Why ‘Cost Plus’ isn’t always what it seems
Part 1 of 2
‘Cost-plus’ is a pricing strategy in which the selling price is determined by adding a specific amount of markup to a product's unit cost. It is often portrayed as a clean, transparent pricing mechanism and carries with it a perception of buyer visibility, transparency and advantage.
However, this can be a smokescreen, with suppliers using Cost-plus pricing as a vehicle to inflate costs and take money out of the bottom line.
Bringing this to life: The equipment maintenance sector
A good example of some of the challenges associated with this form of pricing is in the building equipment maintenance sector where suppliers will often purchase and install spare parts on a Cost-Plus basis. The cost shown on the invoice comes from two main areas; time (e.g. labour) and materials (e.g. the actual spare parts).
When supplying parts, maintenance providers will often add a percentage markup to the cost of the parts. This is usually a result of;
- Not knowing the exact parts that will be required in the future (for the most part, it's unlikely the same component will fail year on year).
- To cover any storage, transport and purchasing costs.
Whilst simple, in theory, organisations often struggle to adequately assess value-for-money during the sourcing process and on an ongoing basis can allow significant cost inefficiencies to build.
Supplier evaluation: the lowest rate doesn’t always equal the best value!
The most common pitfall in evaluating suppliers based on a percentage markup is the perception that the lowest rate offers the best value. But without knowledge of unit costs this is, at best, hopeful thinking.
Imagine a scenario where we have two proposals, one from Supplier A and one from Supplier B. Both proposals include a one-line cost element under a detailed maintenance schedule of costs. Supplier A offers a markup on spare parts of 10% whereas Supplier B offers 20%.
It would appear that Supplier A is offering the best value; however, this assertion may be incorrect. Two assumptions about suppliers can influence the wrong call on this:
- The opinion that suppliers who buy a large volume of spare parts will get broadly the same deal as those buying smaller numbers. If this were true, a markup of 20% would obviously result in higher costs than a markup of just 10%.
- The cost stipulated by the supplier is the price that they actually pay.
But as any procurement professional knows, two companies can pay widely different prices for the same item.
In addition, much of the maintenance industry operates by using ‘rebates’. This means buyers cannot be sure that the price shown on an invoice will reflect the actual price paid - or the “true net cost” of the part.
Goods can be discounted in less conspicuous ways than an invoice price reduction. Spare parts suppliers can give volume related discounts when maintenance providers hit certain thresholds. For example, take an instance where, when sales reach £100,000 the supplier will return 2% as a £2000 cash rebate. This will not affect the invoice price which is being marked up by the provider but it will reduce the true net cost of the part for the supplier.
With this information in mind, lets revisit the example.
Supplier A and B have secured equally good deals for parts, however, supplier A secretly retains a percentage of this without your knowledge. Supplier B is open and honest about the true cost of the good but has a higher markup. In our example supplier B in fact offers the best value.
Points to consider
- Maintenance providers often hide behind a percentage margin but this may not represent value for money.
- When contracts come to tender, its ‘unit cost, or no cost’ and thus essential to work down to the unit price of spare parts and not agree to a percentage markup on a price that isn’t visible to you.
View Part 2 of 2: Deconstructing ‘cost plus’ pricing to achieve ‘cost ‘value’