Purchasing and Negotiation Training

Robert Menard, Certified Purchasing Professional, Certified Professional Purchasing Consultant

Our dominant obligation and duty as purchasing professionals is to manage costs.  To do so, we must be able to identify and analyze the costs that make up the goods and services we buy. 

What is Cost Analysis?

Simply defined, Cost Analysis is a breakdown and examination of constituent costs.  We will use a basic model for convenience here, but in practice, your breakdown will have a greater or lesser degree of sophistication, depending upon the importance of the purchase; the more critical the buy, the more in depth the breakdown.  For instance, a buyer of manufactured parts may need to know the amounts and percentages of the cost of raw material, production, logistics, indirect, and overhead.  Indirect is always tricky as there is no precise, uniform definition.  Some organizations lump packaging, advertising, marketing, and sales expense into the indirect category, often by percentage allocation.  No matter what it is called, we must know about it.

How is Cost Analysis information obtained?

There are a variety of ways but the easiest way is to ask.  Provide a non disclosure or secrecy agreement to facilitate the exchange of information. You are ethically bound to keep the information confidential anyway so memorialize the agreement in writing.  In some instances, if the supplier suspects that you could make the part, you may need to sign a non-compete agreement as well. 

Refusal to disclose cost information waves a red flag.  The supplier may not know its costs, which is dangerous as it could easily slip into a situation where it cannot perform because of underestimated costs.  Conversely, a supplier may not want to divulge the cost because we are paying far more than is economically justified.  Either one of these two situations requires immediate remedial action. 

When is it obtained?

There are two ideal times, with a new supplier and at periodic performance review.  For a new supplier undergoing the qualification process, the risk of losing a new customer makes it more responsive to cost analysis requests.  Compare its cost structure to other similar suppliers and verify reasons for differences.  Recall that purchasing pros buying goods may not induce or receive a discriminatory (not cost justified) price.  Edges in raw mat sourcing, proximity to customers, or other strategic advantages may benefit a supplier and thus justify the cost difference. 

Contract renewal or evaluation is the other ideal time, particularly if there has been a failure in the recent period.  Supplier and customer have an opportunity to examine how to collaboratively reduce costs.  Elimination of needless costs reduces the price.  For example, assume you buy a part for $100. If you remove $2/piece in needless logistics or packaging costs, that entire $2 savings can be applied to reducing the price to $98.

Quo vadis?

Not that you have all this information where do you go with it?  Begin with the cost drivers, a buzz word meaning either the greater or more volatile cost elements.  Consider the example in this chart.  

 The place to begin your analysis is in the raw material category as it contains 60% of the cost, the greatest single category.  The main cost driver is copper as it comprises the single biggest item of raw mat.  Copper and PVC are commodities whose price is established daily on major exchanges around the world.  Raw material should be the easiest category to justify or in which to spot problems.  For instance if the supplier claims it needs a price increase because the raw material have increased, you can easily verify the claim.  Moreover, the copper price increase applies only to 40% of the price you pay.  A 10% price increase in copper raises the cost by $0.16 (10% @ $1.60), not 10% of the $4.00 selling price. 

Production costs will vary depending upon the supplier’s capacity, technology, efficiency, etc.  It is our job as purchasing pros to understand and verify differentials amongst suppliers so that we are comfortable that the costs are properly analyzed and that we have made a prudent and professional decision.

The more we focus on reducing costs, the less adversarial the buy/sell relationship becomes.  Cost Analysis is a perfect example of how data driven decisions lead to sound business judgment.