How to do First Principal Costing in Contract Negotiations
- Arvind Dang
- Jan 6
- 4 min read
Updated: Jan 14
This blog covers the following aspects of negotiating contracts in any Industry.
1. First Principle Costing FPC)
2. What are the benefits of FPC
3. Where all can FPC be used?...
4. Five Illustrations for First Principle Costing
5. What are 9 cost elements & what is included in each cost element
6. Specimens of resource templates for five illustrations
7. What are the factors that can influence cost estimation accuracy during FPC computation?
8. What are the limitations of doing FPC?:
What is the first principal costing (FPC)?
1. FPC is a cost estimation method that breaks down a product or service's costs to their fundamental components.
2. This approach starts with the identification of the most basic cost elements, considering the direct material, labor, installation, testing, commissioning costs as applicable, overheads, Taxes, statutory, and any other relevant costs involved in professionally creating the product or service as also profit margins assessment.
3. It provides a transparent, detailed, and fact-based cost structure, enabling professionals to negotiate rates effectively for categories 1, 2, and 3 types of contracts-Types are defined in the table in a subsequent paragraph).
What are the benefits of FPC:
1. Accuracy as costs are itemized in cost elements
2. Transparency & fact-based cost structure
3. Potential cost risks & optimisation opportunities
4. Inspires confidence in the negotiating team to negotiate logically & facilitate win-win
Where all can FPC be used?...
For estimating costs for the following:
1. High-value BOM items that the client company procures and then assembles in-house to make end and sell products such as Vehicles or any other product (Category 1 contracts)
2. High-value Assets that the company procures, such as Plant & machinery, vehicles, F&F (Category 1,2 &3 contracts )
3. Projects that the company outsources and that involve SITC-Supply, installation, testing, and commissioning (category 2 & 3 types of contracts-Categories defined in below table)
Five Illustrations for First Principle Costing
For the below examples, this author has demonstrated how to do the first principle costings in the context of the Manufacturing Industry, but concepts are similar in almost all Industries
Type contracts & Scope of contract | Illustration |
Category 1 -only Supply of materials | 1-Grey Iron Castings |
2-Hot forgings | |
3-Machined parts | |
Category 2 – Small value- stand-alone contracts involving supply installation, testing & commissioning (SITC) | 4-Jacuzzi system- |
Category 3 - High value-contracts needing integration with many other ongoing contracts at the site & involving SITC | 5-Lift system for a high-rise building |
The costing computations for five illustrations are included in my series of lectures at Udemy as per the following link.
What are 9 cost elements & what is included in each cost element in addition to raw material costs (Please refer to 5 illustrations)
1. Rates Allocating Equipment costs
a) for Casting/ forgings, etc, sold on kg basis: Annual depreciation cost costs) divided by Annual production: i.e., so cost allocation will be on an Rs/kg basis (like in the case of equipment cost allocation)\
b) for Machined items sold on per piece basis: Annual depreciation cost +AMC +financing costs) divided by annual hours put to use in a year for (1,2 or 3 shifts) : so cost allocation will be on Rs/hour of machine time
c) For other types of items sold on a number basis: Annual depreciation cost +AMC costs) divided by the annual production in the number of units of the cat 1 item: so cost allocation will be on Rs/unit of the item produced
2. For Tool costs :
The formula is (Annual consumption value + resharpening costs) divided by Annual production, annual hours used, or annual capacity/number of units.
3. For Jigs/fixture costs: As above
4. For Manufacturing variables, costs :
include power, fuels, Coolants, production consumables, etc. (Annual consumption value) divided by the annual number of units produced. Other manufacturing variable costs may consist of QC gauges, compressed air, rejections, and indirect labor associated with production, such as maintenance or tool room labor.
5. For Marketing, variable costs:
include costs of secured packing, labeling, mandatory certification costs if applicable, outward freight, marine insurance, warranty costs, and sales promotion expenses.
6. For Manpower costs:
cost to the company, including payroll, overtime, inflation, all benefits , bonuses & incentives
7. For overhead costs:
Include electricity for offices, HVAC running costs, Depreciation of buildings, vehicles, office equipment, their repair and maintenance, insurance, lease rentals-others, communications, travel and conveyance, legal and professional, entertainment and so on.
Specimens of resource templates
Thirteen 13 resource templates have been designed and included in section 3 of my video course on Udemy -60 lecture course on Contract Negotiations. The resource templates are ready to use vis a vis five demonstrations mentioned above or can be easily customised to incorporate relevant cost elements in any Industry
Nine benefits for enrolling in this course on Contract Negotiations, are depicted in my YouTube post below.
What are the factors that can influence cost estimation accuracy during FPC computation?
1. Appropriateness & completeness of applicable cost elements
2. Assumptions on the type of technology the vendors /contracts deploy to manufacture products & execute contracts as these impact costs
3. Accuracy in assessing manpower numbers and skills needed
4. The complexity of the design/ drawings for which cost estimation to be done
5. Appropriateness in the selection of manufacturing processes and process flow
What are the limitations of doing FPC?:
1. Time-consuming
2. Accuracy of computing & populating cost elements
3. Deep Knowledge of manufacturing processes for ensuring realistic cost estimations.
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