Is Price Analysis a Lost Art?
Dr. LeRoy H. Graw, C.P.M., CPCM
Dr. LeRoy H. Graw, C.P.M., CPCM, Consultant, Cattan Services, 1667 N. Vallejo Way, Upland, CA 91784, 909-985-9771.
83rd Annual International Conference Proceedings - 1998
Abstract. "Is Price Analysis a Lost Art?" There is evidence available that would suggest it is. Some professional purchasers fail to recognize the obvious (and nonobvious) benefits of an effective price analysis program in their organizations, whether they be private or public. This presentation covers those programs, policies, and procedures any Purchasing Manager can implement in order to implement an effective, efficient price analytical system in support of negotiation.
The Opportunity. Most organizations are concerned first of all with the "bottom line", whether that be increased earnings (for profit) or increased services for less cost (public sector and non-profit). Unless professional purchasers in these organizations employ price analysis as a tool of negotiation to get better pricing, the "bottom line" will be higher than necessary. By employing time and cost saving procurement techniques, professional purchasers can make time available to "rediscover" price analysis from its status as a "lost art".
Objectives. This workshop provides the knowledges needed for professional purchasers to:
- Determine whether or not their organizations are using price analysis to its fullest advantage.
- Employ price analytical/comparison techniques in their organizations.
- Implement time savings purchasing procedures which "free up" time to use price analysis and negotiation to obtain "best value" for their organizations.
"Price Analysis" (Graw, 1994) is the "process of examining and evaluating a proposed price without evaluating its separate elements of cost and profit".
"Art" (Webster's, 1984) is the "skill, dexterity, or the power of performing certain actions, acquired by experience, study, or observation".
"Lost" (Webster's, 1984) is "not spent profitably or usefully; wasted".
Evidence of Price Analysis as a "Lost Art".
Having been afforded the opportunity to work with both private and public sector organizations in a variety of circumstances, the author has observed purchasing professionals who are skilled in sealed bidding (public sector) or competitive bidding (private sector) but equally unskilled with those situations falling outside these two situations which rely on the presence of price competition. Price competition is, of course, a desired objective in most procurements, and is one which we achieve more than 75 or 80% of the time (more for some and less for others).
It is in the absence of price competition that price analysis takes on increased importance and significance. Price analysis (supported by some cost analysis if necessary and available) is the one technique needed to get the purchaser through the pitfalls of sole source and single source procurement. Borrowing from some old military clichés, purchasers who attempt to negotiate without the benefit of a thorough price analysis are "shooting in the dark" and "going into battle with their weapons half-cocked". Purchasers who conduct systematic and through price analysis are "forewarned and forearmed" and capable of "carrying the battle to the opposition". Empirical evidence has shown that price analysis (and the accompanying negotiation of price) provides a "return on investment" (time and effort) from a minimum of 5 to 1 to as much as 20 to 1 (depending on the product, service, and circumstances).
Evidence of lack of use of price analysis can be readily discerned in purchase order and contract files. It is most evident in the evidence that purchase orders reflect the initial price(s) offered in a single/sole source situation. It is also evident in the absence of any explicit price comparison or negotiation documentation in the file.
Why Does This Situation Exist?
There are a number of reasons why purchasers fail to take advantage of the cost-saving potential of price analysis and negotiation. In some organizations, (public, primarily), negotiation is either outlawed or discouraged. Although the "wheels of progress" move slowly, there is evidence that the Federal Government (in its "Acquisition Reform" and the Federal Acquisition Regulation (FAR) Part 15 Rewrite), as well as some State, County, and Local Governments are beginning to see the benefits of price analysis and negotiation and are starting to change their laws and regulations accordingly. In many organizations, "time is of the essence" in the procurement process. Requisitioning and program management personnel just don't have enough time in their client-imposed "budget" to allocate to purchasing/procurement. This situation is typically exacerbated by the belief among technical personnel that purchasing/procurement is an "ordering function"-- that the "real work" of source selection and pricing is a technical responsibility, and that all purchasing/procurement needs to do is "issue the order" to the firm selected by the technical personnel.
In most of the organizations where the above situation exists, there is an absence of thorough, written purchasing policies and procedures. It is almost a "universal truth" that organizations without written purchasing procedures have difficulty moving beyond the situation where purchasers are thought of as orderers and something less than professional. In Chapter 3 of The Purchasing Handbook (Fearon, Dobler, and Killen, 1993),Carvey, Hawk, and Buddress assert that "availability of written policies and procedures, whether or not in the form of a complete purchasing manual, is widely recognized as an essential cornerstone for building an effective professional purchasing organization." Thorough, written purchasing procedures alone will not suffice to professionalize the purchasing organization to the point where price analysis and negotiation are "systematized", but they do go a long way toward achieving that end!! In addition, they serve as tremendous communication and planning/control devices!
In addition, of course, both purchasers and technical personnel need to be trained in the proper application of price analysis and negotiation. This should preferably take place AFTER price analysis and negotiation are thoroughly explained in the purchasing policies and procedures. This training should typically be done by someone outside the organization who knows the organization and its staffing and who further knows how price analysis can/should operate within the context of that organization. An "off-the-shelf" presentation rarely works!! And public seminars which are attended by 20-30 people from vastly disparate organizations rarely "transplant" the skills needed within the organizations represented!!
What Are Price Analytical Skills and Techniques?
To perform price analysis, the buyer must have a base or reference to which the quoted price can be compared. That basis for comparison must itself be known to be reasonable. Then the buyer must ensure that the quotation and the base are truly comparable and that the comparison is not being made between apples and oranges. That is why the comparison of competitive quotations is such an effective method of price analysis. If the buyer can be reasonably assured that the items are comparable and, presuming that the firms involved are really competing with one another, then the lowest price submitted will be reasonable.
In performing any price analysis, then, comparability is the key. One must consider quality of the items for which prices are being compared; quantities involved in the sale; delivery conditions (f.o.b. origin versus f.o.b. destination); and market conditions (for some items, tomorrow's price may be different from yesterday's, often by a wide margin).
If the buyer can arrive at a reasonable base for comparison, even though it includes adjustments for differences in relation to some of the items listed above, the use of price analysis techniques will determine whether a price is fair and reasonable.
Many methods of price analysis are available. Selection of the method to use depends on the specific features of the procurement situation. In many instances, a combination of methods is best. The following methods are among the most commonly used:
Comparison with competing offers on the instant purchase
This is generally considered a primary method of price analysis. It is nothing more than the act of seeing what price quoted is the lowest among those received. Unless there is some doubt about the adequacy of competition, this method is generally considered a conclusive judge of price reasonableness.
Comparison with established catalog prices
In the absence of price competition this method of price analysis should be considered a primary method of comparison. The method is supported by the fact many vendors publish prices for items which are regularly offered for sale. Quotations can be compared to those published prices, but caution is required. First, the buyer must make sure that the catalogs represent actual prices which are now or were recently being charged. (Catalog prices are frequently discounted for Government agencies and large corporations, which are generally considered "most favored customers" because of the large volume of business they engage in). Second, the buyer must be sure that the price listed applies to an item which is sufficiently similar to the required item to provide a sound basis for comparison. Third, the buyer must be sure that the catalog or price list applies to the same class of trade.
Comparison with established market prices
Like the comparison with established catalog prices, this method of price analysis should be considered a primary method in the absence of price competition. Many items are regularly traded at prices which tend to fluctuate over short intervals. Catalogs of prices for these items are not published because changes occur too rapidly. But if the Buyer can establish the price range in which sales are being made to the general public (through trade journals or other sources), that range can be used as a basis for comparison.
Comparison with prices set by law or regulation
This is another primary method of price analysis which is appropriate when dealing with regulated utility services. Regulated utilities (electric companies and the like) are required to seek the approval of their regulatory commission before they can adjust their rates. If the buyer is buying regulated services, the regulatory commission approved rates will be published and available to the buyer.
Comparison with current prices paid for the same or similar items, past prices paid for the same or similar requirement, and past offers
This method of price analysis should be considered only after one or more of the primary methods discussed above has been attempted. If the price quoted is the same or less than that which was recently paid for the same or similar items, the current quotation is likely to be reasonable. Buyers should be careful, however, to ascertain that the historical prices to which a comparison is made were themselves adequately analyzed for reasonableness. Further, buyers should take into account price trends (up or down) caused by market or economic conditions, rapidly fluctuating commodity prices, or other factors. Often the buyer will have a basis for comparison in the form of prices for an item that is similar but not identical to the one being bought. If the buyer can, through some method of price analysis, determine what the difference in price should be between the item being purchased and the one for which prices are available, that difference can be used as an adjustment in order to arrive at a valid comparison.
Comparison with producer price and other market indexes
This technique, although it is generally considered a secondary method of price analysis, is very powerful and should be considered for use even when other more obvious comparative methods are available. This method is often used in conjunction with the method discussed immediately above in order to make prices from different points in time comparable with respect to a specific point in time.
Comparison with cost estimating relationships, to include rough yardsticks and parametric relationships
This comparison technique is considered by many to be a powerful secondary method of price analysis. Cost estimating relationships are defined as relationships between cost and an item or service characteristic. An example of a cost estimating relationship would be the (straight line) relationship between the cost of construction and square feet of floor space.
Comparison with in-house estimates
If the requisitioner has developed a competent cost estimate for the item or service to be acquired, the quoted price can be compared with that estimate. The estimate should have been prepared when the PR was submitted, without knowledge of the quotes received. The estimate is not to be based on the amount of program funds available, but in consideration of the current market prices for the goods and services being requisitioned. Detailed, "bottom-up" estimates are particularly important in purchasing of services, particularly construction services.
Comparison with values determined by value and visual analysis
These techniques are generally considered tertiary or "auxiliary" price analysis techniques. Value analysis is the task of determining why seemingly similar products should be priced differently.
Value analysis normally takes place in two stages. In the first stage the buyer lists the functions required and compares the required functions to those of alternative products. In doing this, the buyer assumes that an item with a lower use value should have a lower price (an assumption which may not be supported in fact). In the second stage, the buyer identifies and compares the aesthetic functions to those of alternative products. Upon completing the second stage, the buyer often finds that the price differentials, if any, are supported by the aesthetic differences rather than the use differences. Commercial and industrial entities are generally more interested in use than aesthetic value.
Visual analysis is a simpler technique in that it involves visual inspection of the item (or alternatively, the representations of the item in drawings), in order to develop a rough estimate of the value. Because it concentrates on obvious, external features of an item, it should be used only to get you "into the ballpark".
What Can Purchasers Do to Implement Time Saving Purchasing Procedures Which "Free Up" Time to Use Price Analysis and Negotiation to Obtain "Best Value" for Their Organizations?
We have already suggested that professionalism in price analysis and negotiation are greatly aided through development of thorough written policies and procedures and further by training in the employment of price analysis and negotiation consistent with those procedures. But what procedures will "free up" time needed to do price analysis and negotiation?
Among those which warrant consideration are the following: (1) use of blanket orders/agreements with technical personnel and requisitioners established as authorized orderers; (2) use of Purchasing Credit Cards, with all users of MRO and related items and services so equipped; (3) use of Email, fax, and fax-modem to send solicitations and receive offers; (4) use of Email for contracts-related correspondence with clients, vendors, and contractors; (5) posting of solicitations on web-sites for download; (6) use of the Internet to conduct market and vendor/contractor research; (7) use of bidding and solicitation services to "leverage" the available purchasing staff; (8) "outsourcing" or contracting out for specialized purchasing functions like claims management, contract closeouts, training, and records administration.
Price analysis often is, but need not be, a "Lost Art." With proper planning, organization, and control, (including development of thorough written policies and procedures and training in the use thereof), as well as judicious application of time-saving procurement and contract administration methods and techniques, the various methods of price analysis in support of negotiation can be employed to make purchasers more professional and greater contributors to the organization's "bottom line".
Air Force Institute of Technology and Federal Acquisition Institute. Contract Pricing Resource Guide, Volume I, Price Analysis and Volume V, Federal Contract Negotiation Techniques. Washington, D.C., 1997. (Available on the Internet at http://www.gsa.gov/fai).
DOD, GSA, and NASA. Federal Acquisition Regulation Part 15 Rewrite; Contracting by Negotiation and Competitive Range Determination. Published in the Federal Register. Washington, D.C., September 30, 1997.
Fearon, Harold E., Donald W. Dobler, and Kenneth H. Killen, Editors. The Purchasing Handbook. New York: McGraw Hill, 1993.
Graw, LeRoy H. Cost/Price Analysis: Tools to Improve Profit Margins. New York: Van Nostrand-Reinhold, 1994.
Webster's New Twentieth Century Dictionary, Unabridged, 2nd Edition. New York: Collins World, 1984.