Should Cost Model

Should Cost Model

Build a bottom-up cost model from first principles to establish what a product or service should cost — before supplier negotiations begin. Should costing gives you a defensible target price based on materials, labour, overhead, and a fair margin, rather than accepting whatever a supplier quotes.

Inputs
Direct material cost per unit
Wages for production labour per unit
Factory overhead as % of material + labour (typically 15–40%)
Shipping, customs, last-mile per unit
Tooling cost spread across production volume per unit
Fair margin for supplier (industry-dependent, typically 8–18%)
Enter to see the gap vs. your should cost
Results
Should Cost Price
your defensible target price
Cost of Production (ex-margin)
total before supplier profit
Material Share
of should cost
Labour + Overhead Share
of should cost
Quoted vs. Should Cost
enter a quoted price to calculate
Should Cost — Formula
Cost of Production = (Material + Labour) × (1 + Overhead%) + Logistics + Tooling Should Cost = Cost of Production × (1 + Target Margin%) Price Gap = Quoted Price − Should Cost

Should costing is a bottom-up cost estimation method. Rather than anchoring to the supplier’s price, you independently construct a fair cost from its constituent elements and add only a reasonable margin. The resulting figure becomes your negotiation target — and the gap between it and the quoted price quantifies the negotiation opportunity.

Overhead covers factory fixed costs allocated per unit: rent, utilities, equipment depreciation, and quality control. Industry norms range from 15% (lean, high-volume manufacturers) to 45% (complex, low-volume production). Benchmarking supplier overhead rates is one of the most valuable intelligence activities in strategic sourcing.

Target margin should reflect a fair return for the supplier’s risk and capital. Setting it too low is unsustainable and damages supplier relationships; setting it at a competitor-validated rate gives you a defensible position in negotiation.

Cost Component Breakdown
Summary Memo
Run the calculator above to generate a shareable Should Cost memo.

History of Should Cost Analysis

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Should cost analysis was pioneered by the United States Department of Defense in the 1960s as a method for evaluating defence contractor pricing. The DoD found that contractors often priced bids based on what the government could afford or had historically paid, rather than actual production costs. Should cost audits — detailed independent cost estimates — became a formal requirement under the Truth in Negotiations Act (TINA) of 1962, later codified in the Federal Acquisition Regulation (FAR).

The methodology was subsequently adopted by the automotive industry in the 1970s and 1980s. General Motors and Ford developed internal should cost departments to benchmark component pricing against their own cost models, enabling supplier negotiations anchored to manufacturing economics rather than market price. Japanese manufacturers, particularly Toyota, developed parallel approaches as part of target costing — working backwards from a market price to set allowable cost targets for suppliers.

Today, should costing is a core competency in direct materials procurement across automotive, aerospace, electronics, and FMCG sectors. Software tools for detailed should cost modelling — capable of accounting for machine rates, country-specific labour rates, and material commodity pricing — are standard in leading procurement organisations.

How the Calculator Works

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The calculator builds cost from the ground up in three layers. The first layer is direct cost: material + labour. The second applies the overhead rate to this base. The third adds logistics, tooling amortisation, and finally the margin multiplier to arrive at the should cost price.

The variance section compares your should cost to the supplier’s quoted price. A positive gap (quoted > should cost) quantifies the negotiation opportunity — this is the amount by which the supplier is pricing above a fair, bottom-up cost. A negative gap may indicate that your cost inputs are too high, that the supplier is cross-subsidising, or that there are costs you have not accounted for.

How to Use This Tool

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Step 1. Gather commodity prices for raw materials. Use market price data from trade publications, commodity exchanges (MCX, LME), or supplier-provided material cost breakdowns if disclosed. Apply the volume-adjusted rate relevant to the supplier’s purchase scale.

Step 2. Estimate labour cost by researching prevailing wages in the supplier’s manufacturing region. For India, the Ministry of Labour publishes sector-specific minimum wages; actual rates in organised manufacturing typically run 1.5–3× minimum wage.

Step 3. Validate your overhead assumption. Overhead rates are industry-specific: 15–20% for high-volume electronics assembly, 25–35% for precision machining, 35–50% for low-volume complex fabrication. Use industry benchmarks or request an open-book cost disclosure from the supplier.

Step 4. Enter the supplier’s quoted price in the final field to calculate the price gap. Use this gap as the opening anchor for your negotiation, supported by your cost model as evidence. Even if you don’t share the model, having it increases your negotiating confidence and precision.

Frequently Asked Questions
Should I share my should cost model with the supplier?
It depends on the relationship and your negotiating strategy. Sharing the model transparently signals sophistication and confidence, and often prompts the supplier to engage more seriously with cost discussions. In collaborative partnerships, open-book costing is increasingly common and can unlock joint cost reduction opportunities. In more adversarial relationships, keeping the model internal preserves information asymmetry. A middle path: share the headline should cost figure and your cost structure assumptions without revealing every line item.
What if my should cost is higher than the quoted price?
This is a valuable signal. It may mean the supplier has genuine cost advantages you haven’t modelled (scale, proprietary process, lower-cost inputs). It may indicate that one of your input assumptions is too conservative. Or it may mean the supplier is pricing below cost — a red flag for financial sustainability. In this case, investigate before negotiating further down; an unsustainable supplier price leads to quality compromises or supply failure.
What is a fair profit margin to allow in a should cost model?
Sector benchmarks vary widely. Electronics manufacturing: 5–12%. Precision engineering: 10–18%. Chemical manufacturing: 8–15%. Services: 15–25%. Research public financial statements of comparable listed companies in the supplier’s sector to calibrate margin expectations. A useful approach: identify the supplier’s industry average EBITDA margin from sector reports and use that as your benchmark for a fair return.
How do I model should cost for services, not just manufactured goods?
Replace material cost with any third-party cost (software licences, subcontractors, travel). Replace labour with the supplier’s fully-loaded staff costs: hourly rate × utilisation rate × number of hours required. Overhead covers management, facilities, and support functions. The structure is the same; the cost categories shift from physical to human capital.