5 Evaluating Price

Note. From Firmbee, 2015. Licensed for reuse under the Unsplash License.

Learning Objectives

1. Apply different methods of price analysis to determine if the price offered by the supplier is fair and reasonable.
2. Perform a cost analysis to determine if the price offered by the supplier is fair and reasonable.
3. Calculate the Total Cost of Ownership to compare different suppliers’ pricing.
4. Consider the Learning Curve when evaluating supplier pricing.
5. Understand discounts that may be applicable to supplier pricing.

What do you know about evaluating price?

When a quotation is received from a supplier, how does the buyer know the price and terms and conditions they are proposing are fair, reasonable, and competitive? If the buying organization has a long-term supplier, how do they know the price they continue to charge is fair, reasonable and competitive? There are several methods to determine this. The price can be analyzed by comparing the supplier prices against other suppliers and external price benchmarks. The cost elements that make up the final price can also be analyzed. Another option is analyzing the total cost of ownership by analyzing the lifetime costs associated with buying a good or service. There are also other concepts to consider when evaluating prices, such as learning curves and discounts.

How does one know if a price analysis, cost analysis, or total cost analysis should be done? If products have many potential suppliers and competition exists, a price analysis should be conducted. If there are few suppliers and adequate price competition does not exist a cost analysis should be performed. A total cost analysis should be done on all procured items as it is important to understand the total value being received from a supplier.

Price Analysis

Price analysis is a method of looking at a price and deciding if the price is fair and reasonable without looking at specific elements. The price is compared with information such as pricing from other suppliers, historical prices, indexes, catalogue pricing, comparable product prices, and prices paid by other customers to determine reasonableness.

Methods of Price Analysis

Competition Analysis

Comparing quotations received when competitively bidding items and prices from published lists from multiple vendors is a way to determine if prices are fair and reasonable. Bids and listed prices within a reasonable amount of one another are considered competitive bids/prices. Bids that are considerably lower than their competitors should be evaluated for reasonableness. The considerably lower supplier should be investigated for past performance with other customers and/or the bid. The supplier needs to be analyzed to ensure the bid includes all required components and no mistakes have been made in preparing the bid.

Analysis of Previous Prices Paid

If the buying organization has purchased the same item before, the historic prices can be used and increased/decreased based on inflation and volumes to determine if the price is reasonable. If a price cannot be obtained for the exact item but can be obtained for a similar item with commercially available pricing, the price can be adjusted based on the differences between the items. The price differences need to be detailed and the price of the extras need to be compared to other purchases with similar differences or evaluated by technical experts. Historical prices paid by other customers can also be used to determine if the price is fair and reasonable.

Compare Price Sold to Public Sector Contracts

The Federal and Provincial Governments frequently buy many goods and services. Government bids are open to public inspection; as a result, a price offered by a supplier can be compared to a public sector bid. This would be sufficient information to determine if the price is fair and reasonable. When comparing prices with government contracts, volume discounts need to be considered. Information on goods bought and sold to the Government of Canada can be found at Public Services and Procurement Canada. Information on goods bought and sold to the Province of Ontario can be found at the Ministry of Government and Consumer Service’s Supply Chain Ontario.

In-House Estimate

If no other information is available, in-house engineers and financial analysts can prepare an in-house estimate to determine if the price is fair and reasonable.

Market Price Analysis

For market-based products where the price is largely a function of supply and demand, Indexes can be used to determine if the price is fair and reasonable or if you should negotiate a better price. An index you can use to determine if a price is fair and reasonable is Index Mundi.

Example 5.1 Market Price Analysis:

Company Z was paying $52.50 for iron castings on November 30, 2013.  On April 30, 2014, their supplier increased the price to $53.20 / unit.  Is this price increase fair or should you negotiate a better deal?

Go to  Index Mundi and click on “Commodities” under “Sector”.  Then click on the pull-down menu for “Metals” and choose “Iron Ore”.  Click on the 10-year range.  The price for Iron Ore in November 2013 was $136.32 USD per metric ton.  The price for Iron Ore in April 2014 was $114.58 USD per metric ton. (IndexMundi, n.d.)

The price increase received from the supplier is ($53.20 – $52.50)/52.50 = 1.3%

The price increase in the iron order is ($114.58 – $136.32)/136.32 = -15.9%

In this case, the price increased by 1.3% but the index decreased by 15.9%.  The purchaser should definitely question the supplier about this price increase and negotiate a better price.

Cost Analysis

A cost analysis is a process of analyzing each individual cost element that makes up the final price. These individual items can include but are not limited to direct and indirect labour, direct and indirect materials, tooling costs, overhead, equipment, General and Administrative expenses, and profits. Cost analysis involves analyzing all of these elements. Overhead and General and Administration rates may be evaluated and found fair by the supplier providing an explanation of how the rates were established and by comparing to other suppliers and benchmarks. The number of hours proposed can be supported with actuals or evaluated by the buying organization’s engineers. Material costs and equipment costs can be verified with quotations. Hourly rates can be compared with industry rates and actual hourly rates paid to employees. The profit rate charged can be compared to profits charged by similar industries and is always negotiable.

Example 5.2 Cost Analysis:

The following quote was received from Supplier X for Gadget B based on an order of 300. Table 5.1 is a breakdown provided by the supplier as to how the price was calculated.

*Includes scrap factor of 20%

The buyer analyzed and researched these costs. The Material Costs were found to be reasonable as the supplier provided quotes for the material from three different suppliers and $5.50 was based on the lowest cost and 20% scrap was in line with industry benchmarks. The buyer along with a team visited the supplier did a walkthrough of the manufacturing process. The buying organization’s team felt the seven hours of Direct Labour was too high. The seven hours was based on the time it took to manufacture the very first Gadget B and therefore did not consider a learning curve. The buying organization negotiated six labour hours when considering the learning curve. The hourly rate was determined to be fair and reasonable based on actual salary rates paid by the supplier and industry standards. The tooling costs were based on an order of 300. The buyer expects to place a follow-on order of another 300 units next year and negotiated that the tooling costs be spread over 600 units rather than 300 units resulting in tooling costs being $1.50 per unit. The production overhead head rates and General and Administration Rates were found to be reasonable as they have been certified at this rate for government contracts. The profit rate of 10% was negotiated to 7% with the promise that the supplier will receive the follow-on order for the next year if it is realized.

As a result of this cost analysis and negotiations, the savings per unit are $209.68 – $174.50 = $35.18, resulting in $10,554 in savings in the first year.

Total Cost of Ownership Analysis

According to Supply Chain Management Quarterly, businesses are finally beginning to grasp the importance of emphasizing value over price:

For significant spend areas, procurement teams at best-in-class companies are abandoning the outmoded practice of receiving multiple bids and selecting a supplier simply on price. Instead, they consider many other factors that affect the total cost of ownership. This makes good sense when you consider that acquisition costs account for only 25 to 40 percent of the total cost for most products and services. The balance (and majority) of the total comprises operating, training, maintenance, warehousing, environmental, quality, and transportation costs as well as the cost to salvage the product’s value later on. (Engel, 2011, para. 19)

A good practice for purchasers is to estimate the Total Cost of Ownership before selecting the preferred supplier. The Total Cost of Ownership (TCO) includes the purchase prices of items and other costs expected to be incurred during the life of the product. It considers total costs of acquisition, use, administration, maintenance, and disposal of goods and services (LINCS in Supply Chain Management Consortium, 2017)  Total Cost of Ownership is sometimes referred to as Total Landed Cost (TLC). Some additional costs to include in the Total Cost of Ownership may include follow-up, expediting, inbound transportation, quality, inspection, testing, rework, storage, scrap, warranty, service, downtime, customer returns, lost sales, and end-of-life costs.

Watch this video for an explanation of The Total Cost of Ownership:

P&S Buddy. (2016, October 8). Total Cost Of Ownership [Video]. YouTube. https://youtu.be/YKdcEOTA7Pk

Example 5.3:  Choosing a supplier using Total Cost of Ownership

Company A in London, Ontario received two quotes from Supplier X and Supplier Z for Gadget Cs based on an order of 1 million units. Supplier X quoted a unit price of $127 and Supplier Z quoted a price of $144. The buying company is located in London, Ontario. If the supplier was chosen on the lowest price Supplier X would have been chosen. Table 5.3 outlines the information that outlines the information needed to conduct a Total Cost of Ownership and compares Supplier X and Supplier Z.

In doing a Total Cost of Ownership, Supplier Z is the lowest total cost supplier even though Supplier X has the lowest quoted unit price. The lower transportation, duties, customs, insurance, safety stock, and administrative costs associated with having a local supplier resulted in this lower total cost of ownership. This $5.62 unit cost different totals $5,620,000 for the entire 1 million unit order.

Learning Curve Analysis

When analyzing the costs associated with a price proposed by a supplier, the Learning Curve should be considered. Suppose a product or service has direct labour and is being produced for the first time or is young in its production life cycle. In that case, the manufacturer will become more proficient in said product’s production with experience. The Learning Curve is defined by APICS (2011) as “a phenomenon where the labour content of large manufacturing projects, such as aircraft, decline steadily as cumulative production increases. This decline in labour content is predictable and related to a doubling of production. The curve takes the form of an exponential decay curve”. For example, if the item being produced has an 80 percent learning curve, every time the volume doubles, the time per unit drops to 80 percent. The improvement process may have a considerable impact on the buyer’s total purchase price. It should be considered that a supplier’s costs will decrease as volumes increase and a buyer should look for this in the supplier’s quotations.

Watch this video for an explanation of Learning Curves:

Policonomics. (2015, November 24). C.8 Learning curve | Cost- Microeconomics [Video]. YouTube. https://www.youtube.com/watch?v=ftbPnUSRQHs

NASA provided the following guidelines in relation to the learning curve:

• If the process involves 75% hand labour and 25% machine labour, the learning percent is in the region of 80%.
• If the process requires equal hand labour and machine labour (50% each), the learning percent is in the region of 85%.
• If the process involves 75% machine labour and 25% hand labour, the learning percent is in the region of 90%.

(Good Calculators, n.d.)

The standard learning curve equation is as follows:

T _n = T ₁ n ^b

where,

n = the unit number (1 for the first unit, 2 for the second unit, etc.)

T_n = the amount of time to produce unit n

b = the learning curve factor, calculated as In (p)/ln(2), where ln(x) is the natural logarithm of x

p = the learning percentage

Or you can use online calculators such as Good Calculator’s Learning Curve Calculator.

Example 5.4 Learning Curves in Procurement:

The following quote was received from Supplier X for Gadget B based on an order of 300. The supplier provided the following table as to how the price was arrived at. During discussions regarding the quotation, it was discovered that the learning curve was not considered in preparing the quotation. This is the first time Gadget B has been manufactured. Gadget B involves a process that involves 75% machine labour and 25% hand labour.  What should the revised quote be if the learning curve is considered?

*Includes scrap factor of 20%

Solution:

Using the Learning Curve Calculator and considering the time to produce the first unit is 7 hours, the learning rate is 90% and the total number of units is 300. Thus, the resulting cumulative total time is 1037.428 hours. This results in the average number of direct hours per unit would be (1037.428 / 300) = 3.458 hours. Table 5.6 outlines how the buyer should negotiate a new price.

Considering the learning curve the price could be negotiated from $209.68 to $116.74. This results in a $92.94 unit savings and an overall contract savings of $27,881.

Discounts

When receiving quotations and pricing from suppliers, an additional item a buyer should consider is discounts. In negotiating prices a buyer should be requesting discounts for things like volume, paying early / or on time, and buying directly from the manufacturer.

Quantity Discounts

A buyer should request discounts based on larger volumes of items purchased. Investopedia (2021) defines quantity discounts as “an incentive offered to a buyer that results in a decreased cost per unit of goods or materials when purchased in greater numbers. A quantity discount is often offered by sellers to entice customers to purchase in larger quantities.” (para. 1). The supplier’s per-unit costs should decrease with higher volumes sold. Unit production costs should be lower due to tooling costs, set up costs, and equipment costs being spread over more units.  Material costs could be lower for the supplier due to buying in higher quantities. Transportation costs could be lower as a larger order may result in fewer trips or full truckloads compared to half-full trucks. Administration unit costs may also be reduced as it costs the same to handle a high volume order as it does to hand a low volume order.

However, a buyer must also balance the lower unit price associated with higher volumes with higher inventory costs. If the buying organization buys more and they do not use them right away they will have to store them resulting in storage costs such as increased manpower and larger warehouses.

Cash Discounts

When comparing quotations and prices from different suppliers cash discounts should be considered. Investopedia (2021) describes cash discounts as “an incentive that a seller offers to a buyer in return for paying a bill before the scheduled due date. In a cash discount, the seller will usually reduce the amount that the buyer owes by either a small percentage or a set dollar amount [..] An example of a cash discount is a seller who offers a 2% discount on an invoice due in 30 days if the buyer pays within the first 10 days of receiving the invoice”.

Trade Discounts

“A trade discount is the amount by which a manufacturer reduces the retail price of a product when it sells to a reseller, rather than to the end customer. The reseller then charges the full retail price to its customers in order to earn a profit on the difference between the amount by which the manufacturer sold the product to it and the price at which it then sells the product to the final customer.” (Accounting Tools, 2021, para. 1).  A buyer may negotiate pricing direct from the manufacture to avoid paying distributor prices.

Key Takeaways

Your job as a buyer is to negotiate a fair and reasonable price for your goods and services. To determine if the price is fair and reasonable a buyer can compare the price they are paying to other suppliers, compare to the price the buyer has paid for the same or similar product in the past, compare to public contracts, compared to an in-house estimate or do a market analysis if it is a market-based product. A buyer can also do a Cost Analysis by analyzing each individual cost element that makes up the final price. A Total Cost Analysis can also be performed to identify costs beyond the purchase price and compare suppliers on total lifetime and landed costs associated with buying that good or service. Which method is used to determine fairness and reasonableness depends on what is available to compare to, the value of the purchase, and the strategic importance of the goods and services. As suppliers make goods or provide services they get more efficient in providing these goods and services. Therefore learning curves so should be considered when determining the price being offered by the supplier is fair and reasonable. Discounts should also be offered to buyers for paying early or on time or buying higher volumes.

Review Questions

1. Explain the different methods there are to compare prices?
2. What elements can be included in a cost analysis?
3. What is the difference between a Cost Analysis and a Total Cost of Ownership analysis?
4. Why should a buyer consider learning curves when evaluating a quotation from a supplier?
5. What are the different discounts available to buyers from a supplier?

Check your understanding of this chapter’s material by completing this quiz.

References

AccountingTools.  (2021, April 12). Trade discount definition. https://www.accountingtools.com/articles/what-is-a-trade-discount.html

APICS The Association for Operations Management. (2011). APICS operations management body of knowledge framework (3rd ed.).

Engel, B. (2011, March 22). “10 best practices you should be doing now.” CSCMP’s Supply Chain Quarterly (Quarter 1). http://www.supplychainquarterly.com/topics/Procurement/scq201101bestpractices/.

Good Calculators. (n.d.). Learning curve calculator. https://goodcalculators.com/learning-curve-calculator/

IndexMundi. (n.d.). Iron ore monthly price – US Dollars per Dry Metric Ton. https://www.indexmundi.com/commodities/?commodity=iron-ore&months=120.

Investopedia. (2021, May 22). Cash discount. https://www.investopedia.com/terms/c/cash-discount.asp

Investopedia. (2021, March 20). Quantity discount. https://www.investopedia.com/terms/q/quantity-discount.asp

LINCS in Supply Chain Management Consortium. Supply management and procurement certification track. March 2017. Version: v2.26. https://www.skillscommons.org/bitstream/handle/taaccct/14294/LINCS%20Supply%20Management%20and%20Procurement%20Content.pdf?sequence=1&isAllowed=y.  

Ontario Ministry of Government and Consumer Services. (n.d.). Supply chain Ontario. https://www.doingbusiness.mgs.gov.on.ca/

Public Services and Procurement Canada. (n.d.) Find opportunities with Buyandsell.gc.ca/tenders.  https://buyandsell.gc.ca/