1. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 14 Price and Cost Analysis 14-2

3. Key Concepts General Economic Considerations »Conditions Of Competition »Variable-Margin Pricing »Product Differentiation »Six Categories Of Cost »Regulation by Competition 14-3

4. Key Concepts Price Analysis »Competitive Price Proposals »Regulated, Catalog, and Market Prices »Internet/e-Procurement »Historical Prices »Independent Cost Estimates 14-4

5. Key Concepts Cost Analysis »Cost Analysis Defined »Capabilities of Management »Efficiency of Labor »Amount and Quality of Subcontracting »Plant Capacity Sources of Cost Data »Potential Suppliers »Supply Partners »Cost Models 14-5

6. Key Concepts Direct Costs »Direct Labor »Direct Materials Tooling Costs Learning Curves »Cumulative Curve and the Unit Curve »Target Cost Estimation 14-6

7. Key Concepts Indirect Costs »Engineering Overhead »Materials Overhead »Manufacturing Overhead »General And Administrative »Selling »Recovering Indirect Costs Activity-Based Costing Target Costing Profit 14-7

8. 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 14-8

9. General Economic Considerations Conditions Of Competition Variable-Margin Pricing Product Differentiation Six Categories Of Cost Regulation by Competition 14-9

10. 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 14-10

11. Conditions of Competition Pure Competition (price taker) Monopoly (price maker) Area of Imperfect Competition Monopolistic Competition Oligopoly 14-11

12. 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 14-12

13. Product Differentiation Undifferentiated: not distinguished by specific differences Differentiated: products appear different from those of their competitors 14-13

14. Six Categories of Cost Variable Manufacturing Costs Fixed Manufacturing Costs Semi Variable or Mixed Manufacturing Costs »Examples: Maintenance, Utilities and Postage Total Production Costs »Sum of variable, fixed and semi variable costs Direct Costs Indirect Costs (Overhead) 14-14

15. Cost, Volume, Profit Relationships Figure 14-1 14-15

16. Regulation by Competition The factors stemming from competition determine the exact price each firm will quote That is, when faced with the realities of competition, the price any specific firm will quote will be governed largely by its need for business and by what it thinks its competitors will quote, not by costs or profits A firm tends to seek the highest price that is compatible with its long-range goals 14-16

17. Long versus Short Run Considerations In the long run, a firm must recover all costs or go out of business »Plant and machinery must be maintained, modernized, and replaced In the short run, a firm should recover variable costs and some portion of overhead rather than undergo a significant decline in business »Unless such additional business would affect the pricing of current or future orders 14-17

18. Price Analysis Competitive price proposals Regulated, catalog, or market prices Internet / e-procurement Comparison with historical prices Independent cost estimates 14-18

19. 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 14-19

20. 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 14-20

21. 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 14-21

22. 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? 14-22

23. 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” 14-23

24. 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 14-24

25. 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 14-25

26. Elements Affecting Cost Capabilities of management Efficiency of labor Amount and quality of subcontracting Plant capacity and the continuity of output 14-26

27. How Production Volume Affects Fixed Costs, Variable Costs and Profit Table 14-1 14-27

28. 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 14-28

29. Example of a Typical Request for a Cost Breakdown Figure 14-2 14-29

30. Direct Costs Direct costs are normally the major portion of product or service costs They are usually easily traceable They generally serve as the basis for allocation of supplier overhead costs A tiny reduction here is worth more to the buying firm than a major reduction in the percentage of profit 14-30

31. Direct Costs and Prices Table 14-3 14-31

32. Direct Costs Direct Labor »Allowances for rework »Geographic variations »Variations in skills Direct Materials 14-32

33. Tooling Costs Several benefits exist when a buying firm pays for and takes title to special tooling: »The buying firm gains greater control »Analysis of production costs is easier –Labor learning curve effect is reduced »Tooling can be moved if needed 14-33

34. 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 14-34

35. Uses of Learning Curves Estimation of Target Costs Improving Make-or-buy Analyses Estimating Delivery Times Developing Supplier Progress Payment Schedules 14-35

36. 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 14-36

37. Comparison of a Cumulative Average Learning Curve and a Unit Learning Curve Figure 14-3 14-37

38. A 90% Cumulative Average Learning Curve, Plotted on an Arithmetic Grid Table 14-4 14-38

39. The 90% Cumulative Average Learning Curve, Plotted on Log-Log Grid 14-39

40. Ninety Percent Cumulative Learning Curve Data CumulativeAverage labor Unit Labor hourslabor hourshours required producedrequiredrequiredper unit 1st100100100.0 2nd8018090.0 3rd7425484.7 4th7032481.0.9 X 90.9 X 100 14-40

41. Problems with Learning Curve Applications Non-uniform learning rate Low-labor-content items Small payoffs Incorrect learning rates Established items Misleading data 14-41

42. 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? 14-42

43. 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) 14-43

44. Estimating Labor Cost for the New Contract 400 10 20 30 40 60 100 200 500 1,000 (50,1000) (100,800) (400,510) Units Produced Average Labor Cost per Unit $2,000 1,000 100 200 300 500 14-44

45. 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 14-45

46. 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 14-46

47. 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 14-47

48. 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 160---- 25185.0% 44384.3 83786.0 163183.8 322683.9 We can graph these points on a log-log grid. 14-48

49. 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 14-49

50. Indirect Costs Engineering Overhead Material Overhead Manufacturing Overhead General and Administrative Selling 14-50

51. Recovering Indirect Costs A supply professional must understand how the supplier estimates and applies overhead Many suppliers use outdated overhead allocation methods that no longer reflect the true costs of the products they produce and sell A small error in estimating and applying overhead can significantly affect the final cost A supply professional should motivate a selling firm with poor cost control to improve its system of collecting and applying costs to products 14-51

52. Activity Based Costing Improves the tracing of costs to the product or service that consumed the cost Usually, these costs were arbitrarily allocated in the past using a volume based driver, such as direct labor ABC identifies the true (or more logical) drivers of indirect costs Examples of cost drivers include: number of orders, length of setups, engineering changes 14-52

53. Target Costing Target costing focuses on the price the customer will be willing to pay for a product or service »After removing a reasonable profit from the price, the target cost is identified »Designers can then focus on meeting the needs of the customer within the target cost constraint Supply professionals can apply target costing to analyses of supplier’s products and services 14-53

54. Profit Profit is the basic reward for risk taking as well as the reward for efficiency A higher profit per unit is generally justified for small special orders Products and services requiring highly technical personnel usually require higher profit A higher profit is generally justified for a firm that repeatedly turns out superbly reliable technical products 14-54

55. Profit Temporary, unfavorable supply-demand factors may force a firm to sell its products at a loss A firm that incurs the risk of manufacturing to its own design is entitled to higher profit than one that does not 14-55

56. 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 14-56

57. 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 14-57

58. 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 14-58