PRICE AND COST ANALYSIS
© American Certification Institute, 2004

Purchasing and Supply Chain Managers must become experts at cost and price analysis. Not only that. They must be experts at knowing when to employ the two methods. This article provides such guidance.

Price analysis is the process of examining and evaluating a proposed price without evaluating its separate elements of cost and profit. It may be accomplished by the following comparisons, which are listed in their relative order of preference:

• Comparison with other prices and quotations submitted.
• Comparison with published catalog or market prices.
• Comparison with prices set by law or regulation.
• Comparison with prices for the same or similar items.
• Comparison with prior quotations for the same or similar items.
• Comparison with market data (indexes).
• Application of rough yardsticks (such as dollars per pound or per horsepower or other units) to highlight significant inconsistencies that warrant additional pricing inquiry.
• Comparison with independent estimates of cost developed by knowledgeable personnel within the Buying organization.
• Use of value analysis.
• Use of visual analysis.

Cost analysis is the review and evaluation of the separate cost elements included in an offeror's cost proposal, including the judgmental factors applied by the offeror in projecting from historical cost data to the estimated costs included in the cost proposal. Cost analysis is done to help the buyer form an educated opinion on the degree to which the proposed costs represent what the contract should cost, assuming reasonable economy and efficiency. It includes the verification of cost data, and evaluation of cost elements, including:

• The necessity for and reasonableness of proposed costs.
• The offeror's projection of cost trends, on the basis of current and historical cost or pricing data.
• A technical appraisal of the estimated labor, material, tooling and facilities requirements and of the reasonableness of scrap and spoilage factors.
• The application of approved indirect cost rates, labor rates, or other factors.

Among the evaluations that should be made, where the necessary data are available, are comparisons of an offeror's current estimated costs with:

• Actual costs previously incurred by the same supplier or offeror;
• Previous cost estimates from the offeror or from other offerors for the same or similar items.
• Other cost estimates received in response to the solicitation.
• Independent cost estimates by technical personnel.
• Forecasts of planned expenditures.

Price analysis is generally the simplest transactional analysis technique and is considered the least resource intensive. Price analysis can be conducted in a relatively short period of time and can normally be conducted by the buyer without any outside assistance from members of the "Pricing Team". Price analysis with incremental cost analysis adds complexity to the analysis and requires more resources by virtue of the fact that certain elements of cost (but not necessarily all) require some degree of cost analysis. A common situation calling for this technique occurs when the buyer is purchasing modified commercial items. The basic unmodified item can be analyzed by use of price analysis and the modifications can be analyzed by partial cost analysis. The buyer can often perform this type of analysis on his/her own, but may require assistance from one or more members of the "Pricing Team". Price and (full-blown) cost analysis is still more complex, usually invoking other members of the "Pricing Team". This type of analysis is appropriate in sole and single source purchases of significant magnitude and complexity. Cost analytical efforts, and the accompanying negotiations which invariably ensue, may extend for several weeks or even months.

Types of Markets and Supplier Pricing Strategies and the Analytical Methods Appropriate to Each

Preparation of Buyer In-House Estimates

Although different organizations have different policies concerning the degree and type of documentation needed to support a pricing decision, most organizations, public and private, insist that a cost estimate be prepared by requesters on every purchase as an aid to pricing. This estimate is normally a detailed, bottom-up estimate for services (Architect-Engineering, construction, etc), and for specially engineered or fabricated hardware or one-of-a-kind items. In most supply and material purchasing, an estimate based on previous prices paid often suffices. Preparation of an in-house estimate by the buying organization is a good mental discipline, requiring the buying organization to place itself into the supplier's "shoes". As explained below, understanding the supplier's competitive situation is important in determining the appropriate analytical method. There is a uniform policy within the purchasing community that every purchase transaction, regardless of dollar amount, should have a determination that the price is fair and reasonable. This determination is based on price analysis, (often using the in-house estimate as a basis for comparison), supplemented by cost analysis if necessary. Documentation of the facts that support a price reasonableness determination (to include a copy of the in-house estimate) should be included in the purchase file.

Degree of Competition in Markets

Most goods and services are bought in a competitive marketplace where the forces of competition cause the supplier to price his goods and services according to the competition. In these situations, the supplier is less interested in his costs and profit margin than he/she is in the prices being charged by his major competition. Effective competition is most pronounced in those industries having few barriers to entry. Even the American automobile industry provides effective competition in what is commonly referred to as an "oligopolistic industry" (few sellers and many buyers). In those situations where the buyer can rely on competition to set the price, price analysis alone will suffice to assure reasonableness of price. A cost analysis may be required as a supplement to the price analysis, particularly in situations where the presence of price competition among offerors is nonexistent or questionable. Such a situation is often prevalent in purchases of highly specialized or extremely technical equipment or for certain services available from limited sources (specialized consulting services come readily to mind.) Because cost analysis is such a costly and administratively burdensome process, it should generally not be employed when reasonableness of price can be established by adequate price competition (or, as an acceptable substitute) by use of a comparison with catalog or market prices of commercial items sold to the general public in substantial quantities. Another special situation which often arises is in the purchasing of regulated utility services. Price competition is not present in these situations, and cost analysis is unnecessary because of the involvement of public utility commissions and other regulatory bodies in the rate-setting process. Regulated utilities provide services at prices set by law or regulation. Price analysis alone (comparing the offered prices against the regulated rate) is sufficient in those instances.

Matching Buyer Analytical Method With Supplier Pricing Method

The buyer must understand the degree of competition in the marketplace in order to determine the method used by the supplier to price his products and/or services. If the supplier is operating in a market where there is effective competition, the supplier will generally price to the competition. In that circumstance, the supplier will be less interested in his costs and a reasonable mark-up on those costs than he/she will be in pricing the product or service to beat the competition. The forces of competition will operate to keep the supplier's offered prices fair and reasonable. Because the supplier based his/her price on a "bottom-line" basis, the buyer should respond by using a "bottom-line" analytical method, which is, of course, price analysis. If, however, the supplier is free to pass on all of his costs plus a substantial profit amount to the buyer as a result of operating in a market without effective competition, the buyer should respond to this "bottom-up" pricing with a "bottom-up" analytical method, which, is of course, cost and profit analysis, supplemented with price analysis. This concept is illustrated in the diagram below:

IF THE SUPPLIER ESTIMATES BASED ON: THE BUYER SHOULD USE:

1. "BOTTOM LINE" COMPETITIVE PRICING "BOTTOM LINE" PRICE ANALYSIS
2. "BOTTOM-UP" COST & PROFIT BUILDUP "BOTTOM-UP" COST AND PROFIT ANALYSIS (WITH PRICE ANALYSIS)

Notice the one analytical method appropriate to all markets is price analysis. Price analysis should be used to supplement cost analysis in situations where there is ineffective competition because it serves to answer the question: "What would the supplier charge if he were operating in a competitive market-place". Many experienced analysts maintain that price analysis is more powerful than cost analysis for that very reason. They also believe it is possible to generate multiple negotiation positions more easily using both cost and price analysis than it is using cost analysis alone.

Summary

The buyer is ultimately responsible for determining that the prices he/she pays for his/her purchases are fair and reasonable. This is accomplished through price analysis and/or cost analysis of the individual purchase transaction. The degree and extent of the analysis performed depends on the circumstances. In certain circumstances, particularly those where extensive cost analysis is required, the buyer will be assisted by specialized functional personnel, to include auditors, cost/price analysts, estimators, engineers, and/or other technically-oriented personnel. The results of the price and/or cost analysis of the individual purchase transaction will be used by the buyer to negotiate price and other terms with supplier (s).

In addition to transactional analysis, which concentrates on price and/or cost analysis of individual purchase transactions, the buyer and his purchasing management will be challenged to effect major, organization-wide cost savings through the use of "strategic cost analysis". This type of analysis takes "the long haul" approach not keyed to specific purchase transactions. Buyers undertaking strategic analysis will be dealing with fundamental business systems and procedures, generally of a type which must be institutionalized before they can be effective. Various strategic cost analytical methods, including a formalized make-or-buy decision system, are discussed later in the book.

Preparation of an in-house estimate by the buying organization requires the buying organization to place itself into the supplier's "shoes". Understanding the supplier's competitive situation is important in determining the appropriate analytical method. Every purchase transaction, regardless of dollar amount, must have a determination that the price is fair and reasonable. This determination is based on price analysis, (often using the in-house estimate as a basis for comparison), supplemented by cost analysis if necessary.

Most goods and services are bought in a competitive marketplace where the forces of competition cause the supplier to price his goods and services according to the competition. In those situations where the buyer can rely on competition to set the price, price analysis alone will suffice to assure reasonableness of price. Although price analysis generally suffices to document price reasonableness, a cost analysis may be needed to supplement price analysis, particularly when the presence of price competition among offerors is nonexistent or questionable. Such a situation is often prevalent in purchases of highly specialized or extremely technical equipment or for certain services available from limited sources (specialized consulting services come readily to mind).

The buyer must understand the degree of competition in the marketplace in order to determine the method used by the supplier to price his products and/or services. If the supplier is operating in a market where there is effective competition, the supplier will generally price to the competition and the buyer should respond by using price analysis. If, however, the supplier is free to pass on all of his costs plus a substantial profit to the buyer as a result of operating in a market without effective competition, the buyer should respond by using cost and profit analysis, supplemented with price analysis.

The one analytical method appropriate to all markets is price analysis. Price analysis should be used to supplement cost analysis in situations where there is ineffective competition because it serves to answer the question: "What would the supplier charge if he were operating in a competitive market-place". Price analysis is also helpful in generating multiple positions for negotiation.