What Is ‘Should Cost’ Analysis and Why It Matters for Outsourcers

Originally published on Optimum Design Associates blog

Should cost analysis (“should costing”) was developed by the Defense Department to assist procurement officers in determining fair and reasonable pricing and today is embedded in government procurement practices via the Federal Acquisition Regulations (FAR). It was adopted by industry beginning in the 1980’s, and today is the dominant technique used by best in class outsourcing companies like Apple and Cisco. Should cost analysis involves determining what a product should cost based on materials, labor, overhead, and profit margin.

Strategic sourcing: What you’re doing today

The most common procurement method is strategic sourcing. Using strategic sourcing, supply chain professionals identify a range of potential suppliers, usually diversifying between size, capabilities, geography, and many other potential factors. The selected suppliers are then given the opportunity to quote. Supply chain analyzes the quotes to make a sourcing decision. This process is referred to as strategic sourcing. It is most appropriate when the suppliers products/services being procured are very similar, i.e. when purchasing catalog off the shelf (COTS) items from distributors.

 

But what can you do if the item is custom? The prevailing answer is to use the same techniques used to procure COTS items. Buyers simply treat the custom package as if it were COTS, submit RFQ’s to multiple vendors, and compare the quotations. The logic of strategic sourcing has worked well. By comparing quotations from multiple potential suppliers supply chain gains insights that can be used to leverage spend. It is largely responsible for driving offshore procurement as companies search for the lowest possible comparative quotation. Strategic sourcing is particularly useful to organizations that lack the resources to effectively analyze what the product should cost (basically, all of us!).

Should cost: What you’ll be doing within 5 years

In contrast to strategic sourcing, should costing begins with an internal assessment of the product’s expected cost. Generally, engineering helps assess the necessary labor, procurement gathers the expected material cost, and supply chain assigns expected labor rates and profit margins. Supply chain collects the costs and sums them to determine should cost.

In the case of printed circuit board assemblies (PCBA’s), note that should costing still utilizes strategic sourcing. This is because PCBA’s cost structure is typically 80% materials and it is not reasonable (even for Apple and Cisco) to fully analyze the fabrication cost of every component, so they must cost material using strategic sourcing techniques.

Most companies do not conduct should costing for PCBA’s because they believe the process is to complex for their existing resources. Upon closer inspection, this is probably not true. Remember, materials is likely 80% of your PCBA cost. By simply taking control of your material cost you will have achieved 80% of your should cost goal. You can begin by requiring your suppliers to submit quotations with fully disclosed material costs (they won’t like this!), then focusing your resources on negotiating directly with the component suppliers of the highest cost material. This will require a contract manufacturing partner who is willing to provide open book costing.

Yes, should costing can get complex quickly. It’s easier to just get a bunch of quotes. But the tools are evolving quickly to ease the task and we believe all OEMs who aspire to best practice sourcing will adopt some elements of should costing in the very near future.

Use this quick and easy guide to benchmark your current price for an individual pcb assembly and determine if it is competitive.

Step 1: Get your material cost

• If you already know it, go to step 2, or else…
• Get it from your pcb assembly supplier. Ask them for the total BOM cost, including pcb (bare) fab. They will give you the total BOM cost with (relatively) little resistence. They won’t like being asked for line by line costs, but you don’t need that detail for this quick & easy method. If they won’t give the total BOM cost to you, be very insistent, and if that still doesn’t work…
• Estimate the material yourself. Gather the prices from online distribution sources like Digikey. Use the price column closest to your estimated annual usage. Because online prices are higher than production volume prices, reduce the online prices by 20% to estimate total BOM cost.

 

Step 2: Estimate labor cost

• Count the number of SMT placements. Do this by summing the “quantity per” column on your BOM.
• Multiply your SMT placements by .04 for mid-volume (less than $5 million annual). The result is typically between 8-10% of your material cost. You can adjust the .04 multiplier down to as low as .01 if necessary to get labor into this 8-10% zone. If labor is higher than 10% it may be worth getting a more precise labor estimate. If labor is less than 5% of material, don’t worry about it.
• Add .05 for each through hole component if there are 1 to 15  through hole components (typically connectors). If there are more than 15 use .03.

Step 3: Calculate Profit

• A reasonable expectation in this model is 20% gross profit.
• To calculate 20% gross profit, divide the sum of costs by 1 -Profit Margin. So if you want to calculate a resale based on 20% profit margin, divide the cost by 1 – .20 = .80.
• You may think 20% is too high, it’s probably not. EMS companies manipulate the labor, overhead, and profit to show customers what they want to see.

Example

• Materials $900, 230 SMT placements, 20% profit margin: (900 + [230 x .04]) / .80 = 1136.50

How to use the results

• If your actual prices paid are within +/- 5% of this model, you’re likely getting a good price (read why) and don’t need to worry about this assembly.
• If your prices are higher than the model by 5% to 15%, there is a reasonable chance you can lower your prices by 5-10%. Calculate how much this means in real dollars and decide if it is worth pursuing.
• If your price is above the model by more than 15%, you have an excellent opportunity to save 10% or more.