Three Reasons to Use Should Cost Modeling
In the face of immense cost pressures and ever-increasing competition, packaging has become a key competitive differentiator and a focus area for CPG companies. A question that is often asked by category managers and procurement leaders is: “Is the business being correctly charged by the supplier?”
This often requires further probing into supplier pricing, with new questions arising – Is the pricing in accordance with industry standards? Is the supplier providing optimum quality relative to price? How should I address a sudden price increase from the supplier’s side? Are there other suppliers in the market offering the product or service at a better price?
Should Cost Modeling (SCM), a process which helps build a holistic picture of the economics behind the production of a product, is a good starting point for answering these questions. By establishing the cost structure of the inputs sourced from suppliers and the finished product – including raw material costs, manufacturing costs, process overheads, labor costs, etc. — a procurement organization can gain an estimate of the real product cost.
For example, a high-end spirits company wanted to investigate whether they were paying a premium for its glass bottle labels. The supplier had moved its manufacturing base from the U.S. to Mexico, but there had been no change in label pricing, and the category manager wanted answers. The SCM found that the price charged by the supplier was 70 percent higher than the actual manufacturing cost in Mexico. Our insight enabled the client to renegotiate with its supplier, delivering cost savings which improved the company’s bottom-line.
Here are three reasons for applying SCM and the significant benefits it can bring to the overall business.
1. Supplier Negotiations
Should Cost Modeling is helpful in both contract renegotiations with existing suppliers and engagement with new suppliers. A view of the product cost-breakdown provides a good foundation for discussions and gives negotiating power to a procurement organisation, by highlighting potential areas of buyer advantage – is it in labour costs, raw materials, production costs or somewhere else? Any cost reduction, or avoidance of cost increases, has significant value in consumer packaged goods — an industry of very fine margins.
Recently, the packaging category manager of a global food processing company was entering into negotiation discussions with its suppliers for rigid and flexible packaging. The Smart Cube conducted a cost breakup for different geographies for each of PET bottle, PP tray and and PP cap. The Should Cost Model gave the differential between the actual production cost and the final price charged — specifically insights on aspects such as the margins charged by suppliers in different regions and the differences in raw material costs. These insights were utilized as negotiation levers by the client in the discussions with its packaging suppliers. For instance, the raw material costs were found to be high in many regions, and expected to rise further, which would impact the production costs further. This type of insight can be used to enter long-term contracts with suppliers and save costs. In this case, the procurement organisation successfully used these differentials as negotiation levers and saved more than $2.5 million in the flexible and rigid packaging categories.
But what if a Should Cost Modeling exercise reveals a huge gap in the estimated and the supplier’s pricing and negotiations do not bring the cost at par with the industry margin? In those situations, CPG companies can seek alternate suppliers in the market, using an estimate of the product cost to empower the business in both supplier identification and negotiation.
2. Strategic Decision-Making
A cost-structure breakdown of a final product gives a transparent picture of how much each commodity affects the final product price. CPG companies can use insights like these to make informed strategic decisions. For example, a company may decide to change the formulation of a packaging product if it finds out that a substitute raw material could lower the final cost without affecting quality. What if environmental sustainability is a strategic goal for the business? Procurement teams can check the cost differential with the inclusion of biodegradable packaging by inputting the various packaging prices into a dynamic cost model.
The Smart Cube recently worked with a beverages company to develop a Should Cost Model for packaging its glass bottles. Using the SCM, the procurement team found that the supplier was operating at higher-than-industry margins. The supplier could not claim that the increased labour and shipping costs were being reflected in the final product price; as the procurement team had the data and knew the industry margins. By applying the SCM and the evidence it showed, the company now had a strong base to either renegotiate with the supplier for better prices or take the strategic decision of bringing the packaging of the bottles in-house, which the SCM data showed could be a more cost effective and operationally efficient solution.
3. Forecast Impact on Product Price
It is difficult to forecast a product price if its historical price isn’t available. But because of the dynamic nature of a Should Cost Model, if the price of all the commodities used to manufacture a product can be forecast, then the future product price can also be estimated. For instance, take the example of a packaging label. Secondary research cannot yield a forecast price of a packaging label, but the forecast price of paper is available. Input that in the model, along with all the other costs (manufacturing, labor, overheads, etc.) and the model will give a forecast price of the packaging label. A regression analysis can also be used to determine how the final product price will be impacted by a change in commodity prices. Therefore a CPG company can use its commodity price forecasts to predict how that change will impact the cost of the final product.
As we have seen, although the main use of intelligence from SCM may be to provide an evidence base to support supplier and cost negotiations, it can also be applied more widely, to aid strategic decision-making and forecast future impacts on product prices. A Should Cost Model can be of great use to packaging category managers — bringing wider strategic insights which go beyond the traditional remit of procurement.