Price and Cost Analysis in the Supply Chain
- Slides: 65
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 Area of Imperfect Competition Pure Competition Monopoly (price maker) (price taker) 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
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 SCM 602
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 advan tage 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 Table 14 -1 Profit
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 Figure 14 -3 Learning Curve
A 90% Cumulative Average Learning Curve, Plotted on an Table 14 -4 Arithmetic Grid
The 90% Cumulative Average Learning Curve, Plotted on Log Grid
Ninety Percent Cumulative Learning Curve Data Cumulative Average labor Unit produced 1 st 2 nd 3 rd 4 th Labor hours required labor hours required per unit 100 80 74 70 100 180 254 324 100. 0 90. 0 84. 7 81. 0 . 9 X 90 SCM 602 . 9 X 100
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? SCM 602
Graphing the Learning Curve • All we need are two points to graph a line on a log grid • Point #1: Average cost of 1 st 50 was $1, 000 each (this was given) – giving the point (50 , $1000) • Point #2: Average cost of the 1 st 100 according to the 80% curve is: –. 8 x $1, 000 = $800 – giving the point (100, 800)
Average Labor Cost per Unit Estimating Labor Cost for the New Contract $2, 000 (400, 510) 1, 000 500 400 (50, 1000) 300 200 10 (100, 800) 20 30 40 60 100 200 Units Produced SCM 602 500 1, 000
Cumulative Average Curve Example • 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
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 SCM 602
The Manufacturer’s Production Data Column 1 Unit produced 1 2 4 8 16 32 Column 3 Labor hours required as Labor required to produce the a % of those required corresponding unit in col. 1 for the preceding unit 60 51 43 37 31 26 ---85. 0% 84. 3 86. 0 83. 8 83. 9 We can graph these points on a log-log grid. SCM 602
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 512 th 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. (Ti + Oi + Mi – Sn) i=1 A = delivered acquisition cost P. V. = net present value Ti = training costs in year i Oi = operating costs in year i Mi = maintenance costs in year i Sn = salvage value in year n
PVA Incorporated into a TCO Analysis Acquisition Cost = $120, 000 PV Cash Outflows, yrs 1 - 6 = 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 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
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