Chapter 2.1 Flashcards
Describe the types of costs and prices in commercial negotiations
What do all commercial organisations need to make in a free market?
They need to make a profit in the long run on their operations, otherwise they will fail through inability to pay their staff, suppliers and taxes
Direct costs
Costs that are directly associated with the production of a good or a service
Name 4 examples of direct costs
- Materials and services bought-in
- Utilities directly related to the manufacturing or delivery process
- Labour or wages
- Expenses
Indirect costs
The general running costs of the organisation - these costs cannot easily be attributed to specific products or services (also known as overheads)
Overheads (OHD)
Costs related to the overarching business structure and existence, which are normally independent of sales or turnover
Are all overheads indirect?
No
Are all indirect costs overheads?
No
Name 3 examples of indirect costs
- Materials and services not used in production
- Labour
- Expenses
Fixed costs
Business costs that remain the same irrespective of the volume of activity of a business
Variable costs
Costs that change in proportion to the output of the business. They increase as the volume of the product or service produced is increased. As sales increase, variable costs increase. As sales go down, variable costs go down. For example, the amount of material that are used or the cost of hours worked
Firm costs
Firm costs are fixed to some extent, but can move in line with predetermined criteria, such as through being tied to a particular index
Addressability of spend
Spend that is infuenceable through negotiations or application of other savings effort or leverage with suppliers
What can firm costs also be known as?
Semi-variable costs
Name 4 implications for negotiations depending on suppliers fixed and variable costs
- At high levels of output, suppliers may need to open a new factory, buy more equipment or make some other fixed-cost investment. This may mean they charge higher prices to cover this step change in fixed costs
- Alternatively they may price higher to discourage demand at high capacity levels so that they do not need to open a new factory or recruit new staff
- Suppliers with high FC:VC ratios need high volumes to break even, but once achieved may be able to offer significant discounts for bulk orders
- Suppliers with low FC:VC ratios will not be able to offer significant discounts for bulk orders as most of their costs are variable
How can you express cost information?
Through graphs that can be created through using excel and power point
What are the benefits of displaying cost information through graphs
They are more easily understood by wider stakeholder groups, and can assist in focusing them and getting their buy-in for negotiations
Give an example of a cost information graph
Spend tree
Value analysis
Process of analysing costs to identify cost reduction and cost control opportunities to ensure that a product or service production costs are as efficient as possible in order to maximise profit
Value engineering
A process used to review and amend new products to reduce costs and increase value to customers
When is understanding the cost elements that make up a price useful?
If the item you are buying is large spend item and is bought regularly or repeatedly
What does understanding cost elements allow you to apply?
Value analysis and value engineering
What acronym can be used to remind you of the 10 cost-reduction ideas
STOPS WASTE
STOPS WASTE
Standardisation
Transportation
Over-engineered
Packaging
Substitutes
Weight
Any unnecessary processing
Suppliers input
To make
Eliminate
How can you manage the risk of exchange rate movements
Pricing contracts in your own currency
What can you do to minimise the impact of currency fluctuations for international trade
Add clauses
How can you increase your leverage in regards to vendor supply capacity
Through developing an understanding of how busy their vendors are at particular times during the year or business cycle and targeting them at quieter periods
Should procurement get involved early?
Yes
Break-even (BE) point
The level of output of a business ay which revenue equals total costs
How can you make a profit
By ensuring all costs are covered by sales revenue
What is the break even point formula
Price - variable cost = Contribution
Fixed cost/contribution = break even point (volume)
Whats the formula for contribution
Price - variable cost = contribution
Absorption costing
A process where overheads are absorbed proportionally or by some defined mechanism into product prices
Marginal costing
An approach where the cost of producing one more item is clearly understood, to determine where cost boundaries occur
Dynamic pricing
The practise of varying the price for a product or service to reflect changing market conditions, in particular the charging of a higher price at a time of greater demand
What is total absorption costing?
An approach to dealing with allocation of overhead costs in which all the overhead costs such as rent, rates, premises, head office admin etc are fully recovered by being incorporated into the costs of the products created
Activity based costing
A costing model where costs are allocated proportionally to the usage
What does activity based costing recognise?
That traditional approaches such as allocating a standard percentage are relatively arbitrary and can lead to incorrect understanding of actual costs and profitability
Why will a cost driver be used to apply the overhead cost under activity based costing?
So that its real profitability can be measured
Name 4 things activity based costing looks at
- Looks at what is done in terms of activities
- Assigns costs to activities based on the resources they consume
- Provides the information required to take action and realise improvements
- Associates the cost of products with the actual effort spent
What is an ethical issue with activity based costing
In some consumer markets it may be accepted that all customers should pay the same for the sake of equity
Name 2 other cost concepts that are important in negotiations
- Cost plus
- Total cost of ownership/total cost of supply/whole life costing/life-cycle costing
What are cost plus contracts
Agreements where the contractors pricing is based on itemising allowable costs and then adding an agreed margin
Name a benefit of cost plus contracts
Reduction in the contractors contingencies
What is cost plus often associated with
Cost transparency, where the buyer can see/has access to the supplier’s costs for verification and benchmarking purposes
What is WLC/TCO/LCC
Methods for identifying and calculating the whole cost of an asset throughout its life from the ‘cradle to the grave’
What is the total cost of acquisition
It typically considers all the activities and costs associated with the procurement of goods and services but does not typically consider their running or operating costs
Total cost of ownership
Considers all of the costs associated with the planning, tendering, procurement, contract management and importantly the disposal or termination of an asset or service. It does not usually look beyond this by considering the benefits derived from the goods or services
Life-cycle costing
Used traditionally within the construction industry, life-cycle costing is normally associated with the costs of site clearance, constructing and operating a building or large piece of capital equipment but rarely includes the cost of disposing of the building at the end of its life
Whole-life costing
Includes all the elements of life cycle costing but includes other factors such as the financing of the project. Whole life costing is commonly used in relation to property, and as such considers additonal factors such as the acquisition of the land as well as associated benefits and earnings derived from the building phased over its life. Disposal in these projects is often seen at the start of the cost model as ‘site clearance’, ‘demolition’, ‘enabling works’
Name 5 factors that need to be considered when considering the total cost of supply
- Payment terms
- Delivery speed and lead time
- Service levels and response times
- Willingness and ability to hold inventory
- Provision of value-added services
Why do estimates need to be made with wide parameters?
So that competing bids or negotiated offers can be compared from the total cost perspective
Margin
Profit given as a percentage of the sales price
Mark up
The amount of profit expressed as a percentage of cost
What do mark up and margins typically do
Confidential measures used by suppliers in formulating prices
What is the formula for Mark Up (%)
Mark-up (%) = (Price - cost) / Cost x 100
What is the formula for margin (%)
Margin (%) = (Price - Cost) / Price x 100
What do mark ups and margins allow suppliers to make?
Gross profits
When would you charge a high margin
At low volumes
What is the formula for gross profit
Sales revenue - cost of sales (direct costs) = gross profit
What is the formula for net/operating profit
Gross profit - (Indirect/operation costs) = Net/operating profit
What can net/operating profit also be known as?
Profit before interest and tax (PBIT) or Earnings before interest and tax (EBIT)
Is profitability a good indicator of company strength?
Not necessarily
Zone of potential agreement (ZOPA)
The overlap between a buyer’s and seller’s MDO (most desirable outcome) and LDO (least desirable outcome) where a deal is feasible
Procure to pay (P2P)
The systems that connects the steps of the procurement process - from the commencement of the acquisition process through to the final payment
What is the main benefit of procurement teams gaining insight into other supplier’s prices costs
They will end up with a view of what a purchased input ‘should cost’
When is it important to do a should cost analysis
when procuring or buying goods or services where price benchmarking may be difficult or not applicable
Give an example of a benchmark source that can give you an indication of market prices
Hays, CIPS HR partner, publishes salary guides for procurement and supply staff and contractors
When is knowledge of cost structures critical in driving a good deal?
In situations where the purchased goods or services are fairly commoditised and easily available and the ongoing relationship with the supplier is not important
Name 6 types of pricing strategies used by suppliers
- Cost-plus pricing
- Skimming pricing
- Premium pricing
- Penetration pricing
- Marginal cost pricing
- Market pricing
What is cost plus pricing
Supplier calculates total variable and fixed costs and adds a percentage
What is skimming pricing
Adoption of a high price to take advantage of the early excitement and high levels of demand in a launch or introduction phase
What is premium pricing
Supplier determined to charge a very high price, not connected with the costs structures, usually based on its reputation and/or the perception that the product/service is of a superior quality
What is penetration pricing
Supplier attempting to enter a new market or extend its share in an established one. Characterised by price reductions to increase volume, followed by steady price increases
What is marginal cost pricing
Supplier recovers only the variable cost elements in its price
What is market pricing
Supplier sells in line with what the market is prepared to pay
Name 7 types of savings levers
- Volume concentration
- Demand management
- Best price evaluation
- Global sourcing
- Specification improvement
- Joint process improvement
- Relationships restructuring
Purchase price cost analysis (PPCA)
A detailed and systematic analysis of cost elements in a purchase price and understanding how they might fluctuate going forward
What does PPCA typically focus on?
One process, one manufacturing line, one supplier and one product or service
What is the purpose of PPCA
Method of gathering, analysing and using price and cost information in a systematic way.
What does PPCA involve?
Identifying the supplier’s price for a specific product, an assessment of prices for the same/similar products in the wider marketplace to determine where the supplier’s pricing fits within this, and an assessment of the cost breakdown of the supplier’s product (or service). The assessment can then be used to negotiate a lower price and identify cost improvement opportunities
What 7 things does PPCA allow you to do
- Set negotiating goals
- Validate pricing or support a challenge to pricing
- Identify cost drivers in the value chain
- Identify opportunities for improvement
- Establish a dialogue with a supplier based on cost versus price
- Establish supply relationships based on cost plus pricing
- Identify loss leader quotes
Name 4 scenarios where you should use PPCA
- On big spend items, relative to total purchasing spend
- On items within categories that are ‘Strategic’ or planned to move into ‘Strategic’ from ‘leverage’
- Especially on items within categories that are ‘Tailored’
- On items within categories that have major impacts on your cost base
Name 5 keys to success of PPCA
- Start building up detailed cost profiles on the categories
- Shift the emphasis in discussion with suppliers from price to cost
- Beware, across-the-board percentage price increases
- Try to obtain cost breakdowns during the initial enquiry. Suppliers tend to be most receptive at this stage
- Map out each stage of the value chain and examine them critically for cost-reduction opportunities
Name the 7 steps of getting started with PPCA
- Create a simple cost model on paper starting with your best guesses about cost categories
- Visit the suppliers, if feasible and appropriate
- Ask questions in personal interviews, round table discussions with supplier management and through solicitation tools
- Do desk research
- Update and expand your starting point cost model, filling in data as it is gathered
- Repeat the process
- Consider presenting your model to the suppliers for reaction and feedback
Work in progress (WIP)
In inventory management the expression relates to stock that is in the process of being manufactured but is not yet finished. In the service sectors the term is also used for anything between order and delivery
Name the 7 cost drivers involved in PPCA
- Material costs
- Process and labour costs
- Employment costs
- Overhead costs
- Distribution costs
- Depreciation on equipment
- Profit
Name 4 things that understanding suppliers costs assists procurement with
- Explain to internal stakeholders what drives costs and so seek to reduce these to become a more attractive customer with a lower cost to serve, attracting lower prices
- Understand what elements of expenditure with suppliers are addressable and so potentially influenceable through commercial negotiations
- Establish realistic opening offers/price positions with suppliers and walk-away points
- Know the circumstances when suppliers can afford to make price concessions without it hurting their profits too much and so focus on these
