The famous cost breakdown.

But why is this concept so important in Procurement?

Certainly you, a purchasing professional (or Supply Chain), have heard of cost breakdown. But, why is this concept so important that even exercises related to it are often used as an elimination criterion in job interviews?

The cost structure not only allows an understanding of the material or service’s cost composition, but also guides the authorization of price adjustments when they are requested. Let’s use an example to facilitate understanding: You are responsible for the glass packaging category in your company. Therefore, the first step in good category management is to know the material you buy. You can search on your own, talk to the Packaging Engineering department (if your company has one) or simply go straight to your supplier. It is always important to remember that no matter how much we should know about a subject, our supplier is always (or should be) “more” knowledgeable than we are. In this case, selling glass containers is the main activity of the supplier; therefore, they must know how to explain the glass manufacturing process to you in detail.

In a world where pandemics do not exist, one of the best ways to obtain information is through visits to the supplier (this experience is very rich and provides us with a lot of information about the supplier, which is not always revealed with a phone call or questionnaires — we will discuss about it in an upcoming text).

When you are visiting a supplier, a golden rule is to ask the supplier to go over the, “Production path,” with you. That is, to show you everything that happens, from the receipt of raw materials, production, inspection, packaging and shipping to the customer. Through this, you will be able to understand the flow of raw materials and processes that culminate in your final product.

For exemple, when it comes to glass packaging, the main raw materials are Silica, Sodium Carbonate and Limestone. The supplier must show you the receipt, inspection and storage of all raw materials. At this point, you must question what the participation of these raw materials is in the composition of the glass. You should get something like 70% Silica, 15% Sodium Carbonate (commonly called “soda”) and 10% Limestone. Keep this information, it is very valuable for your cost breakdown.

Moving on to the processing part of our visit to the supplier, you should look for signs of anything that might add cost. For example: Material parked somewhere waiting for the machine set-up, manual inspection of the raw material received, batches of raw materials rejected and lack of space for storage of raw materials, among others. A rule of thumb here is to think that each person (or department) that somehow “touches” the raw material or the final product, entails cost. And it’s up to you, the buyer, to ask the questions: How much does the raw material inspection cost? What fuel is used in your ovens? These ovens need to reach a temperature of approximately 1500 degrees Celsius for the transformation of raw materials into glass. Water boils at a temperature of 100 degrees Celsius, so extreme energy (heat) is needed to melt the raw materials and turn them into glass. Thus, the item “energy” is important for its cost structure).

We will pay attention during our visit and ask the supplier about the labor. How many people did are working at the supplier’s production plant? Are the operations mostly automated or manual? Again, you should ask the supplier what the impact of labor is on the final cost of the product.

The next part of the cost breakdown that you should be aware of can be called “SG&A” (from, Selling, General and Administrative expenses) or operating costs. It is basically the cost to maintain the business, which includes, among others, rent, marketing costs, equipment and employee benefits.

And the last (and incredibly significant) part of cost structure is understanding what the supplier’s profit margin is. This information is often treated as confidential and requires a huge partnership with the supplier (and confidentiality contracts) in order to be disclosed. It is important to note that the profit margin may vary according to the product and the customer.

Right! You must be wondering what to do with all of this information right now. Ideally, you should set up a simple table on a spreadsheet with the items that make up your cost in one column, and their respective percentages in the column next to it. Remember that the sum of the percentages of the items must be 100%. It is the sum of all items, so it needs to be the total amount you pay for the material or service. This tool is worthwhile to spend a little time initially on research, conversations, investigations and visits to the supplier, because it does not tend to change in the short term after being developed. Something that could alter it is a change in the supplier’s production process, such as the purchase of a robot that automates one of the manufacturing steps.

In this spreadsheet, you must put the current price paid in a third column, next to the total sum of the percentages of your cost composition, and “break” your total price according to the percentages of each item. For example, if the total amount paid for a glass container is $1.00 (100% of the cost breakdown) and you know that the participation of Silica in the cost is 20%, $0.20 of its total cost is “caused” by Silica, and so on.

Whenever there is a request for readjustment by the supplier, you must understand what led to this request. Let’s say, that something happened, and Silica had a 10% adjustment. You should never apply the 10% adjustment to your total cost. In our example above, if you apply the 10% adjustment to your total cost, the packaging will cost $1.10. As a buyer, you have already done your homework and have developed your cost breakdown spreadsheet. You know that you should apply the 10% adjustment only on the 20% of Silica that makes up your final cost. If the only reason for adjustment requested by the supplier was the increase in Silica, your new adjusted total price will be $1.02 (and not $1.10, which you would get if you simply apply a 10% adjustment over the total amount).

In addition, suppliers might request adjustments to cover inflation. Yes, this is fair, but it is not fair that the supplier’s profit is also adjusted. The price can be adjusted to cover inflation, but there is no reason to increase the supplier’s profit. Again, the cost spreadsheet must be used, applying the adjustment to the SG&A line. Raw materials are usually adjusted according to their own indexes, while SG&A can be adjusted using a specific index agreed between the buyer and the seller. In a next text we will also address the should cost model, another tool that is based on the opening of costs.

Anyway, always remember that knowledge is a very valuable exchange currency for the purchasing professional, and that knowledge of cost structure can bring a competitive advantage to your company, in addition to results (savings) for you and your area.

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