1. Materials Management BUS 3 – 141 Pricing and Make/Buy Decisions Weeks of Mar 15 and Mar 22, 2011

2. Page 2 2 Agenda –Price –Cost –Value –Make vs. Buy

3. Price

4. Page 4 4 Definitions What the seller is paid for goods and services provided Price The expenses incurred in operating the enterprise, making and buying materials, and converting the materials to finished goods Cost The ability to pay, without compromising cash balances Affordability The difference between Price and Cost Value

5. Page 5 5 Price –Market Price Not necessarily based on supplier cost Important for comparing alternative suppliers Required when deciding whether to make in-house or buy Good for discovering improvement opportunities for your business –Suppliers have to make profits to stay in business It is important to know what is a “reasonable” price and profit are The Selling Price is MUCH more dependent on the MARKET than on Cost

6. Cost

7. Page 7 7 Types of Costs Specifically assigned to a given unit of production Examples are: component materials, assembly labor Direct Cost Necessary to operate the enterprise, but not specifically assigned to a given unit of production (e.g. Rent, management salaries) Indirect Cost Vary directly & proportionately with the number of units produced Examples are: BOM x units produced Variable Cost Does not change, regardless of the number of units produced Examples are: Rent and advertising Fixed Cost

8. Page 8 8 Relationship of Cost to Selling Price and Profit * Adapted from Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin 1,000 Units Average Cost = $11.50 / unit Selling Price = $12.42 / unit Profit percentage = 8%

9. Page 9 9 Impact of Volume on Cost (and Selling Price ) 2,000 Units Average Cost = $9.50 / unit Selling Price = $12.42 / unit Profit percentage = 31% Changes as Volume Changes Direct materials$11,000DirectVariable +Direct labor4,000DirectVariable +Factory Overhead2,500IndirectFixed* =Manufacturing Cost$17,500 + General, administrative, and Selling cost 1,500IndirectFixed* =Total Cost$19,000 +Profit5,840 =Selling Price$24,840 Cost Behavior No Change as Volume Changes

10. Page 10 10 Comparison of Fixed & Variable Costs with Volume Understanding Supplier Fixed and Variable costs is CRITICAL to any Negotiation

11. Value

12. Page 12 12 Applying Value Principles to your Career –When you work, the company is BUYING what you are SELLING The work you do is WORTH something. Your company will continue to pay you when the work you do is worth more to them than what you cost –Do more than your Job Description You really are not paid to do a specific job; you are paid to make money for your company The more valuable that you are, the more you will get paid – either by your company or the next company –Don’t say, “It’s not my Job” Think like the Boss Pick the BEST people and try to be like them Don’t look at how little the poor performers are doing and complain that you are doing more –Think about how you can be worth MORE than what you are being paid

13. Factoring Supplier Price in Buying Decisions

14. Page 14 14 Pricing data varies for different Purchase Types Raw Materials Standard Production Items of Small Value Special Items Services Capital Goods Resale –Published market prices; bought and sold in well-organized markets –Monitor trends for opportunities to leverage unexpected dips in price –Price indexes are available for escalator clauses Raw Materials (Commodities) –Can be found in catalogues from manufacturers, distributors, and retailers –Published “list price”, with opportunities for better prices based on volume –Good candidates for online buying, using searches and/or auctions –Frequently a broad category is covered by a single Sales Representative who pools buys for volume discounts Standard Production and Items of Small Value

15. Page 15 15 Quotations and Bidding –Qualify your bidders Ability to execute the technical requirements Potential to be a Partner –Include a reasonable number of bidders (not too many and not too few) –There must be NO appearance of favoritism –Specifications need to be VERY CLEAR and not open to interpretation –Price is not the only thing that matters –Firm bid: first bid is the last bid too –BAFO Bid: Best And Final Offer – The potential supplier is given additional information after the initial bid and is given the opportunity to prove a second bid Time and budget must be planned to account for the effort of negotiations. Major negotiations should be outside routine production support. Production support should focus on delivery and quality, with pricing previously negotiated

16. Page 16 16 Alternatives when Bids are virtually Identical –Choose a supplier already doing business with you –Negotiate non-price concessions Freight Warranty Consigned inventory –Choose a supplier with social benefits Largest domestic content Women and minority owned Closest in proximity –Select based on recommendations by customers Beware of Collusion

17. Page 17 17 Key Elements of Negotiated Contracts –Price, Volume, Quality, Service –Price protection –Escalator clauses –Cancellation clauses –Liability –Ethical practices Will be covered in a subsequent chapter

18. Cost Types

19. Page 19 19 Labor and Material Costs Labor: –Direct hours worked X Hourly Rates –Often charged based on Standard Hours per job Material: –Taken from Bill Of Material (if provided) –When purchasing manufactured items, some supplier material costs can be reasonably estimated Raw material cost is openly available Component cost can be obtained from catalogues and the internet There should be little – or no – Supplier Markup on material used to make the Purchased Item

20. Page 20 20 Examples of Overhead and General & Administrative Costs Overhead: –Indirect facilities and personnel costs incurred in: Manufacturing Research Engineering –Equipment depreciation –Other General & Administrative (G&A): –Selling –Promotion –Advertising –Executive Salaries –Legal –Other Overhead and G&A are a major factor in calculating Standard Cost at expected overall volumes, but less relevant for calculating the cost of incremental units for unexpected orders or additional volumes

21. Page 21 21 Additional Cost Items –Understanding cost helps you negotiate Price –Previous estimates when analyzing make / buy decisions become a basis for understanding supplier cost –Co-workers who were previously employed at suppliers often understand supplier cost structure –Start-up costs and Setup costs are frequently separated from future unit costs Common in printing business Common in subcontract manufacturing –In New Product Development, it is recommended to separate research and start-up costs from production unit costs Nonrecurring Engineering as a separate line item Tooling as a separate line item Units produced as a separate line item

22. Target Pricing

23. Page 23 23 Target Pricing Cost Profit Sales Price Traditional: + = Sales Price (Market) Profit Cost Target Pricing: - = Instead of adding profit and cost to establish a selling price, the organization starts with the market price and required profit to establish a target cost to achieve the necessary profit. The Supply function becomes responsible for working internally and with suppliers to achieve the target

24. Page 24 24 Target Pricing drives cost reduction beyond Purchasing –Design-to-Cost on the part of Design Engineering –Manufacture-to-Cost on the part of Production –Purchase-to-Cost on the part of Supply The targets also drive cross-functional communication and shared problem-solving You get what you EXPECT and what you MEASURE

25. Page 25 25 Target Pricing is key in Defining Product Specifications 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 012345678 % of Dollars SPENT on the Item over Time % of Dollars COMMITED to the Item * For illustration only; numbers are approximations The Initial Development & Design is the biggest factor in Life Cycle spend While volume buying takes place to support full scale production

26. Make vs. Buy

27. Page 27 27 Definitions Producing the product or service with resources from your own enterprise Make Purchasing the product or service produced by resources from an outside supplier Buy Sourcing the product or service “back in” after the original Buy decision Insourcing Sourcing the product or service “outside” after the original Make decision Outsourcing

28. Page 28 28 Factors in deciding whether to Make or Buy –Quantities too small for outside tooling and economies of scale –Quality requirements are too tight for outsider to produce –Manufacturing is a core competency –Greater assurance of supply with dedicated production capacity –Lower cost –Protect Intellectual Property –Avoid sole-source dependency –Distance to supplier too great –Significant customer requires it –Backup capacity –Manufacturing is not a core competency –Supplier has expertise in a technology or product –Greater capacity –More flexible capacity –Buying Modules or subassemblies, rather than many component parts, simplifies operations –Lower risk with multiple sources of Supply –Lower cost –Negotiated unit cost removes temptation to overbuild to absorb fixed cost –Good supplier in close proximity –Significant customer requires it –Open up new markets (e.g. NAFTA) Reasons to Make (keep in-house) Reasons to Buy (go outside) There is no single “Right Answer” that applies to every business and every situation

29. Page 29 29 Insourcing and Outsourcing A Make or Buy decision can be reversed, or modified, if business conditions justify it –Supplier no longer produces the product or goes out of business –Volumes become too low –Major price increases –Reinforce the linkage between Design and Production –Projected savings of “Buy” decision were not realized Insourcing would be recommended when: –Capable suppliers have entered the market –Volumes increased dramatically –Major internal cost increases –Core competencies re-evaluated –IT systems enable effective communication and control –Government incentives Outsourcing would be recommended when:

30. Page 30 30 Risks of Outsourcing –Supplier priorities can be re-directed (often to competitors) –Limited control during times of scarcity –Original savings projections not realized –Additional fees and charges introduced after original agreement –Pricing and terms from the original agreement significantly changed in subsequent negotiations –Supply, Legal, Technical, and other resources are frequently re-directed to ensure benefits are achieved and relationships maintained –Customer, employee, market, or political criticism Domestic vs. offshore Union vs. non-union Increased turnover of key individuals

31. Page 31 31 The Role of Purchasing in Outsourcing –Ensure that an objective, fact-based decision process is in place –Provide several sources –Provide expertise in Requests for Proposals –Take the lead in developing and negotiating Contracts (with Legal) –Monitor and manage the ongoing relationship –Take the lead in negotiating subsequent contracts and identifying back- up suppliers over time

32. Other Cost Items Learning Curve & Discounts

33. Page 33 33 Learning Curve With practice and repetition, performance improves. Expected improvement can be calculated and incorporated into future cost projections The “Learning Curve” is a calculation that estimates the rate of improvement as output doubles. It implies that improvement NEVER stops. The relevance to Supply is lower price targets for future deliveries

34. Page 34 34 Discounts Discounts are a LEGITIMATE and effective means of reducing prices. They may offered by Suppliers or negotiated by Buyers

35. Total Cost of Ownership

36. Page 36 36 Total Cost of Ownership Understanding total costs is a good early step in identifying Improvement opportunity ALL costs associated with the item: –Acquisition (purchase) –Administration –Follow-up –Expediting –Transportation –Inspection & Test –Rework –Storage –Scrap –Warranty –Service –Downtime –Customer Returns –Lost Sales

37. Page 37 37 Total Cost of Ownership

38. Page 38 38 The Components of Total Cost of Ownership –Identifying need –Investigating sources –Qualifying sources –Adding supplier to internal systems –Educating: Supplier in firm’s operations Firm in supplier’s operations –Price –Order placement/preparation –Delivery/transportation –Tariffs/duties –Billing/payment –Inspection –Return of parts –Follow-up & correction –Line fallout –Defective finished goods rejected before sale –Field failures –Repair/replacement in field –Customer goodwill / reputation of firm –Cost of repair parts –Cost of maintenance and repairs Pre-transaction Transaction Post-transaction Source: Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasing and Materials Management, Winter 1993. * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

39. Negotiation

40. Page 40 40 How this Course supports Supply Chain Objective & Process The Right QUALITY The Right QUANTITY The Right TIME The Right PLACE The Right SUPPLIER The Right SERVICE The Right PRICE at the with the at the with the and paying

41. Page 41 41 Background –Not the same as “haggling” Honest Professional Fact based Data driven –Different approaches for different situations One-time purchase with a non-partner supplier (buying a car) Recurring purchases with an ongoing partner supplier Initial purchase with a potential partner supplier –Different approaches for different Purchase Types Less leverage for most raw materials, standard, and low-value items More leverage in special items and Capital Goods ABC classification is key –Get EVERYTHING in WRITING

42. Page 42 42 Relationship between ABC Classification and Negotiation –Highest dollar items need to also have the highest focus –Cross-functional teams contribute input –Significant time commitment from many people –Significant fixed cost that should be recovered in better pricing Focus negotiating efforts on the BIGGEST PAYBACK for the time and cost invested

43. Page 43 43 Different approaches for different Purchase Types Raw Materials Standard Production Items of Small Value Special Items Services Capital Goods Resale –Global sources of Supply –Potential for design and specification modifications Special Items –Very high dollar purchases –Many non-price items can be included Capital Goods –Can often be “A” items, especially with outsourcing relationships –Often very competitive market, with many alternative sources of supply Services Best Opportunity to Negotiate

44. Page 44 44 Non-price Negotiation Quality Specification compliance Performance compliance Test criteria Rejection procedures Liability Reliability Design changes Support Technical assistance Product research, development, and/or design Warranty Spare parts Training Tooling Packaging Data sharing, including technical data Supply Lead times Delivery schedule Consignment stocks Expansion options Supplier inventories Cancellation options Transportation FOB terms Carrier Commodity classification Freight allowance/equalization Multiple delivery points * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

45. Negotiation Planning and Execution

46. Page 46 46 The Basic Steps in Developing and Negotiation Strategy * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin 1. Develop the specific objectives (outcomes) desired from the negotiation 2. Gather pertinent data 3. Determine the facts of the situation 4. Determine the issues 5. Analyze the positions of strength for both (or all) parties 6. Set the buyer’s position on each issue, and estimate the seller’s position on each issue based on your research 7. Plan the negotiation strategy 8. Brief all persons on the negotiation team 9.Conduct a dress rehearsal 10.Conduct the actual negotiations with an impersonal calmness

47. Page 47 47 “Game plan” for Negotiation * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

48. Page 48 48 The “Zone of Negotiation” The overlap between what the Buyer will pay and what the Seller will accept defines the Zone of Negotiation

49. Page 49 49 The “Zone of Negotiation” There is a gap between what the Buyer will pay and what the Seller will accept. There is NO DEAL without Creativity or Compromise