IPSCMI Monthly Newsletter 2011-1, February 22, 2011
Types of Markets and Supplier Pricing Strategies and the Buyer Analytical Methods Appropriate to Each
By Dr. LeRoy H. Graw, CPP, CPPM, C.P.M., CPCM, CISCM, CIPTC
Most of us appreciate the necessity of being prepared for negotiation. And most of us realize the best preparation for price negotiation is a thorough price analysis (sometimes supplemented by cost analysis, particularly for buyer specification items and certain industries, like defense and aerospace and architect-engineering, among others).
A key factor in buyer selection of analytical method is the pricing method used by the supplier to develop his price. The following factors should be considered by the buyer in developing the appropriate method of analysis.
Preparation of Buyer In-House Estimates
Although different organizations have different policies concerning the degree and type of documentation needed to support a pricing decision, most organizations, public and private, insist that a cost estimate be prepared by requesters on every purchase as an aid to pricing. This estimate is normally a detailed, bottom-up estimate for services (Architect-Engineering, construction, etc), and for specially engineered or fabricated hardware or one-of-a-kind items. In most supply and material purchasing, an estimate based on previous prices paid often suffices. Preparation of an in-house estimate by the buying organization is a good mental discipline, requiring the buying organization to place itself into the supplier's "shoes".
As explained below, understanding the supplier's competitive situation is important in determining the appropriate analytical method. There is a uniform policy within the purchasing community that every purchase transaction, regardless of dollar amount, should have a determination that the price is fair and reasonable. This determination is based on price analysis, (often using the in-house estimate as a basis for comparison), supplemented by cost analysis if necessary. Documentation of the facts that support a price reasonableness determination (to include a copy of the in-house estimate) should be included in the purchase file.
Degree of Competition in Markets
Most goods and services are bought in a competitive marketplace where the forces of competition cause the supplier to price his goods and services according to the competition. In these situations, the supplier is less interested in his costs and profit margin than he/she is in the prices being charged by his major competition. Effective competition is most pronounced in those industries having few barriers to entry. Even the American automobile industry provides effective competition in what is commonly referred to as an "oligopolistic industry" (few sellers and many buyers). In those situations where the buyer can rely on competition to set the price, price analysis alone will suffice to assure reasonableness of price. A cost analysis may be required as a supplement to the price analysis, particularly in situations where the presence of price competition among offerors is nonexistent or questionable.
Such a situation is often prevalent in purchases of highly specialized or extremely technical equipment or for certain services available from limited sources (specialized consulting services come readily to mind.) Because cost analysis is such a costly and administratively burdensome process, it should generally not be employed when reasonableness of price can be established by adequate price competition (or, as an acceptable substitute) by use of a comparison with catalog or market prices of commercial items sold to the general public in substantial quantities. Another special situation which often arises is in the purchasing of regulated utility services. Price competition is not present in these situations, and cost analysis is unnecessary because of the involvement of public utility commissions and other regulatory bodies in the rate-setting process. Regulated utilities provide services at prices set by law or regulation. Price analysis alone (comparing the offered prices against the regulated rate) is sufficient in those instances.
Matching Buyer Analytical Method With Supplier Pricing Method
The buyer must understand the degree of competition in the marketplace in order to determine the method used by the supplier to price his products and/or services. If the supplier is operating in a market where there is effective competition, the supplier will generally price to the competition. In that circumstance, the supplier will be less interested in his costs and a reasonable mark-up on those costs than he/she will be in pricing the product or service to beat the competition. The forces of competition will operate to keep the supplier's offered prices fair and reasonable. Because the supplier based his/her price on a "bottom-line" basis, the buyer should respond by using a "bottom-line" analytical method, which is, of course, price analysis. If, however, the supplier is free to pass on all of his costs plus a substantial profit amount to the buyer as a result of operating in a market without effective competition, the buyer should respond to this "bottom-up" pricing with a "bottom-up" analytical method, which, is of course, cost and profit analysis, supplemented with price analysis. This concept is illustrated in the diagram below:
IF THE SUPPLIER ESTIMATES BASED ON: THE BUYER SHOULD USE:
1. "BOTTOM LINE" COMPETITIVE PRICING "BOTTOM LINE" PRICE ANALYSIS
2. "BOTTOM-UP" COST & PROFIT BUILDUP "BOTTOM-UP" COST AND PROFIT
ANALYSIS (W/ PRICE ANALYSIS)
Notice the one analytical method appropriate to all markets is price analysis. Price analysis should be used to supplement cost analysis in situations where there is ineffective competition because it serves to answer the question: "What would the supplier charge if he were operating in a competitive market-place". Many experienced analysts maintain that price analysis is more powerful than cost analysis for that very reason. They also believe it is possible to generate multiple negotiation positions more easily using both cost and price analysis than it is using cost analysis alone.
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