As a buyer, how can you tell whether you got a good price for what you purchased?
Cost analysis is one of the key elements in a business case. From the perspective of executive management, understanding the true costs of purchased products is essential to ensure that purchases deliver value for money. According to the CIPS study guides, buyers have various methods for analyzing the costs of purchased items, depending on the nature of the purchase and the type of supplier relationship. The nature of the purchase refers to how frequently items are bought, either as one-off purchases or on an ongoing basis. The type of supplier relationship refers to the level of collaboration between buyers and suppliers, ranging from arm’s-length relationships to strategic partnerships.
Item A has a lower purchasing frequency and an arm’s-length relationship with suppliers.
Items A have a low impact on the core business, so buyers make less effort to analyse the costs of these items. According to CIPS’s advices, buyers should conduct price analysis to choose the supplier who offers the best price. A good price indicates that the supplier is opperating effectively. There are several ways to conduct price analysis:
- Competitive bids: When receiving supplier’s bids based on business requirements, buyers begin evaluating them (normally the evaluation criteria is mainly price and quality), then choose the one offering the best value for money.
- Comparison price list: This refers to a document that shows prices of similar products from different sellers, brands and locations.
- Market comparisons: Buyers assess the prices of purchased items by comparing them with prices offered by other suppliers in the market. Buyers may also compare the prices of purchased items with their historical prices.
- Price indexes: This is a method of measuring changes in the price of a product over time. The price in the starting year (Po) is considered 100%, and the price of the following year (Pn) which is calculated using the formula: Pn/Po*100. If the index is above 100, it indicates a rise in the price of the product. Conversely, if the index is below 100, it reveals a fall in price.
Item B has high purchasing frequency and an arm’s – length relationship with suppliers.
These items have a higher impact on the business compared to the item A, so buyers need to do conduct cost analysis methods which are more complex than price analysis. Some cost analysis techniques can be:
- Cost estimating: Buyers need to estimate all costs associated with a product. It can be costs of materials, costs of labours, costs of overheads, costs of marketing, costs of logistics…Buyers with a good analytic skill can provide an accurate estimation of cost.
- Value Analysis: This method aims to reduce unnecessary costs of a product without compromising its quality or performance. It begins by identifying the essential functions of the product, then examines the costs associated with delivering those functions. Afterward, it explores alternative ways to achieve the same or better functionality at lower costs.
- Supplier Cost Breakdowns: Buyers require suppliers to provide a breakdown of their costs and profits. Normally, in an arms-length relationship, suppliers rarely share true costs of their products.
- Should-Cost Analysis: This is a cost estimation method used to determine what a product or service should cost under efficient, competitive market conditions. Buyers need to understand the component costs that make up a product, such as raw materials, labor, overhead, non-manufacturing costs, and markup. For example, suppose you are sourcing Component A. The supplier quotes a price of $15. However, your should-cost analysis estimates the cost should be around $7. Clearly, you have room to negotiate a discount with the supplier.
Item C has a low purchasing frequency and a strategic relationship with suppliers.
Normally, Item C represents a company’s project or capital purchases, which are one-off and high-value. Due to the high value of the purchase, buyers need to collaborate closely with suppliers to deliver the project effectively. To analyze the cost of Item C, buyers should conduct whole-life costing or a total cost of ownership analysis. This technique considers all costs associated with a project or asset, including purchase price, installation cost, operational cost, maintenance cost, decommissioning cost, and disposal cost. Because the asset has a long useful life, buyers need to estimate all possible costs to avoid budget overruns.
Item D has a high purchasing frequency and a strategic relationship with suppliers.
Item D represents a company’s strategic items, which have a significant impact on its survival. With Item D, buyers need to analyze costs carefully and thoroughly. This analysis requires a spirit of collaboration and openness from suppliers, where they are willing to share detailed cost information with buyers. Not every supplier agrees to reveal their full cost breakdown; they typically do so only when they aim to build a close relationship with the buying organization. Buyers can apply several techniques to analyze the cost of Item D:
- Open book costing:
In this method, suppliers share detailed cost information with buyers, allowing both parties to understand the true cost of a product or service. Both parties are encouraged to exchange ideas on cost savings and quality improvements, fostering continuous improvement.
- Whole-life cost analysis
It is essential to consider all possible costs associated with purchasing Item D. Focusing solely on the purchase price may overlook hidden costs that can negatively impact a company’s cash flow.
- Target cost analysis
In this technique, a supplier starts from the market price that a buyer is willing to pay, then identifies the desired profit margin to arrive at the target cost. If both parties are open-minded and cooperative, they can work collaboratively to achieve their goals.
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