General Economic Considerations Conditions Of Competition Variable-Margin Pricing Product Differentiation Six Categories Of Cost Regulation by Competition Price Analysis Competitive Price Proposals Regulated, Catalog, and Market Prices Internet/e-Procurement Historical Prices Independent Cost Estimates 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 Direct Costs Direct Labor Direct Materials Tooling Costs Learning Curves Cumulative Curve and the Unit Curve Target Cost Estimation Indirect Costs Engineering Overhead Materials Overhead Manufacturing Overhead General And Administrative Selling Recovering Indirect Costs Activity-Based Costing Target Costing Profit

1. Chapter 14
Price and Cost
Analysis
14-1

2. Key Concepts
• General Economic Considerations
» Conditions Of Competition
» Variable-Margin Pricing
» Product Differentiation
» Six Categories Of Cost
» Regulation by Competition
14-2

3. Key Concepts
• Price Analysis
» Competitive Price Proposals
» Regulated, Catalog, and Market Prices
» Internet/e-Procurement
» Historical Prices
» Independent Cost Estimates
14-3

4. 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
14-4

5. Key Concepts
• Direct Costs
» Direct Labor
» Direct Materials
• Tooling Costs
• Learning Curves
» Cumulative Curve and the Unit Curve
» Target Cost Estimation
14-5

6. Key Concepts
• Indirect Costs
» Engineering Overhead
» Materials Overhead
» Manufacturing Overhead
» General And Administrative
» Selling
» Recovering Indirect Costs
• Activity-Based Costing
• Target Costing
• Profit
14-6

7. 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
14-7

8. General Economic Considerations
• Conditions Of Competition
• Variable-Margin Pricing
• Product Differentiation
• Six Categories Of Cost
• Regulation by Competition
14-8

9. 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
14-9

10. Conditions of Competition
Pure
Competition
(price taker)
Monopoly
(price maker)
Area of Imperfect Competition
Monopolistic
Competition
Oligopoly
14-10

11. 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
14-11

12. Product Differentiation
• Undifferentiated: not distinguished by
specific differences
• Differentiated: products appear different
from those of their competitors
14-12

13. 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)
14-13

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

15. 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
14-15

16. 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
14-16

17. Price Analysis
• Competitive price proposals
• Regulated, catalog, or market prices
• Internet / e-procurement
• Comparison with historical prices
• Independent cost estimates
14-17

18. 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
14-18

19. 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
14-19

20. 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
14-20

21. 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?
14-21

22. 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”
14-22

23. 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
14-23

24. 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
14-24

25. Elements Affecting Cost
• Capabilities of management
• Efficiency of labor
• Amount and quality of subcontracting
• Plant capacity and the continuity of output
14-25

26. How Production Volume Affects Fixed Costs,
Variable Costs and Profit
Table 14-1
14-26

27. 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
14-27

28. Example of a Typical Request for a Cost
Breakdown
Figure 14-2
14-28

29. 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
14-29

30. Direct Costs and Prices
Table 14-3
14-30

31. Direct Costs
• Direct Labor
» Allowances for rework
» Geographic variations
» Variations in skills
• Direct Materials
14-31

32. 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
14-32

33. 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
14-33

34. Uses of Learning Curves
• Estimation of Target Costs
• Improving Make-or-buy Analyses
• Estimating Delivery Times
• Developing Supplier Progress Payment
Schedules
14-34

35. 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
14-35

36. Comparison of a Cumulative Average Learning
Curve and a Unit Learning Curve
Figure 14-3
14-36

37. A 90% Cumulative Average Learning Curve,
Plotted on an Arithmetic Grid
Table 14-4
14-37

38. The 90% Cumulative Average Learning Curve,
Plotted on Log-Log Grid
14-38

39. Ninety Percent Cumulative
Learning Curve Data
Cumulative Average labor
Unit Labor hours labor hours hours required
produced required required per unit
1st 100 100 100.0
2nd 80 180 90.0
3rd 74 254 84.7
4th 70 324 81.0
.9 X 90 .9 X 100
14-39

40. Problems with
Learning Curve Applications
• Non-uniform learning rate
• Low-labor-content items
• Small payoffs
• Incorrect learning rates
• Established items
• Misleading data
14-40

41. 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?
14-41

42. 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)
14-42

43. 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
AverageLaborCostperUnit
$2,000
1,000
100
200
300
500
14-43

44. • 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
14-44

45. • 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
14-45

46. 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
14-46

47. The Manufacturer’s Production Data
Column 1 Column 2 Column 3
Labor hours required as
Unit Labor required to produce the a % of those required
produced corresponding unit in col. 1 for the preceding unit
1 60 ----
2 51 85.0%
4 43 84.3
8 37 86.0
16 31 83.8
32 26 83.9
We can graph these points on a log-log grid.
14-47

48. 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
14-48

49. Indirect Costs
• Engineering Overhead
• Material Overhead
• Manufacturing Overhead
• General and Administrative
• Selling
14-49

50. 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
14-50

51. 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
14-51

52. 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
14-52

53. 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
14-53

54. 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
14-54

55. 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
14-55

56. 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
14-56

57. 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
14-57