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Industries:  General 

Cost Benchmarking can help formulate good contract terms

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By: Shobana J
Senior Cost Modeling Specialist

calender02 Dec 2018

cost-benchmarking-can-help-formulate-good-contract-terms

Procurement function of any organization plays a key role in saving costs. Category managers usually work toward cost savings through negotiations, margin reduction, supplier switching, supply base extension via imports, etc.

Besides traditional methods, cost savings can also be achieved by designing the best contract terms with the suppliers. Cost benchmarking will help sourcing managers to design the best contract terms; it can be achieved with the help of the following:

  • Cost Models
  • Cost Indices

Cost Models

Cost models can be used to identify major cost drivers and their impact on the total production cost, as well as the landed cost of the product. They can also be used in understanding the cost comparison between two different locations, suppliers, substitute products, etc.

One of the largest beverage companies in the world wanted to frame the best contract terms for its film packaging category. The resultant cost model provided the cost comparison of packaging products from different suppliers located across various countries in Latin America.

country-cost-comparison

The model was also used by the buyer to identify the cost difference among the specifications in the same product category. This comparison helped the buyer in weeding out costlier specifications/SKU of the product category.

total-cost-comparison

Benchmarked information on major cost parameters, high value specs (after considering its price and value generation abilities), cost effective supplier, and low cost region or country will help procurement teams design an optimum purchasing contract.

Cost Indices

Another important parameter in contract mechanism are the forecasted cost and price of the product or category. Cost Indices of commodities and economic indicators can be used to capture historic changes in the costs of any given product or commodity.

Cost indices are used for complex product or product categories such as mining equipment, automobile vehicles, electrical devices, etc.

In order to build an index, each of the cost components must be allocated a weightage. The components would include materials, labor, utilities, capex, forex rate, interest rate, inflation, logistics, etc. To plot the trend line, the forecast of each cost component must be combined based on its impact on the final product. This will help the buyer achieve the following:

  • Estimate the future quotes received from category suppliers
  • Frame a supply contract, negotiation and bidding
  • Identify the lockin period based on cost and price index movements

Cost index of Product A is calculated as follows:

CPI, t2 = t1*(i1/i2)

            t1= time point in the past and the cost at that point in time

t2= time point in the present and current cost to be estimated

i1= index value at t1

i2= index value at t2

Cost index-based benchmarking is an important tool at the contract renewal phase of procurement cycle. The past and present price performance of input commodities, along with macro-economic indicators such as inflation and interest rates, will be analyzed to plot the future price movements of the product to be purchased.

One of the world’s largest gold mining companies was in the middle of renewing its contract for heavy mining equipment (HME) and had requested for a cost index tool to help evaluate the proposals from the incumbent suppliers.

For the benchmarking study, prices of steel, chromium, nickel, and macro-economic indices had been analyzed. The supplier had quoted a year-on-year price increase of 5% and 10%. However, the analysis revealed that the price increase could not be justified, given the decrease in the input costs index.

hme-cost-components

hme-category-index

*Note: Values used in the charts are for illustrative purposes

Based on the price trend, the buyer was advised to negotiate/discuss with the supplier in order to understand the rationale behind price increase, prior to renewing the contract. This ultimately led to a healthy discussion with the suppliers, who are prominent in the segment.

Cost models can be effectively used as a benchmarking tool. This will help sourcing managers to frame good contract terms. Nevertheless, a favorable contract will eventually lead to cost savings.

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