Cost Breakdown — Optimizing Procurement Costs

When procuring products or services, the first thing that procurement professionals will consider is how much will it cost them. Due to this, many procurement professionals use cost breakdown as a tool to optimize their procurement spending. 

In this article, we are going to discuss what cost breakdown is and its importance in optimizing your procurement costs. We will walk you through the steps of how to create a cost breakdown for your products. 

Additionally, we are going to share with you a template that you can use to help you with your cost breakdown objectives. 

After reading this article, you will gain a deeper insight into how you can cost breakdown template to maximize the value of your purchases. 

What is the Cost Breakdown?

A cost breakdown, also known as should cost model, is a tool used to estimate the ideal cost of a product or service. It is usually used by many businesses for them to gain insights into the detailed breakdown of the costs. This cost includes the costs of materials, labor, and other factors involved in producing or delivering goods or services.

Additionally, businesses use cost breakdowns to compare the actual and the estimated cost of production. By doing this, businesses can identify areas where they can reduce their costs. 

It is an essential tool for many supply chain and procurement professionals. They use the tool to assess and negotiate the pricing terms with their suppliers to achieve cost-saving opportunities. 

The Importance of Cost Breakdown Tool

The cost breakdown model is an invaluable tool in the procurement process. Businesses use this to negotiate and collaborate with suppliers effectively.

Knowing the factors behind the cost of raw and manufacturing materials is essential. By gaining insights into why costs are rising, businesses can create cost-saving opportunities. 

As an experienced procurement manager at companies like Ahold Delhaize and Friesland Campina, I dare say that good procurement managers stand out from the rest when they have a sharp understanding of the cost breakdown model for their key products. 

In almost all negotiations, suppliers claim that the cost price of their products has increased. When you, as a procurement manager, can respond to this with substance, you’re ahead 3-0. 

It may indeed be true that certain raw materials have increased in price, but you’ll often find that the impact on the total cost price is much lower than what the supplier suggests. 

Additionally, there may also be raw materials that have decreased in price. The number of times a manufacturer has proactively brought this up can be counted on one hand. 

So, make sure you have this insight, and you’ll see a significant improvement in your negotiation results!

How to Create a Cost Breakdown Model for Your Products?

Creating a cost breakdown model requires a methodological approach to examining and assessing the cost components of a product or service. 

Although it may seem difficult, this process is needed to guarantee that you receive the most value for your purchases. Below are the steps that you should follow when creating a cost breakdown model:

1. Identify The Scope

The first step that you need to consider is to identify the scope. Here, you will determine the product or service that you want to analyze to know the cost drivers.

For example, if you want to analyze the cost of making a phone, the scope would include identifying all components and processes. This includes components such as the screen, processor, battery, assembly, and packaging.

After this, you may come up that the key cost drivers here would be the complexity of the smartphone design. This is because more intricate designs require more expensive materials and manufacturing processes. 

2. Gather Data

After you identify the scope of your model, the next step is to gather data. Research and collect data on material costs, labor costs, overhead costs, and profit margins. 

Accurate and up-to-date information is essential for a cost breakdown model to be effective. One way to obtain material costs is by directly contacting suppliers for quotes or using market research reports.

3. Analyze Cost Drivers

In this step, you will identify the significant factors that affect each cost element. For instance, to understand the market demand for raw materials, you may need to analyze the industry reports on global supply and demand trends for materials such as rare earth metals used in smartphone components.

4. Quantify Cost Drivers

In this step, you need to have a thorough knowledge of the market dynamics and supplier relationships. 

Here, you will assign weights or percentages to the identified cost drivers, taking into account their impact on the overall cost. 

For instance, you might assign a higher weight to this cost driver in your model if the availability of a particular material fluctuates due to geopolitical factors. 

Similarly, if a specific labor skill set is in high demand, driving up wage rates, you would allocate a larger percentage of the labor cost to reflect this impact.

5. Create Your Model 

In the final stage, the gathered data and insights are used to create a cost breakdown model that includes all the cost drivers identified. 

This model can be in the form of a spreadsheet or a specialized software tool, where the different cost elements and their respective weights are entered to determine the estimated total cost of manufacturing, in our example, a smartphone.

For a bonus step, you must compare the estimated cost derived from the cost breakdown to the actual cost incurred in manufacturing the smartphone. Any disparities between the two would highlight potential areas for cost reduction. 

For example, if the actual material expenses exceed the estimated cost by a notable margin, you could explore alternative supply sources or engage in negotiations with suppliers to secure more favorable pricing, thereby reducing costs. 

Cost Breakdown Example Template

Before we start to share with you our template, please take note that the values are hypothetical. These values are provided to illustrate what a cost breakdown looks like. 

Moreover, it is important for you to customize the figures based on specific products or services through data analysis. Let’s now dive right in!

The table provided above displays the breakdown of raw materials used in a soda product. It also shows the percentage share of the total cost price, the percentage development compared to the previous year, and the percentage impact on the cost price.

The first column of the table lists the raw materials used in making a soda. These include carbonated water, sugar, caramel coloring, natural flavorings, other ingredients, and phosphoric acid. The packaging material is also considered a raw material as it is used as the container or base for the soda and affects the overall cost of the soda product.

The second column shows the percentage contribution of each raw material to the total cost price of the soda. You can calculate this by analyzing the cost breakdown of the product and determining the proportion of each raw material’s cost in relation to the total cost. It is essential to ensure that the percentages for all raw materials add up to 100%.

Formula: S = (Cost of Raw Material / Total Cost of Product) * 100

The column “Development in % vs last year” represents the percentage change in the cost of each raw material compared to the previous year. To calculate this, you need cost data for the current year and the previous year. Subtract the cost of the raw material in the previous year from the cost in the current year, divide the difference by the cost in the previous year, and multiply by 100 to get the percentage change.

Formula: D = (Current Year Cost – Previous Year Cost) / Previous Year Cost) * 100

The last column, “% Impact on Cost Price,” demonstrates the percentage impact of each raw material on the overall cost price of the soda. To compute this, you need to consider the cost share of each raw material and the percentage development calculated in the previous steps. Multiply the % Share of Total Cost Price by the Development in % vs Last Year for each raw material to determine the % Impact on Cost Price. This will indicate the influence of each raw material on the overall cost.

Formula: I = S x D x 100

The “Total” row summarizes the entire cost structure of the soda product. In this case, the total percentage share of all the listed raw materials is 100%. The “Development in % vs Last Year” and “% Impact on Cost Price” columns in the Total row provide an overview of the overall changes in cost and their impact on the final cost price. In this example, the Total row shows a 0.954% impact, indicating a slight increase in the overall cost price compared to the previous year.

By using this cost breakdown template, businesses can analyze the cost breakdown of their product, understand the contribution of each raw material, track changes in costs over time, and identify areas for cost optimization and negotiation with suppliers. It helps professionals gain insights into the cost structure and make informed decisions to achieve cost savings.

Furthermore, click the download button below to access our free-to-download editable cost price breakdown template. This will help you to be guided more on how to use our cost breakdown model that you see in this article. 

Conclusion

In conclusion, the cost breakdown tool is used to optimize procurement spending. This tool is commonly used by procurement professionals to gain insights into the detailed breakdown of costs.

Additionally, this tool can help compare actual and estimated costs of production to further reduce costs. By following our steps, businesses can ensure that they are receiving the most value for their purchases. 

As prices continue to go up in the market, this tool becomes more invaluable in procurement. By understanding the factors affecting the products or services, procurement professionals can negotiate and collaborate effectively with suppliers and improve their negotiation results.