Should Cost Modeling. Method based on Industry Averages

1Copyright © 2010 Kevin Lemmens. All rights reserved.

Should Cost Modeling based on Industry Averages

Should Cost Modeling

Based on

Industry averages

Version 1: 04-01-2011



Agenda

Introduction

Steps to take when using industry averages

Case description

Steps

- Step 1 Determine the industry

- Step 2 Source selection

- Step 3 Extract and calculate data per cost category (1/2)

- Step 3 Extract and calculate data per cost category (2/2)

- Step 4 Calculate per cost category the percentages of the total sales

- Step 5 Calculate the price for the materials used in the product

- Step 6 apply the percentages calculated in step 4 on the direct material price (1/2)

- Step 6 apply the percentages calculated in step 4 on the direct material price (2/2)

Conclusion

More information and Contact



Introduction

In previous articles I wrote about should cost modeling and more specifiec about ways how to apply those models. In one article I elaborated on Should Cost Modeling based on Industry Averages and provided an example. This presentation is a summary based on that article and will focus on the example based on a real case. For more information read the article or contact me.



Steps to take when using industry averages

In order to estimate the should cost price several steps need to be taken.

1. Determine the industry you are active in or select the one that is the nearest to your activities (take also geographical aspects into consideration).

2. Use the most relevant and recent sources for your information (or combine multiple sources)

3. Extract (and calculate if necessary) the figures per cost category

4. Calculate per cost category the percentages of the total sales

5. Calculate the price for the materials used in the product

6. Apply the percentages calculated in step 4 on the direct material price calculated in step 5

7. Take forecasts and inflation into account



Case description

An organisation, here called ES (Engine Solutions) needs large cooling systems for his engines. One of his suppliers is CS (Cooling Solutions). ES wants to know what costs CS makes to manufacturer cooler type A to determine whether CS offers a fair price. The first step is to determine industry in which CS is active with respect to cooler type A.



Step 1 Determine the industry

Determine the industry you are active in or select the one that is the nearest to your activities (take also geographical aspects into consideration)

Source used: North American Industry Classification System (NAICS)

Industry the supplier is active in: ‘Plate work and fabricated structural product manufacturing’

The NAICS-based code (code of the industry): 33231



Step 2 Source selection

In the previous step I used the NAICS, therefore I will use this source througout this presentation, but bear in mind that there are many other sources for industry information

- The more sources you combine the more accurate and reliable you information will be

- Take geographical aspects into account

Below you find a table with the information for the industry of the case



Step 3 Extract and calculate data per cost category (1/2)

In previous articles I splitted the costs a supplier makes for manufacturing a product in different categories:

- Direct Materials

- Direct labour

- Manufacturing overhead

- General, selling and administration

- Profit

Based on the NAICS information I have calculated the costs per category. On the next slide you will find those costs



Step 3 Extract and calculate data per cost category (2/2)

The calculated figures for each category

See article about Industry Averages if you want to know how the figures of this case are extracted from the data of the NAICS

Figure based on data

Total sales 37,664,048

Direct materials 21,748,651

Direct labour 4,020,776

Manufacturing overhead 5,241,986

GSA 3,217,724

Profit 3,434,911



Step 4 Calculate per cost category the percentages of the total sales

In the right column you find each cost category as a percentage of total sales

Figure based on data Percentage of total sales

(%)

Total sales 37,664,048 100

Direct materials 21,748,651 57

Direct labour 4,020,776 11

Manufacturing overhead 5,241,986 14

GSA 3,217,724 9

Profit 3,434,911 9



Step 5 Calculate the price for the materials used in the product

This step is important because it forms the baseline of the should cost price. The actual costs per category is based on these costs. This category is chosen because it it relatively easy to calculate.

In the case of the cooling systems, the direct material costs were determined by engineers and purchasers which had scrutinized drawings of cooler type A and used average market prices to determine how much each part of material costs. This resulted in a should cost price of: €529

Note:

Using average market prices market prices you should take into account 1) whether the source is reliable, 2) whether it is the correct source (e.g. Geographical location) 3) the amount your supplier purchased of the material (e.g. economies of scale?), 4) and many more.



The next step is to calculate the should cost price. In order to calculate the should cost price, we need to know the real costs for one cost-category of the product. It does not matter which cost category it is, because all percentages are known. But mostly the direct material category is used as this can relatively easy be calculated (as is done in the previous slide). In this example the direct material costs are € 592. The should cost price can then be calculated by dividing the direct material costs by the direct material percentage.

Direct material costs € 592

_________________ = _____________ = € 1038,60

Direct material percentage 0.57 (57%)

Step 6 apply the percentages calculated in step 4 on the direct material price (1/2)



Step 6 apply the percentages calculated in step 4 on the direct material price (2/2)

In the same way you can calculate the real amount of the other costs categories. This provides you insight where the costs actually origin from. This knowledge allows you to compare these figures with other suppliers, industry averages, provides grip for discussion or discuss it together with your supplier and search for cost reductions, etc. On the next slide you’ll find the amount of the costs per category.

Figure based on

data

Percentage of total

sales (%)

€ Product

Total sales 37,664,048 100

Direct materials 21,748,651 57 592

Direct labour 4,020,776 11 114,25

Manufacturing

overhead

5,241,986 14 145,40

GSA 3,217,724 9 93,47

Profit 3,434,911 9 93,47

Should Cost Price 1038,60



Conclusion

The should cost method based on industry averages is…

a quick method

a relatively easy method

not expensive because a lot of information is for free

But…

not always very accurate because the price is compared to a should cost price based on average figures. The supplier may not be average for several reasons (delivers customized solutions instead of standardized solutions to name just one reason)



More information and Contact

For more information you can visit my blog and read the different articles on should cost modeling

http://scmprocurement.blogspot.com/

The article about the case used here:

http://scmprocurement.blogspot.com/2010/12/industry-averages-example.html

By further questions don’t hesitate to contact me

[email protected]

http://nl.linkedin.com/pub/kevin-lemmens/1b/1ba/487


http://scmprocurement.blogspot.com/2010/12/industry-averages-example.html

mailto:[email protected]

http://nl.linkedin.com/pub/kevin-lemmens/1b/1ba/487


Copyright © 2010 Kevin Lemmens All rights reserved.

Date post:	04-Dec-2014
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Should Cost Modeling. Method based on Industry Averages

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