Defining Business Need

Diploma in Procurement and Supply

The distinction between costs and prices
• Price is what a supplier charges the buyer for
an item
• Cost is the expenditure that the buyer incurs
to acquire and own the purchased goods or
services
Market data about prices (1)
Why a buyer needs market data:
• To find out what current prices are, and what it should be (or
could be) paying for purchases in the future
• To compare prices from competing suppliers
• To learn more about what might happen to prices in the
market in the future
• To learn about prices for items that it has not purchased
before, or for capital items that it only purchases occasionally
Market data about prices (2)
• Primary data is data collected especially for a
particular purpose, directly from a relevant source
• Secondary data this is data collected from a
‘secondhand source’
Sources of primary data about market prices (1)
Source of data Comment
Historical records of purchases If an organisation has purchased a product or service regularly in the past, it will have
records of the price or prices that it is currently paying.

Standard price list or price schedule Suppliers might have a standard price list or price schedule, available in printed form, or
posted online, or published within a catalogue. Discounts on ‘list price’ are often available.

Prices quoted on request Prices may be quoted on request: based on an internal price list (not seen by buyers) or on
specially prepared estimates for the proposed contract.

Market prices for commodities There are formal markets or trading exchanges for some products, particularly
commodities. Prices are announced for current market transactions in the commodity, and
price data are subsequently published in the national press and trade journals. 
Sources of primary data about market prices (2)
Source of data Comment
Request for information (RFI) At an early stage in a procurement process, a buyer may send out
formal requests to a number of suppliers, asking for information.
These are known as requests for information or RFIs.

Meetings with suppliers or Information might be obtained from meetings with suppliers or
potential suppliers potential suppliers, in which the supplier is asked to give an
indicative price for an item.

Trade fairs Occasionally there are trade fairs or industrial shows where
participants in an industry demonstrate their products to industrial
buyers. Examples include agricultural shows and book fairs.
 Sources of secondary data about market prices (1)
Source of data Comment
Publications and specialist websites Data about prices or movements in prices might be obtainable from the trade or industry
press (printed or online newspapers, magazines, journals and bulletins) and specialist
procurement journals which may carry market analysis, statistical digests on price trends
and so on.

Published economic indices A retail prices index (RPI) or commodity prices index (CPI) is published by the
government’s national statistics office in many countries, together with price indices or
cost indices for specific industries. 
Commodities indices track the weighted average of selected commodity prices.

Published and online market analysis Published and online market analysis is occasionally available, in the form of searchable
databases and reports provided by organisations such as Gallup, MORI, Euromonitor and
Mintel.
 Sources of secondary data about market prices (2)
Source of data Comment

Price comparison websites Price comparison websites might be a useful source for comparing
prices, primarily of consumer items. However in some cases, price
comparisons are available for industrial products.

Labour costs Procurement staff may want to obtain information about

movements in labour costs. For example, they might want to
monitor increases in labour pay rates in the industries of key
suppliers.
Market data about costs
Reasons for understanding costs:
• The purchase price of an item may be only a part of
the overall cost.
• Comparing the cost of different purchase options.
• Monitoring the costs of a project where the contract
price is based on the supplier’s costs.
• To understand the relative importance of
procurement costs in the cost of the organisation’s
products or services.
Open book costing and cost transparency
• Open book costing is where suppliers provide
information about their costs to buyers
• Cost transparency is where both buyer and supplier
share cost information
Materials, labour and other expenses 
Three categories of costs:
• Materials: materials costs are the costs of purchased
goods
• Labour: labour costs are the costs of the wages and
salaries of workers employed by the organisation
• Other expenses: there are many items of cost that
are neither materials costs nor labour costs
Categorising costs by function

In a manufacturing organisation, operating costs are also

categorised by function and divided into: 
• manufacturing costs
• sales and distribution costs
• administration costs
A supplier’s costs and the buyer’s material price

Supplier’s costs Buyer’s costs

Materials costs SUPPLIER’S COSTS Purchase price paid

+ SUPPLIER’S PROFIT MARGIN
Labour costs = BUYER’S COST (100% = materials cost
or expense for the buyer)
Expenses
Definitions of direct and indirect costs
• Direct costs are costs that can be attributed directly
and in full (100%) to a particular item of product, a
service or an activity.
• Indirect costs (or overheads) are costs that cannot be
attributed in full to a particular item or product,
service or activity.
Total costs analysed in different ways

Materials costs Labour costs Other expenses

Direct costs Indirect costs = Overhead costs

Direct materials Indirect materials
Direct labour Indirect labour
Direct expenses Indirect expenses
Costs for a manufacturing company

Direct
Directcosts
costs Productio o verheads
(Direct
(Directmaterials,
materials,labour, expenses)n
labour,expenses) (Indirect materials, labour, expenses)

Selling andn Total productio Administratio

n
distributio o verheadsn costs overheads

Total costs
Total cost of a manufactured product (illustrative figures)
Direct costs and indirect costs
• Direct costs are costs that are incurred as a direct
consequence of buying or making a product, providing a
service or carrying out an activity.
• Indirect costs are costs that are ‘shared’ by more than one
item
Fixed and variable costs
• A fixed cost is a cost that remains the same in total regardless
of ‘the volume of activity’.
• A variable cost is a cost that increases or decreases in direct
proportion to increases or falls in activity level. 
Costs fixed over a short range and variable over a wider range (1)

Total
cost $

Volume of activty
Costs fixed over a short range and variable over a wider range (2)

• Do not confuse direct and indirect costs with fixed and

variable costs.
• Analysing costs into fixed costs and variable costs can be a
complex task, particularly in the case of indirect costs
(overheads). In many organisations, overhead costs are a
mixture of fixed costs and variable costs.
Estimating costs
• The items of direct cost should be identified and estimated
individually
• An allowance for overheads may therefore be added to the
direct costs, often as a percentage amount of the direct costs.

A cost estimate should begin with an estimate of the

direct costs.
Estimating direct costs (1)
Sources of information for an estimate of price:
• Prices that have been paid for the item in the past
• Published prices, for example in supplier catalogues
• Use of a pricing formula
• Competitive bidding
Estimating direct costs (2)
A record should be kept of cost estimates, and the
assumptions that were made in arriving at them. 
• The cost estimate should be provided in support of
the business case you are making.
• If the activity or transaction is approved and goes
ahead, actual direct costs should be recorded, and
compared with the original estimate
Budgets and budgeting
Budgeting for the costs of an activity or operation is similar to
making cost estimations.
• Items of direct costs should be identified and listed
• For each item of direct cost, an estimate of the cost should
be prepared
• The total of the cost estimates for the direct cost items is
the total direct cost estimate
• An allowance may then be added for a share of overheads
• If the budgeted cost is considered too high, senior
management might order a review of the budget
Target costs and target prices
• A purchase transaction might have a price based on a
target cost, which is prepared by the supplier but
approved by the buyer
• An organisation might set a target cost for a
procurement transaction, as part of the business case
for the transaction
The price-cost iceberg: total costs of ownership
The total cost of ownership of an IT system might include all the costs listed in the table below.

Purchase costs Operating costs

Network hardware and software Salaries of dedicated system personnel
Server hardware and software Accommodation (for server etc)
Workstations hardware and software Energy costs
Installation costs  Failure costs (costs of repairs)
Purchasing research System upgrades
Cost of migrating from the previous IT system Security costs
Costs of system testing and trials User training
Insurance

End-of-life costs
Decommissioning costs
The price-cost iceberg
Whole life costing (WLC): definition (1)
Whole life costing (also called lifecycle costing, whole lifecycle
costing and through-life costing) can be defined as ‘economic
assessment considering all agreed projected significant and
relevant cost flows over a period of analysis, expressed in
monetary value.
Whole life costing (WLC): definition (2)
Put more simply, ‘whole life costing is the systematic
consideration of all relevant costs and revenues
associated with the ownership of an asset’ (National
Platform for the Built Environment).
The use of whole life costing
• To determine whether the expected (estimated) costs of
ownership of an asset over its entire useful life justify the
expected benefits that will be obtained from it.
• To compare the costs of two or more assets, where a
choice must be made about which asset to buy.
• To choose between different methods of financing a new
item of equipment.
• To choose between whether to carry out an activity ‘in
house’, or whether to outsource the work to an external
organisation. 
Whole life costing and the time value of money (1)
• The whole life cost should be expressed in terms of
‘today’s money’.
• To do this, costs that are expected in the future
should be reduced to a present day equivalent value.
• A cost is therefore measured according to its money
value and the timing of the cost, ie when it is
expected to occur.
Whole life costing and the time value of money (2)
Benefits and limitations of whole life costing (WLC)
Benefits Limitations
Makes it possible to compare different It is not an exact science, and many cost
investment options estimates are inevitably subjective,
especially for costs a long time in the future
or costs where there is much uncertainty.

Recognises the total cost of acquiring an A wide range of intervening factors may
item over its full expected life affect costs over the lifecycle of a product
or asset.
Highlights, at an early stage, risks (future
costs) associated with a purchase

A WLC exercise can be time-consuming,

labour-intensive and costly.