Should-Cost vs the Incumbent's Last Offer
A buyer spends $2.52 million annually on a machined injection-molded bracket: 600,000 units at $4.20. The incumbent offers $4.05 for a two-year contract with a 3% annual productivity reduction, but asks for 100% of volume and 90-day payment terms (currently 60 days). A second supplier quotes $3.95 but has not produced this part, needs six weeks for first-article approval, and would require $40,000 in tooling. The buyer's should-cost model shows resin $1.85, machine time 0.65 minutes at $65/hour, labor 0.25 minutes at $32/hour, overhead 22% of conversion, packaging $0.18, freight $0.10, scrap 4%, and supplier margin 15%. The current supplier's on-time delivery is 98.5%, quality PPM is 320, and it holds safety stock for the buyer. Finance values cash at 8% annually. What should the buyer recommend?
1. Calculate the should-cost and the gap to the incumbent's current and offered prices.
Read the worked answer
Machine cost = 0.65/60 x $65 = $0.704. Labor = 0.25/60 x $32 = $0.133. Conversion = $0.837. Overhead = 22% x $0.837 = $0.184. Subtotal before packaging, freight, and scrap = $1.85 + $0.837 + $0.184 = $2.872. Scrap = 4% x $2.872 = $0.115. Add packaging $0.18 and freight $0.10: total cost = $3.267. With a 15% margin on price, should-cost = $3.267 / 0.85 = $3.84.
Gap to current $4.20 = $0.36, or 9.4%. Gap to the offer of $4.05 = $0.21, or 5.4%. The model excludes tooling amortization and the value of the incumbent's safety stock, so the true gap may be smaller. Still, the offer is above should-cost, which gives the buyer a negotiation fact base rather than a purely price-comparison argument.
2. Evaluate the two offers on total cost of ownership and risk, including payment terms and tooling.
Read the worked answer
Incumbent year 1 at $4.05 x 600,000 = $2.43 million. Year 2 with 3% reduction = about $2.357 million; two-year product spend = $4.787 million. The 90-day terms versus 60 days add 30 days of financing on roughly $2.43 million at 8% = about $16,000/year, or $32,000 over two years. The incumbent also provides 98.5% on-time delivery, 320 PPM, and safety stock; those reduce expedite and stockout risk but are not free.
Alternate: $3.95 x 600,000 = $2.37 million/year, plus $40,000 tooling in year 1. Tooling amortized over one year is $0.067/unit; over two years it is $0.033/unit. The alternate is cheaper on unit price but unproven, needs six weeks for first-article approval, and carries ramp and quality risk. On pure year-1 cash, the alternate is about $2.41 million including tooling versus about $2.45 million for the incumbent with payment-term cost. The gap is too small to justify single-sourcing an unproven supplier.
3. What should the buyer recommend at the negotiation table? Include contract terms and a dual-sourcing plan.
Read the worked answer
Do not accept 100% volume and 90-day terms at $4.05. Use the should-cost of $3.84 to target $3.90-$3.95 with 60-day terms, a 3% annual reduction, and a commitment tied to performance. Award the incumbent 70% of volume at the improved price, and qualify the alternate for 30% after first-article approval. Keep tooling ownership and access rights clear, and require the alternate to demonstrate 98% on-time delivery and acceptable PPM before increasing its share.
If the incumbent refuses, move a smaller pilot share to the alternate and keep the incumbent on a short extension. The objective is not the lowest quoted price; it is the lowest total cost with a qualified second source. Document the should-cost assumptions so the negotiation is based on cost drivers, not just the last bid.