Chapter 3.3 Flashcards
Recognise types of pricing arrangements in commercial agreements
Cost-plus
The cost price of an item or service plus am agreed margin
What 2 things must be very clear whether the contract is tendered or negotiated
- Which pricing model the purchaser envisages using
- Whether it is willing to look at other options
What three things must the pricing mechanisms used permit?
- Variations or changes to the contract to be adequately costed
- Price adjustments to be applied correctly
- Any recharges or distribution over different cost centres to be accurately produced
What is price
The amount expressed in units of currency to be paid by the purchaser to the supplier in order to obtain the goods or services
What is cost
The total sum of amounts paid by the supplier in order to produce the goods or provide the services
Name 5 ways in which pricing schedules in commercial contracts can be complex
- Call off contracts will not have a predetermined total price; it will depend on exactly what is called off, how many orders there are.
- Even where the total fee is known, payment might be made in stages as key milestones are reached
- The price may need to be broken down into various elements so that any changes to the contract can be accurately priced
- The price may have to be broken down for accounting reasons
- There may be changes to the scope or duration of the contract which require variation orders
Day rate
A pricing method where the contractor charges by the day
Guaranteed maximum price (GMP)
A pricing method where the contractor guarantees the maximum price a project will cost
Price schedule
Sometimes this is called a ‘fee schedule’ when it applies to professional or consultancy services. It is an appendix to a contract setting out what the prices are
What should the design of the price schedules take into account?
How the price information may need to be used, other than for the primary function of invoicing and payment
Schedule of rates
A list of prices associated with the products or services to be provided. Note that the rate may be different for different order volumes
Lump-sum
A pricing method where a single price is given for the whole project
Do price schedule and schedule of rates mean the same thing?
No, however the terms are often used interchangeably
What is the simplest pricing method?
Unit price
What is unit pricing commonly used for
Goods
What pricing is commonly used for services
Hourly or daily rates
Why may there need to be a pricing schedule for hourly or daily rates
Because the hourly rate may differ depending on the seniority or expertise of the person providing the service
When may a schedule of rates (combination rates) be produced?
Where the service being provided is a mixture of goods and services
Name 3 examples of standard schedules of rates
- APS (Australian Psychological Society)
- NHF (National Housing Federation)
- DPSA (Department of Public Service and Administration)
What are standard schedules used for?
To give a reasonable estimate of the price for a given product or service
How are pricing schedules properly incorporated into the contract as a contract document?
By a simple contract term that states that the goods or services will be charged for at the rates set out in the schedule
Are standard schedules compulsory?
Rarely
How may standard schedules be used in tendering and negotiating?
Using them as reference points against which prices can be compared
Fixed pricing
In most cases, this relates to a set of prices that have been agreed and are fixed in the contract for a period of time
Firm prices
Prices which have stability but which can move under some predetermined mechanisms. The UK MoD however reverses this logic with fixed prices being allowed to move in line with some contractual mechanisms
What is an alternative to the schedule of rates approach
Fixed-fee pricing or fixed-pricing arrangements
Name 2 circumstances where fixed-pricing arrangements can be used for services or works
- It is useful for small to medium scope projects, with short timelines, where what is delivered can be adequately specified and the likelihood of changes to the specification, scope and input costs is limited
- It can also be used where a service is repeatedly required but the specifics of which vary slightly on each occasion. It may take a shorter or longer period of time, or may need more or fewer resource inputs
Is the cost risk of fixed pricing arrangements shared between the parties?
Yes but it may not be shared equally
What is the main advantage of fixed pricing arrangements
Planning advantage. The purchaser has budget certainty, the supplier has income certainty
Will fixed-fee pricing cover the whole of the contract?
It might not
Name 2 advantages of fixed-pricing arrangements
- Budget/income certainty - prices are fixed up front and should not change
- The impact of changes to the supplier’s cost base is not fed through to the purchaser. If costs diminish, the supplier will benefit from this, and if costs rise, the purchaser will benefit
Name 4 disadvantages of fixed-pricing arrangements
- Time needed to fully specify exactly what is included and excluded in the price
- The impact of changes to the suppliers cost base is not fed through to the purchaser. If costs diminish, the supplier will benefit from this, and if costs rise, the purchaser will benefit
- Assumptions could lead to disputes
- Potential for quality issues if the fixed price is too low - supplier will deliver down to price
Why may fixed pricing and schedule of rates be combined within a single contract?
To cover different aspects of supply
Are cost plus and cost-reinbursable used interchangably?
Yes
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 business. They increase as the volume of the service or product produced is increased. As sales increase, variable costs increase. As sales go down, variable costs go down. For example, the amount of materials that are used or the cost of hours worked
How will a contract be sustainable
By at least breaking even
How do you make a profit
Income must exceed costs
What has happened once the breakeven point has been reached?
Fixed costs are covered
What can help purchasers determine whether they are getting a reasonable deal?
Understanding supplier mark ups and margins
Whats the difference between costs and income
Profit
What is mark up?
Profit as a percentage of total costs
What is profit margin
Profit as a percentage of total sales value
Where is a supplier’s overall profit margin reported?
In its income statement
What happens to the mark up if costs go up?
It shrinks
Name 3 things that may happen if a supplier starts to make a loss
- It will become disputatious
- It will become claim happy
- It will cut corners on quality
What is the formula for cost plus pricing
Cost + (cost x % mark-up) = price
What is the cost plus pricing model set on the basis of?
Cost, plus an agreed profit mark-up
What 4 things must the supplier demonstrate to reach an agreed cost figure in cost plus pricing model
- Exactly what the input costs are
- Whether they are fixed or variable
- How the variables normally move
- How much control the supplier has over them and that they are exercising that control
Name 2 advantages to the purchaser of cost plus pricing
- Value for money demonstrated by fixed profit mark up
- Risk of supplier collapse is reduced
Name 3 advantages to the supplier of cost plus pricing
- All costs are covered
- Guaranteed profit levels aid forward planning and may assist small companies in accessing cheaper credit
- Easy to justify price increases
Name 3 disadvantages to the purchaser of cost plus pricing
- Lack of certainty over supplier cost base
- Changes in the supplier cost base feed directly into the price paid, with no room for negotiation
- Supplier has no incentive to manage costs
Name 4 disadvantages to the supplier of cost plus pricing
- Profit is limited, cannot gain from cost efficiencies
- Cannot leverage market advantage to charge a higher price
- Cannot refuse price reductions in response to input cost reduction
- No incentive for supplier to reduce costs
What do cost plus contracts do in relation to risks
Place all of the risks of increased cost on the purchaser and so there is no motivation for the supplier to control cost
Name 5 possible approaches to a desire on the part of either the purchaser or the supplier to change the prices during the life of a contract
- The contract could unequivocally state that prices are fixed for the duration and there are no possible grounds for adjustment
- The contract could remain silent on the matter, not providing any grounds or mechanisms for ajustments but not ruling it out altogether
- The contract could state circumstances in which price adjustment will be considered, but leave the nature of the adjustment open for free negotiation between the parties
- The contract could state circumstances in which price adjustment will be permitted and describe how such adjustment will be calculated
- The contract could allow for automatic periodic adjustment of pricing by linking to a specified price index
Indexation
The linking of a payment (be it a price, a salary or some other due payment) to an index and the adjustment of the payment in line with the movements of the index
Price Index
A way of showing the percentage change in prices over a given period, based on the starting year (the base) which is taken to be equivalent to 100%. Indices above 100 indicate a rise; indices below 100 indicate a fall
Name the 2 most widely used indices in the UK
- Retail Price Index (RPI)
- Consumer Price Index (CPI)
What do RPI and CPI look at?
The movement in the total price of a metaphorical basket of goods commonly purchased by UK citizens
What is the percentage shift in the overall basket of goods commonly called?
The change in the cost of living
What does the change in the cost of living provide?
A simple measure of the rate of inflation
Are RPI increases greater than CPI increases?
Yes
How often are the price movements of most commodities published?
They are published on a regular basis
When is inflation negative?
When prices fall
Name an advantage of no price adjustment being permitted
Fixed price gives budget certainty to purchaser, income certainty to supplier
Name 5 disadvantages of no price adjustment being permitted
- Inflexible
- One party will gain and the other party will lose from a change in the cost base, no facility share benefits
- May lead to claims and disputes
- Could undermine sustainability of the contract
- Supplier likely to quote higher initial price to cover expected costs
When is it suitable to not permit a price adjustment
Short-term contracts which can be closely specified and will have limited or no variations
Name an advantage of the contract silent approach to price adjustment
There is an implication that no adjustments will be permitted and this may discourage the weaker party from seeking them, which is an advantage for the stronger party
Name 2 disadvantage of the contract silent approach to price adjustment
- Claims can quickly escalate into disputes as the contract offers no guidance on how to proceed
- The lack of a specified route to seeking adjustment can result in quality being ‘managed down to price’ rather than price being ‘managed up to quality’
When is it suitable to use the contract silent approach to price adjustment
Never recommended
Name the 2 advantages to the circumstances outlined, but no calculation mechanism quoted approach to price adjustment
- Clearly limits the circumstances in which discussions are possible avoiding time wasted on those where no change will be considered
- Flexibility in calculating the change could provide a greater gain for the party with more bargaining power or better negotiations
Name the 2 disadvantages to the circumstances outlined, but no calculation mechanism quoted approach to price adjustment
- Time may be wasted debating appropriate bases for the calculation, prior to the substantive discussion on what adjustment is actually sought
- Weaker negotiators will lose out
When is it suitable for the circumstances outlined, but no calculation mechanism quoted approach to price adjustment
A partially inequitable approach that might suit a party confident of their ability to influence future negotiations, while willing to give some ground to the other party in order to maintain the relationship
Name the 5 advantages to the circumstances and mechanisms described approach to price adjustment
- Clearly limits when the adjustment will be considered
- Clearly states how such adjustment should be calculated
- Contractual and legal certainty for both parties
- Can be linked to contract specific indices or general economy indices depending on the nature of the contract
- Supplier may quote lower initial price knowing that some of the risk of cost increases is covered
Name the 4 disadvantages to the circumstances and mechanisms described approach to price adjustment
- Relies on good market knowledge to be able to predict relevant circumstances and plan for them
- Failure to capture key influence could lead to a dispute
- Can distort prices if the index chosen suggests an impact that is not actually felt by the contracting party
- Reduces incentive for supplier control
When is it suitable to use the circumstances and mechanisms described approach to price adjustment
Despite the limitations this is the best option
Name an advantage of the automatic periodic adjustment approach to price adjustment
Budgetary certainty for the purchaser. Income certainty for the supplier
Name 2 disadvantages of the automatic periodic adjustment approach to price adjustment
- As normally linked to broad based indices such as the retail price index or consumer price index it can result in unwarranted price rises
- No incentive for the supplier to reduce or control costs
When is it suitable to use the automatic periodic adjustment approach to price adjustment
Not recommended - does not deliver value for money
What is a useful way of predetermining price adjustments?
Indexation
Target costs
The expected cost of making a product or delivering a service
Target fee
In a cost-plus incentive contract, the fee or profit element which will be paid if actual costs equal target costs
Sharing ratio
Within a cost-plus incentive contract, the proportion of the cost/benefit which is allocated to the purchaser and supplier
What is an incentive in the context of a contract?
An extra payment to encourage better performance
Name 3 ways that you can address the issue of the supplier having no motivation to control costs in a cost-plus contract
- Target cost
- Target fee
- Sharing ratios
Define fee
The amount payable by the purchaser over and above the cost element
What is the formula for final fee?
Target fee + ((target cost - actual cost) x supplier share) = final fee
What is the formula for final price
Actual cost + final fee = final price
What can you do to ensure that the focus on cost reduction does not harm quality aspects
Set a maximum fee
Define maximum fee
Once costs had reduced to a given point, any further reduction would not change the fee payable
Why may the supplier wish to seek a minimum fee?
To ensure that some base level of profit is achieved
What is another way of ensuring that costs are not permitted to be uncontrolled?
To set a ceiling price
Ceiling price
A maximum that will be paid by the purchaser irrespective of cost
Stage payments
A payment of part of the total fee following the completion of set ‘work stages’ or ‘project milestones’
Whats a benefit of stage payments
It can help to ensure momentum on a project as it relates directly to the supplier’s cash flow
Name 2 contract incentives
- For contracts to be extended
- For better payment terms
When should incentives be used?
Where the improvement sought is of financial benefit to the purchaser
What do payment term clauses look at?
When and how payment is to be made
Name 6 things payment term clauses include
- Documentation required
- VAT and other taxes
- Payment period and how it is calculated
- Disputed invoices and pay-less notices
- Treatment of retentions
- Remedies for late payment
Name 6 things to consider in respect of payment terms
- Documentation required
- VAT and other taxes
- Payment period
- Disputed invoices and pay-less notices
- retentions
- Remedies for late payment
Commercial Queries (CQ)
These are queries, administrative omissions or minor disputes that have arisen in the contractual operation
Pay-less notice
A formal notice under a contract stating that an invoice will only be paid in part and giving the reasons why the lower amount is being paid
Retention
A sum of money withheld from payment for a fixed period of time to be used to cover any costs associated with remedying defects that are not corrected by the supplier
