When buying a custom item that only one supplier can produce, using a should cost model is one way of determining whether the price is fair. A should cost model is a documented calculation of an estimated price that you create by researching all material costs, labor costs, overhead costs, and profit margins that would apply to an item. Essentially, you are behaving as if you were responsible for manufacturing the item yourself.
If a supplier’s quoted price exceeds your estimate, your “should cost model sets the stage for future negotiations,” according to Tim Reis, SPSM, a Sourcing Manager for Continental Commercial Products. When using should cost models in negotiations, Reis notes that accuracy is key “because you know with 100% certainty that the supplier will challenge your assumptions in attempt to turn the cost discovery negotiation process back to their side.” The credibility you need to negotiate successfully can be lost with a poorly researched model, so you need to “be more knowledgeable about the supplier’s business than the supplier is” he says.
To maximize accuracy, Reis advises peers to “study every aspect of the item being modeled to assure that the supplier can raise only minor objections rather than to be able to challenge the integrity of the model itself.” In addition, he proposes enlisting the help of your Finance team in the role of devil’s advocate. “You should encourage a cost accountant to try and poke holes in your model to fine tune your estimates” Reis suggests.
Even a well-researched should cost model isn’t exempt from scrutiny, though. However, “you want to encourage the supplier’s challenge,” Reis says. “When a supplier challenges the model, the model is beginning to work for you because the supplier is now using your model and your data.”
In this regard, Reis uses a favorite line to get suppliers to reveal cost data that they typically protect: “If you think that my data is wrong, then please tell me where I’m in error.” He says that this forces a supplier to either admit that your data is correct or to tell you “exactly where your model is in error thereby turning your estimates into known, factual data.” You then revise the should cost model and base negotiations on even better data.