Cost-based Price Modeling
This method of calculating target prices requires a significant understanding of the product's production process or the service delivery model. Cost-based price modeling is grounded in a bottom-up calculation of the price using a detailed breakdown of the cost structure along the value chain of the product. We start by building a model to price a product based on all value-adding steps in the creation of the product, starting with production. Each production step is evaluated based on key cost drivers. Using this approach, we can determine a target cost along with a reasonable target margin for the supplier. Employing the method across several supplier bids, we can compare not only total cost by variances across production steps but also the productivities of each supplier. In negotiations, best of breed can be used as a target for suppliers, which may also include productivity improvement measures after the product launch.
Cost-based price modeling begins by mapping the overall manufacturing process into individual steps. For example, for desktop PC production, the steps would be stamping, bending, and sub-assembly of steel chassis; assembling the printed circuit board including mounting the component surface , soldering, and testing; and the final step, assembling the final product, including packaging and preparing for shipping. For each step, we develop a cost model using cost drivers to determine a cost per unit. Typical cost categories covered and respective cost drivers could be raw materials (estimate weight, scrap rate, material type, and cost per ton or kilogram), purchase parts used (estimate which parts and the cost per piece), direct labor (measure man hours required to perform the manufacturing process using cycle and takt time and unit per hour), equipment cost (estimate the value of equipment, depreciation, capacity and utilization, and cycle time), indirect material used in production (est imates), and overhead (estimate indirect labor, utilities, plant cost, and general percentage mark-up). The same logic can be repeated for any additional level of sub-components. At the end, you can also add costs for overhead ( sales, general, and administrative) and engineering (related to product development, product servicing, and factory support).
With this cost model, you can calculate the target price by applying a reasonable margin—one that is competitive in the industry. Visit at least one of your supplier's production lines to validate the hypothesis related to cycle time, output, typical labor content, and equipment use.
Once the basic model is built, the easiest way to validate and expand it is to request a detailed cost breakdown from the supplier during the request for proposal (RFP) phase. Because suppliers tend to be reluctant to agree on an open-book policy that allows this level of transparency, especially at this early stage, you need to be in a very strong buying position. If you are in a less favorable position with suppliers or have sufficient in-house knowledge, you can use internal experts to conduct a product costing analysis. Refer to your product engineers and manufacturing process engineers to understand how a product is being built. Usually, mechanical, electrical, and system engineers can provide enough insights into production processes. However, there is a risk of overestimating the manufacturing cost since suppliers tend to be more specialized and cost-efficient in their process. It is also possible to involve third-party experts—for example, for very new or special technologies .
When we want to calculate the price of a similar product compared with an already known and analyzed product, we can look for analogies in production steps and materials used and then quickly adjust the model. The initial model can be validated further with the supplier during the RFP or negotiations process.
The final output of the model is a detailed analysis of the target cost. This can be compared with one or more supplier quotes. Have at least some level of cost break-down available from suppliers. Their improvement potential can be drilled all the way down from general cost-reduction potential on the final product price to the cost for each process step (cost per unit) and the key cost drivers, such as scrap rate for material and inefficient assembly process steps. The biggest gaps can be analyzed in detail with the suppliers. Then, either negotiate a cost reduction directly or define productivity improvement targets for the supplier after the product launch.
Cost-based price modeling might seem like a monstrous task that is not worth the effort. However, it makes sense to apply it for products and services that are crucial to your core and where the buyer company will have sufficient knowledge of specifics to be able to develop such a model without too much effort. It can also be applied to parts that have a shorter value chain, are produced in fewer and rather homogeneous production steps, or have low complexity in terms of materials used and limited product development effort. typically , such products or services will also have high competition—and thus low supply power—and procurement can quickly develop a model to evaluate the target cost. When this is not the case, the next method—cost-regression analysis—may be a better way to quickly derive a target cost and enter into negotiations with a supplier.