Cost-Driven Pricing:
An Innovative Approach
for Managing Supply
Chain Costs
Robert J. Trent, Ph.D.
Supply Chain Management Program Director
and Eugene Mercy Associate Professor of
Management, Lehigh University
rjt2@lehigh.edu
Robert M. Monczka, Ph.D.
Distinguished Professor of Supply Chain
Management, Arizona State University
Director of Sourcing and Supply Chain
Research Center for Advanced Purchasing
Studies (CAPS) Research
RMM@monczka.com
Competing successfully on a worldwide basis demands new and
innovative ways to identify and reduce supply chain costs. Buyers and
sellers who view each other as strategically important must consider
non-traditional pricing practices in their pursuit of competitive market
advantages. This discussion presents cost-driven pricing as an innovative
approach for managing the costs of selected items over the life of a
purchase contract. Without creative cost management approaches and
techniques, supply-chain members risk losing ground to those companies
that truly understand how to cooperate to succeed. This article discusses
when to apply cost versus price analytic techniques, develops the concept
of cost-driven-pricing and contracting, presents a best-practice example
that illustrates the cost-driven pricing concept, and identifies the
potential risks that must be managed within cost-driven agreements.
Across virtually every industry
firms are experiencing unrelenting
pressure to improve at dramatic
levels. This includes customer and
competitive pressure to improve in
quality, service, cycle time,
innovation, and responsiveness to
customer needs. Perhaps more
than any other area, however, is the
need to satisfy cost reduction
pressures.1
An analysis of how to improve
costs must include a discussion of
how firms create and manage
cross-organizational relationships.
An important part of improved cost
competitiveness may very well
center on a firm’s ability to develop
and manage inter-firm relationships
that lead to the creation of new
value within the supply chain. An
earlier study by the Harvard
Business School confirmed that
a primary reason for the
competitiveness of many non-U.S.
firms resulted from a greater
commitment
in
intangible
investments such as supplier
relationships.2 Executive managers
must begin to endorse a
non-traditional perspective toward
those suppliers that affect a
firm’s competitive position. While
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An International Journal
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2
progressive firms are able to
capture the value offered by their
critical suppliers, others are failing
to respond.
Competing successfully on a
worldwide basis requires the
development of approaches that
help identify and reduce supply
chain costs. This article presents
cost-driven pricing as an innovative
way to manage important items
over the life of a purchase contract.
To better understand this concept
we discuss when to apply cost
versus price analytic techniques,
develop the concept of cost-driven
pricing and contracting, and
present a best-practice case that
illustrates the successful use of a
cost-driven approach. We conclude
by identifying the potential risks
that must be managed within a
cost-driven framework.
Applying Price versus Cost
Analytic Techniques
A major responsibility of a buying
company is to ensure that the
prices it pays for externally
acquired goods and services are
fair and reasonable.
In many
situations the need to control costs
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requires a focus on the cost
elements
associated
with
producing an item or service
versus simply analyzing a quoted
price. In other cases, however, it is
not necessary to commit much
effort or time to understanding
costs. A comparison of whether a
price is fair given competitive
market conditions is all that may be
required.
Throughout this discussion it is
important to recognize that
fundamental differences exist
between price and cost analysis.
Price analysis refers to the process
of comparing one price against
another price, comparing against
external price benchmarks, or
comparing against other available
information
without
in-depth
knowledge about underlying costs.
Examples
of
price
analytic
techniques include competitive bid
comparisons, comparisons against
published catalog prices, price
behavior relative to an external
benchmark such as government
price indices, and comparisons
against historical price behavior.
Cost analytic techniques focus
primarily on the costs that are
aggregated to create a purchase
price. By better managing and
reducing the elements of cost, a
buyer should see the result of these
efforts in a lower purchase price
compared with prices where cost
management did not occur.
Cost-driven approaches require the
identification and management of
costs and cost drivers, which are
the factors that directly affect cost
levels. A change in a cost driver
will cause a change in the total cost
(and usually the price) of a related
product or service.
A primary difference between price
and cost analysis is that cost
analysis requires a more technical
and detailed understanding of
costs. Cost analysis also requires
greater cooperation with a seller
to
quantify
costs,
identify
cost
drivers,
and
develop
strategies to improve performance.
Increasingly, supply chain managers
must become skilled at managing
supply chain costs.
Supply Chain Forum
An International Journal
The issue of when to apply cost
versus price analytic approaches
within a supply chain is an
important one. Exhibit 1 presents a
matrix that helps conceptualize
when to apply price versus
cost-analytic approaches. In fact,
a progressive supply chain
practice involves segmenting
supply requirements according to
the characteristics of those
requirements.3 This matrix helps
identify when to apply cost analytic
approaches, such as cost-driven
pricing, versus traditional price
analytic approaches, such as bid
comparisons or comparisons
against market price indices.
Exhibit 1 segments purchase
requirements
across
two
dimensions—the number of active
suppliers in a marketplace and the
Competing on a
worldwide basis
requires the
development of
approaches that help
identify and reduce
supply chain costs.
value of the good or service to the
buying organization. The goods
and services in the lower left
quadrant, or the transaction
quadrant, have a lower total value
with a limited supply market.
Unfortunately, most organizations
commit a disproportionate amount
of time and resources obtaining
and managing transaction items,
also referred to as nuisance items
by some supply chain managers.4
Reducing the transactions cost of
the purchase is the primary way
to create value in this quadrant
(such as through the use of
e-procurement systems). Even
when an item has many potential
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3
suppliers, the cost of searching for
and comparing supply chain
sources usually outweighs the
value resulting from the search.
Any price analysis that occurs is
cursory due to the low value of
the good or service. Routine office
supplies, one-time purchases,
magazine subscriptions to trade
journals, and emergency tools
needed at remote locations are
examples of transaction purchases.
The lower right quadrant, or
the market quadrant, includes
standard items that have an
active supply market. Commodity
chemicals, fasteners, corrugated
packaging, and other basic raw
materials are logically part of this
quadrant. The common trait shared
by these products and services is
they have a lower to medium total
value, many suppliers that can
provide substitutable products and
services, and lower supplier
switching costs.
Price rather
than cost analytic techniques
usually work best when obtaining
these items. Competitive bid or
price comparisons, shorter-term
contracting,
reverse
Internet
auctions, and blanket purchase
orders are often used techniques
when obtaining market items.
The upper right quadrant, or the
leverage quadrant, includes those
items where consolidating volumes
and reducing the size of the supply
base can lead to economic benefit.
Supply chain managers leverage
their requirements not only to
obtain favorable pricing, but also to
gain advantages in other non-price
areas. For example, leveraging
volumes through longer-term
contracts may lead to discussions
with a supplier about quality,
delivery, packaging, and service
(all factors that can affect cost).
Depending on the leveraged item, a
cost rather than price focus should
begin to emerge in this quadrant.
The upper left quadrant, or the
critical quadrant, includes goods
and services that are essential to
the purchaser’s operation. This
means the good or service
consumes a large amount of
purchase dollars, the item or
service affects a product’s function,
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to suppliers because a buyer
commits to a fair return on a
supplier’s
investment
while
agreeing to share any savings that
accrue throughout a contract.
Exhibit 3 shows the interrelated
factors that must be present when
pursuing a cost-driven approach
with critical suppliers.
Exhibit 1
Purchasing and Supply Segmentation Matrix
High
Value to
Buyer
Critical Items
Leverage Items
Collaborative relationships
through alliances or partnerships
Longer-term purchase
agreements
Transaction Items
Market Items
Low dollar purchase systems,
such as procurement cards
Competitive bidding
Reverse Internet auctions
Cost
Focus
Price
Focus
Low
Many
Few
Number of Qualified Suppliers in Marketplace
and/or the item or service
differentiates the product in the
eyes of the end customer. By
definition this quadrant includes
fewer suppliers that can satisfy a
purchaser’s requirements, which
often involve customized rather
than standardized items. Although
these items represent a small
portion of total transactions,
opportunities exist to create value
through collaborative supply chain
efforts. This involves, but of course
is not limited to, a strong focus on
cost and cost drivers.
Supply chain managers must
recognize that the items residing in
the lower half of the matrix will
benefit most from the application of
price analytic techniques. At times
an item may have such a low value
or be part of a highly competitive
market that any analysis beyond
price comparisons yields minimal
return. At other times, supply
chain managers must apply
innovative
cost
management
techniques to manage and control
costs and cost drivers for items
that are more important or higher
in value. It would be unproductive
to apply cost analytic techniques
when a situation requires basic
price analysis. Conversely, applying
price analytic techniques to
situations that would benefit from
cost analysis could leave a degree
of
value
or
improvement
opportunity unrealized. One of the
more innovative cost-focused
approaches, something we have
termed cost-driven pricing, is one
way to manage those items and
services that are vital to an
organization’s competitiveness and
even survival.
Supply Chain Forum
An International Journal
Understanding
Cost-Driven Pricing
Cost-driven
pricing
is
a
collaborative
approach
for
managing the cost, and therefore
the price, of critical items. This
approach,
which
offers
an
opportunity
to
promote
cooperative behavior between a
buyer and seller, has as its primary
objective accelerated supplier
improvement with continuous cost
reductions achieved over the life of a
contract.
Cost-driven pricing
enables buying and selling firms to
achieve real cost reductions over
time while simultaneously reducing
the conflict typically associated
with pricing approaches that
promote
short-term
profit
maximization. Exhibit 2 summarizes
the key features of cost-driven
pricing. As will be explained, this
approach should intuitively appeal
A
cost-driven
approach
to
contracting promotes cooperative
behavior between buying and
selling firms. Joint buyer/seller
evaluation
and
analysis
of
product cost structures lead to
agreed upon return-on-investment
requirements, target price setting,
and cost-saving sharing goals that
drive subsequent or future
purchase/selling prices.
Once a buyer establishes price
and profit targets for an item
(often through a broader target
costing approach), the buyer and
seller must manage costs through
effective product, component, or
subassembly design along with the
management of variable and fixed
cost drivers.
Cost-driven pricing contracts
differ
radically
from
costplus contracting. With cost-plus
contracting, profits often increase
or decrease based on actual costs
incurred. Cost-plus contracting
results in conflicting goals because
increasing costs eventually benefit
the supplier at the buyer’s expense.
Exhibit 2
Cost-Driven Pricing Key Features
■
A cost-driven pricing approach is most applicable when the seller adds
higher levels of value through direct and indirect labor or design
■
A buyer and seller's joint agreement on the target price, profit, and full
cost to produce an item is the foundation of a cost-driven price
■
A supplier's asset investment and return requirements provide the basis for
establishing the profit for each item produced
■
Profit is a result of an agreed to percentage return on assets employed directly
by the seller to satisfy the buyer’s contract
■
Joint assumptions and agreement on product cost, production volumes,
quality, targeted costs, quantifiable productivity improvements, risk
sharing, and contractual sharing of supplier initiated savings are essential
elements of cost-driven pricing
■ Pricing
improvement results from a better understanding of requirements
and costs, information sharing between firms, and the continuous
reduction of a supplier's product cost structure
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Exhibit 3
Cost-Driven Pricing Interrelated Factors
Targeted Rate of
Return on Investment
Relationship-Specific
Investment
and Accurate Volume
Estimates
INTERRELATED
For Cost-Driven
Princing Benefits and
Sharing
Variable Cost,
Productivity, and
Performance
Improvement Targets
Continuous Individual
and Joint Improvement
Strategies
Cost-driven pricing is also not
market-driven
pricing.
In
a
market-driven approach, the buyer
or seller maintain an advantage
depending on supply and demand,
the level of product differentiation,
or the number of firms involved
within a market. Suppliers focus on
achieving the highest allowable
price while buyers strive for prices
that are often unrealistic. Pursuing
advantages at the expense of the
other party, unstable pricing, and
conflicting goals do not promote
cooperative
behavior
across
the supply chain. Furthermore,
market-driven pricing typically
ignores the cost drivers behind a
purchase price.
It becomes necessary to discuss
several concepts further to
understand cost-driven pricing.
First, a buyer and seller's joint
agreement on the target price,
profit, and full cost to produce an
item becomes the foundation of a
cost-driven price. This requires
agreement not only about target
prices and allowable profit, but also
agreement about standard material,
labor, and other direct and indirect
costs associated with producing an
item. The parties must also agree
on any variances due to start up
and normal aberrations beyond
standard efficiencies. Reasonable
administrative, selling, and other
general
expenses
are
also
recognized as a fundamental part of
the supplier's full cost base.
Perhaps the most important
element of a cost-driven pricing
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contract is that a supplier's
asset investment and return
requirements provide the basis for
establishing the profit for each item
produced. Profit is the result of
an agreed to return on assets
employed directly by the seller to
satisfy the buyer’s contract. This
differs from traditional pricing
approaches that establish profit as
a percentage of the selling price
or manufacturing cost. Thus, once
a buyer and seller agree upon
an
appropriate
asset
base,
fluctuations in manufacturing costs
(labor, material, etc.) do not affect a
supplier’s return.
Establishing
profit based on asset and return
requirements should encourage the
supplier to commit resources
specifically to the buyer-seller
relationship. In cost-driven pricing,
the buyer explicitly acknowledges
the need to satisfy a supplier’s
financial return requirements.
Joint assumptions and agreement
on product cost, production
volumes,
quality,
targeted
costs, quantifiable productivity
improvements,
specific
cost
content definition, and contractual
sharing of supplier-initiated savings
are also essential to a cost-driven
approach. Agreeing on these issues
requires higher levels of trust,
information sharing, negotiation,
and joint problem solving. The
complexity of cost-driven pricing
ensures it will only be applied
as a strategic cost management
technique in selected relationships
that feature mutual trust and a
willingness to share information.
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Cost-driven pricing contracts
require the establishment of joint
improvement targets in areas such
as cost, quality, scrap, and delivery.
These agreed-upon improvement
targets help drive continuous cost
reduction over time. Furthermore,
shared cost-saving takes effect only
after the supplier achieves initially
targeted price/cost improvements.
For example, if the buyer and seller
target a material content cost
reduction of 10 percent per year,
shared cost-saving would take
effect on any savings beyond
the 10 percent level. Productivity
improvement
targets
must
be aggressive and mutually
established with both parties
developing an action plan to attain
the targeted goals. Shared costsavings provide the incentive to
accelerate price/cost improvements
beyond those agreed to in the
purchase contract.
Joint agreement on productivity
targets, cost reductions driven by
cost-saving sharing arrangements,
and risk-sharing further enhances
the potential for cooperative
efforts when creating cost-driven
agreements. Within this type of
agreement a buyer benefits from
lower priced goods while the
seller enhances its competitive
position by improving its total
cost structure and the possible
transfer of acquired learning and
improvement to other products
and customers.
As previously discussed, not all
products or items are candidates
for cost-driven pricing. A costdriven approach is most applicable
when the seller adds significant
value through direct and indirect
labor or design capabilities. It is
also applicable when sophisticated
technologies provide opportunities
for product design and process
alternatives. Raw materials or other
commodity items, even those with
high value, are least likely to benefit
from cost-driven pricing. Market
forces encourage the buyer and
seller to take advantage of "market
opportunities" and "play the
market."
Cost-driven pricing requires a
complete evaluation of suppliers
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and their capabilities. The supplier
selection process and decision,
however, are usually separate from
the mechanics of cost-driven
pricing. Supplier selection usually
occurs before the parties have
formally discussed a cost-driven
agreement. A willingness to enter
a relationship that features
approaches such as cost-driven
pricing, however, may influence the
final choice of a supplier. In our
experience, the parties within a
cost-driven pricing contract almost
always have a lengthy history of
interaction before entering into a
relationship that requires higher
levels of trust and information
sharing.
Cost-Driven Pricing
Case Example
Without question, this discussion
of cost-driven pricing appears
conceptual. This creates a need to
further refine this topic by
demonstrating how two supply
chain members managed and
improved cost to the point where
the producer began to realize
competitive market advantages
through its cost and pricing
strategies.
This section presents a case
example based on the experiences
of a producer of industrial pumps.5
The buyer, a large U.S. producer
with annual sales of several billion
dollars, approached a supplier with
whom it had a close working
relationship and initiated a
discussion about taking a different
approach to supply contracting.
The level of familiarity between the
buyer and supplier was critical to
the initial discussion and eventual
success of applying a cost-driven
pricing approach. This case
highlights the mechanics of costdriven pricing by presenting a
three-year contract developed
through collaborative cost analysis
and negotiation.
This example relates to a
mechanized subsystem used in
a newly designed industrial
pump. Both parties have agreed to
negotiate
and
analyze
the
supplier's cost structure for the
subassembly, which requires a high
degree of trust and confidentiality.
An important assumption is that
the most efficient manufacturing
processes to produce an item form
the basis of the supplier's cost
structure. A cost-driven pricing
contract should not reward
supplier inefficiency. Supply chain
cost analysts become an integral
part of this process when
developing cost-driven agreements.
Investment requirements for this
product were established jointly at
$12,000,000 over the contract's
expected three-year life.
This
includes $6 million in working
capital requirements and $6 million
in net capital assets over the
projected product life. In addition,
the supplier committed to annual
productivity improvements of 10
percent and 50 percent for direct
labor and scrap reduction,
respectively. (See the sidebar to
see how learning improvements
integrate with a cost-driven pricing
approach). The agreement also
included a 50/50 cost saving
sharing agreement covering any
cost reductions due to design
modifications initiated by either
party. Finally, both parties shared
volume fluctuation risk equally if
volume increased or decreased by
more than 20 percent in a year
compared to the plan (the +/-20
percent band is a negotiated item
Exhibit 4
Negotiated or Agreed Upon Contractual Issues
Product :
Subassembly for industrial pump
Initial Expected Price :
$98.50 per unit
Negotiated/Analyzed Cost Structure :
Direct Labor Rate
Overhead Rate
Scrap Rate
Selling, General, and Administrative Expense
Effective Volume Range
Projected Product Life
Return on Investment Agreed to
Contract Length
Volume Fluctuation Risk
$13.50 per hour
175% of direct labor
10% of total material, direct labor, and overhead
10% of total manufacturing cost
100,000 units per year +/- 20%
3 years
20%
Life of product with annual pricing recalculation
Shared equally if volume fluctuates more than +/20% in a year
Contract Specific Investment :
Working Capital
Net Capital Assets
Year 1
$2 million
$3 million
Total Investment over Three Years
$12,000,000
Supplier Productivity Commitment :
Direct Labor Content
Scrap Rate
10% reduction from previous year level
50% reduction from previous year level
Joint Effort Design Revision/Cost Reductions:
Savings shared jointly on a 50/50 basis
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Year 2
$2 million
$2 million
6
Year 3
$2 million
$1 million
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Exhibit 5
Year One Agreement and Events
Dollars
Economics
Productivity Commitment
and Changes
Material Costs
$36.00
3% increase
$2 per unit joint design saving
Direct Labor Costs
$14.85
2% increase
10% annual improvement
Overhead (Direct Labor x 175%)
$25.99
Total
$76.84
Scrap ($76.84 x 10%)
$7.68
Manufacturing Cost
50% annual reduction
$84.52
SG&A (Mfg. Cost x 10%)
$8.45
$92.97
Total Cost
Profit Per Unit
$8.00
Selling Price
$100.97
Year One Notes :
■
Cost and procurement engineers determined each unit requires 1.1 hours of direct labor ($13.50 x 1.1 = $14.85 year one direct labor) and material
costs are $36 per unit
■
Total profit = ($12,000,000 supplier investment x 20% agreed upon ROI)/3 year life of contract = $800,000 expected profit per year.
$800,000/100,000 units per year = $8 profit per unit
Year Two Agreement and Events
Dollars
Economics
Material Costs
$35.02
5% increase
Direct Labor Costs
$13.63
4% increase
Overhead (Direct Labor x 175%)
$23.85
Total
$72.50
Scrap ($72.5 x 5%)
$3.63
Manufacturing Cost
$76.13
SG&A (Mfg. Cost x 10%)
Productivity Commitment
and Changes
10% annual improvement
50% annual reduction
$7.61
$83.74
Total Cost
Profit Per Unit
$9.00
Selling Price
$92.74
Year Two Notes :
■
Material costs = $34 ($2 material design saving from $36) x 1.03 (3% supplier material cost increase from Year One events) = $35.02.
■
Direct labor costs = $14.85 x .9 (reflects 10% agreed upon productivity commitment from Year One level) = $13.36. $13.36 x 1.02
(2% increase in supplier labor costs in Year One) = $13.63
■
$9 per unit profit includes supplier share of material design saving ($1.00) plus the original $8 per unit profit
Year Three Agreement and Events
Dollars
Material Costs
$36.77
Direct Labor Costs
$12.76
Overhead (Direct Labor x 175%)
$22.33
Total
$71.86
Scrap ($71.86 x 2.5%)
Productivity Commitment
and Changes
Economics
$1.80
50% annual reduction
$73.66
Manufacturing Cost
SG&A (Mfg. Cost x 10%)
$7.37
$81.03
Total Cost
Profit Per Unit
$9.00
Selling Price
$90.03
Year Three Notes :
■
Material = $35.02 x 1.05 (5% material cost increase from Year Two events) = $36.77
■
Direct labor costs = $13.63 x .9 (reflects 10% agreed upon productivity commitment from Year Two level) = $12.27. $12.27 x 1.04
(4% increase in supplier labor costs in Year One) = $12.76
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that can vary from contract to
contract). They also agreed on
ways to limit price adjustments
that may result from severe
volume increases or decreases.
Exhibit 4 highlights the details of
the cost-driven pricing contract as
it appeared at the start of Year
One.
Exhibit 5 shows what
transpired over the three-year
contract.
Working jointly, the buyer and
seller have agreed on an initial
target price of almost $101 (see
Exhibit 5). This price is based on
the buying firm's cost expectations
for this item as well as a fair return
that allows the supplier to achieve
return-on-investment targets. The
buyer could also establish a
target price as part of a broader
target costing approach that
allocates finished product costs
across subsystems and individual
components.
The buyer and seller would have to
agree how to reduce cost if the
agreed upon first-year price of
$100.97 was not close enough to
the buyer’s initial expected price
(which was $98.50 as indicated in
Exhibit 4). Reevaluating return-oninvestment requirements could
also
affect
the
supplier’s
profit and selling price. If target
costing is applied, which is often
the case during new product
development, then cost-driven
pricing is interdependent with
rather than independent of target
costing.
The two parties in this case agreed
to reevaluate product pricing at
the end of years one and two,
which will reflect the changes that
have occurred over years one and
two. Major year one occurrences
include economic increases for
material and direct labor of 3 and 2
percent, respectively. Furthermore,
a joint study team developed and
approved a substitute material
that reduced the material cost by
$2 per unit, resulting in a 50/50
sharing of savings during year two.
At the beginning of the second
year, material cost decreased from
$36 to $35.02. This resulted from
the $2 material reduction (from $36
Supply Chain Forum
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to $34) from the material
substitution along with a 3 percent
increase in the supplier’s material
costs ($34 x 1.03 = $35.02). The
buyer and seller shared the
material cost reduction equally.
The buying company received its
share in the form of a $2 direct
material reduction, with $1.00
given back to the supplier in
higher per unit profit from $8 to $9
per unit. See Exhibit 5 for profit
calculation using ROI requirements.
A further downward movement in
cost reflects agreed upon labor
and scrap reduction commitments.
The selling price at the beginning
of Year Two ($92.73) reflects the
modifications to cost and profit.
The year two selling price is over 8
percent lower than year one, even
though material and labor costs
increased during the year. During
the second year of the contract,
economic increases for material
and labor were 5 percent and 4
percent, respectively.
Adjustments to labor productivity
and scrap reduction lessened the
subassembly’s price at the start of
Year Three to $90.03. The reduced
selling price, now almost 11
percent lower than year one, is
important given that material and
direct labor costs increased 8
percent and 6 percent respectively
from years one to three.
Productivity goals, which the
buyer and seller agreed to at the
onset of the contract, offset the
negative
economic
changes.
Supplier profit increased by
$1.00 per unit in year two and
three (from $8 per unit to $9 per
unit) due to the cost-saving
sharing provision within the
agreement. Although the supplier’s
internal
costs
are
rising
throughout this agreement, a
negotiated price with contractual
performance improvement goals
resulted in a lower purchase price
to the buyer while still providing a
profit that satisfies the seller’s
return requirements.
The parties in this case might have
realized
even
greater
cost
reductions if they had focused
Vol. 4 - N°1 - 2003
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their attention more closely in
several areas. First, the analysis
presented here assumed that
overhead was strictly a function of
direct labor costs. Today, firms
should use progressive cost
management techniques such as
activity based costing to better
understand, allocate, and manage
overhead costs. No such efforts
occurred in this case. Second,
the responsibility for direct labor
improvements rested solely with
the supplier. The buyer assumed
the supplier would benefit from
the effects of learning and
investments in process improvement.
A more collaborative approach
would feature the buyer working
directly with the supplier to
accelerate the supplier’s productivity
gains, perhaps through supplier
development activities. Even with
room for improvement, this case
highlighted a win-win relationship
between the buyer and seller. By
working jointly, the parties have
expanded the value they each
received from the contract. The
supplier received a long-term
contract while the buyer realized
price reductions that were not
available through a traditional
market contract. Presumably, a
lower cost on an important
subsystem will make the entire
product more competitive, which
should lead to a stronger product
position within the marketplace.
As the final product becomes
more competitive, the seller
realizes a steady stream of orders
that protect financial return
requirements.
Cost-Driven Pricing Risk
Considerations
Buyers and sellers must agree on
the risks associated with a
cost-driven
approach
before
agreeing to a final contract, making
risk management a joint rather
than individual challenge. The
parties should also agree on a plan,
often presented in the form of
contract clauses, to reduce the
effect of these risks if they were to
materialize. Examples of risk
include
unforeseen
volume
changes, forecast unreliability,
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sharing takes effect only when
actual demand moves outside the
+/- 20 percent band.
Exhibit 6
Volume Risk Sharing Calculation
Volume (units)
Volume outside
the 20% band (units)
Expected profit
(Volume x $8 per unit)
Year One Expected
Year One Actual
80,000 - 120,000
75,000
0
5,000
$800,000
$600,000
(100,000 units x $8) (75,000 units x $8)
Profit shortfall
$0
$200,000
($800,000 - $600,000)
Profit shortfall outside
the 20% band
$0
$40,000
($80,000 - $75,000) x $8
50/50 sharing remitted
to supplier
$0
$20,000
($40,000/2)
liabilities associated with program
cancellation,
establishing
an
inaccurate asset or capital base
that distorts return and profit
requirements, and a supplier’s
inability to achieve promised labor
and scrap reductions. A large labor
turnover, for example, could
prohibit
the
supplier
from
capturing the benefits of the
learning and experience curve.
Maintaining cost confidentiality is
often a concern or risk to buyers
and sellers, particularly since costdriven pricing applies to critical
rather than standard items. In fact,
the buying firm's view regarding
confidentiality is consistently a
highly rated factor limiting
interaction, early supplier design
involvement, and information
sharing across the supply chain.6
Supply chain members must take
great care ensuring the protection
of proprietary information.
Perhaps one of the biggest
unknowns in any contract involves
forecast reliability, particularly for
new products.
Unanticipated
volume increases usually result in a
reduction of the average cost to
produce a product as fixed costs
and overhead are allocated across
a larger number of units. In this
situation the buyer will expect even
greater price reductions than what
was planned during negotiation.
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An International Journal
Unanticipated volume decreases
usually increase per unit costs due
to research and development and
fixed costs being allocated over
fewer units. Buyer and seller must
agree either to price adjustments if
volumes change or agree that
pricing will not be volume
sensitive. If lower than expected
volumes result, the buyer might
request that the supplier obtain
additional business to compensate
for the decrease (i.e., the supplier
assumes volume fluctuation risk).
The agreement should address the
specific volumes at which prices
will change, the maximum financial
exposure each firm is willing to
accept, and the opportunity for
additional business from the buyer
in the event of a volume shortfall.
Since forecasts are inherently
inaccurate, the need to address
forecast risk is vital to cost-driven
contracts.
To illustrate volume fluctuation risk
using the case illustrated here,
recall that projected volumes are
300,000 total units at 100,000 units
per year.
Included in the
contractual agreement is a risk
sharing plan that takes effect when
actual volume varies from the
forecast by +/- 20 percent annually.
The buyer and seller have agreed
that a +/-20 percent fluctuation
represents normal risk that each
party is willing to assume. Risk
Vol. 4 - N°1 - 2003
9
If actual demand fell below 80,000
units the buyer would calculate a
reimbursement to compensate the
seller for lower than anticipated
volume.
This
reimbursement
occurs only for the volume that is
outside the 20 percent band. If, on
the other hand, demand increases
20 percent or more than the
forecast, the buyer would expect
additional price reductions beyond
those agreed to in the contract.
This assumes that the volume
increase did not place costly
capacity constraints on the
seller. The +/- 20 percent band is
similar to international purchasing
agreements that allow currencies to
fluctuate within some range before
reviewing or reopening a contract.
Exhibit 6 illustrates how the buyer
and seller operationalized the 50/50
risk sharing agreement in the case
presented here. Although actual
volumes did not fluctuate outside
the agreed upon bands over the
three year agreement, assume that
year one volume was actually
75,000 units instead of the expected
100,000 units. The 50/50 sharing
takes effect only for the shortfall
(5,000 units) that was outside the
range that the buyer and seller
considered normal risk. This is
certainly not the only way to
manage risk sharing. This exhibit
simply illustrates one way to
proactively address this issue
within a contract. Risk adjustment
calculations are usually an annual
exercise
conducted
by
the
relationship “owners” or managers
from the buyer and seller.
Cost-driven pricing agreements
require appreciably more time and
effort to develop than typical
purchase agreements, which itself
presents a risk compared with
traditional contracts. However,
once firms gain experience with an
initial cost-driven agreement, we
would
expect
subsequent
agreements
to
require
less
intensive effort to develop. The
experience curve applies to
contracting as well as production.
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Concluding Remarks
Firms that must confront relentless
pressure to improve need to
become more innovative in their
use of leading-edge supply-chain
approaches, including cost-driven
pricing. As an example, General
Motors recently entered a ten-year
agreement with Alcan, a major
supplier of aluminum. In this
agreement, the two parties
have agreed to apply pricing
mechanisms to maintain price
stability, something that is difficult
to achieve in the volatile aluminum
market.
The agreement also
guarantees Alcan a specific return
on its investment similar to the
ideas presented in this article.
Finally, the two sides established a
joint research program with
engineers from the two companies
working together to identify ways
to increase the use of aluminum in
cars,
to
make
automotive
aluminum more recyclable, and to
reduce total costs.7
Buyers and sellers who view each
other as strategically important
must consider non-traditional
supply chain practices in their
pursuit of competitive market
advantages. Cost-driven pricing is
an innovative approach that
promotes the development of
supply chain relationships and
continuous price/cost improvements.
Each party to a cost-driven
agreement sees its future success
linked to the success of the other.
The
parties
capitalize
on
opportunities to modify product
designs,
specifications,
and
manufacturing
processes
to
achieve mutual benefits. Without
the use of cost management
approaches and techniques like
the one presented here, supplychain members risk falling behind
those companies that truly
understand how to cooperate to
succeed.
End notes
1. Monczka, Robert M. and Robert J.
Trent,
“Global
Sourcing
Benefits,
Barriers, and Critical Success Factors”
study, a researched study conducted
through
the
Global
Electronic
Benchmarking Network, Michigan State
University, East Lansing Michigan, 2000.
This study found that competitive and
customer pressure to achieve price/cost
improvement was the most intense of ten
potential improvement areas
2.
Porter,
Michael,
Competitive
Advantage of Nations, Free Press: New
York, 1990, pages 101-105.
3. Monczka, Robert M., from the Global
Electronic and Benchmarking Network
study of supply chain strategy
development, Michigan State University,
East Lansing Michigan, 1996.
4. Trent, Robert J. and Michael G.
Kolchin, “Reducing the Effort and
Transactions Costs of Obtaining Low
Value Goods and Services,” Center for
Advanced Purchasing Studies, 1999.
5. Both the supplier and buyer have
requested that company names not be
disclosed. Furthermore, some data have
been disguised at their request.
6. Monczka, Robert M. and Robert J.
Trent, citing data collected at the
Executive Purchasing and Materials
Management Seminar, Michigan State
University, East Lansing, Michigan 1999.
7. Simison, Robert L., “GM Commits To
Aluminum in Alcan Pact,” The Wall
Street Journal, November 11, 1998, page
A3.
Applying Learning Improvements to Cost-Driven
Pricing Contracts
One reason the buyer in this case is confident that the supplier will realize the agreed upon productivity improvements is
due to the effects of learning. Learning curves establish the rate of direct labor improvement that results as production
volumes increase. When referring to learning improvement, the learning rate represents the improvement (reduction) in
direct labor requirements as production doubles from a previous level. For example, with an 85% learning rate, the
average direct labor required to produce a unit declines by 15% each time production doubles. The fundamental principle
underlying learning curve is that as production doubles, direct labor requirements decline by an observed and predictable
rate. The rate of improvement varies from situation to situation.
Not all processes or items benefit from or exhibit improvement from learning. In fact, when used incorrectly this approach
can result in a significant underestimation of true production costs. Applying a learning curve is appropriate when a
supplier uses a new production process, produces an item for the first time, or produces a technically complex item where
the design is still evolving.
Learning curve application requires accurate collection of cost and labor data, particularly during the early stages of
production. A buyer and seller must be confident that learning occurs at a uniform rate and that any improvement results
from employee learning rather than process redesign or other continuous improvement activity. The term experience curve
refers to the longer-term factors of production that systematically reduce production costs. These factors include the
shorter-term labor component along with longer-term product and process modifications.
Unfortunately, many buyers agree to contracts that ignore cost improvements due to learning. If learning occurs and the
buyer neglects to address this issue, the supplier captures the benefits in the form of more productive direct labor. A costdriven pricing approach recognizes the need to achieve continuous cost reductions, which learning curve supports.
Supply Chain Forum
An International Journal
Vol. 4 - N°1 - 2003
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