Procurement managing cost & price

Procurement: Managing Cost & Price

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Managing Cost and Price

Whole Life Costing:

Whole life costs apply to goods and to services.

For goods, the whole life cost is the total of what it costs now to buy the goods, own them, use them over their life time and dispose of any waste at the end of their life.

For services, the whole life cost is what it costs now to buy the services plus on-going costs of receiving the service plus any cost of discontinuing the service.

Whole life cost is also known as life cycle costing. It is used to evaluate value when procuring complex goods and services. It can be used for simple goods and services but, for these, the whole life cost is often not much different to the original price.

The advantage of using whole life costing to evaluate value is that it makes it possible to compare the cost over the life time of goods or services which have different initial prices and different costs of use, disposal etc. over what might be different life times. Whole life costing does this by taking account of the time value of money. This involves the use of an accountancy technique called discounted cash flow in order to calculate the net present value of the various cash outflows and inflows.

Although the technique sounds complicated, it has the same basis as the calculation of compound interest and with a little practice, it is not difficult to understand and apply.

Supposing an organisation wishes to buy an IT system and there are several which can offer the service which is required but each has a different purchasing price, different service and maintenance costs and different useful life times. Which system offers the best value. For each system, the basic steps are to identify all the costs and when they occur? Apply the discounted cash technique to the costs to calculate each cost's net present value. Add together the net present values of the costs of each system to calculate the total net present value for that system. Do the same for each of the competitor systems. Compare the total net present values and select the lowest. Assuming that this system offers the same level of service as all the others, then this system will offer the best value.

In business to business buying and selling transactions, however, such buyer friendly legislation either does not exist or is much more limited in its scope. Moreover, many vendor organisations have a much more hard nosed approach to their customers. The importance of power in a relationship is much more evident and so is the vendor organisation's use of its power to more aggressively protect itself.

The consequences of poor procurement of goods and services can be more evident. Consumers buy relatively few things which are seriously likely to damage their wealth if they buy badly (examples are a home, a pension, may be a savings plan and a loan scheme). Organisations buy critical goods and services much more frequently and they can be are put out of business by the cost of a poor procurement.

In many organisations, staff are often given little or no formal training in procurement. There is also widespread ignorance of the causes of commercial failure arising from poor procurement of goods and services. We look here at some of the things which you should know and which are covered by a series of modular courses which are designed using the Pareto 80:20 principle to quickly bring purchasing and contracting staff up to speed without the need for long term study.

Managing cost and price:

It is often asserted that total cost is more important than price. This makes it sound as if price and cost are different. However, one party's price is another party's cost and total cost is simply the sum of all prices paid. It is not possible to manage total cost without managing individual prices.

The difficulty with managing total cost is that not all costs are easy to identify. This is because they do not all occur at the same time. Future costs (or future prices to be paid) are very easy to miss or disregard because it can be difficult to know when they will occur or even whether they will occur.

It helps to have checklists of possible future costs and to verify for any particular purchase whether and when the cost is likely to arise.

Management of price and cost takes into account its relationship with quantity, the type of pricing mechanism which is used and the type of payment method. These critically interact to affect the whole life cost of any goods or services to be purchased.

The management of price/cost is often hindered by a number of fallacies. These are often accepted as corner stones of conventional wisdom: 'you only get what you pay for', 'price goes down with quantity', 'price lists are fixed', 'the bigger purchaser gets the best prices' etc. The management of cost/price requires these fallacies to be identified, explored and often rejected and for more rigorous methods of price/cost management to be employed.

The basis of any rigorous method of management is the use of competition plus a clear understanding of the concept of value plus supplier management. The word 'value' is often used without consideration or understanding as if it is always self evident what value is. In fact, value is judgemental, situation dependent and varies from person to person or organisation to organisation.

Once value has been identified, competition and supplier management are the routes to its achievement. Organisations which are good at managing competition and good at managing supplier relationships are good at achieving value.

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~ Stephen Cannon ~

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