When negotiating, it is important to understand what exactly drives the costs of an overall product or service. Understanding what the key cost drivers are and which can be manipulated to reduce cost and/or improve quality will aid the negation process. So how do we assess the drivers of cost?

Product Cost Drivers

When a physical product is the focus, the breakdown of cost drivers is a simple albeit time consuming process. In order to determine what exactly drives cost, you first need to break down the various aspects of creating the product:

  • Materials used: what materials are used during the process and in what quantities? The cost here could be cut by shopping around, however if quality is a high priority the cost may be justified to maintain high quality.
  • Components of the product: How many components are needed and what materials, design, packaging are needed for each? Can the cost be reduced by changing the materials/packaging or switching supplier?
  • Overheads: Any facilities needing to be maintained/rented, the cost of using and maintaining machinery, etc. Is the cost of the facility justifiable? When machines break down would it be more cost effective to repair or replace?
  • Labour costs during production: The cost of the workforce versus efficiency rate and manufacturing methods used. Could the workforce’s time be used more efficiently?
  • Transportation of the product: What are the logistics of the transportation of materials, components and the finished product? What can be done to improve efficiency and/or reduce cost?
  • Research and development of the product: In certain markets there is a demand for innovation and adaptation to changing trends, so R&D is often a necessity, but could it become more efficient?
  • Admin costs: Administration, sales and other general admin costs are often the most flexible cost drivers. Ensuring they remain efficient and effective to maximise return on investment is the key.

Service Cost Drivers

Analysing the costs of a service can be much more complex, especially if the costs of the service are predominantly for labour. The key to understanding the cost drivers in terms of a service is to understand the supplier’s process.

Procurement Leaders are working on bringing the level of cost driver analysis we can see in physical products into service-buying. Here’s their process so far:

  • Map the supplier process: With input from the supplier, create a detailed breakdown of the process the supplier goes through to provide you with the service.
  • Allocate costs to each activity: Using a combination of information from job boards and the indicators of labour prices we can get a better idea of how much each activity is costing.
  • Next consider the overheads: The supplier’s overheads can be gleaned from annual reports. You can then assign these based on either the percentage of the supplier’s revenue you embody, or the according or the quantity of their workforce you use.

Although these costs can’t be considered as set in stone as physical production costs, they can be used as educated estimates for use in discussions with the supplier regarding productivity.