Landed Cost Model vs. Should Cost Model

If your business is going to function effectively and efficiently, it needs to occasionally make purchases or procure items from time to time. There are two types of procurement — direct spend and indirect spend. Direct spend procurement involves purchasing the materials and supplies that your business will use to make its products. Indirect spend refers to the purchase of materials that your business needs to carry on. Examples of indirect spend procurement include office supplies, lab supplies and transportation costs.

Part of the procurement process is determining the cost of the items your business is purchasing. There are a few different methods you can use to evaluate product costs and to determine whether or not a supplier is charging you appropriate prices. Understanding the costs of items can also help you see whether the prices you are paying for supplies are going to have a positive or negative effect on your company's bottom line.

Among the methods you can use to determine the appropriate prices for items are the should cost model and the landed cost model. Below, learn more about each option and when it makes sense to use each one.

What Is the Should Cost Model?

The should cost model examines what something should cost based on a variety of factors. The factors that go into calculating a cost using this model can include the following:

• Cost of materials
• Cost of manufacturing
• Overhead costs
• Labor costs
• Profit margins

Businesses often use should cost modeling when they are procuring custom items. In the case of non-custom items, it's relatively straightforward to look at the prices charged by various companies that all sell the same product. A business can then choose the vendor with the most competitive price.

When there's no way to compare costs from company to company, a business will have to take a closer look at the details behind an item's production. In many cases, determining the appropriate price will require a business to act as if it is the one responsible for producing the item in question.

There is usually a difference between the price determined by a should cost model and the price quoted by a supplier. Several factors can account for the difference between the quoted price and price determined by the should cost model.

When a company determines the should cost price of an item, it makes multiple assumptions about the production, design and procurement of the item. For example, a business might assume that the designers or engineers behind the product will make the most cost-effective design choices. The reality might be somewhat different, and the engineers or designers might use more expensive or less efficient methods, raising the cost of production. Another factor that can contribute to the difference between a should cost price and an actual price is an inefficient and expensive production method. Having higher than anticipated storage costs and working with a distant supplier rather than a local company can also contribute to the disparity.

The should cost model is a helpful tool in indirect procurement, as it can be a jumping-off point for negotiating with a supplier.

How to Calculate Should Cost

A should cost model can help you determine whether or not you are paying more than you should for supplies. One formula often used with should cost calculation is as follows:

(Material Cost + Labor Cost) / Profit Margin = Should Cost

Using a should cost model may require you to think like a supplier and, in some cases, to know more about a product than a supplier does. You might use the should cost model to ensure that you are paying prices for supplies that are as fair as possible.

The more details you can include in your should cost calculation, the better you can see whether the prices you are paying for certain supplies are in line with the amounts you should be paying. Developing a should cost formula for indirect procurement categories typically involves working with several different departments. For instance, procurement experts can provide an accurate idea of the materials cost while those working in the technology or development departments of your business might be able to give you a specific idea of the labor cost. Procurement and supply chain experts can also provide an accurate idea of the profit margin for an item you are considering.

Let's use a printer as an example of how the should cost formula can work. Assume the materials cost of a printer is $150 per unit. Your company is interested in buying 10 printers. The labor costs of assembling and installing the 10 printers in your office are $1,000. The company that sells and installs the printers would like to earn a 20% profit. The materials and labor costs combined are $2,500. Then taking the 20% profit margin into consideration, the should cost amount is $3,125.

If your company spends $3,125 or less on the printers, it is paying a reasonable amount. But if you're paying considerably more than $3,125, you might consider negotiating with your printer supplier to get a better price.

What Is the Landed Cost Model?

While the should cost model gives you an accurate idea of what you should be paying for supplies and products, the landed cost model focuses on calculating the costs of getting products and supplies to your door. The initial components of a landed cost are in addition to the cost of purchasing something from a vendor or supplier.

Examples of the initial components of landed costs include the following:

• Insurance costs for importing or shipping products
• Cost of renting or purchasing containers
• Storage or warehousing costs
• Customs fees or tariffs
• Shipping or freight costs

When calculating the total landed cost of a shipment, the purchase price of the item should be added to the initial components described above.

Understanding landed costs gives you an idea of whether or not you are paying the best prices for your supplies. Knowing what landed costs are can also help you figure out where you can cut costs, or if cost-cutting is even an option. In the case of indirect spend procurement, negotiating on landed costs can allow you to save money. In the case of direct spend procurement, understanding landed costs can help you price your products appropriately to ensure the highest profit.

How to Calculate Landed Cost

Since many variables affect landed cost, it can be challenging to calculate upfront. You might not know how much customs duties will cost or the total cost of shipping until after a product has made its way to your door. However, having a reasonably accurate estimate of landed costs will help you determine the best suppliers to work with.

The formula commonly used to calculate landed cost is as follows:

Product Cost + Shipping + Customs + Risk (Insurance) + Overhead = Total Landed Cost

For example, let's say you are considering purchasing cleaning supplies for your office. You compare two similar products, one from Company A and the other from Company B.

Company A's product costs $10 per gallon bottle, while Company B's product costs $15 per gallon bottle. At first glance, Company A's product seems like it has a better price.

But then you look closer and realize that Company A charges $500 to rent a container to ship the product to you, plus an additional $10 per bottle shipping fee. Since Company A ships from overseas, you also have to pay a customs duty of $500.

Meanwhile, Company B is located domestically and sends shipments via train. Total shipping costs are $500, and there aren't any customs duties to pay.

If you were to buy 100 bottles of Company A's product, you would end up paying $3,000:

• $1,000 for the products
• $1,000 for shipping
• $500 for the container
• $500 for customs

Should you buy 100 bottles from Company B, you would pay $2,000:

• $1,500 for the product
• $500 for shipping

Should Cost Model vs. Landed Cost Model in Procurement

When it comes to procurement, is it best to use the should cost model or the landed cost model? Both options have their pros and cons. In some cases, it might make more sense to use the should cost model, such as when you are considering purchasing a custom-made product. The landed cost model might be more appropriate when you are procuring items that have a direct impact on your company's bottom line.

Below, take a closer look at the should cost and landed cost models and the roles they play in procurement.

Pros and Cons of Using a Should Cost Model

There are several advantages and a few drawbacks to using a should cost model.

Here are the top pros:

• Opens the door to negotiations: One of the most significant advantages of using a should cost model is that doing so can help your business negotiate with your suppliers. If the price you come up with after using the formula is considerably lower than the amount you are paying for a product, you can approach your vendor and ask about the difference. It might be that the practices the vendor uses require it to charge you more. If that's the case, you can try to negotiate or reach out to other vendors to get a price that is more in line with your should cost value.
• Can increase business profitability: Paying less for your supplies can help to boost your business profits and save your company money in the long run.

Here are the top cons:

• Can be complicated to construct: Putting together a should cost model can be challenging, as there might be several unknowns. In the case of a custom product, your team might need to have specialized knowledge of the product to put together an accurate model.
• Doesn't work in all cases: The should cost model isn't always the most appropriate option. Typically, it's best suited for products that are one-of-a-kind.

Pros and Cons of Using a Landed Cost Model

Like the should cost model, the landed cost model has its own set of pros and cons. There are cases when using a landed cost model makes sense and times when it isn't appropriate.

These are the main pros:

• Gives you the true cost of a product: Perhaps the most significant benefit of landed cost is that calculating it helps you see what a product actually costs your business. Understanding landed costs allows you to make changes that can save you money.
• Helps you choose the product with the best overall price: If you have access to all the numbers you need, or if you have data from past purchases that you can use to estimate landed costs, this formula is an excellent way to figure out whether one product is priced better than another. You can use the model to figure out which products will boost profits and help you save money and which ones will likely be a drain on resources.

These are the main cons:

• Can be difficult to calculate if you are missing data: Several costs go into making up total landed cost. If you have all the numbers at your fingertips, the formula to calculate landed costs is a matter of simple addition. But if you're missing numbers, it can be challenging to know whether the landed cost of one product is more or less than the price of a similar product.
• Not appropriate for all businesses: Like should cost, the landed cost model isn't right for all applications. It's usually best when used to figure out the cost of products that you're importing from overseas. The formula can help you calculate and compare costs of importing from one country versus another.

Should Cost Model vs. Landed Cost Model: Which Model Drives Profitability?

Comparing landed cost and should cost models is a bit like comparing apples to oranges. There might be times when one model is the best option for you, and there might be times when the other model is the most appropriate choice. In the right circumstances, both landed cost models and should cost models can increase your company's profitability.

The should cost model is most appropriate and most likely to increase profits and savings when used to calculate the price of a particular product, especially if there are not other sources of the product available for you to compare and contrast costs.

The should cost model also gives you the facts and data you need to negotiate with suppliers or vendors. If you are currently sourcing a product from a vendor that tells you it plans on raising the price, you can use your should cost model to point out that a price increase isn't justified.

The landed cost model can help increase profitability and cost savings when used to compare the costs of similar products. Typically, these products will come from different countries and will have different shipping, customs and overhead expenses. Examining the total cost of a particular product, rather than just its unit price, will allow your company to see whether or not product A costs less than product B.

Looking to Increase Profitability and Cut Costs? Dryden Can Help

Using the right cost model is just one way your company can save money and increase its profits. Dryden specializes in helping companies control their indirect procurement spend to increase their profits and improve their bottom lines. To learn more about how our procurement consulting services and procurement audits can help your business, contact us today.