Cost Modelling: A Key Armament in Your Procurement Arsenal

Cost modeling as a tool has been present for decades now, but its implementation has been restricted to a few top manufacturing companies. It is primarily used when companies purchase goods and materials of high value that are susceptible to market volatility. Companies have been deterred from developing cost modeling tools because of the high initial investment, such as streamlined IT infrastructure and dedicated cost modeling staff, required during early stages of development. The unpredictable ROI of the effort further impacts adoption.

The Benefits of Cost Modelling

The key focus for a company is to improve profit, which can be achieved by either increasing the top line or reducing operating expenses. Cost modeling aids in better managing operating expenses and the concept has now evolved into an organizational technology exercise, where the involvement of multiple departments is required for the success of the endeavor.

Cost modeling for procurement supports in identifying key cost components present in the material or service. This helps companies understand how variations in these key components can alter the overall cost of the procured category and decodes the cost drivers impacting the category. The most common use cases for cost modelling include:

• Price Forecasting: Companies use cost models to project future costs of materials and services, as the cost is broken down into individual components. Understanding changes in prices of individual components helps predict the overall cost.
• Supplier Negotiations: Should-cost analyses aid enterprises in negotiating with suppliers by determining profit margins and operational inefficiencies of the supplier.
• Budget and Planning: Cost modelling helps business unit leaders with budgeting as they give a clear picture of expected spending.
   

Who Should Focus on Cost Modelling?

Categories such as MRO, IT and volatile products and materials such as steel, crude and natural gas can see substantial benefits from developing a cost model. Applying cost models for the sourcing of business-critical categories can result in long term cost savings for an enterprise.

Higher spend category should also be targeted for building cost models. This would result in greater cost savings, as any reduction in category cost will have major implications on the company’s overall procurement spend.

What to Think About When Modelling Cost

Companies need to have proper technology systems and IT infrastructure in place before designing a cost model. Spend data and historical price information should be present in the system to aid in developing an appropriate model.

Members of senior management should believe in the benefit of utilizing cost models, as the initial stage requires the investment of substantial resources. Confidence from the leadership team will help in developing robust cost models.

And Finally, How to Implement Cost Modelling

Implementation is critical to the success of a cost modelling exercise. The ideal phase is when product development is about to move from the ideation to the defining phase. This is just before the product gets defined and one has an idea on the key materials and services required for developing the product. Developing a cost model based on the identification of top spend categories would result in greater cost-savings.

Conclusion

Cost modeling is a resource and time-intensive process. Hence, it should not be performed for low spend categories or when buying decisions are critical for business operation. However, they are imperative for business-critical and volatile categories. Incorporating the usage of cost modelling far outweighs neglecting it as a business tool altogether. Streamlining of spend data and historical price information will make it easier to deploy cost modeling across an enterprise.

Further Reading

• https://www.strategy-business.com/article/9625?gko=078dd
• https://www.tms.org/pubs/journals/jom/9612/szekely-9612.html
• https://galorath.com/the-art-and-science-of-cost-modeling/