1. Diploma in Procurement & Supply
Business needs in
Procurement & Supply
Session 2
Estimating costs and prices
Welcome to Session 2 – Estimating Costs and Prices

2. Session Learning Outcomes
On completion of this session you should be able to:
Explain how costs and prices can be estimated for procurement activities.
Syllabus reference 1.2
In session 2 we are going to explore how costs and prices can be estimated to support procurement activities.
The type of market data that can be found, direct and indirect costs and approaches to total costs of ownership and total lifecycle costings
In particular we are going to look at how you can use these to support your business cases.
Full information can be found in Chapter 2 of your Profex text book

3. Some definitions
Costs The total sum involved including price plus any additions that may be associated with ownership, use and/or disposal. Note: Cost is not, and should not be used as a synonym for PRICE or VALUE. (Source: adapted by CIPS from The official dictionary of purchasing & supply by KH Compton and DA Jessop) Price ‘What a seller charges for a package of benefits offered to a buyer. CIPS (2012)
Cost is the total sum involved – it will involve much more than just the price
It can also include costs such as:
Acquisition costs
Installation costs
Maintenance costs
Operating costs
Insurances
Disposal
etc

4. What is the price?
There are a range of ways prices are communicated to potential buyers including:
Standard price lists
Quotes
Negotiation
Competition
Market
Economic indices
There is a wide range of ways that prices can be communicated to buyers. You will be familiar with price lists and it may be that discounts can be achieved against ‘list prices’ subject to, for example, the quantity bought.
Buyers may be provided with a quote on request. Subject to the procurement / project these may be provided as sealed bids or tenders.
Negotiations – we will discuss price / cost analysis in a later slide
Competition – examples include auctions / reverse auctions
Market – prices determined by the market for commodities (such as precious metals) and other materials traded on market exchanges
Economic indices. The base is generally 100, over 100 denoting a price increase and under 100 a price decrease.
The more specialised or customised a buyer’s requirement is the less likely there is to be a ‘standard’ price or price list and as such prices are more likely to be negotiated based on the buyer's requirements

5. Research Primary research Secondary research Quantitative research
Qualitative research
It is important when looking at the cost/price that procurement professional do their Market Research, but this can be expensive both in terms of time and money. However any purchase should not be undertaken without some kind of market intelligence having been undertaken
Formal Market research is more appropriate for strategically important procurements and tools such as Kraljics matrix discussed in Session 1 can help identify these.
Primary research is research undertaken for a specific purpose and the research data is acquired directly from the relevant source. An example of primary research would be a supermarket chain gaining primary data directly from its customers using a questionnaire.
Secondary research makes use of secondary data – data that have already been gathered for another purpose. Secondary research is often referred to as desk research – based on the image of someone sitting at a desk looking up information that already exists – a process made much easier by the internet!
Sources of primary data include: questionnaires, interviews, observations, focus groups, etc.
Sources of secondary data include: trade press, published research reports.
There are advantages and disadvantages of both primary and secondary research. As a general approach secondary research is undertaken prior to primary research.
Two commonly used terms in marketing research are qualitative and quantitative, often abbreviated to qual and quant – although not in an examination or formal report!
Quantitative data focuses on numbers. For example 85% of people asked said….
Qualitative data focuses on issues such as thoughts and feelings
To use the example of a house
Quantitative data would give you information such as how many bedrooms, the size of each bedroom
Qualitative data would give you information such as ‘it smells a bit damp’, ‘it looks unloved’
But to focus on the role of research in procurement and costs and prices in particular– please see the next slide

6. Primary sources of market data on costs and prices
Communication with suppliers
The buyer’s database of market data
The marketing communications of suppliers
Online market exchanges, auction sites and forums
Advisory and information services
Trade fairs, exhibitions and conferences
Informal networking and information exchange
There are numerous primary sources of market data that you can use to find information on costs and prices. These include but is not limited to those set out on the slide.
Pages 24 and 25 of your profex book provides you with numerous examples of primary and secondary data sources

7. Secondary sources of market data on costs and prices
Financial and trade or industry press
Published economic indices
Published and online market analysis
Published statistical surveys compiled by the government
Price listing and price comparison websites
The internet is a great source of market data on cost and price and makes pulling together all of this information in to one place much more effective.
Secondary sources include those detailed on the slide.

8. Suppliers pricing decisions
External factors
Prices charged by competitors
Extent of competition (market structure)
The nature of competition in the market
Market conditions
Market penetration
Customer perceptions of value
Price elasticity of demand
What a particular (desirable, powerful) customer is prepared to pay
Environmental factors affecting the cost of raw materials
Environmental factors affecting demand and affordability
Suppliers take a wide range of both internal and external factors when setting / negotiating prices.
It is essential for a supplier to charge ‘the right price’ If prices are too high they will not achieve the required level of sales If prices are too low they will not make sufficient profit.
Pricing decisions are critical to how an organisation fares competitively and ultimately to its survival. Often a company will try and undercut competitors in order to gain market share and put competitors under pressure
The above are just some examples of the external factors suppliers may need to consider

9. Suppliers pricing decisions Cont/d
Internal factors
Costs of production and sales
How badly the supplier needs the business
Risk management
How attractive a particular customer is
Financial position and product portfolio
Where the product is in its ‘lifecycle’
Shareholders’ expectations and managerial objectives in regard to profit margins
The strategic objectives of the organisation
As well as external factors buyers need to consider a number of internal supplier factors - above are some examples of the internal factors suppliers may need to consider when making pricing decisions

10. Supplier pricing strategies
Cost based pricing
Market driven pricing
There are a wide range of pricing strategies that a supplier organisation (or indeed any organisation) can adopt
We will be focusing on two broad types of pricing strategies and discussing each in more detail.

11. Cost-plus or mark-up pricing Marginal pricing
Cost based pricing
Full-cost pricing
Cost-plus or mark-up pricing
Marginal pricing
Rate of return or ‘target return’ pricing
Contribution pricing
Section 2.3 of your profex book goes into detail on cost based pricing
Examples of cost based pricing strategies are: -
Full cost pricing - is the practice where the price of a product is calculated by an orgainsation based on its direct costs per unit of output plus a markup to cover overhead costs and profits
Cost plus or mark-up ricing = A  pricing method in which a fixed sum or a percentage of the total cost is added to the cost of the product to arrive at its selling price
Marginal pricing = Selling at a price that is above the marginal cost but below the total of full cost which includes all overheads. Marginal pricing is based on the assumption that since fixed and variable costs are covered by the current output level, the cost of producing any extra unit (marginal output) will comprise only of variable costs of additional labour and materials consumed Rate of return = Rate of return is a profit on an investment over a period of time, expressed as a proportion of the original investment. The time period is typically a year, in which case the rate of return is referred to as annual return
Contribution pricing = Method of estimating a product’s selling price so that the price, at the least, contribute to the gross income even if a net income is not possible ie it covers it own costs.

12. Market driven pricing Price volume
Market share pricing (or penetration pricing):
Market skimming
Current revenue pricing (or contribution pricing)
Loss Leader
Promotional pricing
Market segment pricing (also called differential pricing or price discrimination)
Competition pricing (or dynamic pricing)
Examples of market driven pricing strategies for the exam are: =
Price volume – price based on volumes bought the general premise being the more you buy the less you par per unit.
Market share (Penetration) pricing includes setting the price low with the goals of attracting customers and gaining market share. The price will be raised later once this market share is gained
Market skimming - goods are sold at higher prices so that fewer sales are needed to break even. Selling a product at a high price, sacrificing high sales to gain a high profit is therefore "skimming" the market. Skimming is usually employed to reimburse the cost of investment of the original research into the product: commonly used in electronic markets when a new range, for example ’Apple’ products are firstly dispatched into the market at a high price.
Current revenue pricing - Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs
Loss Leader - A loss leader or leader is a product sold at a low price (i.e. at cost or below cost) to stimulate other profitable sales. This would help the companies to expand its market share as a whole
Promotional pricing - the price is set to align with a wider marketing plan ie Buy one get one free
Market segment pricing -Setting a price based upon analysis and research compiled from the target market. This means that marketers will set prices depending on the results from the research.
Competition (Dynamic) pricing - Dynamic pricing is a pricing strategy in which businesses set flexible prices for products or services based on current market demands. Business are able to change prices based on algorithms that take into account competitor pricing, supply and demand, and other external factors in the market
For the exam you will need to be able to describe each one and when you would use them – refer to your proflex book for practical examples

13. Buyers pricing decisions
Relative bargaining power
Number of potential suppliers
Type of purchase
Prices paid by competitors
The total value offered
What can be afforded
What is a ‘reasonable’ price
What is a ‘fair’ price
If you work for a large and significant organisation you are likely to be in a stronger position to negotiate prices
If there are multiple routes to are market as a buyer you are likely to be in a stronger position to negotiate prices
How business critical / strategic is the purchase? If an item is non business critical you may be more prepared to use a cheaper untested provider.
Paying more for supplies than a competitor is unlikely to help an organisations competitive position.
A higher price may offer better value subject to the additional benefits offered by a supplier
A fair price refers to whether a price is fair and sustainable price from both parties perspective.

14. Price and cost analysis
Price analysis – is the price offered to the buyer by the supplier fair and appropriate Cost analysis – a supplier is required to justify it’s price in relation to the cost of production. Open book costing Cost transparency
‘Price analysis is designed to show that the proposed price is reasonable when compared to current or recent prices for the same or similar goods and services, adjusted where necessary to reflect changes in market conditions, economic conditions, quantities, or / and terms and conditions, under contracts that resulted for adequate price competition achieved through a request for quotation or tendering process’ Lysons and Farrington (2012)
‘Cost analysis is the review and evaluation of the separate cost elements, overhead recovery and profit in the tendered price (including cost or pricing data or information other than cost of pricing data) and the application of professional judgment to determine how appropriate the proposed costs are to setting the purchase price, assuming economy and efficiency. Lysons and Farrington (2012)
If there is an close, long term buyer / supplier relationship the supplier may be prepared to provider the buyer with information about their costs. With cost transparency both parties share cost information with the aim of collaborating on joint cost reduction initiatives .

15. Costs Components of the costs base
Raw materials (and/or components, subassemblies and consumables)
Labour
Overheads
In section 3 of your Profex book we now turn to understanding the components of the cost base and how these can be calculated
The cost of an item is based on
Raw materials
Labour and
Overheads
It is important to note that profit is not a cost!

16. Direct and indirect costs
Main examples include
direct materials
direct labour
Indirect costs
Often many and varied
Direct costs are costs that can be directly attributed to the production of a unit of a specific good or service.
Main examples of direct costs are direct materials and direct labour
Indirect costs are also referred to as overheads
Indirect costs are all other costs – those that cannot be measured directly in relation to each unit produced.
An example
You run a small carpentry firm that designs bespoke tables.
Direct costs Indirect costs
The carpenter’s wages Depreciation of the tools used by the carpenter
The cost of the wood/ materials used The rent of the warehouse where the materials are stored
for the job

17. Total costs
The diagram above gives a useful overview of a manufacturers operating costs .

18. Fixed and variable cost
Fixed costs – costs that stay the same even though the volume of activity changes - these could include HR costs
Variable costs – costs that vary according to the volume of activity
It should be noted that small changes in volume may not impact on fixed costs ie storage however if the business has a significant increase in output it may be that all costs need to be reviewed.

19. Understanding costs The importance of understanding costs
Some other cost issues
Calculating costs
Profit
Contribution
Break even analysis
A good understanding of a suppliers costs will help you better understand their pricing strategy and inform your price negotiations
The two main approaches to calculating costs are marginal costing and absorption costing
Profit – as we said earlier – profit is not a cost.
Profit is the difference between what it costs to produce an item and the selling price
The objective of most businesses is to make a profit
‘It is important to allow suppliers to make a reasonable profit’ (CIPS 2012)
Why? For example, if you don’t the supplier may go out of business endangering supply. If you don’t it could jeopardise quality. If you don’t jobs could be put at risk. It is important to also consider corporate social responsibility and sustainable objectives.
Contribution – sales revenue per unit less the variable cost per unit. This is called the contribution as it is the contribution made to meeting the fixed costs. Knowing the contribution per unit enables us to calculate how many units we need to sell in order to break even and how many we need to sell to go on to make a profit.
Breakeven analysis – the diagram on the Fixed and variable costs slide is a typical visual representation of a break even analysis – the break even point being the point at which the variable cost line crosses the fixed cost line.
The formula for calculating a breakeven point is:
Breakeven point (units) = Fixed costs
______________________________
Selling price minus variable costs per unit

20. Lifecycle costing Total cost of ownership Whole life costing (WLC)
Investment appraisal methods
Accounting rate of return (ARR)
Payback period (PP)
Discounted cash flow (DCF)
Internal rate of return (IRR)
There is an important difference between the purchase costs of an item and the total lifecycle costs
There are three phases to the total lifecycle of a product or service
Pre production
Production
Post production
There are costs associated with each. For example – pre-production costs could include research and development, set up costs etc
Post production costs could include decommissioning.
Other costs over and above the purchase price can include:
The cost of finance
Costs of delivery, installation, commissioning
Transaction costs – for example taxes, costs of developing the contract, foreign exchange costs
Operating costs – spares, servicing, operator training, etc.
Storage costs and any other handling, assembly or finishing needed
Quality costs – costs of inspection, reworks, rejects , lost sales, customer compensation etc
End of life cots – decommissioning, removal, disposal etc. On the other hand if there is a resale value there may be an income (negative cost)
Whole life costing (WLC) is also known as lifecycle costing or through-life costing
There are four methods businesses tend to use to evaluate investment opportunities
Accounting rate of return (ARR)
Payback period (PP)
Net present value (NPV)
Internal rate of return (IRR)
ARR = Average annual operating profit
___________________________ x 100%
Average investment to earn that profit
For a project to be acceptable to an organisation it much achieve a target ARR as a minimum
PP - this is the time taken for an initial investment to be repaid out of the project’s net cash inflows. For a project to be acceptable the payback period should be no longer than the maximum payback period acceptable to the organisation.
NPV – discounted cash flows enable us to calculate the net present value of an asset. The basic premise of DCF is that a £100 received in a year’s time Is not equal to a £!00 received now. Three basic reasons for this are: interest lost, risk and inflation. Therefore we apply a discount factor to future cash flows to enable us to calculate the present value.
IRR – the IRR is the discount rate that when applied to future cash flows produces a NPV of zero.

21. The price-cost iceberg
The above diagram by (Bailey, Farmer, Jessop and Jones 1998), shows just some of the costs in addition to price that need to be considered.
Some may be within the price, some may not be
There is often a trade off between price paid and the total package of benefits received
So best value may not be the lowest price
Best value can more appropriately be defined as the lowest whole life costs that meets the purchasers requirements.
Bailey, Farmer, Jessop and Jones 1998 ,

22. Statistical forecasting techniques
Simple moving average
Weighted average (or exponential smoothing)
Time series (trend) analysis
Regression analysis
Controlling costs involves estimating in advance what costs are expected to be, comparing the estimate with the actual and investigating variances.
Will will talk more abut budgetary control in the next unit.
But in order to estimate effectively we need to understand how costs behave.
Fixed costs are just that fixed – well until production reaches a point when they ‘step up’. For example where volume of production reaches a point where the company needs to rent additional space.
We discussed fixed and variable costs earlier.
To introduce a new term – semi variable costs (sometimes also referred to as semi fixed costs) – these are costs that have an element of both fixed and variable costs. An example is electricity in a hair dressers – some of the electricity will be used for heating and lighting (fixed) some will be used for drying hair – this will variable with the level of activity (variable cost) hence electricity in this company is a semi variable costs.
Cost estimate generally use four main sources of information
Historic data
Current data
Market research / environmental monitoring
Above are four techniques for forecasting future costs. These have their strengths but are unlikely to account for all the various environmental factors that could cause costs to vary. Hence the need for more qualitative market research such as supply market research and gaining the opinion of experts.
Please refer to pages 36 and 37 Profex for more detail on statistical forecasting

23. Estimating or predicting costs
What are the direct or variable costs of sales?
What are the indirect or fixed costs or overheads?
Premises costs
Labour and staff costs
Utilities
Printing, postage and stationery
Equipment costs
Fleet and vehicle costs
Advertising, promotion and sales activities
Financing costs
Legal and professional costs (including insurance)
What are the one-off capital costs for the period or project?
Estimating costs can involve a range of personnel / functions including procurement staff and colleagues from, for example finance and accounts and marketing
Going back to the Business case – business case goals are usual stated in the form of a budget – in our case a procurement budget
Preparing a budget involve:
Establishing projected sales demand for a product / service
Establishing projected usage of materials, components, etc.
Estimating or predicting costs - see the list of potential costs above
Remember – historical data alone may not be enough. Foe example - what if the rate of inflation changes? What is the structure of the supply market changes?
It is important to note that we have talked about profit / costs etc. but it is said that most business fail not because they don’t make a profit but because they don’t have any cash! It is important that companies many their cashflow effectively – more about cash flow in the next unit .