Chapter 1 Introduction

Purpose of This Book

This book is dedicated to providing advice to public and private sector buyers of both goods and
services concerning those procedures and methods which will help them improve their effectiveness in
obtaining fair and reasonable prices on their purchases. Specifically, it will address use of the "Pricing
Team"; methods of evaluating the market and bids/offers; price analytical/comparison techniques;
various cost analytical methods; procedures for establishing realistic pre-negotiation profit positions; use
of price, cost, and profit analysis in negotiations; and employment of "Strategic Cost Analysis" to effect
significant organization-wide cost savings.

The Buyer's "Pricing Team" and the Respective Roles and Responsibilities of Team Members

Individual buyers

Buyers are the most important members of the "Pricing Team". They are responsible for
determining that the prices for their purchases are fair and reasonable; (this is accomplished through the
analyses that are the topic of this book); recognizing during preparation of their advance procurement
plan whether supporting cost data and information required for performing price and/or cost analysis will
be needed, and obtaining such data and information from the prospective supplier; performing some form
of price analysis on each procurement; performing a cost analysis on procurements in which the fairness
and reasonableness of the price cannot be justified by price analysis alone; and negotiating the price to be
paid, if appropriate to the purchase.

Other "Pricing Team" Members

Some buyers, particularly those within the public sector and those working for large commercial
or industrial firms, may have the benefit of assistance from several specialized members of the "Pricing
Team". Performance of cost analysis, for example, normally requires the services of people specially
trained to review cost proposals. These individuals are generally trained in accounting and auditing and
may indeed be an auditor of some type. Some large organizations train people with business, accounting,
and finance backgrounds in preparing estimates and in performing cost/and or price analysis. They are
often called cost/price analysts or cost estimators. Auditors, cost/price analysts, and estimators are
generally made responsible for performing a review and evaluation of the cost elements and proposed
profit/fee of a supplier's proposal when requested by the buyer. The person assigned this task should
request as much assistance from engineering or other technical departments as needed to properly
evaluate manhours and materials proposed by the supplier; conduct an audit or review of the supplier's
proposed labor rates, burdens, overheads and other financial cost elements; and/or request an assist audit
of the supplier's proposal as required. The auditor/analyst/estimator is also generally charged with
reviewing Price/Negotiation Memoranda on procurements of significant dollar value to assure that all
cost/financial guidelines in the buying organization's policies are followed. Specialized purchases may
require expertise in packaging, transportation, quality assurance, or other disciplines.

Definitions

A comprehensive list of the basic definitions that will be used throughout this book can be found
in the glossary of terms. The four most important terms, which we shall explore at some depth, are price
analysis, cost analysis (with its accompanying profit analysis), strategic cost analysis, and transactional
analysis. These definitions are restated here for your benefit:

©American Certification Institute, 2004 1

 Price analysis is the process of examining and evaluating a proposed price without evaluating its
separate elements of cost and profit. It may be accomplished by the following comparisons, which are
listed in their relative order of preference:
* Comparison with other prices and quotations submitted.
* Comparison with published catalog or market prices.
* Comparison with prices set by law or regulation.
* Comparison with prices for the same or similar items.
* Comparison with prior quotations for the same or similar items.
* Comparison with market data (indexes).
* Application of rough yardsticks (such as dollars per pound or per horsepower or other
units) to highlight significant inconsistencies that warrant additional pricing inquiry.
* Comparison with independent estimates of cost developed by knowledgeable personnel
within the Buying organization.
* Use of value analysis.
* Use of visual analysis.

Cost analysis is the review and evaluation of the separate cost elements included in an offeror's
cost proposal, including the judgmental factors applied by the offeror in projecting from historical cost
data to the estimated costs included in the cost proposal. Cost analysis is done to help the buyer form an
educated opinion on the degree to which the proposed costs represent what the contract should cost,
assuming reasonable economy and efficiency. It includes the verification of cost data, and evaluation of
cost elements, including:
* The necessity for and reasonableness of proposed costs.
* The offeror's projection of cost trends, on the basis of current and historical cost or
pricing data.
* A technical appraisal of the estimated labor, material, tooling and facilities requirements
and of the reasonableness of scrap and spoilage factors.
* The application of approved indirect cost rates, labor rates, or other factors.

Among the evaluations that should be made, where the necessary data are available, are
comparisons of an offeror's current estimated costs with:
* Actual costs previously incurred by the same supplier or offeror;
* Previous cost estimates from the offeror or from other offerors for the same or similar
items.
* Other cost estimates received in response to the solicitation.
* Independent cost estimates by technical personnel.
* Forecasts of planned expenditures.

Strategic Cost Analysis is characterized as the sum total of the broad-based, organization-wide
plans and analyses designed to increase purchasing savings in the long-run. This type of analysis is not
related to specific purchasing transactions.

Transactional Analysis is the narrowly-based plans and analyses performed by the individual
buyer (with expert assistance, as appropriate), to increase purchasing savings in the instant purchase order
or contract.

Although this book will concentrate on the analysis of instant purchase transactions
("Transactional Analysis"), a chapter will be devoted to the more broad-based cost analytical approach
which we define here as "Strategic Cost Analysis".

©American Certification Institute, 2004 2

Comparison of Different Analytical Methods From the Viewpoint of Complexity and Quantity of
Resources Required

Because the author is a firm advocate of the adage "A picture is worth a thousand words", a
picture representation of the above terms will be used to clarify them for the reader. The diagram will
also be used as a skeletal outline for the discussions which will follow. In the diagram (below) the
different types of analysis which will be discussed in this manual are portrayed. All but "Strategic Cost
Analysis" are considered to be methods of "Transactional Analysis".

|
|
C |
O |
M |
P | STRATEGIC
L | COST
E | ANALYSIS
X |
I |
T | PRICE
Y | AND
| COST
O | ANALYSIS
F |
|
A | PRICE
N | ANALYSIS
A | WITH
L | INCREMENTAL
Y | COST ANALYSIS
S |
I | PRICE
S | ANALYSIS
|______ONLY____________________________________________________________

QTY OF RESOURCES REQUIRED

©American Certification Institute, 2004 3

 Price analysis is generally the simplest transactional analysis technique and is considered the least
resource intensive. Price analysis can be conducted in a relatively short period of time and can normally
be conducted by the buyer without any outside assistance from members of the "Pricing Team". Price
analysis with incremental cost analysis adds complexity to the analysis and requires more resources by
virtue of the fact that certain elements of cost (but not necessarily all) require some degree of cost
analysis. A common situation calling for this technique occurs when the buyer is purchasing modified
commercial items. The basic unmodified item can be analyzed by use of price analysis and the
modifications can be analyzed by partial cost analysis. The buyer can often perform this type of analysis
on his/her own, but may require assistance from one or more members of the "Pricing Team". Price and
(full-blown) cost analysis is still more complex, usually invoking other members of the "Pricing Team".
This type of analysis is appropriate in sole and single source purchases of significant magnitude and
complexity. Cost analytical efforts, and the accompanying negotiations which invariably ensue, may
extend for several weeks or even months. "Strategic Cost Analysis" is the most complex and resource
intensive of the four analytical methods. This type of analysis takes "the long haul" approach not keyed
to specific purchase transactions. Buyers undertaking strategic analysis will be dealing with fundamental
business systems and procedures, generally of a type which must be institutionalized before they can be
effective. A formalized make-or-buy system used by the organization to assure cost efficient sourcing of
materials and services would be one example of such a system. Additional examples are discussed in
Chapter 12.

Types of Markets and Supplier Pricing Strategies and the Analytical Methods Appropriate to Each

Preparation of Buyer In-House Estimates

Although different organizations have different policies concerning the degree and type of
documentation needed to support a pricing decision, most organizations, public and private, insist that a
cost estimate be prepared by requesters on every purchase as an aid to pricing. This estimate is normally
a detailed, bottom-up estimate for services (Architect-Engineering, construction, etc), and for specially
engineered or fabricated hardware or one-of-a-kind items. In most supply and material purchasing, an
estimate based on previous prices paid often suffices. Preparation of an in-house estimate by the buying
organization is a good mental discipline, requiring the buying organization to place itself into the
supplier's "shoes".

As explained below, understanding the supplier's competitive situation is important in

determining the appropriate analytical method. There is a uniform policy within the purchasing
community that every purchase transaction, regardless of dollar amount, should have a determination that
the price is fair and reasonable. This determination is based on price analysis, (often using the in-house
estimate as a basis for comparison), supplemented by cost analysis if necessary. Documentation of the
facts that support a price reasonableness determination (to include a copy of the in-house estimate) should
be included in the purchase file.

Degree of Competition in Markets

Most goods and services are bought in a competitive marketplace where the forces of competition
cause the supplier to price his goods and services according to the competition. In these situations, the
supplier is less interested in his costs and profit margin than he/she is in the prices being charged by his
major competition. Effective competition is most pronounced in those industries having few barriers to
entry. Even the American automobile industry provides effective competition in what is commonly
referred to as an "oligopolistic industry" (few sellers and many buyers). In those situations where the
buyer can rely on competition to set the price, price analysis alone will suffice to assure reasonableness of

©American Certification Institute, 2004 4

price. A cost analysis may be required as a supplement to the price analysis, particularly in situations
where the presence of price competition among offerors is nonexistent or questionable. Such a situation
is often prevalent in purchases of highly specialized or extremely technical equipment or for certain
services available from limited sources (specialized consulting services come readily to mind.) Because
cost analysis is such a costly and administratively burdensome process, it should generally not be
employed when reasonableness of price can be established by adequate price competition (or, as an
acceptable substitute) by use of a comparison with catalog or market prices of commercial items sold to
the general public in substantial quantities. Another special situation which often arises is in the
purchasing of regulated utility services. Price competition is not present in these situations, and cost
analysis is unnecessary because of the involvement of public utility commissions and other regulatory
bodies in the rate-setting process. Regulated utilities provide services at prices set by law or regulation.
Price analysis alone (comparing the offered prices against the regulated rate) is sufficient in those
instances.

Matching Buyer Analytical Method With Supplier Pricing Method

The buyer must understand the degree of competition in the marketplace in order to determine the
method used by the supplier to price his products and/or services. If the supplier is operating in a market
where there is effective competition, the supplier will generally price to the competition. In that
circumstance, the supplier will be less interested in his costs and a reasonable mark-up on those costs than
he/she will be in pricing the product or service to beat the competition. The forces of competition will
operate to keep the supplier's offered prices fair and reasonable. Because the supplier based his/her price
on a "bottom-line" basis, the buyer should respond by using a "bottom-line" analytical method, which is,
of course, price analysis. If, however, the supplier is free to pass on all of his costs plus a substantial
profit amount to the buyer as a result of operating in a market without effective competition, the buyer
should respond to this "bottom-up" pricing with a "bottom-up" analytical method, which, is of course,
cost and profit analysis, supplemented with price analysis. This concept is illustrated in the diagram
below:

IF THE SUPPLIER ESTIMATES BASED ON: THE BUYER SHOULD USE:

1. "BOTTOM LINE" COMPETITIVE PRICING "BOTTOM LINE" PRICE

ANALYSIS

2. "BOTTOM-UP" COST & PROFIT BUILDUP "BOTTOM-UP" COST AND

PROFIT ANALYSIS (W/ PRICE ANALYSIS)

Notice the one analytical method appropriate to all markets is price analysis. Price analysis
should be used to supplement cost analysis in situations where there is ineffective competition because it
serves to answer the question: "What would the supplier charge if he were operating in a competitive
market-place". Many experienced analysts maintain that price analysis is more powerful than cost
analysis for that very reason. They also believe it is possible to generate multiple negotiation positions
more easily using both cost and price analysis than it is using cost analysis alone.

©American Certification Institute, 2004 5

Summary

The buyer is ultimately responsible for determining that the prices he/she pays for his/her
purchases are fair and reasonable. This is accomplished through price analysis and/or cost analysis of the
individual purchase transaction. The degree and extent of the analysis performed depends on the
circumstances. In certain circumstances, particularly those where extensive cost analysis is required, the
buyer will be assisted by specialized functional personnel, to include auditors, cost/price analysts,
estimators, engineers, and/or other technically-oriented personnel. The results of the price and/or cost
analysis of the individual purchase transaction will be used by the buyer to negotiate price and other terms
with supplier (s).

In addition to transactional analysis, which concentrates on price and/or cost analysis of

individual purchase transactions, the buyer and his purchasing management will be challenged to effect
major, organization-wide cost savings through the use of "strategic cost analysis". This type of analysis
takes "the long haul" approach not keyed to specific purchase transactions. Buyers undertaking strategic
analysis will be dealing with fundamental business systems and procedures, generally of a type which
must be institutionalized before they can be effective. Various strategic cost analytical methods,
including a formalized make-or-buy decision system, are discussed later in the book.

Preparation of an in-house estimate by the buying organization requires the buying organization
to place itself into the supplier's "shoes". Understanding the supplier's competitive situation is important
in determining the appropriate analytical method. Every purchase transaction, regardless of dollar
amount, must have a determination that the price is fair and reasonable. This determination is based on
price analysis, (often using the in-house estimate as a basis for comparison), supplemented by cost
analysis if necessary.

Most goods and services are bought in a competitive marketplace where the forces of competition
cause the supplier to price his goods and services according to the competition. In those situations where
the buyer can rely on competition to set the price, price analysis alone will suffice to assure
reasonableness of price. Although price analysis generally suffices to document price reasonableness, a
cost analysis may be needed to supplement price analysis, particularly when the presence of price
competition among offerors is nonexistent or questionable. Such a situation is often prevalent in
purchases of highly specialized or extremely technical equipment or for certain services available from
limited sources (specialized consulting services come readily to mind).

The buyer must understand the degree of competition in the marketplace in order to determine the
method used by the supplier to price his products and/or services. If the supplier is operating in a market
where there is effective competition, the supplier will generally price to the competition and the buyer
should respond by using price analysis. If, however, the supplier is free to pass on all of his costs plus a
substantial profit to the buyer as a result of operating in a market without effective competition, the buyer
should respond by using cost and profit analysis, supplemented with price analysis.

The one analytical method appropriate to all markets is price analysis. Price analysis should be
used to supplement cost analysis in situations where there is ineffective competition because it serves to
answer the question: "What would the supplier charge if he were operating in a competitive market-
place". Price analysis is also helpful in generating multiple positions for negotiation.

©American Certification Institute, 2004 6