Buyers are always under pressure to consider the lowest price “the right price”, mainly because the amount of expenditure incurred on a purchase is immediately obvious to everyone when the invoice is received. The most obvious situation where this pressure exists is the public sector where the lowest quotation is usually accepted in the mistaken notion that this satisfies the buyer’s responsibility for public Accountability.
But “prices” emanate from the “costs” incurred by the supplier in terms of the materials, labour, overheads, and profit he considers reasonable in producing the goods or services required. Low prices may therefore mean that low costs have been incurred by the supplier which may result in poor quality or service to the buyer.
Additionally, low prices to the buyer may mean that higher costs will be incurred in the conversion of materials, or in maintaining products more frequently when they are in use. These costs tend to be hidden and therefore ignored.
A “reasonable” price to the supplier therefore must cover his costs and leave him with an acceptable profit margin, bearing in mind the quality and services demanded by the buyer. The “right” price for the buyer must be that which results in the best overall cost to his company, bearing in mind conversion, maintenance or service costs subsequently incurred.
Price Factors in Different Situations
One of the main problems in determining what constitutes the “right” price is that there are few situations in commercial buying in which a firm’s universal price exists which is applicable to everyone.
The following factors are likely to have a varying effect on the prices applicable in different situations:
(a) Location: In addition to the packing and transport cost which may be incorporated in prices based on distance from the supplier, there may also be a variety of shipping and insurance charges.
(b) Size of Order: Depending upon the amount of goods purchased, the quoted price might be subject to various discounts such as trade discount, quantity discount or seasonal discounts.
(c) Time Factor: Time may have a number of effect on price, for instance, when buying commodities, one my have a “spot” or “future” price if one purchases at different times. Time escalation clauses may be agreed so that the price increases in line with costs or inflation.
(d) Taxation: Price in certain circumstances might be subject to various forms of duty on taxation, such as excise duty, value added tax or price legislation.
(e) Trade Practice: In some industries, prices may be subject to discriminatory additions or rebates depending upon the type of buyer involved. Electricity, gas, telephone charges are simple examples, viz (commercial vs private users); but this factors applies in many other areas too.
(f) Nature of Requirement: In many circumstances: commercial buying is concerned with “special” requirements to the buyer’s own design and specification. In such cases price is most often determined or based upon the work to be carried out, the cost incurred, and negotiation between the parties. Other factors which may affect prices in these areas could be methods of pricing employed, and terms of payment, such as:
(I) Fixed price contracts
(ii) Cost plus fees contracts
(iii) Unit price
(iv) Price variation agreements
(v) Progress payment agreements
(vi) Delay or default agreements
Apart from commodity prices which are always published in business/economic journals very regularly, there are a number of ways in which a buyer can obtain information regarding prices, such as catalogues and price lists; trade journals, Database, soliciting quotations and tendering.
(a) Catalogues: Prices that are stated are always ‘asking’ prices and can be subject to trade, cash or quantity discounts. The disadvantage is that catalogue prices rapidly become stale. Unless the catalogue is revised and reissued frequently, it will be necessary to ensure that price detail are amended to prevent their being misleading.
(b) Trade journal: They provide essential and useful information on prices that are applicable to particular commodities and industries but are always subject to change without notice.
(c) Database For changeable factors such as price and availability: on-line database can provide up-to-date information and may be space saving substitutes for large reference collections.
(d) Soliciting quotations: Prices are usually obtained by sending enquiries to some selected suppliers. On receipt, the quotations are compared.
(e) Tendering: Tendering can be defined as the procedure by which intending suppliers are invited to make a firm and unequivocal offer of the price and terms which, on acceptance, shall be the basis of the subsequent contract. It is at times used to obtain prices more especially in cases of construction and service contracts. It is more widely used in the public sector to ensure compliance with the principle of public accountability.
Tendering may take two main forms open and selective. In open tenders, all potential contractors reply to a public advertisement and are allowed to quote. In selective tendering, a public advertisement is issued and a “shortlist” is drawn up from contractors who reply, who are then asked to bid; alternatively, there may be no advertisement, rather suppliers are picked from an approved list and invited to tender. Such list is subject to review periodically.
“This is the breaking down of a quoted price into its constituent elements for the purpose of determining the reasonableness or otherwise of the proposed charge” (Lyson, 1996). Constituent elements relate to costs and profit. The reasonableness of the proposed charge is an appraisal of the quoted price to ensure that it covers the direct and indirect costs of an efficient producer and allows a fair profit commensurate with the risks involved in undertaking the work.
Price analysis can be based on the following:
(a) Cost experience of the buyer’s past productions
(b) Cost estimates prepared by the buyer’s organisation
(c) Cost information supplied by the vendor
Element of Cost
Cost is the amount of expenditure incurred on a given thing, Costs can be classified in several ways according to the purpose for which they are required. The most common classifications are:
(i) Direct costs which comprise direct wages, materials and all expenses that can be directly allocated to specific cost units or centers.
(ii) Indirect costs this comprises indirect wages, materials and other expenses that cannot be allocated but which can be apportioned or absorbed by cost units or centers
Cost can also be classified as follows:
(i) Fixed- cost which is not affected by variation in volume of output.
(ii) Variable cost which varies directly with variations in the quantity produced.
(iii) Semi-variable-cost which is partly fixed and partly variable.
With price analysis, it is possible for the buyer to arrive at a reasonably close estimate of the prime cost of a bought-out part. This requires the assistance of design, production and finance personnel
Profit – the supplier is entitled to a reasonable profit as this is the essence of his accepting the order. Profit expectation can also be a source of incentive to do the job.de Rose, (1962) in his book listed ten factors that buyer should consider in analysing the supplier’s anticipated profits: The factors are as follows:
(i) Competitive Price -Seller who offers lowest price should be allowed what profit he can make, providing this is not excessive.
(ii) Initial Orders – A high profit may be necessary on initial orders to persuade the vendor to undertake the risks of a new line of production.
(iii) Size of Order – A higher profit may be justified on a small order.
(iv) Amount of Value added to a Product – Vendors who produce all the components incorporated in a product generally make larger profits than assemblers of purchased part.
(v) Management expertise Required – High profits may be required to keep vendors with products requiring a high degree of designer production expertise interested in the buyer’s business. Subcontracted items usually requires less skill and therefore lower profits.
(vi) Risks Assumed by Vendor – The greater the risks the higher the profit allowable.
(vii) Efficiency Vendor – A vendor who has demonstrated reliability with regards to quality and delivery should not be lost because his prices do not allow him adequate profit.
(viii) Production increase Lower prices – Which include profit, should be passed on to the buyer when increased order have enabled the vendor to achieve higher sales without exceptional efforts of proportionate cost increases. Conversely, where the vendor has assumed higher capital expenditure or risk to meet this demand, he or she should be allowed an appropriate profit adjustment.
(ix) Buyer Furnished Property – Where the buyer has provided plant or materials, the vendors is entitled to less profit than when he has furnished these items.
(x) Reliability of cost estimates – Cost estimates are more significant than profit estimated in determining real profits. A past record of accurate cost estimates gives confidence to the buyer to award a reasonable profit.
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