How to approach cost analysis in Procurement

It’s becoming more prevalent than ever in today’s competitive business landscape to focus on cost efficiency and value creation, bringing the role of procurement to the forefront - continuously seeking ways to optimise operations.

One of the most powerful tools in a procurement professional’s arsenal is procurement cost analysis. By examining all the direct and indirect costs associated with sourcing, buying, and managing goods and services, like a little procurement detective it’s possible to understand and uncover hidden expenses, negotiate better contracts, and ultimately drive sustainable savings.

What Is Procurement Cost Analysis?

Procurement cost analysis is a structured approach to identifying, assessing, and controlling expenses related to acquiring goods or services. It goes beyond the initial purchase price to capture every cost driver across the procurement lifecycle, including:

• Direct costs (e.g., product price, transportation, tariffs)

• Indirect costs (e.g., overhead, storage fees, supplier performance risks)

• Lifecycle costs (e.g., maintenance, disposal, potential upgrades)

By comprehensively analysing these costs, businesses can better understand the total cost of ownership (TCO) of any purchase decision and identify where and how to optimise.

Step-by-Step Guide to Procurement Cost Analysis

A comprehensive procurement cost analysis involves several key steps to ensure cost efficiency, supplier transparency, and strategic decision-making. Below is a detailed step-by-step process:

1. Define Objectives and Scope

   • Identify the purpose of the cost analysis (e.g., cost reduction, supplier evaluation, process optimisation).

   • Determine the scope, such as category-specific analysis or a company-wide procurement assessment.

2. Collect and Organise Data

   • Gather historical procurement data, including purchase orders, supplier contracts, and invoices.

   • Obtain market research data, such as industry cost benchmarks, pricing trends, and competitive analysis.

   • Collaborate with internal teams (finance, operations, R&D) to gather additional cost-related insights.

3. Break Down Cost Components

   • Direct Costs: Product pricing, transportation, tariffs, taxes.

   • Indirect Costs: Storage fees, overhead, supplier performance risks.

   • Lifecycle Costs: Maintenance, disposal, upgrade potential.

   • Hidden Costs: Delivery delays, quality failures, supplier financial instability.

4. Conduct Benchmarking and Competitive Analysis

   • Compare supplier pricing and costs against industry benchmarks and historical spending trends.

   • Identify cost variances and evaluate whether suppliers are providing fair pricing.

5. Perform Should-Cost Analysis

   • Estimate a reasonable price for goods or services based on material costs, labor, overhead, and profit margins.

   • Identify opportunities to negotiate lower prices or alternative sourcing options.

6. Analyze Supplier Cost Structures and Identify Inefficiencies

   • Review supplier pricing models and cost drivers.

   • Determine if cost inefficiencies exist due to outdated processes, high labor costs, or excessive overhead.

   • Explore alternative suppliers or cost-reduction strategies.

7. Develop Actionable Insights and Negotiation Strategies

   • Use findings to negotiate better contract terms, bulk discounts, or volume rebates.

   • Identify opportunities for supplier collaboration to improve cost efficiency.

   • Recommend process improvements, such as automation or alternative material sourcing.

8. Implement Cost-Saving Measures and Monitor Results

   • Track the impact of implemented strategies using key performance indicators (KPIs), such as procurement cost reductions and supplier performance improvements.

   • Continuously revisit cost structures to ensure long-term cost efficiency and supplier alignment.

9. Review and Adjust Strategies Regularly

   • Conduct periodic procurement cost analyses to stay updated on market conditions.

   • Adjust strategies based on supplier performance, market fluctuations, and organizational needs.

Should-Cost Analysis in Procurement

Should-cost analysis can lead to significant cost-saving opportunities and process improvements by providing procurement teams with a clear understanding of the cost structure behind products and services. This insight helps drive efficiency, reduce unnecessary expenditures, and foster better supplier relationships.

Examples of Cost-Saving Opportunities and Process Improvements

1. Informed Supplier Negotiations

   • By understanding the detailed cost structure of a product, procurement teams can identify discrepancies between the supplier's quoted price and the calculated should-cost. This knowledge enables more effective negotiations, potentially leading to price reductions.

   • Example: A company analyzing the should-cost of a custom component discovers that the supplier's profit margin is significantly higher than the industry standard. Armed with this information, the company negotiates a lower price, aligning the profit margin with market norms.

2. Design Optimisation

   • Should-cost analysis can highlight expensive materials or manufacturing processes that contribute to high production costs. By identifying these cost drivers, companies can explore alternative designs or materials to reduce expenses.

   • Example: An analysis reveals that a specific alloy used in production is a major cost contributor. The engineering team evaluates alternative materials that offer similar properties at a lower cost, leading to a redesigned product that maintains quality while reducing material expenses.

3. Process Improvement Initiatives

   • Understanding the cost breakdown of manufacturing processes allows companies to pinpoint inefficiencies. Collaborating with suppliers to address these areas can result in streamlined operations and cost reductions.

   • Example: A should-cost analysis indicates that a supplier's production line has a high labor cost due to manual assembly. The company works with the supplier to implement automation technologies, reducing labor costs and improving production speed.

4. Benchmarking and Supplier Selection

   • By comparing the should-cost of products across multiple suppliers, companies can benchmark performance and select partners who offer the best value.

   • Example: A procurement team calculates the should-cost for a component and compares it with quotes from various suppliers. One supplier's price aligns closely with the should-cost estimate, indicating efficient operations. The company selects this supplier, confident in their cost-effective processes.

Implementing should-cost analysis not only uncovers cost-saving opportunities but also fosters a culture of continuous improvement and collaboration between companies and their suppliers.

Should-cost analysis plays a crucial role in supplier evaluation and relationship management. By providing a transparent and data-driven approach to cost estimation, it helps procurement teams assess whether suppliers are offering fair pricing and identify potential areas for negotiation.

Role of Should-Cost Analysis in Supplier Evaluation

1. Assessing Supplier Competitiveness: Procurement teams can use should-cost analysis to compare a supplier’s proposed price against industry benchmarks and alternative providers. This ensures that the supplier’s pricing aligns with reasonable cost expectations.

2. Enhancing Negotiation Leverage: Having a clear understanding of expected costs allows procurement professionals to negotiate more effectively, reducing unnecessary markups and securing better contract terms.

3. Identifying Cost Inefficiencies: Should-cost analysis helps uncover areas where a supplier may be inefficient, such as high overhead costs or outdated production methods, providing opportunities for collaborative cost-saving initiatives.

4. Supporting Supplier Selection Decisions: By evaluating suppliers based on cost efficiency, organizations can choose the most value-driven and cost-effective partners, ensuring long-term sustainability and reliability.

Role of Should-Cost Analysis in Relationship Management

1. Building Transparency and Trust: Engaging suppliers in discussions around should-cost analysis fosters transparency and aligns both parties on pricing expectations, leading to stronger business relationships.

2. Encouraging Continuous Improvement: Suppliers can use should-cost insights to streamline their operations, invest in cost-saving technologies, and improve overall efficiency.

3. Driving Collaboration on Cost Reductions: Procurement teams and suppliers can work together to identify opportunities for mutual cost savings, such as bulk purchasing strategies, optimized logistics, or lean manufacturing improvements.

4. Ensuring Long-Term Value Creation: By incorporating should-cost analysis into ongoing supplier management, organizations can maintain cost discipline, prevent price inflation, and ensure sustainable procurement strategies.

Should-cost analysis is a methodology used in procurement to estimate the reasonable cost of a product, service, or solution. It helps organizations determine fair pricing by analyzing expected production costs, profit margins, and supplier overheads, rather than relying solely on supplier quotes.

Methodology of Should-Cost Analysis

1. Data Collection: Gather information on material costs, labor rates, manufacturing processes, and logistics expenses.

2. Breakdown of Cost Components:

   • Raw Materials: Evaluate material costs based on market rates and supplier quotes.

   • Labor Costs: Analyze wages, labor efficiency, and work hours involved in production.

   • Overhead Costs: Consider expenses such as facility costs, utilities, and administrative overheads.

   • Profit Margins: Assess reasonable profit expectations based on industry benchmarks.

3. Benchmarking: Compare costs with similar products, industry standards, and historical data.

4. Modeling & Analysis: Use cost models and simulations to validate pricing structures and identify cost-saving opportunities.

5. Negotiation & Decision Making: Use insights from should-cost analysis to negotiate fair pricing with suppliers and optimize procurement budgets.

When to Use Should-Cost Analysis

• When purchasing complex, high-value, or custom-made goods and services.

• When seeking to understand the cost drivers behind a supplier’s pricing.

• When aiming to improve cost transparency and drive competitive procurement strategies.

• When conducting supplier negotiations to ensure fair pricing and cost efficiency.

Cost Analysis vs. Price Analysis

Understanding the distinction between cost analysis and price analysis is crucial in procurement decision-making. Each method serves a different purpose and is used in different scenarios:

Cost Analysis

Cost analysis is the detailed breakdown of all cost components associated with a product or service. This includes direct costs, indirect costs, and profit margins. It is typically used when:

• The supplier is offering a unique or custom product/service with no clear market price.

• There is a need to understand supplier cost structures for negotiation purposes.

• Government or regulatory compliance requires a breakdown of cost components.

For example:

• A manufacturing company purchasing custom-designed machinery will require a full breakdown of material costs, labor expenses, and supplier overhead to ensure fair pricing and prevent overcharging.

• A government agency procuring defense equipment may conduct a cost analysis to verify that a supplier’s pricing aligns with production and labor expenses before awarding a contract.

Price Analysis

Price analysis, on the other hand, is the process of evaluating a supplier's price without analyzing its individual cost elements. It is often used when:

• Multiple suppliers offer the same or similar product/service, allowing for price comparison.

• Benchmarking prices against industry averages or historical data.

• Conducting competitive bidding where the lowest price wins without the need for cost breakdowns.

For example:

• A retail company sourcing office supplies may compare the prices of different vendors without investigating their internal cost structures, selecting the lowest bidder for standard products like paper and ink cartridges.

• An automotive company purchasing standardized spare parts for vehicle maintenance may use price analysis to compare offers from different suppliers without requiring a cost breakdown.

Competition Analysis as a Method of Price Analysis

Competition analysis is a key method of price analysis that involves evaluating the pricing strategies of multiple suppliers offering the same or similar products and services. By analyzing competitive market data, procurement professionals can determine whether a supplier's pricing is fair and in line with industry standards.

Key Steps in Competition Analysis:

1. Identify Competitor Pricing: Research and collect pricing data from multiple suppliers for the same or comparable products.

2. Benchmark Against Industry Standards: Compare supplier prices to industry averages, historical data, and publicly available benchmarks.

3. Evaluate Value Proposition: Consider factors beyond price, such as product quality, lead times, warranty, and additional services.

4. Leverage Competitive Insights: Use competition analysis to negotiate better pricing, alternative sourcing strategies, and improved supplier terms.

5. Monitor Market Trends: Regularly review pricing data to stay updated on industry fluctuations and supplier pricing behaviors.

Example of Competition Analysis in Procurement:

A manufacturing company seeking to procure electronic components collects price quotes from five different suppliers. The company identifies that three of the suppliers are offering similar prices, while two are significantly higher. By conducting competition analysis, the procurement team successfully negotiates with the higher-priced suppliers to match the competitive market rate, leading to significant cost savings.

Competition analysis ensures that procurement professionals make informed purchasing decisions based on market-driven price comparisons, optimizing costs while maintaining supplier relationships.

Types of Discounts in Procurement

Discounts play a crucial role in reducing procurement costs and improving overall value. Procurement professionals can leverage different types of discounts to enhance cost efficiency and supplier relationships. The main types of discounts include:

• Quantity Discounts: Offered when bulk purchases are made, reducing the per-unit cost. For example, a manufacturing company purchasing raw materials in large volumes may receive a 10% discount on orders exceeding a certain threshold.

• Cash Discounts: Given for early payment of invoices, helping improve supplier cash flow. A supplier may offer a 2% discount if payment is made within 10 days instead of the standard 30-day term.

• Trade Discounts: Provided to specific business customers, such as resellers or distributors, based on their role in the supply chain. For instance, a wholesaler may receive a 15% trade discount from a supplier for purchasing goods for resale.

• Seasonal Discounts: Offered during specific periods to encourage off-season purchases. A retailer may secure discounts on winter clothing when purchasing during summer.

• Promotional Discounts: Given during sales events or special promotions. A company buying office supplies may benefit from promotional discounts during back-to-school sales.

Implications of Discounts on Procurement Costs

• Lower Total Procurement Costs: Discounts reduce the overall expense of acquiring goods and services, allowing businesses to allocate savings to other areas.

• Improved Cash Flow Management: Taking advantage of cash discounts can improve liquidity by incentivizing early payments.

• Enhanced Supplier Relationships: Negotiating trade or bulk discounts can strengthen supplier partnerships, leading to long-term cost benefits.

• Inventory Management Considerations: While quantity discounts offer savings, excessive bulk purchasing can lead to increased storage costs and potential obsolescence.

Strategies for Negotiating Discounts with Suppliers

• Establish Long-Term Contracts: Suppliers are often willing to provide better pricing when long-term contracts are in place, as it ensures consistent business and reduces their sales uncertainty.

• Use Competitive Bidding: Running a formal bidding process where multiple suppliers compete can help secure the best discounts by creating a competitive environment.

• Negotiate Value-Added Services: Instead of focusing solely on price reductions, negotiate for additional services such as free shipping, extended warranties, or better payment terms.

• Demonstrate Loyalty and Reliability: Suppliers are more likely to offer discounts to buyers who have a history of on-time payments and consistent order patterns.

• Leverage Market Conditions: If supply is high and demand is low, use market conditions to your advantage to push for better pricing.

• Consolidate Supplier Base: Reducing the number of suppliers and increasing order volumes with fewer vendors can improve bargaining power and result in more significant discounts.

• Leverage Volume Commitments: Suppliers are more willing to offer discounts for higher order quantities. Procurement teams should consolidate purchases across departments to increase order sizes.

• Utilise Early Payment Incentives: Discussing early payment discounts with suppliers can improve cost efficiency while benefiting supplier cash flow.

• Benchmark Industry Rates: Comparing discount structures across multiple suppliers helps secure competitive pricing.

• Strengthen Supplier Partnerships: Long-term relationships with suppliers often result in better pricing and exclusive discount offers.

• Bundle Purchases: Combining different product categories in a single purchase order can increase negotiation power and potential savings.

Conclusion

Procurement cost analysis is a critical component of a modern, strategic procurement function. By taking a holistic view of cost drivers, organisations can uncover new pathways to savings, improve supplier performance, and create lasting competitive advantages. Incorporating discount strategies, leveraging technology, collaborating across functions, and fostering long-term supplier relationships will help businesses stay agile in an evolving global market.