The following article was prepared by Mike Taylor, C.P.M., for distribution to ISM affiliate newsletters.

Why Cost Analysis?

February 2007

You may be asking yourself; ďWhy do I care about cost analysis. I donít place government contracts where a cost breakdown analysis is required. The sellerís bottom line price is all I need to know.Ē

You have a good point. It would be very nice to only have to worry about the final price; but consider these examples:

  1. The seller claims that because of a 10% world-wide price increase for copper, the selling price of the valve must be raised by 10%
  2. The seller announces that his utility company has raised electric rates by 10% because of a water shortage and so all of his selling prices are being raised by 10%.
  3. Your maintenance manager decides that he does not need a new flange gasket and the seller agrees to reduce the selling price by $10.
  4. You agree to accept the valve unassembled so your inspectors donít have to take it apart to inspect on receipt. The seller claims that will result in 1 less hour of labor at $9.00 per hour and so reduces the selling price by $9.00.
  5. You have a chance to back-haul the shipment from the sellerís plant on one of your trucks. In exchange the seller agrees to reduce the selling price by $175 Ė the actual cost of commercial transportation.
  6. Because you are in the food service business, sellers are required to use very expensive food-grade grease that is only available in 5-gallon pails. The seller raised the price of his normal roller assembly by the value of a 5-gallon pail of the special grease.
  7. The seller calls one week before the valve is due to ship and says in order to make the delivery schedule he will need 4-hours of overtime for the shop to rework a defective casting.

True, you may not have to prepare a cost breakdown analysis before awarding your order Ė but in each of these real life situations, the more you know about the sellerís cost, the better. 

Using the above scenarios, here are a few reasons why knowing the cost breakdown might help:

  1. Sure, the price of copper may have risen 10%. But the copper part of our valve is only a small percentage of the total price. You know that the seller adds indirect overhead costs on top of the copper material, plus G&A, plus profit. Thus, if the copper part is only worth $10 then you only want to agree to a $1 increase not a 10%  increase to the whole selling price.
  2. Utility costs are generally included in G&A expenses and added to the selling price. But Utility costs are only a piece of the G&A adder. So even if it might be appropriate to pass along the whole utility price increase (and it might not be for a lot of reasons) the 10% increase should only be allocated based on the net change to G&A. example: utility costs are $500 (per year) and other G&A expenses are $500 so a 10% net change to utility costs means that the total G&A pool rises to $1050 (only a 5% increase to the pool).
  3. How much should the price be reduced? The sellers cost for the gasket; the price list price or something in between? A $10 gasket has been incremented by overhead, G&A and profit adders and could be worth $13 by the time it gets to the bottom line.
  4. Obviously Ė requesting that the valve not be assembled will save some amount of labor Ė but how much time is that per valve? Is it just assembly, or does it also affect time for cleaning, testing and packaging.  Donít forget that labor charges will have an indirect overhead component added, plus G&A plus profit. So even if we save an entire hour of time, the time is worth much more than just the direct wages of the laborer.
  5. Is the commercial transportation a separate adder on top of all the other components of the selling price? If so, itís easy to compare with other transportation options if you know how much the transportation was quoted in the first place.
  6. Sometimes it just makes sense to supply a specialty commodity to the seller instead of paying the seller to procure it on his own. In this situation we end up paying for a lot of wasted grease (plus cost adders). Our option is to supply the seller with a small amount of grease to use on the job and cut the grease expense completely out of the price.
  7. Casting defects happen all the time and generally allowances are made as part of a normal casting process. Was there a backup casting poured? Is there already rework time and labor allowances included in the price? Even if not, the casting defect should have been discovered early in the production process not at the last minute. Also we'd want to know which labor category has to work overtime because some are paid at different rates.

In all of the above examples, the real question is "What is the value to the order?" The change in price should be fair to both the buyer and seller - but what's fair? Starting the negotiation without any information will result in a doubtful outcome. The change to the contract will be hard to support and justify.

Have I convinced you that in some cases it would be helpful to have a cost breakdown of a seller's proposal even if it wasn't needed it to satisfy a procedure?  Having the cost breakdown  - or at least a good idea of the process and cost adders can open a lot of doors in a negotiation. Process knowledge can also help spot delays and impacts to the job much earlier - when corrective action will be more helpful. Understanding the cost breakdown will also help us correctly identify impact of price increases or specification changes.

IMPORTANT NOTE: It is much easier to find out what a sellerís true production expenses are before you place an order. I consider Fact Finding before placing an order mandatory Ė itís not an optional exercise. The more you know before you buy - the better. We'll talk more about fact finding later.


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