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Price Discipline (tm) (1): A Tough, But Fair Approach to Price Negotiation<

Author(s):

Jimmy Anklesaria
Jimmy Anklesaria, President & CEO, Anklesaria Group, Inc., Del Mar, CA 92014, 619/755-7119, anklesaria@compuserve.com.
Sanjit Menezes
Sanjit Menezes, Senior AssociateAnklesaria Group, Inc., Del Mar, CA 92014, 619-755-7119, anklesaria@compuserve.com.

83rd Annual International Conference Proceedings - 1998 

Abstract. Most discussions on requests for price changes today, unfortunately, factor around bottomline price. Suppliers respond to RFQ's and customers counter. Price Discipline( is a tool that will enable both customers and suppliers to move away from arbitrary demands for price decreases or increases and base their decisions on logic and reason instead. The article describes the concept in detail and illustrates its application through a real life example.

The Need For Price Discipline(tm). The fact that the 1990's is the decade of cost management is one that is rarely disputed. Companies are rigorously pursuing cost management objectives, some more aggressively than others. The procurement function is at the forefront of these efforts. As America moves away from "make" towards "buy" through outsourcing or contract manufacturing, the dependencies on an external supply base increase dramatically. As this trend continues to take root, the negotiation methods of old must give way to new processes that focus on cost solutions. It is time to abandon the traditional "bargaining" approach to price negotiation where, after a sometimes bitter back and forth discussion, an agreement is reached between customer and supplier on a number somewhere between the range of the suppliers' proposal and the buyers counter.

Both customers and suppliers have various explanations justifying their demands for price decreases or increases. Sales people have often used the "excuse" of "our costs have been increasing" to explain the reason behind a proposal for an increase in price, while customers often explain the demand for a 20% cut in price as a top-down management mandate. Both approaches are arbitrary and wrong. They are far from solution focused. What is needed, instead, is a logical and fair approach to deal with a situation where there is first a reluctance to share information and second an arbitrary justification for either supplier or buyer negotiating positions. One such approach is "Price Discipline(tm)".

Price Discipline (tm) Defined. The concept of Price Discipline( is simply an understanding that the various elements of cost are not directly correlated and are impacted by factors that are specific to each element. There are 5 main cost elements:

  • Direct Materials
  • Direct Labor
  • Manufacturing/Service Overhead
  • Operating & other expenses
  • Profit

The application of the concept involves first breaking down a previously paid price into the above five elements and then evaluating and adjusting each element for the various factors that impact it over time. In the following paragraphs, each these factors has been discussed and illustrated through an example.

Direct Materials. Direct Material cost consists of all raw materials, parts and accessories that form the material content of a product. In the case of service contracts Direct Material refers to materials that are necessary and incidental to the execution of the contract. Cleaning supplies for janitorial services would be an example. The main factors that impact Direct Material costs include:

Market Price. In the case of market driven commodities (base raw materials), fluctuations in market forces can significantly affect material costs. If, for example, a customer purchased plastic cases for overhead projectors, printers or copy machines, price movements in the market for plastic resin could significantly affect the material cost of the cases purchased. It is important to track market price movements through suitable tracking mechanisms such as the Producer Price Index(i) or more specific industry indices.

Volume and Stability of Volume. Higher volume contracts enable suppliers to negotiate better pricing on their raw material purchases. Stability of volume is another, often overlooked, factor. Stable volumes allow suppliers to better plan their manufacturing, purchasing and inventory schedules. Not only does it help to improve yields, it also helps suppliers obtain better pricing from their suppliers. Suppliers often prefer guaranteed, stable volumes that are uniformly spread out over the course of the contract, rather than requests for high volumes which may not materialize into real orders.

Material Yields. Companies today continuously invest to improve quality levels. This is done through better equipment, better processes, higher quality raw materials and higher skilled operators. As scrap rates decline, less material is purchased for production, which should lead to a decrease in material cost. While there is no industry data readily available to assess such productivity improvements, engineered estimates are often fairly accurate.

Direct Labor. Direct Labor includes wages paid to production workers or in the case of service contracts to those actually performing the service. In cafeteria services, for example, this would include chefs, waiters, dishwashers and cashiers. Supervisory labor is not included in this category. Direct Labor is impacted by the following factors:

Wage rates. Wage rates significantly drive Direct Labor costs. Rates in turn are impacted by several factors including geographic location, skill levels and the cost of living. It is important to track wage rates carefully, especially in the case of service contracts where Direct Labor is a significant proportion of the contract price. The Bureau of Labor Statistics (BLS)(ii) is a comprehensive source of labor cost data for the United States. International wage rates can be obtained through various international statistics agencies, many of whom now have sites on the Internet. Some of these sites can be accessed through the BLS website.

Productivity. Productivity refers to the efficiency of labor. Productivity of labor is driven by factors such as learning curves, equipment capability, process capability and the quality of materials.

The Bureau of Labor Statistics has recently begun compiling productivity data that is now available on-line at the BLS website. The Industry Productivity Index contains productivity information and trends for various industries. This index is not all encompassing but is certain to improve over time. Major sector productivity data is also available through the Quarterly Labor Productivity Index. As in the case of material costs, in the absence of formal productivity data, an engineered estimate will need to be made.

Overhead. Overhead consists of Manufacturing/Service Overhead (OH) and Operating & Other expenses (O&O). Manufacturing/Service Overhead comprises all overhead expenses associated with the manufacturing of a product such as depreciation, utilities, space and supervision. Operating & Other Expenses includes all support expenses necessary to keep the organization functional and competitive such as advertising, R&D, training, legal, accounting and information systems. Both these overhead buckets consist of costs that are fixed (vary with volume on a per unit basis) and costs that are variable (are not affected, in the short run, on a per unit basis, by volume). While it is necessary to determine approximately how much of each overhead bucket is fixed and how much is variable, this could become an extremely time consuming and theoretical exercise. To simplify the process, the following guidelines may be used:

  1. Manufacturing/Service Overhead: 80% fixed and 20% variable.
  2. Operating & Other Expenses: 90% fixed and 10% variable.

Overhead costs are impacted by two factors, time and volume. While both the fixed and variable portions of overhead costs must be adjusted for changes due to time (inflation), only the fixed portion is impacted by volume on a per unit basis.

Profit. Profit is, perhaps, the stickiest point in a customer-supplier negotiation. A supplier that undertakes a greater risk or provides added value from the customers perspective, would expect to be compensated appropriately.

The Application of Price Discipline(tm). In the preceding section the theoretical concept of Price Discipline( was discussed. The following example will illustrate its use in a real-life situation.

The Case. A contract with a Supplier (Company X) for printed material (could be anything from annual reports to technical manuals) has come up for review. In response to an RFQ, Company X has proposed a decrease in price from $250 per 100 copies in 1996 to $240 per 100 copies in 1997. During the same period, the proposed volume for the contract has increased from 10,000 units to 11,000 units. A request for a cost breakdown has been denied by the supplier on the grounds that it violates company policy. The customer does not wish to sign a contract without first establishing whether the decrease in price is fair.

The application of Price Discipline(tm) consists of two phases:

Phase 1. This phase involves the breaking down of a previously paid price into its 5 cost elements using an approach called " Percentage of Sales". The five elements of cost that make up price are as follows:

  • Direct Material
  • + Direct Labor
  • + Manufacturing/Service Overhead
  • = Cost of Goods Sold
  • + Operating & Other Expenses
  • + Profit
  • = PRICE

In order to obtain the required data, the following facts must first be determined:

  1. The product or service being purchased. (Printed Material)
  2. The supplier's business. (Commercial Printing, Lithographic)
  3. The suppliers size either in assets or in sales (Sales = $30 million)

Once this information has been obtained, a price breakdown can be computed as follows:

Step 1.1. Identify the supplier's Standard Industrial Classification code (SIC) code.iii In the example, Supplier X's SIC code (commercial printing, lithographic) is 2752.

Step 1.2. For the selected SIC code use data from Robert Morris Associate, Annual Statements Studiesiv income data section. For a company with sales greater than $25 million, the following are the percentages:

  • Net Sales - 100.0
  • Gross profit - 25.5
  • Operating Exp - 19.8
  • Other Exp. - 1.6
  • Profit - 4.1

The Cost of Goods Sold (COGS) can be obtained from the above using the equation:

Cost of Goods Sold = Net Sales - Gross Profit
COGS = 100 - 25.5
  = 74.5%

Step 1.3. COGS can be broken down into its three components Direct Material, Direct Labor, and Manufacturing Overhead using information from the Annual Survey of Manufacturers: Statistics for Industry Groups and Industries, (ASM).v The following information for SIC Code 2752 (commercial printing, lithographic was obtained from the ASM (figures are in millions of dollars):

Column H: Value of Industry Shipments (Net Sales) 45,846.8
Column G: Cost of Materials 19432.4
Column E: Wages to production workers 7940.5

From the above information COGS can be broken down in percentage terms as follows:

Direct Material = 19,432.4/45,846.8
= 42.4%
Direct Labor = 7,940.5/45,846.8
= 17.3%
Factory Overhead = COGS from Step 1.2 - (DM+DL)
= 74.5-(42.4+17.3)
= 14.8%

The 1996 price can be broken down using the percentage for each cost element computed above. Remember no cost data has been provided by Company X in this case.

Cost Element Percentage $
Direct Material 42.4 (Step 1.3) 106.00
Direct Labor 17.3 (Step 1.3) 43.25
Manuf./Service Overhead 14.8 (Step 1.3) 37.00
Cost of Goods Sold 74.5 (Step 1.2) 186.25
Operating & Other Expenses 21.4 (Step 1.2) 53.50
Profit 4.1 (Step 1.2) 10.25
PRICE 100.0 250.00

Phase 2. In Phase 2, each of the 5 elements is evaluated and adjusted for the factors that impact it.

Step 2.1. Break down the Bill of Material (BOM) into its major components, identify the SIC codes for each of those components and assign weights (percentage of total material cost) to them. In the case of a service contract, start with Direct Labor instead of Direct Material, break down the Statement of Work into the various skill levels required for the job and assign weights based on the percentage of total time. In the example, the BOM breaks down as follows:

Item Element SIC Code Weight (%)
1. Book paper, uncoated 2621-4 0.70
2. Lithographic color plates 2796-231 0.16
3. Lithographic and offset ink - sheet type 2893-23234 0.06
4. Miscellaneous supplies - 0.08
  Total   1.00

Step 2.2. Identify a suitable tracking mechanism for each of the SIC codes listed in Step 2.1, and use it to calculate the percentage change in price over the period of time being considered. In the example the Producer Price Index (PPI) was used as the tracking mechanism and the following percentage changes were recorded:

Item Element Weight (%) % Price Change Weighted % Change
1. Book paper, Uncoated 0.70 -21.5 -15.05
2. Lithographic color plates 0.16 2.8 0.45
3. Lithographic and offset ink - sheet type 0.06 1.0 0.06
4. Miscellaneous supplies* 0.08 3.0 0.24
  Total 1.00   -14.30

* the prevailing rate of inflation was used for miscellaneous supplies

From the above table it is observed that average material prices have decreased by 14.3%. A material price multiplier (MPM) is then calculated using the formula:

  • MPM = (1+i)n , where 'i' is the rate of change, and 'n' is the number of time periods

In this case the multiplier is 0.857 {(1.00 + (-0.143)}. Direct Material costs can be adjusted for price as follows:

Adjusted Direct Material (ADM) = Base Price * MPM
= $106.00*0.857
= $90.84

Step 2.3. Estimate the productivity improvements in raw material and adjust the material cost accordingly. In the example, this estimate is 3%. The productivity multiplier (PM) is calculated using the formula:

  • PM = (1-p)n , where 'p' is the productivity rate, and 'n' is the number of time periods

In the example, PM = (1-0.03) = 0.97. Direct Material costs can be adjusted for productivity as follows:

Estimated Material Cost = ADM * PM
= $90.84*0.97
= $88.12

If there are other factors that impact material cost, they must be included. In the example only price changes and productivity improvements have been considered.

Step 2.4. Direct Labor is the next cost element to be evaluated. Changes in wage rates over the period of time being considered can be computed using data from the Bureau of Labor Statistics (BLS). In the example BLS data revealed that the average wage rate for production workers for SIC code 2752 increased by 3.2 percent from 1996 to 1997. The wage rate multiplier (WRM) is calculated using the formula:

  • WRM = (1+r)n , where 'r' is the change in wage rate, and 'n' is the number of time periods
Adjusted Direct Labor (ADL) = Base wage rate * WRM
= $43.25*1.032
= $44.63

Step 2.5. Productivity is the next factor to be considered. In the example the estimate for productivity improvements in labor due to learning curves and other process improvements is 4%. The labor productivity multiplier is calculated using the formula:

  • LPM = (1-p)n, where 'p' is the productivity rate, and 'n' is the number of time periods
Estimated Direct Labor = ADL * LPM
= $44.63 * 0.96
= $42.85

Step 2.6. Manufacturing/Service Overhead costs are initially split into fixed and variable components and then adjusted for time and volume.

In the example:

  • Fixed OH = $37.00*0.8 = $29.60
  • Variable OH = $37.00*0.2 = $7.40

Adjust for inflation using the formula:

F/V OH = Base OH * (1+i)n
where 'i' is the average rate of inflation and 'n', the number of time periods

The average rate of inflation in the example is 3.1%. Thus,

  • Time Adjusted Fixed OH = $29.60*1.031 = $30.52
  • Time Adjusted Variable OH = $7.40*1.031 = $7.63

Next, adjust only the Time Adjusted Fixed OH for volume using the formula:

Volume Adjusted Fixed OH

  • = Time Adjusted Fixed OH * (BV/CV)
  • Where BV = volume in base year and CV is the proposed volume
  • = $30.52 * (10,000/11,000)
  • = $27.74

Total Adjusted OH

  • = Adjusted Fixed OH + Adjusted Variable OH
  • = $27.74 + $7.63
  • = $35.37

Step 2.7. Operating & Other Expenses (O&0) follow the same methodology as in Step 2.6 except that the rule of thumb for O&O is: 90% fixed and 10% variable. In this example, the calculation would be as follows:

Adjusting for inflation and volume:

  • Adjusted Fixed O&O = $53.50 * 0.90 * 1.031 * (10,000 / 11,000) = $45.13
  • Adjusted Variable O&O = $53.50 * 0.10 * 1.031 * 1 = $ 5.52
  • Total adjusted OH = $50.65

Step 2.8. Profit is the only element left for evaluation. In the example, profit dollars have been kept constant per unit on a final price of $227.24. Not only does this result in an increase in the profit margin from 4.10% to 4.51%, it also represents an increase in total profit dollars due to the increase in volume from $102,500 to $112,750. Assuming that there is no additional investment on the part of the supplier, return on investment would also increase. This is truly a win-win situation. The treatment of profit in the application of Price Discipline( is flexible. However, since it is often the toughest part of a customer-supplier negotiation, users are encouraged not to come down too heavily on it.

The Price Discipline( exercise is now complete. The table below is a summary of results.

Cost Element 1996 1997 (proposed) Adjustments
Direct Material 106.00 88.12 adjusted for inflation and productivity
Direct Labor 43.25 42.85 adjusted for inflation and productivity
Factory Overhead 37.00 35.37 adjusted for inflation and volume
Cost of Goods Sold 186.25 166.34  
Operating & Other Exp. 53.50 50.65 adjusted for inflation and volume
Profit 10.25 10.25 profit dollars kept constant
PRICE 250.00 227.24  

Conclusion. The above example makes it quite clear that Price Discipline( when applied through a supply base is a tough process. Initially when companies like Polaroid, Hewlett Packard, IBM, Deere & Co., DuPont and others approached their suppliers with the concept, they were looked upon with a great deal of suspicion and skepticism. It is, indeed, an extremely tough process, but it is also a fair approach based on logic and reason. When conscientiously applied across a supply base, it builds credibility and respect in customer-supplier relationships. It forms the base from which customers and suppliers can embark on strategies to achieve their cost management objectives and obtain a sustained competitive advantage for all involved.

(1) Price Discipline( is a trademark of Jimmy Anklesaria and is used with permission

References:

  1. The Producer Price Index (PPI) is a monthly report on producer price movements for selected industries and industry groups. Data is sorted by SIC code. It contains monthly data for the calendar year as well as annual averages. It is available through the Bureau of Labor Statistics (BLS)- (202) 275-3054. It is also available on the Internet through the BLS web site at http://stats.bls.gov
  2. The Bureau of Labor Statistics (Tel.: 202-606-5900), is the principal fact finding agency of the Federal Government in the broad field of labor, economics and statistics. BLS data is available on-line at http://stats.bls.gov. The BLS website is a comprehensive source of data and allows users to do several forms of selective searches. It also has links to several international statistics sites.
  3. All industries in the United States are classified by the Department of Commerce using a Standard Industrial Classification (SIC) code. A company's SIC code can be obtained from the SIC manual or on line through the internet at http://www.wave.net/upg/immigration.sic_index.html. SIC codes can also be obtained from publications of organizations such as Robert Morris Associates, Dun & Bradstreet and Gale Research.
  4. Robert Morris Associates, Annual Statement Studies can be obtained from Robert Morris Associates, 1 Liberty Place, 1650 Market Street, 23rd floor, Philadelphia, PA 19103-9734, Tel: (215) 851-0585. This publication consists primarily of Balance Sheet and Income Statement information categorized by SIC code. Data is sorted two ways; by asset size and by sales.
  5. The Annual Survey of Manufacturers (ASM) is a publication of the Bureau of Census. It provides statistics for manufacturing establishments sorted by SIC code. Data includes no. of employees, total payroll, no. of production employees, production wages, production hours, value added by manufacturer, cost of materials, value of shipments, new capital expenditure, ending inventories. The ASM can be obtained from the Superintendent of Documents, US Government. Printing Office, Washington DC 20402, Tel: (301) 457-4100.

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