Price and Cost Analysis in the Supply Chain – Total Cost of Ownership SCM 432 and 652 UNCG Larry R. Taube

Introduction Obtaining materials at the right price can be a firm’s success or failure Price or acquisition cost, is largest component of total cost. Right price, a fair and reasonable price to both the buyer and the seller no magic formula for calculating The right price is not equal for all suppliers

General Economic Considerations Conditions Of Competition Variable-Margin Pricing Product Differentiation Six Categories Of Cost Regulation by Competition

Conditions of Competition Three fundamental types of competition exist: – Pure Competition Supply and demand determines prices – Imperfect Competition Monopolistic Competition Oligopoly – Monopoly One seller controls entire supply

Conditions of Competition Pure Competition (price taker) Monopoly (price maker) Area of Imperfect Competition Monopolistic Competition Oligopoly

Price Elasticity Generally any change in price will have two effects: – the price effect : For inelastic goods, an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. (The effect is reversed for elastic goods.) – The quantitiy effect: increase in price will decrease unitsold; decrease in price will increase units sold – F(substitutes, income, necessity, duration, brand loyalty, who pays)

How Prices are Set Cost approach – Price is set greater than direct costs, allowing for sufficient contribution to cover indirect costs and overhead, and leaving a margin for profit Market approach – Prices are set in the marketplace and may not be directly related to cost Income approach – Price set based upon the income streams of investments

Regulated, Catalog, and Market Prices Catalog Price – Price included in a catalog or list – Must be dated – Readily available for customer inspection Market Price – Price equals interaction of many buyers and sellers – Supply and demand establish prices

SCM602 Variable-Margin Pricing Frequent in suppliers that sell a line of products Pricing is based on whole line Results in prices on some products that are too high Some prices are also artificially low

Product Differentiation Undifferentiated: not distinguished by specific differences Differentiated: products appear different from those of their competitors

Price Analysis Competitive price proposals Regulated, catalog, or market prices Internet / e-procurement Comparison with historical prices Independent cost estimates

Competitive Price Proposals At least two qualified sources have responded The proposals are responsive to the buying firm’s requirements The supplier competed independently for the award The supplier submitting the lowest offer does not have an unfair advan­tage over its competitors The lowest evaluated price is reasonable

Regulated, Catalog, and Market Prices Catalog Price – Price included in a catalog or list – Must be dated – Readily available for customer inspection Market Price – Price equals interaction of many buyers and sellers – Supply and demand establish prices

Internet / e-Procurement Advanced communications using the Internet allows supply management personnel to view up-to-date pricing Since the Internet does not have geographical constraints, the information is available worldwide Among the capabilities the Internet enables are: – Buying exchanges – Reverse auctions – Tailored global searches

Historical Prices How have conditions changed? Were there one-time engineering, setup, or tooling charges in the original price? What should be the effect of inflation or deflation on the price? Will the new procurement create a situation in which the supplier should enjoy the benefits of learning?

Independent Cost Estimates Independent cost estimates may be used as a basis for comparison of prices This method is not used if other methods are available The price developed through an independent cost estimate should be “fair and reasonable”

Competitive Bidding Bidders must be qualified to make the item in question in accordance with the buyer’s specifications and to deliver it by the date required Bidders must be sufficiently reliable in other respects to warrant serious consideration as suppliers Bidders must be numerous enough to ensure a truly competitive price Bidders must not be more numerous than necessary

Conditions for Competitive Bidding There must be at least two, and preferably more, qualified bidders The suppliers must want the business – a “buyer’s market” Specifications must be clear No collusion between bidders

Cost Analysis Defined Cost analysis is a review and an evaluation of actual or anticipated costs – It involves the application of experience, knowledge, and judgment to data in an attempt to project reasonable estimated contract costs The purpose is to arrive at a price that is fair and reasonable to both the buying and selling firms

Cost Analysis Should be employed when: – Price analysis is impractical – Or price analysis does not allow a buyer to reach the conclusion that a price is fair and reasonable Cost analysis is generally most useful when purchasing nonstandard items and services

Elements Affecting Cost Capabilities of management Efficiency of labor Amount and quality of subcontracting Plant capacity and the continuity of output

Direct and Indirect Costs Direct costs – Can be specifically and accurately assigned to a given unit of production of a product or service – Most direct costs are “variable” Indirect costs – Incurred in the operation of a production plant or service process, but normally cannot be related directly to any given unit of production of a product or service – Often referred to as “overhead”

Variable and Fixed Costs Variable costs – Vary directly and proportionally with the units of products or services produced Fixed costs – Generally remain the same regardless of the number of units of products or services produced Semivariable costs – Vary with the number of units of products or services produced but are partly variable and partly fixed

How Production Volume Affects Fixed Costs, Variable Costs and Profit Table 14-1

Direct Costs and Prices Table 14-3

Example of a Typical Request for a Cost Breakdown Figure 14-2

Sources of Cost Data 1.Potential suppliers as a precondition of submitting proposals and bids 2.Suppliers with whom the firm has developed preferred or strategic supplier relationships 3.Cost models

Independent Cost Estimates Independent cost estimates may be used as a basis for comparison of prices This method is not used if other methods are available The price developed through an independent cost estimate should be “fair and reasonable”

Learning Curves A quantitative model of the commonsense observation that the unit cost of a new product decreases as more units of the product are made because of the learning process In other words, a learning curve is an empirical relationship between the number of units produced and the number of labor hours required to produce them

Uses of Learning Curves Estimation of Target Costs Improving Make-or-buy Analyses Estimating Delivery Times Developing Supplier Progress Payment Schedules

Two Types of Learning Curves Cumulative Average Cost Curve – Commonly used in price and cost analysis – Plots cumulative units produced against the average direct labor cost or average labor hours required per unit for all units produced Unit or marginal cost curve – Used in labor and cost-estimating work – Plots cumulative units produced against the actual labor hours required to produce each unit

Comparison of a Cumulative Average Learning Curve and a Unit Learning Curve Figure 14-3

A 90% Cumulative Average Learning Curve, Plotted on an Arithmetic Grid Table 14-4

The 90% Cumulative Average Learning Curve, Plotted on Log-Log Grid

SCM602 Ninety Percent Cumulative Learning Curve Data CumulativeAverage labor Unit Labor hourslabor hourshours required producedrequiredrequiredper unit 1st nd rd th X 90.9 X 100

SCM602 Cumulative Average Curve Example ABC Corporation has purchased 50 pieces of a specially designed component at $2,000 per unit Of the $2,000 selling price, $1,000 represents direct labor An audit of product costs for the first 50 units established the operation is subject to an 80 percent cumulative average learning curve What should ABC pay for the purchase of 350 more units?

Graphing the Learning Curve All we need are two points to graph a line on a log-log grid Point #1: Average cost of 1st 50 was $1,000 each (this was given) – giving the point (50, $1000) Point #2: Average cost of the 1st 100 according to the 80% curve is: –.8 x $1,000 = $800 – giving the point (100, 800)

SCM602 Estimating Labor Cost for the New Contract ,000 (50,1000) (100,800) (400,510) Units Produced Average Labor Cost per Unit $2,000 1,

Next, we need the direct labor cost for the follow-on order of 350 units: – 400 X $510 = $204,000 – 50 X $1,000 = $50,000 – $204,000 - $50,000 = $154,000 What is the labor cost per unit? – $154,000 / 350 = $440 per unit labor cost – Quite a difference from $1,000! Cumulative Average Curve Example

Now determine the cost for materials, overhead, and profit on the 350 units Add this figure to the labor cost to obtain the total price ABC should pay for the additional 350 units Cumulative Average Curve Example

SCM602 Unit Learning Curve Example Suppose a manufacturer receives an order to produce 515 units of a new product Prior experience leads the manufacturing manager to believe that a unit learning curve will be experienced

SCM602 The Manufacturer’s Production Data Column 1Column 2Column 3 Labor hours required as UnitLabor required to produce the a % of those required produced corresponding unit in col. 1 for the preceding unit % We can graph these points on a log-log grid.

Unit Learning Curve Example Based on the data accumulated, the manager concludes that approximately an 85% unit learning curve effect exists. – Keep in mind: 64, 128, 256, 512 Based on this, it is reasonable to conclude that the 512th unit will require about 13.6 hours of direct labor

The Fixed Percentage Problem Supplier profit should not be based on a fixed percentage of the supplier’s cost For example: – Suppose an inefficient supplier has costs of $1,500 per unit, while an efficient supplier has costs of $1,000 per unit – If a 10% profit is awarded to a supplier, then the inefficient supplier would receive $150 per unit profit, while the efficient supplier would receive only $100

Total Cost of Ownership Total cost of ownership is a philosophy for really understanding all supply chain related costs of doing business with a particular supplier for a particular good or service (Lisa Ellam, May 1999)

Key Concepts TCO, Net Present Value Analysis (NPV), and Estimated Costs The Importance of Total Cost of Ownership in Supply Management – Service Providers – Retail – Manufacturing

Three Components of Total Cost Acquisition Costs Ownerships Costs Post-Ownership Costs

TCO Components Acquisition costs – Purchase price – Planning costs – Quality costs – Taxes – Financing costs Ownership costs – Downtime costs – Risk costs – Cycle time costs – Conversion costs – Non-value added costs – Supply chain costs Post-ownership costs – Environmental costs – Warranty costs – Product liability costs – Customer dissatisfaction costs

Acquisition Costs Purchase Price Planning Costs Quality Costs Taxes – Customs Duties and Tariffs – Regional Trade Agreements – Income-Base Shifting Financing Costs

Ownership Costs Downtime Costs Risk Costs Cycle Time Costs Conversion Costs Non-Value Added Costs Supply Chain Costs

Ownership Costs Supply Chain Costs – Forecasting – Administration – Transportation – Inventory – Manufacturing – Customer service – Supplier selection/relationships – Global sourcing

Post - Ownership Costs Environmental Costs Warranty Costs Product Liability Costs Customer Dissatisfaction Costs

Key Concepts Three Components of Total Cost – Acquisition Costs – Ownerships Costs – Post-Ownership Costs Purchase Price: But One Component of Cost

TCO, Net Present Value Analysis (NPV), and Estimated Costs NPV analysis is frequently incorporated into TCO analyses NPV analyzes present values of the initial expenditure along with the likely future revenue and expenditure streams The present value of a sum of future cash flows discounted by a required rate of return – NPV greater than zero suggests accepting the investment – NPV less than 0 suggests rejecting the investment – NPV = 0 is the point of indifference

Tangential Reprographics Example

TCO Formula n TCO = A + P.V.  (T i + O i + M i – S n ) i = 1 A = delivered acquisition cost P.V. = net present value T i = training costs in year i O i = operating costs in year i M i = maintenance costs in year i S n = salvage value in year n

PVA Incorporated into a TCO Analysis Acquisition Cost = $120,000 PV Cash Outflows, yrs = 23,279 PV of overhaul in yr 3 = 5,208 PV of salvage value in year 6 = (2,512) TCO = $145,975

Importance of TCO in Supply Management Service Providers Retail Manufacturing Supply Chains/Supply Networks

Service and Retail Providers Understanding what drives the cost of overhead expenditures is crucial to any service business Revenue must cover the direct costs, material and labor, and overhead in order to generate a profit – TCO analysis of recurring material costs are often overlooked and can yield great savings – TCO analysis of the labor base can reap lower per person costs, greater benefits, and improved morale – TCO analysis of equipment purchases may help reduce the expenditures for maintenance and parts over the lives of the investments

Manufacturing Manufacturers are concerned with all of the same TCO issues as service and retail firms, with some added issues Issues that are particularly important in cost analysis for manufacturers are: – Direct materials – Manufacturing overhead Emphasis should be placed on the variance between “should cost” and actual cost. – This should not be confused with price variance

Activity Based Costing A major problem in TCO analysis of manufacturers is accurate allocation of manufacturing overhead Many manufacturers have used activity-based costing to help improve cost allocation Activity-based costing (ABC) is a technique for accumulating cost for a given cost object that represents the total and true economic resources required or consumed by the object

Supply Chain/Supply Networks TCO analysis may include the study of: – Manufacturability – Infrastructure – Outsource decision – Analysis of suppliers beyond tier one – Structure of foreign and domestic tariffs/duties/taxes – Costs of delivery – Foreign regulations – Foreign political/economic stability – Foreign exchange risk – Language/communicatio n requirements – Volatility of end- customer demand – Inventory carrying costs – Inventory risk – Quality costs

Concluding Remarks The right price is one of supply management’s most important responsibilities Conditions of competition should be analyzed Cost structure should be understood Price evaluation should consider TCO

Concluding Remarks When price analysis is not possible, cost analysis becomes the basis of obtaining a fair and reasonable price All companies have hidden costs that often reside in overhead A supply professional needs an understanding of costs, cost systems, and overhead composition and allocation

Concluding Remarks TCO is an analytical tool and a philosophy Accurate estimation of total costs requires a cross-functional approach Supply management is a critical member of such a cross-functional approach TCO is also applicable in one’s private life enabling better decision-making