Deconstructing ‘Cost Plus’ to achieve ‘Cost Value’
Part 2 of 2
In the first part of this article we explored how ‘Cost-plus’ pricing strategy can be misinterpreted leading to inflated costs and inefficiencies if left unchecked.
This article examines what measures can be taken to address the issues associated with Cost Plus pricing, creating enhanced Cost Value for the long term.
Procurement professionals have access to a number approaches during the sourcing process.
The most effective approach will depend on the quality of historical data that is available on purchased spare parts. In the best case, this will include access to a list of the most commonly bought spare parts and the price paid them for. This data could be found from internal records or from the incumbent maintenance supplier(s).
The list of parts with the demand can be included in a tender and an accurate comparison can be made when competitors return their unit pricing. Unfortunately, poor data availability often constrains this process.
One organisation, working on an air conditioning maintenance tender, recently faced this problem. Data from both incumbent suppliers and from internal records didn’t give enough detail for competitors to give unit pricing in a tender.
The blockage was ultimately addressed by requesting a list of the suppliers most commonly purchased parts with the unit prices that they would sell them at. This list became the benchmark for assessing the competitiveness of rival bids.
This approach works well when the client makes up a significant proportion of the maintenance suppliers business, so their spare parts list is a good representation.
An alternative approach is to put strict criteria on what the percentage mark-up should be measured against - for example, the manufacturers list price for the part.
In a tender exercise, organisations can request a constant percentage mark-up (or discount off) of the list price. This requires the list prices for spare parts to be visible to both the client and supplier throughout the contract duration.
It is important to note that some suppliers will have access to lower cost parts because of their scale. These suppliers buy large volumes from the manufacturers of parts.
Depending on buying power, organisations may realise a benefit from going to manufactures or ‘Tier 1 suppliers’ directly. For the supplier at each tier (as demonstrated in the diagram) to make a profit they must add their margin on to the part thus increasing the cost.
‘Going direct’ follows the simple concept of cutting out the middle man.
Wording can also play an essential part in getting value for money in a cost-plus contract. Clients need to state that ‘cost’ refers to the true net cost of the good, including any rebates or other bonus payments. An audit process can also be stipulated in the contract to ensure that this is enforceable using an agreed methodology.
Ongoing contract management
Following contract award (assuming the contract has suitable wording referenced), audits, benchmarking and management information can all be used to test the ‘cost value’ of the goods being purchased.
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.
- If you contract correctly, you can manage these costs on an ongoing basis to ensure value is maintained.
View Part 1 of 2: Why ‘cost plus’ isn’t always what it seems’