Benchmarking and Cost Modelling for Successful Procurement: The Basics of a Good Process
The procurement process can be a daunting task for any business. There are lots of
different cost models to choose from, and each one has its benefits and drawbacks. Cost
modeling is the process of predicting how much money will go into production before
anything comes out – it's essentially an estimate of what something should or must cost.
Benchmarking is the practice of gathering data about past performance on projects
similar to yours and using that information to predict your future costs. It's important not
only to know which type of model you're using but also when you should use them to get
accurate results with minimal wasted time.
Cost modeling is a must to ensure the project you are managing has all aspects of cost
accounted for. Here's how it can help in planning, budgeting, forecasting, and
performance management...
There are four types of cost modeling tools. These are: must cost, should cost,
benchmarking, and total cost. The right type of tool will get you good results and save you
lots of wasted time. The wrong type can lead to poor procurement performance, higher
costs, or both. Any one of these tools can be used to drive TCO reduction. Let’s take a
look at when each model should be used to achieve the best outcomes.
’Must Cost’ Model
This model is a budgetary constraint model. It is not standard practice to tell a supplier
what the budget is, however, this is the one exception to that rule. The ‘Must Cost’ model
is used when you don’t have enough finance for what you need to purchase and you
know that price exceeds budget under all scenarios.
In this scenario, you would approach the supplier giving details of your exact budget and
requesting a proposal from them on what they are able to offer in terms of a custom deal
to match your budget. Whether it’s changing the scope of work or the specifications, or
some similar solution to reduce costs in line with your available budget. If the supplier
initially states they are unable to help, simply give them 48 hours to go away and think
about it. They will almost always come back with an innovative solution to enable the deal
to happen.
‘Should Cost’ Model
This model takes into account the three components needed for a usable should cost:
labor, material, and logistics.
‘Should costing’ can become very complex very quickly and can take a lot of time and
resources. Therefore, the only time this should be used is in the case of a custom product
or service, or a sole-source provider.
Benchmarking
The ideal time to use benchmarking is in the case of undifferentiated products or services
ie. when the customer is indifferent to which supplier is chosen as long as the product /
service is the same. The process is a very simple but powerful one of comparing various
suppliers to ascertain which one can provide the lowest total cost solution.
‘Total Cost’ Model
This model should be used when there is a material difference between the acquisition cost
and total cost.
We don’t always consider the total/lifetime cost when making a purchase and often only
focus on the initial acquisition cost. However, this can be a big mistake as further costs, later on, may make certain purchases that appear to be the best deal initially, the most
costly as a whole.
Another important cost-saving practice during your supplier negotiations Is that you don’t
just think about variable costs and expect only purchase price discounts based solely on
variable costs. Securing your business may be helping them to dramatically reduce their
average fixed cost per unit and therefore the supplier must know you are aware of this
and that you are expecting purchase price discounts also based on The average fixed
cost per unit reduction that is coming from your business.
Key rules and cost modeling strategies:
Have a team in place that has visibility to the various cost components
Whenever you are involved in a big negotiation it is important to have a team in place that
has visibility to the various cost components ie. finance, accounting, receiving.
Differentiate between assumptions, estimates, and facts
Assumptions and estimates introduce risk and variability into the cost model and these
need to be minimized as much as possible.
Start with basics and add complexity later
The more complex a cost model is, the higher the likelihood that it is wrong. The smaller
and more basic it is, with the fewest assumptions and estimates the more accurate and
successful it will be.
Do ‘what if’ cost model analysis instead of just ‘what is’
Innovation is an important factor. Ask questions. Ask ‘what if we did this?’, ‘What if we
changed this?’, ‘What if we removed this?’, ‘What if we eliminated that process?’ Always
try to do cost analysis based on ‘what could be’.
Do Pareto analysis on data findings
Pareto was a French economist who said that 80% of the costs are going to be in 20% of
the transactions. It makes sense to focus on the largest expenses and start with the most
expensive components to drive reductions there first to ensure the biggest impact in cost
reductions.
Separate controllable from uncontrollable costs
Some costs are mostly uncontrollable. The focus should be on eliminating these to enable
focus on controllable costs.
When it comes to procurement, hopefully, it’s now clear that having the right cost
modeling tool can make all of the difference. You need a plan that is tailored specifically
for your organization’s needs and provides you with accurate numbers every time. This
article has offered some insight into when each model should be used; now it's up to you
to decide which one might work best for you and the negotiations you are involved in.
What are your thoughts on these different types of models? Which of these keys to
success do you think will be most beneficial for you in your negotiations?
Let us know in the comments below and be sure to let us know if we can help you further.