Complete understanding of the supply market requires that the supply manager have basic knowledge of the pricing models used by the suppliers in that market. In order to remain in business, suppliers must cover their costs and earn an overall profit to provide for future growth, retirement of debt, capital improvements, and rewarding the owners for taking the investment risk. Although pricing models can be very complex, the pricing models used by most suppliers to meet their objectives generally fit into two categories which can be described as Cost Based Models and Market-Driven Models.
In the Cost Markup Pricing Model the supplier simply takes his estimate of costs and adds a markup percentage. This markup percentage could be added to the product cost only (usually direct material plus direct labor plus production overhead), in which case the markup percentage would have to provide for profit plus all other indirect cost of operating the business.
If the markup percentage is applied to the total cost (product cost plus general & administrative & sales expense), then the supplier’s markup covers only profit. It is therefore important that when discussing mark-up percentages, the supply manager has determined whether the mark-up percentage is based on product cost or total costs.
As an example a supplier who wanted a 20% markup over his total cost of $50.00 would quote a price of $60.00 [$50.00 + 20% of $50.00=$60.00].
In the Margin Pricing Model the supplier is still attempting to obtain a profit related to his costs but instead of adding a markup to cost, the supplier establishes a price that will provide a profit margin that is a predetermined percentage of the quoted price (Not a percentage of cost as in mark-up pricing).
For example the supplier discovered that last year his margin as a percentage of sales was 18% and this year he would like it to be 20%. So using the same total cost of $50.00 as above would result in the supplier quoting a price of $62.50 in order to obtain the margin of 20%. [Cost + (Margin Rate)(Unit selling price)=Unit selling price, therefore Unit selling price (1-Margin Rate)= Cost, therefore Unit Selling Price=Cost / (1-Margin Rate), and $50.00/80%=$62.50].
As in Cost Markup Pricing, the buyer must be aware if the margin pricing is based on product cost only or is based on total cost.
A third common model in the Cost Based category is the Rate-of-Return Pricing Model wherein the desired profit is added to the estimated costs. In this model the supplier bases the profit on the desired return on the financial investment, rather than on the estimated cost. If the supplier wanted a 20% return on his investment of $300,000 to make 4000 parts with a total cost of $50.00 each the quoted price would be $65.00 [Unit cost + Unit Profit = Unit Selling Price, therefore $50.00 + .20 ($300,000)/4000=Unit Selling Price, and $50.00 +$15.00=$65.00].
In the Price Volume Model the supplier analyzes the market to find the combination of price per unit and quantity of sales that maximizes their profit on the assumption that 1) lowering the price will result in more units being sold and 2) that greater volume will spread the indirect cost over more units therefore maintaining or even increasing the profit as it relates to the price. The complexity of this common strategy with its significant implications to all those in the supply chain is probably best exemplified by ups and downs in the markets where it is used. The most basic example of the implementation of this model is the offering of quantity price breaks by the supplier to induce the supply manager to buy in greater quantities.
Strategic Sourcing initiatives suggest that supply managers need to develop a thorough awareness of the relationship between price and quantity in the their specific marketplaces through Cost-Volume-Profit Analysis.
In the Market-Share Model, pricing is based on the assumption that long-run profitability depends on the market share obtained by the supplier. When using this strategy, the goal is to dominate the market through market penetration. Suppliers set prices relatively low to win customers and eliminate or discourage competition. In the initial stages of using this model the supplier may even accept loses, but as their volume increases the cost per unit decreases and long-term profits are achieved.
Although supply managers normally take full advantage of this model, a sound sourcing strategy considers the full long term implications to the supply manager of a potentially reduced supply base and the therefore ultimately higher prices.
In the Market Skimming Model, prices are set to achieve a high profit on each unit by selling to supply managers who are willing to pay a higher price because of lack of purchasing sophistication or who are willing to pay for a product or services of perceived higher value. An example of the application of this model is frequently seen by supply managers in the use of “backdoor selling” to non-purchasing professionals in the firm. Application of supply management best practices attempt to reduce the potential negative impact of this pricing model by cost, price, and/or value analysis to insure that the higher price for the product or service is justified by the reported additional benefits.
When downturns in market demand occur, suppliers often must resort to a Current-Revenue Pricing Model. The emphasis of this model is on obtaining sufficient current revenue to pay for operating cost rather than on profit. Suppliers using this strategy are typically concerned about capacity utilization, covering fixed cost, and retaining skilled labor during market slowdowns so they are willing to reduce their prices until market conditions change. Taking advantage of this model requires supply managers to be on guard for negative impacts on quality and services resulting from the supplier’s efforts to still make a profit on current sales by cutting costs.
The Promotional Pricing Model presents pricing for individual products and services that are set to enhance the sales of the overall product line rather than to assure the profitability of each product. Current examples of this are the sale of cell phones at below cost in order to induce supply managers to buy the annual service contract on which profits are made or the use of extremely low prices for printers which require the use of the supplier’s ink cartridges on which substantial profit is made. Total Cost of Ownership analysis help the supply manager avoid surprising and unfavorable financial impacts that can often result from dealings with suppliers who apply this model.
In the Market Segment Pricing Model, products or services sold in different market segments are priced differently even though there is no cost differential to the supplier between the different market segments. This is seen frequently in the lower prices offered by some US suppliers to overseas market segments while prices offered to US segments are maintained at a higher level to protect the established US pricing structure. Supply Management best practices suggest that supply managers have extensive knowledge of the supplier’s pricing levels in the various market segments and that supply managers insist on receiving prices form the supplier that are no higher than that received from the lowest market segment or even better yet, that an even lower price market segment should be developed for the supply manager.
The Competition Pricing Model, focuses on pricing actions or reactions to pricing proposals offered or expected to be offered by the supplier’s competitors. The pricing strategy is based on determining, in order to get award, the highest price that can be offered to the supply manager that will still be lower than the price offered by competitors. An excellent example of this model is the reverse auction process.
Understanding the pricing model used by the supplier can give the supply manager significant insights into the strategies needed to generate world-class outcomes for their firms.
By Robi Bendorf, C.P.M., principle of Bendorf & Associates Consulting in Pittsburgh, Pennsylvania (click here for a bio).