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The Fundamentals of Price and Cost Analyses

Sharon Haught, CPSM, C.P.M.     Every business can benefit from applying an effective pricing formula to their purchasing process. Yet in order to identify which strategy is right for a specific industry, several key factors must be considered. Such determining factors were discussed at the presentation “Performing Price and Cost Analyses,” held by ISM-Nevada, Inc.  Meeting speaker Sharon Hauht is the Manager of Purchasing and Contracts for the Regional Transportation Commission of Southern Nevada. With over 20 years of supply management experience in the private and public sector, Hauht offered valuable insight on effective purchasing strategies and tips that are applicable to supply management professionals.

Most importantly, to determine whether a price is fair and reasonable in a competitive marketplace, it is essential to know how to identify and utilize the correct resources during the assessment process. Identifying the best price involves using the price analysis strategy, which requires performing a marketplace competition comparison. Cost analysis, a more complex process, is a thorough assessment of the direct and indirect costs leading to the final price of the product or service. Once either of these strategies is applied and expenses are identified, negotiation may be necessary to ensure the best price. Below is a breakdown of some essential factors and standard formulas associated with these two strategies.

An Overview of Price Analysis

According to Hauht, the price analysis strategy is effective when applied to products that can be contrasted to other, “similar” procurements. Essentially, the goal of this general analysis is to assess whether a price is reasonable, and this depends on the type of market where the supplier operates. Performing a price analysis typically involves a few additional key components, noted Hauht, which include historical prices, market prices and published prices.

How to Use Price Analysis

How can a purchaser correctly apply price analysis to their process or product and determine the aforementioned highlighted prices? Hauht cited the how to use price analysis on a hypothetical product purchase requisition.

For example, to assess the price of product “X” using price analysis, the following strategies may be applied as part of a price analysis:

  • Perform a general Internet search on the item using various shopping sites and search engines to get an idea of the market and published prices.

 

  • Contact the manufacturer directly for a suggested retail price, or seek pricing quotes on the same item from competitor brands or manufacturers and seek price indices. Hauht also suggests seeking advice from industry peers, to get a better sense of what others have paid for the same item.

 

  • Using the aforementioned strategies can help identify whether there has been any escalation in the price.

Once these strategies have been applied, the purchaser may assess whether a specific product has been priced fairly and if necessary, negotiate a reasonable cost.

An Overview of Cost Analysis  

During purchasing, there will be instances where a specific cost breakdown of a process or product is mandatory. Cost analysis is a more complex strategy than price analyses, because it involves applying direct (traceable) and indirect (all other non-direct expenses) costs into formulas for what is essentially a comprehensive breakdown of the product. A cost analysis is also useful when a price quote cannot be accessed from the manufacturer directly and the procurement is not easily comparable to others or is considered “unique.”Additionally, when producing an item internally, this method may be applied.

 Before Getting Started with Cost Analysis—Professionals may recommend establishing an open line of communication with the manufacturer in the early stages of the contract process, so that they are aware that a request for individualized prices on items will be an ongoing process. Patrick S. Woods., author of “Purchasing At All Costs? Understanding Your Supplier’s Cost Structure,” advises purchasers in his article, “…convince your supplier that your intent in obtaining costing information is not to reduce their profit.”  

How to Use Cost Analysis: To understand the cost drivers behind a product or service, it is helpful to identify direct costs,which Hauht describes as elements—material or otherwise—and profit, which can be attributed to the final cost of the product. This list includes base salary, labor, materials, and workers such as subcontractors, fringe benefits, which Hauht cites as 30-33%, travel, and all that can be billable to the final product. In his article, Woods cites the example of sheet steel for an auto company as a direct cost.

To identify indirect costs, which aregenerally less evident, Hauht cites to consider materials and non-materials that are not directly associated with the final product.

Examples of  indirect costs, may include advertising and marketing, indirect labor, legal fees, travel, rent and repairs, communication and office supply costs, insurance, taxes, depreciation and utilities, as well as additional “non-project specific expenses,” according to Hauht. Sometimes, she notes, indirect costs include overhead rates.

Both indirect and direct costs are usually factored with profit, which is essentially the complexity of the work performed and the risk assumed during the work performed for the project

Overhead rates typically vary by industry, and may sometimes—but not always—indicate that there is business efficiency. These rates can be determined by internet research or by formulating an overheat rate formula. While overhead rates differ according to industry, averages are generally between “1.35 and 2.90,”Hauht states. One effective method/formula that Hauht cites to determine a fair and reasonable overhead rate is the total indirect costs divided by direct costs. She cites the example ($110, 000/$50,000=2.2)

Then, according to Hauht, pricing may perform what is called a break-even multiplier, the formula, “Total Indirect Costs + Direct Costs, divided by Direct Costs”

Hauht writes “If a supplier has an overhead rate of 2.2 (or an Overhead Percentage of 220, then its break even overhead multiplier would be 3.2 ($110,000 +50,000/$50,000=3.2)

According to Hauht, the 3.2 percentage rate means that “if a firm has $2.20 in overhead and general and administrative expenses (G&A) for $1.00 in direct labor and material costs ($1.00 + $2.20), for a total of $3.20, then they need a 3.2 multiplier on every dollar of direct labor and material costs in order to cover their expenses and break even.”  

Additionally, Hauht notes that anything over a 3.2 multiplier would indicate a profit and anything under that number would mean a loss.

As with price analysis, once a rate has been determined, then a negotiation may be necessary to ensure the best price outcome.

Additional Sources:

Smith, M.E., Ph.D., C.Q.A., Buddress, Ph.D., C.P.M, Raedels, A. Ph.D., C.P.M, “The Strategic Use of Supplier Cost Analysis,” 91st Annual International Supply Management Conference, May 2006.

Woods, Patrick S., C.P.M., A.P.P., CPIM “Purchasing At All Costs? Understanding Your Supplier’s Cost Structure,” 84th Annual International Supply Management Conference, 1999.

In addition, source Analytics Services here.


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