Pro-Active Price Analysis: Tools That You Can Use Today!

Author(s):

Jeffery A. White, C.P.M.
Jeffery A. White, C.P.M., Manager, Procurement Compliance, United Defense, L.P., Ground Systems Div., York, PA, 717/225-8229 x2776

81st Annual International Conference Proceedings - 1996 - Chicago, IL

The Issues. Purchasing professionals are entrusted with the responsibilities of procuring quality goods and services on time and at the best overall value. As companies develop strategies aimed at reducing overall costs of materials and services, there is no denying the fact that price plays a major role in purchasing decisions. The primary issues surrounding pricing is: How can we as purchasing professionals pro-actively monitor and analysis a supplier's pricing moves and strategies?

The Opportunity. Statistics show that the purchasing function on the average, controls over 60% of the cost of a typical product manufactured in the USA. As of 1994, there were 32,000 purchasers spending over 10 billion dollars per year on end-item related goods and services. Additionally, studies have shown that a 4% saving in purchasing dollars is equivalent to as much as an 18-20% increase in sales dollars. Today, as companies downsize, rightsize, layoff, and merge, purchasers have a great opportunity to effect the bottom line of their respective companies. Consequently, we need real-world, hands-on, yet powerful tools that can quickly be used in pro-actively monitoring and analyzing a supplier's pricing moves and strategies. The focus of this workshop is the evaluation of price on a pro-active basis; before purchasers are faced with suppliers' price increases.

Objectives. The objectives of this presentation are threefold:

  1. Develop an understanding of how trends in markets and industries effort suppliers' pricing strategies.
  2. Provide exposure to several real world tools that can be used for pro-active pricing immediately.
  3. Discuss external sources of data to assist in developing pro-active pricing strategies.

Pro-Active Price Analysis. Purchasers have a number of tools available to assist in the pricing process. Competition, independent estimates, commodity based analysis, trend analysis of historical prices and pricing based on comparisons to market or catalog prices are only a few pricing tools. It is important to remember that the pricing technique used should be relative to the dollar value of the procurement. All pricing techniques, including those discussed here, require access to resources, both human and information. Like most organizations, additional resources are most likely in short supply at your location. Therefore, chose the technique that will provide the best mix of accuracy, ease of use, and cost effectiveness for your situation.

Competitive Range Analysis. An effective tools which can be used to determine if competition is adequate, involves the establishment of a "competitive range". Prior to evaluating bids received, review the range of prices previously received on the procurement of the same or similar product or service. Notice the distribution of prices between the lowest and highest prices. Use this data to establish a baseline for your competitive range. Here's an illustration of the competitive range analysis in action:

Part Number 288288

Potential Supplier Price %
A $125.00 --
B $ 70.00 78.5%
C $ 60.00 16.6%
D $ 52.00 15.3%

The percentage between bids is determined by pairing the bids and subtracting the low bid from its partner. The result is then divided by the lowest price in the pair. For example:
125-70 = 55; 55/70= 78.5%
60-70 = 10; 10/60 = 16.6%

In this situation, a purchaser could determine that adequate competition historically existed when at least 2 suppliers were within 17% of each other. This example assumes all suppliers are bidding on the same quantity.

Obtaining competition is generally the least expensive, as well as most expeditious method of understanding the dynamics of supplier's prices.

Commodity Based Analyses. Commodity based analysis involves the evaluation of trends within a particular commodity for the purposes of understanding and predicting supplier pricing strategies. Although commodity based analysis involves a certain degree of on-going research, it's rewards can be great. Consider this scenario: The end item produced by a corporation depended heavily upon paper products, which in turn, are made from wood pulp. Would it not be wise for the purchaser responsible for paper products, to not only monitor trends in the paper products commodity, but also in the wood pulp commodity?

There are numerous trade and industry publications tracking countless numbers of commodities and economic trends, currently available to the purchasing professional. They include the Commodity Reports and the Report on Business featured in NAPM Insights. Many find Purchasing Magazine, The Wall Street Journal, and Business Week helpful in this area.

Custom Indices. Once this data is gathered, it is then important for a purchaser to develop a simple in-house indices of the commodities under observation. This can be accomplishes quite simply by using a computer spreadsheet model.

Before the model is developed, one must consider how indices are developed. Indices use a reference point in time, often called the Base Year, as the starting point of the analysis. Changes in prices, either upward or downward, are expressed in terms of percentages of the Base Year price. For example, if the Base Year's price is expressed as 100%, a decrease in the next year's price of 5 points would be expressed as 95%. (Note: The % sign is usually dropped when referring to an index number. The term "points" is used in its place.)

Armed with the above information, one can now develop a spreadsheet model of a commodity index. Here is an example:
Assumptions: Base Year = 1990
Base Year Price = $10.00

Avg. Prices Paid: 1991 1992 1993
$9.00 $8.00 $11.00
Yearly Index = 90 80 110

The results of this analysis can now be used as is or graphed to visually spot trends which would be useful in order to pro-actively project the 1994 trend in the commodity under review.

Graphical Trend Analysis. Another powerful, let useful pricing technique, is graphical trend analysis. Technically, this technique is exactly what its title suggests; that is, the analysis of data by literally plotting points on an XY chart. Once plotted, the points are analyzed to determine if there are any correlation among the points. Such correlation, its discovered, is represented in the from of a trend line. Of course the points discussed here are the item's historical quantities and prices.

A trend line can be generated mathematically by using regression analysis, or just as effectively by visualizing the correlation within the data, and manually drawing a line of best fit. The trend line results from the "smoothing" of the "peaks and valleys" in your data.

Consider the following example graph of historical purchasing data:

Buy Quantity PriceB
A 1 $45.00
B 5 $42.00
C 15 $13.00
D 22 $10.00
E 27 $ 5.00

(Plot graphic not available in the text-only version of this paper.)

The line plot of the Actual Data shows that this particular item's price is quantity sensitive. The Trend Line was manually drawn to roughly illustrate a regression line. Based on the trend line, the purchaser can estimate a reasonable price for a other quantities.

The drawback to using this type of analysis is that it is useless if there is no clear relationship between quantity and price. Additionally, the trend line analysis does not consider the effects of time on price. An estimated price could be identified on the trend line, then escalated based on the dates historical purchases were placed.

The obvious advantage to purchasers by using this type of analysis is that the tools needed to conduct the analysis is readily available; a computer, spreadsheet software, and historical data.

The tools presented here are just a few of the many that I use on a daily basis. It is very possible that others use tools that are also helpful. I actively participate in networking and sharing of ideas on this topic. I can be reached at the number listed earlier in this article or by e-mail at JAWhite@AOL.COM.

REFERENCES
White, Jeffery A., C.P.M. "Pricing Moves and Strategies" NAPM Insights, September 1995, 16-19


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