Should-Cost Modeling: How Enterprise Buyers Estimate What a Product Should Cost
Learn how should-cost modeling helps enterprise buyers estimate fair product prices, break down cost drivers, and negotiate with suppliers—step-by-step.
You've just received a quote from a Tier 1 supplier for a custom machined component. The price is $4.75 per unit. Your team's internal estimate, based on last year's spend, was $3.90. The supplier claims raw material costs have spiked and labor rates in their region are up. Is $4.75 fair, or are you leaving $0.85 per unit on the table? Across a 500,000-unit annual volume, that's $425,000—enough to fund a small team or a new product line. Should-cost modeling is how you answer that question with data, not guesswork.
This article is a practical guide to should-cost modeling for enterprise procurement leaders. You'll learn what should-cost modeling is, how to build a model step-by-step, what data you need, which tools to use, and how to avoid common pitfalls. By the end, you'll be able to estimate what a product should cost—not just what suppliers quote—and use that insight to negotiate with confidence.
What Is Should-Cost Modeling and Why Does It Matter?
Should-cost modeling is a bottom-up estimation of a product's total cost based on its materials, labor, overhead, and profit, rather than market prices or historical quotes. It answers the question: 'What should this product cost if the supplier is efficient and the market is fair?' The model strips out supplier padding, inefficiencies, and market distortions to give you a defensible target price.
For enterprise buyers, should-cost modeling is a strategic weapon. It transforms negotiations from 'your price is too high' (which suppliers dismiss) to 'your price is $4.75, but my analysis shows a fair cost of $3.90—here's why.' It also helps you identify cost reduction opportunities, benchmark suppliers, and make informed make-vs-buy decisions. Without it, you're flying blind.
The Business Case: Where Should-Cost Pays Off
The Core Components of a Should-Cost Model
A should-cost model breaks a product into its fundamental cost drivers. While every product is unique, most models include these five components: direct materials, direct labor, manufacturing overhead, general & administrative (G&A) costs, and profit. Each requires specific data and assumptions.
Direct Materials: The Foundation
Direct materials are the raw inputs—steel, plastic resin, electronic components—that go into the product. You need to know the quantity of each material, its current market price, and any scrap or yield loss. For example, a steel bracket might require 0.5 kg of steel, but with 10% scrap, you actually need 0.55 kg. Material prices fluctuate, so use indexed prices (e.g., from London Metal Exchange) or recent supplier quotes.
Direct Labor: More Than Hourly Rates
Direct labor is the cost of workers who physically produce the product. Calculate it by multiplying the labor hours per unit by the fully loaded hourly rate (wages plus benefits, payroll taxes, and insurance). For a simple assembly, labor might be 0.2 hours at $15/hour = $3.00. But don't forget efficiency: if the supplier's line runs at 80% efficiency, the actual labor cost is $3.75 ($3.00 / 0.8).
Manufacturing Overhead: The Hidden Layer
Overhead includes indirect costs like factory rent, utilities, equipment depreciation, and maintenance. Allocate it as a percentage of direct labor or machine hours. Typical overhead rates range from 50% to 150% of direct labor for labor-intensive operations, but can be higher for capital-intensive processes like injection molding. For our $3.00 labor example, a 100% overhead rate adds $3.00 per unit.
G&A and Profit: The Supplier's Margin
G&A covers corporate costs—sales, marketing, finance, and executive salaries—typically 5-15% of total cost. Profit margin is what the supplier earns, usually 5-15% depending on industry and risk. For a mature component, a 10% combined G&A + profit is reasonable. If the supplier asks for 25%, they're either inefficient or testing you.
How to Build a Should-Cost Model Step by Step
Building a should-cost model is a structured process. You don't need perfect data—you need reasonable estimates and a clear methodology. Here's a step-by-step approach used by top procurement teams.
Worked Example: A Custom Steel Bracket
Let's walk through a real example. A supplier quotes $4.75 for a steel bracket. You build a should-cost model: Material: 0.5 kg of A36 steel at $1.20/kg = $0.60. With 10% scrap, that's $0.66. Labor: 0.15 hours at $15/hour (fully loaded) = $2.25. Overhead: 100% of labor = $2.25. Subtotal = $5.16. Wait, that's higher than the quote? That's because the supplier is in Vietnam, where labor is $5/hour. Let's recalculate: Labor: 0.15 hours at $5/hour = $0.75. Overhead: 100% = $0.75. Subtotal = $0.66 + $0.75 + $0.75 = $2.16. Add 10% G&A ($0.22) and 10% profit ($0.24) = $2.62. The quote of $4.75 is 81% higher than your should-cost. Now you have a clear negotiation target.
Data Sources and Tools for Accurate Estimates
A should-cost model is only as good as its data. You need reliable sources for material prices, labor rates, and overhead benchmarks. Here's where to get them.
Common Mistakes to Avoid in Should-Cost Modeling
Even experienced buyers make errors that undermine their models. Here are the most common pitfalls and how to avoid them.
Using Should-Cost in Negotiations: Tactics That Work
The ultimate test of a should-cost model is in negotiation. A model alone won't lower prices—you have to use it strategically. Here are proven tactics from top procurement teams.
Should-Cost in the Real World: Case Studies and Results
Should-cost modeling isn't theoretical—it delivers results. Here are two real-world examples from my experience.
Case 1: A Fortune 500 electronics company was paying $12.50 for a custom cable assembly. A should-cost analysis revealed that the supplier was using a premium brass connector when a standard one met specs. By switching materials and renegotiating, the cost dropped to $8.20—a 34% reduction on an annual volume of 2 million units, saving $8.6 million.
Case 2: A mid-sized manufacturer sourced a steel enclosure from a Chinese supplier at $45 per unit. The should-cost model, using local labor rates and material prices, estimated $32. The buyer shared the model with the supplier, who admitted they had been using a higher-grade steel than required. After adjusting the spec, the price fell to $33.50—a 25% savings on 50,000 units, worth $575,000 annually.
Conclusion: Your Next Steps to Implement Should-Cost Modeling
Should-cost modeling is a skill that pays for itself many times over. The key takeaways are: (1) Break down every product into its cost components—materials, labor, overhead, G&A, and profit. (2) Use current, location-specific data for each component. (3) Start simple—a spreadsheet is better than no model. (4) Use your model in negotiations proactively, not as a post-hoc justification.
Your next step: Pick one high-spend category or a single complex part. Build a basic should-cost model using the steps above. Compare it to your current supplier quotes. Identify the gap and schedule a negotiation session. You'll likely uncover savings that justify the effort within weeks.