Understanding the Concept of Cost Modeling in Your Procurement Process

Cost modeling is a key purchasing strategy that helps companies understand what factors determine the cost of their products. Even if this is the first time you’ve heard of the term, you are likely doing a variation of it in your own procurement process. Indeed, the most common steps simply involve analyzing the cost of each purchase and then negotiating the best possible price with your suppliers.

However, the unique challenge presented by cost modeling is in studying both cost drivers and cost components to see if the price is right. The process itself may take time, a lot of hard work, and even some know-how with cost modeling tools in order to perfect. But all these are a small price to pay to get rid of inaccuracies from pure guesswork. Indeed, the wrong data can cause your company to overspend during procurement and lose money even before you start selling a product.

Keen to know more about cost modeling? Here’s everything that you and your purchasing officers need to know when you’re evaluating your company’s purchasing and cost.

A Guide to Cost Modeling: What It Involves and What It Influences

Before applying cost models, you have to understand what factors are involved in determining the true cost of a product for companies and suppliers. These are the most important factors that influence true cost:

• Direct labor
• Direct material
• Selling cost
• Research and development (R&D) cost
• Administrative cost
• Potential profit

Once all of these factors are quantified, you’ll end up with a set of accurate cost-related insights, or a realistic picture of where your company’s procurement funds should be going. Among the things that an optimized cost model can then help determine are:

• Optimal order quantities per product, per cycle (not too little or too much)
• An ideal price point for cost components such as materials, labor, and overhead
• The ideal threshold for negotiation with suppliers

Tips on Adapting Cost Models for Your Procurement Processes

Now that you understand what values you are after and what good it will do to quantify them, here are some additional tips to help you arrive at functional cost models during your company’s procurement phase:

1. When making a cost model, factor in the product’s cost drivers as well as its cost elements. Cost elements involve the default costs that are behind a product, or what you already expect to pay for acquiring them. But how about the cost drivers, or the other variables that affect those costs in different situations? Generally, these what ifs are why you should leave a little room in your procurement-related decisions. These variable factors can include potential price surges, scarcity during a certain season, and the like.
2. Recognize that different products have different cost components. It may already be obvious that you’ll spend different amounts to acquire different products. But it’s always good to have a better understanding of what drives the cost of one item versus another. This leads to a sharper awareness of where funds in your procurement budget are going and eventually, better decisions about how to utilize those resources.
3. Figure out what the total cost of ownership is for your products. Beyond the exact prices of procuring goods, companies must also be aware of what they will spend to own and distribute them. Examples of these are shipping costs, storage costs, inventory carrying and management costs, as well as import or export taxes. Remember that cost models won’t be complete without taking these additional expenses into account.
4. If procurement demands have spiked, consider investing in cost modeling technologies. Growth and expansion are wonderful things to anticipate for your business, but your procurement process should be able to keep up. If you’re expanding your lineup of products or entering relationships with a number of new suppliers, you should consider upgrading your in-house technologies. Specialty cost modeling software, which is engineered for this very purpose, will likely help you derive accurate cost-related insights in a consistent manner.
5. Aim to strike a balance between your interests and those of the suppliers. Negotiating with suppliers for the right price is tough, and you may be tempted to apply a take-it-or-leave-it kind of approach. But hitting the sweet spot between your interests and those of the suppliers will increase the chances of both parties meeting their agreements with consistency and in good faith. It can also help if you calculate par costs to identify which suppliers can keep up with you, and with whom you can more easily begin a business relationship.

If applied correctly, cost models will not only curb unnecessary spending. They will also enhance the application of key purchasing skills, such as identifying overpriced components and being able to negotiate more persuasively.

In the end, it’s best to remind your purchasing officers and other employees involved in procurement of their goals when applying cost modeling. Indeed, they can go a long way by focusing on how to develop their talents, how to stay on top of all procurement costs, and how to know what it takes for the price to be right.