, redesigning the product or investing in capability. Sometimes it is simply the fair price of what you are buying.

Informational margin exists because the buyer has not looked. It rests on the information gap alone. It can often be recovered through analysis and a better-informed conversation, without capital. It is frequently the cheapest saving available, and it is often left untouched because nobody owns the question.

Building a simple should-cost model

The method is decomposition: break the delivered price into parts you can estimate independently.

1. Material: the weight or quantity of material in the finished part, divided by the yield (the share of purchased material that ends up in the part after offcuts and scrap), multiplied by the material price.
2. Conversion: the time on each process, such as cutting, machining, folding, moulding, welding or assembly, multiplied by a reasonable hourly rate for that type of equipment and labour.
3. Set-up: the time to set up each process, divided by the batch size.
4. Finishing: painting, coating, plating or heat treatment, often subcontracted and quoted per part or per batch.
5. Bought-in components: hinges, fasteners, seals, electronics.
6. Packaging and freight.
7. Tooling: the cost of dedicated tools spread over the expected volume.
8. Inventory and finance: the cost of holding stock, if the supplier carries it for you.
9. The residual: whatever is left between your estimate and the price.

Much of the data is available without the supplier’s help: published material prices and indices, freight rates, typical process times and hourly rates from industry experience or other quotes, and your own knowledge of the part. Where you lack data, a knowledgeable manufacturing engineer or another supplier can help.

Reading the residual

The residual is the most useful line in the model. It is what you are paying for everything you have not been able to name: overheads, profit, scrap, quoting and administration, risk and anything you have missed. A large residual is not proof of overcharging. It may be where the supplier’s real capability sits. But it is evidence of a question worth asking.

Three tests help interpret it:

• The residual test: can we name what the unexplained portion of this price pays for?
• The function test: if this supplier disappeared, who would do this work, and at what full cost, including working capital?
• The reversibility test: if we change supplier or bring the work in and are wrong, what would it cost to go back, and how long would it take?

Open book is not the same thing

Some suppliers offer open-book pricing, sharing their cost breakdown. That is useful, but it shows the supplier’s own allocation of its costs, including choices about how overheads are spread. It is not an independent estimate. A buyer who has never built their own model cannot meaningfully challenge an open-book breakdown.

What to do with the result

A worked example

This is an illustration. A small business buys a powder-coated steel enclosure for its products at $148 each, about 3,000 a year, delivered in monthly batches of about 250. The owner builds a rough should-cost model using published prices and advice from a manufacturing engineer. All figures are illustrative.

The residual is about a third of the price. That is not evidence of unfairness, but it is worth understanding. The owner meets the supplier and asks about cost drivers rather than demanding a discount. The conversation reveals that the business’s specification requires a special powder-coat colour used by no other customer, which the coater charges a colour-change fee for on every batch, and that the business’s drawings call for a tight flatness tolerance on a face that is hidden in use.

The business adopts a standard colour close to its own and relaxes the hidden-face tolerance after checking it has no function. The supplier reduces the price to $139. The saving of $9 a unit on 3,000 enclosures is $27,000 a year, achieved without changing supplier or volume.

The model also helps later. When the supplier asks for a 10% increase, about $13.90, citing a 20% rise in steel prices, the owner can see that steel is about $15 of the cost, so a 20% rise adds about $3 a unit. The owner accepts an increase of about that size and asks for any further rise to be explained by other cost drivers.

Linking prices to indices

Where a material makes up a significant and volatile share of an item’s cost, an index-linked price can be fairer to both parties than repeated negotiation. The idea is to split the price into a material portion that moves with an agreed published index and a remaining portion that is fixed for an agreed period or adjusted separately.

For example, if a should-cost model shows that material is about 10% of a price, the agreement might say that the material portion changes in proportion to an agreed steel price index, reviewed quarterly, while the remaining 90% is fixed for twelve months. A 20% rise in the index would then raise the total price by about 2%, and a 20% fall would reduce it by the same amount. Both parties can see the calculation, and increases and decreases flow through equally.

Choose an index that genuinely reflects the material the supplier buys, agree the base date and value, set a review frequency and decide whether small movements below a threshold are ignored. Take advice on contract wording for significant agreements.

Appraising bigger sourcing changes

Should-cost models often prompt bigger questions: changing supplier, adding a second source or bringing work in-house. Appraise those carefully. State the comparison you are making and the time horizon, discount future cash flows at a rate that reflects your cost of capital and risk, identify the two or three assumptions the answer depends on and test how far they can move before the conclusion changes, and avoid counting the same cost twice under different labels. The article on cost-benefit analysis for business decisions sets out a practical method.

How this applies to a small Australian business

Small businesses often have limited purchasing power, which makes understanding costs more valuable, not less:

• Start with your three largest bought items and build a rough model for each. A few hours is often enough.
• Use public data: material price indices, freight rates and quotes from other suppliers.
• Ask about cost drivers, not discounts. Suppliers often respond well to informed questions.
• Look for specification-driven cost: special finishes, tight tolerances, unusual materials and small batches.
• Link prices to indices where materials are volatile, so increases and decreases both flow through.
• Watch for supply concentration, including among your suppliers’ suppliers.
• Treat suppliers fairly: a model that shows a supplier is not overcharging is a useful result too.

The article on controlling costs without cutting quality covers wider cost control.

Signals worth watching

• Price increases blamed on inputs whose published prices have not moved.
• Suppliers keen to take more volume but unwilling to discuss cost drivers.
• Consolidation among suppliers or their suppliers.
• A residual that widens year after year.
• Savings measured only against last year’s price rather than against a model.

Common mistakes

• Treating all supplier margin as waste.
• Negotiating on price without understanding cost.
• Accepting open-book figures without an independent view.
• Ignoring specification-driven costs you could change yourself.
• Assuming input increases justify the full increase requested.
• Bringing work in-house without counting the functions the supplier was performing.

Frequently asked questions

Do we need specialist software? No. A spreadsheet is enough for most small businesses. Accuracy within 15% to 20% is usually sufficient to guide a conversation.

Will suppliers resent this? Most suppliers prefer informed customers to arbitrary discount demands. Use the model to discuss drivers and find savings together, including changes on your side.

What if our model shows the price is fair? That is a useful result. It gives you confidence in the relationship and lets you focus elsewhere.

Questions to ask

• For our largest bought items, can we describe the supplier’s cost structure without quoting the supplier?
• Which margins in our supply chain pay for something real, and which exist only because we have not looked?
• Which of our own specifications drive cost without serving a function?
• How would we know whether a requested price increase was justified?
• If a key supplier disappeared, who would do the work and at what full cost?

Bringing it together

The price on an invoice is a negotiating outcome. The cost behind it is the economics, and only the economics tells you what to do next. Build a simple should-cost model for your main bought items, separate defensible margin from margin that exists only because nobody looked, and read the residual as a question rather than an accusation. Use the model to discuss cost drivers, change your own specifications where they add cost without function, link volatile prices to indices and appraise bigger sourcing changes carefully. A business that understands its suppliers’ costs makes better decisions than one that only knows their prices.

Source: KEVOS notes. Examples and figures in this article are illustrations, not market prices. This article is general information, not financial advice.