Anatomy Of A Price

Author(s):

Elaine Whittington, C.P.M., CPCM, A.P.P.
Elaine Whittington, C.P.M., CPCM, A.P.P., G & E Enterprises, Sunland, CA   91040, (818) 352-4995, e_whitt@prodigy.net

86th Annual International Conference Proceedings - 2001 

The ability to analyze a price breakdown is becoming more and more important as the purchasing task continues its evolution into the technology of the millennium. Relationships with suppliers are changing and with these changes which include e-commerce and supply chain management we find that rather than dealing with three bids we are looking at a breakdown of the supplier's costs, rates and requested fees. Now, the prudent purchasing professional finds it necessary to understand how to analyze such a breakdown and negotiate a good price which is fair to themselves as well as to the supplier. Therefore, we must understand all the elements of the price and how to make a correct evaluation of the submittal. To this end we will, in this paper, look at all the elements of a price in an effort to not only understand these but also to explore the types of questions which will help with negotiation of costs and final price.

Let us start the analysis with an understanding of the difference between price and cost. Price is all the cost elements plus the profit or fee. Cost is all the costs (labor, material and overhead costs) without the addition of profit or a fee. The analysis of a price breakdown is usually referred to as price/cost analysis and large firms often have personnel who devote all their time to this task and are referred to as Price/Cost Analysts.

Large firms routinely obtain price breakdowns when purchasing costly products. However, there are other types of procurement which lend themselves to the use of a price breakdown. They are often used in construction projects, maintenance contracts, repair contracts, security contracts, systems contracts and most importantly in the modification of any existing contract. To summarize, such activities are usually employed whenever you must purchase an item, which is costly, and for which direct competition is not possible or for which more insight into pricing detail is necessary.

This paper will explore the major elements of a cost breakdown:

  • MATERIAL
  • LABOR
  • OVERHEAD RATES
  • GENERAL AND ADMINISTRATIVE COSTS (G&A)
  • PROFIT OR FEE

In looking at pricing there are a number of terms which must be understood. Four such terms are direct, indirect, non-recurring, and recurring costs. Direct and indirect are terms that are used for labor, material and overhead rates. In general, direct costs are costs that actually go into the product or service. As we explore the price breakdown some specific examples will be given. Non-recurring costs are those that occur only one time while recurring costs occur each time the product or service is-produced.

A good way to illustrate direct and indirect material is to use the example of taking your car into the shop for a minor tune-up, an oil change and to have the brakes checked. During the process the mechanic (who can be described as direct labor) finds he needs to replace an outer wheel bearing. The spark plugs, air filter, wheel bearing, oil and oil filter are all considered direct material for the job. The oil spout, tools to install the plugs and the bearing and the grease he uses to pack the bearing would be considered indirect material. Even though the grease is used on the car and will be delivered to the customer it is usually thrown into the indirect category. This is because it is difficult to assess the exact amount used on each job. Labor will be covered in more detail later.

MATERIAL

Most cost breakdowns show material in four categories: raw material, subcontracted material, standard parts and interorganizational transfers. In order to understand and analyze material one must understand each of these areas. Raw material is essentially any material that is purchased which is not used just as it is received. An example would be aluminum sheet or bar stock, which is processed into a particular shape. Subcontracted material is generally described in two categories, one being large subassemblies, such as a wing for an aircraft, while the other is outside processing of a part made in house (metal anodize or plating). Standard parts are those which are purchased and used by you for production or in a service without modification (electronic components, small hardware or in the case of a janitorial maintenance contract-soap). Lastly, interorganizational transfers are the category of items which are purchased from a sister division.

What is important in the analysis of the material is the task of determining that the bill of material is correct. All items must be reviewed for quality, quantity and price. The quality being quoted should be consistent with the specific need for your product. Certainly the quality should be high enough to do the job required, however often gold is quoted when silver will do the job. Quantity is also an important aspect of the submittal. Most firms quote a quantity in excess of exactly what the job calls for, this is called scrap allowance. Scrap allowances are nothing more than a percentage added to the quantity required to allow for loss and spoilage. It is important to note that the scrap allowance is consistent with the type of item purchased and that scrap allowances are not assessed to items, which are purchased in excess of needs because of minimum, buys. The prices used on the bill of material should be looked at in view of the rationale used for them. For example, is the material an item they priced from their own stock, a catalog, three bids or a past buy? Analysis should ask the question, how accurate is the price estimate reflected on the breakdown? This gives the buyer a good idea of positioning for later negotiation.

The pricing used on the bill of material deserves a bit more attention. It should be determined exactly how the bidder priced the bill. Three popular methods are: using pricing from a preceding item, projection of the average cost from current inventory or obtaining bids. If the supplier has priced the items from a preceding sale, it is important to note the rationale for the escalation used for the past and the future. However, if average material cost is used you must be sure that none of the lots used in the calculation are substantially smaller than the amount necessary for you. If the supplier did obtain bids you must determine whether the prices submitted are firm or just estimates and again the rate of escalation is important.

To review the process of analysis of the bill of material, one should check the correlation of the items quoted to an accurate list of materials needed. Review any actual buy records used. Check for competition on the submittal. Understand scrap rates and escalation rates employed as well as the type, grade and size of material quoted. The inventory pricing methods should be investigated as well as the possible use of improvement curves in the purchase or scrap rates for material.

Most breakdowns also show "other direct costs" which would include travel, insurance, packaging and like type items. The important item to note in this part of the analysis is that these items are included only once in the breakdown.

LABOR

Now, lets take a look at the labor aspect of the breakdown. Direct labor are those costs which are directly related to the production of the product or service. Indirect labor is that which is not specifically identifiable to a given job or contract. For example, in a firm that manufactures and installs kitchen cabinets, the carpenter is a direct employee while the maintenance person who repairs the plant equipment is usually indirect.

Labor categories have a number of non-recurring and recurring tasks. Some examples of non-recurring tasks are design, planning, preparation of drawings, writing manuals and spares lists. Recurring labor is the labor required to modify the existing design, product fabrication, or the performance of a service (ie: washing windows).

When doing analysis of labor you must ask yourself several questions. They include: how complicated is the task, was the estimate based on judgment or experience, how are the costs gathered? You must be sure that the labor rate quoted is at the right level. For instance if the quote is for an administrative secretary when the job should require a clerk, the use of the more expensive labor category should be questioned. The method used to gather labor costs varies from firm to firm. It is important to note the method used and also that it is indeed consistent. Some firms use a standard cost system. If this is employed you should find out what type of modification is used to account for the actual performance in this firm and additionally when those modification factors were established and last modified. Modification factors should be constantly scrutinized and updated. Labor rates are quoted in a number of different manners: plant wide rates, department rates, individual rates or industry rates. Here it is mandatory that the rates be accurate and applied consistently. Lastly, investigate what factors are used to reflect merit increases, layoffs or new hires at lower rates.

A word about using the web in doing price/cost analysis. Currently, there is a good deal of information available on the web to assist in this task. Mainly the publication of the Consumer Price Index, The Producer Price Index and labor rates published by the Bureau of Labor Statistics (BLS). Most large firms subscribe to the calculations available from Data Resources Inc. for most of this information. Their web site is located at: http://www.dri.mcgraw-hill.com. The data released directly by the Bureau of Labor Statistics can be found at this URL: http://stats.bls.gov. I did a search for compensation of aerospace workers at the government BLS site and received a comprehensive article. It showed that an aeronautical engineer was earning $34.69/hr while the average for all other industries was $32.95. The DRI figures, unlike those shown at the BLS site often compare years and even break down areas of the country. In analyzing a quoted price it is helpful to have a good idea of the supplier's labor rates to be sure they align themselves with their quoted figures and with their industry and geographical area.

The PPI or Producer Price Index shows the average change over time for consumer goods and services. The CPI or Consumer Price Index measures the average change in prices paid by urban consumers over time. The PPI is a good yardstick measure for price increases when performing price/cost analysis on an item, which is readily available in the open market. The CPI is not often helpful in the manufacturing arena.

OVERHEAD RATES

Indirect costs are the hardest to analyze. Most firms will not divulge their overhead rates. However, it is good to understand what makes up such rates. First, there is overhead cost that includes burden or material overhead, labor overhead and manufacturing overhead. Large firms usually have general and administrative costs (G&A) that cover costs which are allocated to all customers. This is quite common when there is a corporate office and a number of divisions of the firm.

Indirect labor is that type of labor, which cannot be assessed directly to the end product. Supervision is often found to be in this category. For example if you have a supervisor who is responsible for several accounts you must somehow allocate the time spent to an overhead account. There are several approaches possible. Let's say that a supervisor has six accounts. You could divide the yearly salary by six. However the supervisor may spend much more time on one account than another. You might choose to allocate time based on the size of the account. Again a smaller account may still be taking all the time. Another approach would be to allocate actual hours spent on the particular account, however in this case you have a problem with hours spent in general meetings and time off the job. In the end most companies take all such costs and estimate them. The number estimated for overhead costs is divided by the amount of business, which is estimated for the year to get a percentage for overhead costs to be added to all proposals. In other words if you estimated that your business base would be $4,235,565 and that all overhead costs to do that amount of business would be $4,027,627 then the overhead rate which you would apply would be 95%.

In the estimation of overhead costs it is important to be as accurate as possible for both the costs and the business base. Errors in either direction can cause a company disaster. Estimates are usually based on past history and salespersons "dreams." If costs are underestimated or the future business is overestimated the business will take a loss. On the other hand if costs are overestimated or business is underestimated the business will price itself out of the market. It can readily be seen that overabsorbtion or underabsorbtion of overhead rates can be a serious problem to a company's ability to succeed.

Small companies often do not use a G&A rate. All overhead costs are estimated and usually called burden. Larger firms apply overhead rates to material, labor, and manufacturing and include a G&A rate. The use of a G&A rate allows them to separate out and allocate the administrative costs between several divisions of their firm. Overhead costs are generally called operating costs and include such items as heat, electricity, building maintenance, property taxes, general supplies, supervision, sales, industrial relations personnel, purchasing personnel and executives. This list is an example and may not be complete but does cover the major areas considered. Some examples of material overhead include acquisition of material, incoming transportation, receiving inspection, and handling and storage of material. Labor overhead often includes supervision, support personnel, tax, vacation and insurance. Manufacturing includes indirect supplies (ie:small tools, janitorial supplies), supervision, rent, property taxes, and insurance. Other categories of costs to be included are independent research and development and bid and proposal rates.

PROFIT OR FEE

No price/cost analysis would be complete without looking at the method of calculation for the profit or fee requested. The profit earned on a project should reflect the amount of risk involved in that project. There are different types of risk involved in each job such as: technical risk, management risk, cost risk and contract risk. The formula should take into account that the less risk involved, the less profit or fee allowed. The government sometimes uses "weighted guidelines" to assess contract risk. This method assigns a different percentage to each element of the contract depending on the amount of risk incurred. For example a firm fixed contract by its very nature has much more risk than a cost plus fixed fee contract wherein the supplier is assured of all costs and an established fee.

A word of caution. In the price/cost analysis process buyers often concentrate on the reduction of the profit or fee. While this is certainly part of the consideration, it is important to note that reductions in this area are often not as productive as reductions in the area of material, labor or overhead. Always remember that the profit calculation is made at the bottom of the equation. Therefore, a 25% reduction at this stage in not as productive as the same percentage of reduction in the area of labor (see attached chart).

As the purchasing profession takes on a new look for the future the purchasing professional will be faced with more analysis and negotiation. The ability to determine the validity of a price breakdown will be necessary in order to complete meaningful and fair negotiations and to obtain the best price for your firm. This paper is only an overview of a rather complicated subject that requires new emphasis in today's environment.

COMPARISON
SAVINGS 25% IN PROFIT VS. 25% IN LABOR COST
COST ELEMENT BASIC QUOTE -25% PROFIT -25% LABOR
LABOR COSTS $ 2.00 $ 2.00 $ 1.50
MATERIAL COSTS $ 5.00 $ 5.00 $ 5.00
TOTAL DIRECT COSTS $ 7.00 $ 7.00 $ 6.50
OVERHEAD COSTS
(180% DIRECT LABOR)
$ 3.60 $ 3.60 $ 2.70
TOTAL MFG. COSTS $10.60 $10.60 $9.20
SELLING & ADMIN.
(5% TOTAL MFG. COSTS)
$ 0.53 $ 0.53 $ 0.46
SUBTOTAL $11.13 $11.13 $ 9.66
PROFIT (10%) $ 1.11 $ 0.83 $ 0.97
TOTAL PRICE $12.24 $11.96 $10.63

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