Lesson 1 of 7 Math checked Facts checked against sources on 16 June 2026 16 min

Procurement and sourcing: where the money goes

Spend analysis, should-cost, supplier power and single against dual sourcing, each with numbers you can recompute.

Key takeaways

For most companies that make or sell goods, bought-in materials and services are the largest cost.
There are few other suppliers who can make the item.
Switching is slow or expensive: new tooling, months of testing and approval, or a design built around one supplier's part.
The item is critical to the buyer but a small share of the buyer's cost, so the buyer will not fight hard on price.

Key idea

For most companies that make or sell goods, bought-in materials and services are the largest cost. Procurement saves money in three ways: knowing exactly where the spend goes, knowing what each item should cost, and knowing how much power each supplier really has.

The toolkit lesson on supply chains showed "source" as one step in the chain. This lesson opens that step up. Procurement is the team that chooses suppliers, negotiates prices and contracts, and makes sure goods arrive. Direct spend is what goes into the product (steel, chips, cotton, packaging). Indirect spend is everything else the company buys (IT, travel, cleaning, consultants). In a manufacturer, bought-in materials are often more than half of the cost of goods sold, so a few percent saved on buying can beat a big sales push.

Start from the toolkit

If lead time, inventory, service level or the bullwhip effect are new to you, read the supply chains lesson in "How industries work: the toolkit" first. This module builds on it and does not repeat it.

Read the supply chains lesson

Spend analysis: find the big buckets first

A spend analysis sorts every purchase in a year by category, by supplier and by business unit. It almost always shows the 80/20 pattern: a few categories and a few suppliers hold most of the money. That tells you where to look first. A 5 percent saving on a category worth 400 crore is worth far more than a 30 percent saving on one worth 5 crore.

Yearly spend of a fictional appliance maker in Pune, India (INR crore)

So-what

Three direct categories hold about two thirds of all spend, so the savings plan starts there.

Timed math drill

In the fictional appliance maker above, total spend is INR 1,250 crore. Steel, compressors and motors, and electronics add up to 400, 300 and 150 crore. What share of total spend do these three categories hold, in percent?

Should-cost: what the part ought to cost

A should-cost model rebuilds a supplier's price from the bottom up: the material in the part, the machine time to make it, the labour, an allowance for overhead and scrap, and a fair profit margin for the supplier. It does not tell you the "right" price, but it tells you how big the gap is between the quote and a reasonable cost, and which line explains the gap. That turns a negotiation from "please go lower" into "your cycle time looks long; can we look at it together?"

Worked case

Should-cost of a moulded plastic part

The prompt

The fictional Pune appliance maker buys 400,000 moulded plastic drum covers a year. The supplier quotes INR 300 per part. Each part uses 1.25 kg of plastic resin at INR 120 per kg. It takes 60 seconds on a moulding machine that costs INR 2,400 an hour to run, including its depreciation and power. Labour to trim and pack is INR 10 per part. Allow 15 percent of direct cost for overhead and scrap, and a 10 percent profit margin for the supplier on top. What should the part cost, and how big is the gap?

Open this case to practice it with a partner

The structure

Should-cost = (material + machine + labour) x (1 + overhead and scrap) x (1 + supplier margin)
- Material: kg per part x price per kg
- Machine: cost per hour x hours per part
- Labour per part
- Overhead, scrap and marginpercentages on top
- Key: Gap to the quote, per part and per year

Working it through

1. Material
1.25 kg at INR 120 per kg.
Material per part (INR):1.25 × 120 = 150
2. Machine time
INR 2,400 an hour is INR 2,400 for 3,600 seconds; the part takes 60 seconds.
Machine cost per part (INR):2,400 ÷ 3,600 × 60 = 40
3. Direct cost
Material, machine and labour.
Direct cost per part (INR):150 + 40 + 10 = 200
4. Overhead and scrap
15 percent of direct cost.
Overhead and scrap per part (INR):200 × 0.15 = 30
5. Should-cost with margin
Add a 10 percent margin to INR 230.
Should-cost per part (INR):(200 + 30) × 1.1 = 253
6. Gap per part
Quote minus should-cost.
Gap per part (INR):300 - 253 = 47
7. Gap per year
400,000 parts, shown in crore (1 crore is 10 million).
Gap per year (INR crore):47 × 400,000 ÷ 10,000,000 = 1.88

The recommendation

The buyer should open a fact-based negotiation, because the quote of INR 300 is about INR 47 a part above a should-cost of about INR 253, worth about INR 1.88 crore a year. First, ask for the supplier's cycle time and resin price, since material and machine time are 190 of the 200 rupees of direct cost. Second, offer something in return, such as a longer contract or a volume commitment, so the supplier can lower its overhead per part. The risk is that the model misses a real cost, such as a tool the supplier paid for; aim for a price nearer INR 265 than 253. As a next step, ask two other moulders for quotes to test the model.

Supplier power: who needs whom

A supplier has more power when

There are few other suppliers who can make the item. One way to measure this is the HHI, a concentration index used by competition authorities: square each supplier's market share in percent and add them up. US competition authorities treat a market above 1,800 as highly concentrated.
Switching is slow or expensive: new tooling, months of testing and approval, or a design built around one supplier's part.
The item is critical to the buyer but a small share of the buyer's cost, so the buyer will not fight hard on price.
The supplier has many other customers, so losing one buyer does not hurt much.

Buyer power is the mirror image: many suppliers, easy switching, large volumes and a credible threat to make the item in-house (the make or buy choice). In a case, say which way the power runs before you promise a saving. A buyer facing one qualified supplier and a two-year approval process will not win a 15 percent price cut by asking.

Timed math drill

Three suppliers make a special motor. Their market shares are 50, 30 and 20 percent. What is the HHI, and is the market highly concentrated (above 1,800)?

Single or dual sourcing

Buying an item from one supplier (single sourcing) gives the best volume price, one set of tooling and a simple relationship. Buying from two (dual sourcing) costs more: the second supplier gets less volume so charges more, and both must be qualified and managed. What you buy with that extra cost is a backup if one supplier stops, and price tension, because each supplier knows the other could take more of the volume.

Worked case

Should the appliance maker add a second compressor supplier?

The prompt

The appliance maker buys 240,000 compressors a year from one supplier at INR 4,000 each. A second supplier would take 30 percent of the volume at INR 4,200 each, and qualifying and managing it costs INR 0.6 crore a year. The team estimates a 10 percent chance each year that the main supplier stops for two months; each lost washing machine costs INR 5,000 of contribution, and the plant makes 20,000 machines a month. With a second supplier, half of the lost output could be saved. The main supplier has also offered a 2 percent price cut on its remaining volume if a second supplier is added. Is dual sourcing worth it?

Open this case to practice it with a partner

The structure

Net value of dual sourcing = risk reduction + price tension saving minus extra cost
- Extra cost: price premium on 30 percent + management cost
- Risk: chance x lost contribution, before and after
- Price tension: 2 percent on the main supplier's volume

Working it through

1. Price premium
30 percent of 240,000 is 72,000 compressors at INR 200 more, in crore.
Price premium (INR crore a year):72,000 × 200 ÷ 10,000,000 = 1.44
2. Total extra cost
Add the INR 0.6 crore to qualify and manage.
Extra cost of dual sourcing (INR crore a year):1.44 + 0.6 = 2.04
3. Loss if the supplier stops
Two months of output is 40,000 machines at INR 5,000 each.
Loss from a two-month stop (INR crore):40,000 × 5,000 ÷ 10,000,000 = 20
4. Expected loss today
A 10 percent chance each year.
Expected yearly loss, single source (INR crore):0.1 × 20 = 2
5. Risk reduction
The second supplier saves half of the loss.
Risk reduction (INR crore a year):2 × 0.5 = 1
6. Price tension saving
2 percent off INR 4,000 on 168,000 compressors.
Price tension saving (INR crore a year):168,000 × 4,000 × 0.02 ÷ 10,000,000 = 1.34
7. Net value
Benefits minus extra cost.
Net value of dual sourcing (INR crore a year):1 + 1.344 - 2.04 = 0.304

The recommendation

The appliance maker should add the second supplier, but only because of the price cut: the net gain is about INR 0.3 crore a year. First, the risk reduction alone (INR 1 crore) does not pay for the INR 2.04 crore of extra cost. Second, the 2 percent cut from the main supplier, worth about INR 1.34 crore, tips the answer. The risk is that the cut is a one-off; if it disappears next year, dual sourcing loses about INR 1 crore a year. As a next step, write the price into a multi-year contract and check whether a cheaper buffer stock would cover a two-month stop.

Check your understanding

A spend analysis shows that 2 of 12 categories hold 60 percent of spend. What should a procurement team do first?

Check your understanding

A supplier quotes 20 percent above your should-cost. What is the best first step?

Terms in this lesson

Pareto principle (80/20)Switching costs Make-or-buy decision COGS (cost of goods sold)Economies of scale Tier 1 supplier

Sources for this lesson (2)

Recognized public explanations of case-interview concepts and terms
US Department of Justice, Antitrust Division: the HHI market concentration index and the 2023 Merger Guidelines thresholds

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