Business Procurement Chapter 10 PDF

page 265 Chapter Ten Price Chapter Outline Relation of Cost to Price Meaning of Cost How Suppliers Establish Price The Cost Approach The Market Approach Government Influence on Pricing Legislation Affecting Price Determination Types of Purchases...

page 265 Chapter Ten Price Chapter Outline Relation of Cost to Price Meaning of Cost How Suppliers Establish Price The Cost Approach The Market Approach Government Influence on Pricing Legislation Affecting Price Determination Types of Purchases Raw and Semiprocessed Materials Parts, Components, and Packaging Maintenance, Repair, and Operating Supplies (MRO) and Small-Value Purchases (SVPs) Capital Assets Services Resale Other The Use of Quotations and Competitive Bidding Steps in the Bidding Process Firm Bidding Determination of Most Advantageous Bid Collusive Bidding Public-Sector Bidding The Problem of Identical Prices Discounts Cash Discounts Trade Discounts Multiple Discounts Quantity Discounts The Price-Discount Problem Quantity Discounts and Source Selection Cumulative or Volume Discounts Contract Options for Pricing Firm-Fixed-Price (FFP) Contract  Cost-Plus-Fixed-Fee (CPFF) Contract Cost-No-Fee (CNF) Contract Cost-Plus-Incentive-Fee (CPIF) Contract Provision for Price Changes Contract Cancellation Forward Buying and Commodities Managing Risk with Production and Marketing Contracts Forward Buying versus Speculation Organizing for Forward Buying Control of Forward Buying The Commodity Exchanges Limitations of the Exchanges Hedging Sources of Information Regarding Price Trends Conclusion Questions for Review and Discussion References Cases 10–1 Wedlock Engineered Products 10–2 Coral Drugs 10–3 Price Forecasting Exercise page 266  page 266 Key Questions for the Supply Decision Maker Should we Use competitive bidding as our principal means of price determination? Take advantage of a volume or cash discount offered by a supplier? Use forward buying? How can we Spot and combat price fixing? Use the futures market to hedge the purchase of raw materials? Know when to allow price changes during a contract? Determination of the price to be paid is a major supply decision. The ability to get a “good price” is sometimes held to be the prime test of a good buyer. If “good price” means greatest value, broadly defined, this is true. Three key decisions are addressed in this chapter: (1) What is the right price to pay? (2) What represents best value? and (3) How can we assure we are paying the right price? While price is only one aspect of the overall supply job, it is extremely important. The purchaser must be alert to different pricing methods, know when each is appropriate, and use skill in arriving at the price to be paid. There is no reason to apologize for emphasizing price or for giving it a place of importance among the factors to be considered. The purchaser rightly is expected to get the best value possible for the organization whose funds are spent. While competitive bidding can be used for some purchases, purchasing in the commodities market requires a much different approach and buyer skill set. This chapter examines how suppliers set prices and techniques that can be used to establish and adjust prices. Chapter 11 complements the material covered in this chapter by addressing supplier cost analysis and negotiation. RELATION OF COST TO PRICE Every supply manager believes the supplier should be paid a fair price. But what does “fair price” mean? A fair price is the lowest price that ensures a continuous supply of the proper quality where and when needed. A “continuous supply” is possible in the long run only from a supplier who is making a reasonable profit. The supplier’s total costs, including a reasonable profit, must be covered by total sales in the long run. Any one item in the line, however, may never contribute “its full share” over any given period, but even for such an item, the price paid normally should at least cover the direct costs incurred. A fair price to one seller for any one item may be higher than a fair price to another or for an equally satisfactory substitute item. Both may be “fair prices” as far as the buyer is concerned, and the buyer may pay both prices at the same time. page 267 Merely the fact that a price is set by a monopolist or is established through collusion among sellers does not, in and of itself, make that price unfair or excessive. Likewise, the prevailing price need not necessarily be a fair price, as, for example, when such price is a “black” or “gray” market price or when it is depressed or raised through monopolistic or coercive action. The supply manager is called on continuously to exercise judgment about what the “fair price” should be under a variety of circumstances. In part, accuracy in weighing the various factors that culminate in a “fair and just price” depends on capitalizing on past experience and thorough knowledge of production processes for goods and services and associated costs, as well as logistics costs such as storage, transportation, service delivery, and other relevant costs. Meaning of Cost Assuming this concept of a fair price is sound, what are the relationships between cost and price? To stay in business over the long run, a supplier must cover total costs, including overhead, and receive a profit. Otherwise, eventually the supplier will be forced out of business. This reduces the number of sources available to the buyer and may cause scarcity, higher prices, less-satisfactory service, and lower quality. But what is to be included in the term cost? At times it is defined to mean only direct labor and material costs, and in a period of depressed business conditions, a seller may be willing merely to recover this amount rather than not make a sale at all. Or cost may mean direct labor and material costs with a contribution toward overhead. If the cost for a particular item includes overhead, is the latter charged at the actual rate (provided it can be determined), or is it charged at an average rate? The average rate may be far from the actual rate. Most knowledgeable businesspeople realize that determining the cost of a particular article or service is not a precise process. There are two basic classifications of costs: direct and indirect. Direct costs can be specifically and accurately assigned to a given unit of production or a specific identifiable task performed by a service provider. For example, in manufacturing, direct material is 10 pounds of steel, or direct labor is 30 minutes of a person’s time on a machine or assembly line. For a service provider that has inventory, direct material costs are parts and supplies used to provide the service—for example, cleaning supplies in a janitorial service. Direct labor costs are the wages paid to the professionals and fees paid to contract or freelance labor to deliver the service. However, under accepted accounting practices, the actual price may not be the cost included in determining direct material costs. Because the price paid may fluctuate over a period of time, it is common practice to use a standard cost. Some companies use the last price paid in the immediately prior fiscal period. Others use an average price for a specific period. Indirect costs are incurred in the operation of a production plant or process or service organization, but normally cannot be related directly to any given unit of production or service provided. Some examples are rent, property taxes, machine depreciation, expenses of general supervisors, information technology, power, heat, and light. Indirect costs often are referred to as overhead. They may be fixed, variable, or semivariable. Classification of costs into variable, semivariable, and fixed categories is a common accounting practice and necessary for any meaningful analysis of price/cost relationships. Most direct costs are variable costs because they vary directly and proportionally with the units produced. For example, a product that requires 10 pounds of steel for one unit will require 100 pounds for 10 units. page 268 Semivariable costs may vary with the number of units produced but are partly variable and partly fixed. For example, more heat, light, and power are used when a plant is operating at 90 percent of capacity than when operating at 50 percent, but the difference is not directly proportional to the number of units produced. In fact, there would be some costs (fixed) for heat, light, and power if production were stopped completely for a period of time. Fixed costs generally remain the same regardless of the number of units produced. For example, property taxes will be the same for a given period of time regardless of whether one unit or 100,000 units are produced. Several accounting methods can be used to allocate fixed costs. A common method is to apply a percentage of direct costs in order to allocate the cost of factory overhead. Full allocation of fixed expenses will depend on an accurate forecast of production and the percentage used. Obviously, as full production capacity is reached, the percentage rate will decline. Factory overhead often is based on some set percentage of direct labor cost because, historically, labor represented the largest cost element. Although rarely true now, standard cost accounting often has not changed. Selling, general, and administrative expense is based on a set percentage of total manufacturing cost or services cost. The following example illustrates the typical product cost buildup in a manufacturing setting: Direct materials $ 5,500 + Direct labor 2,000 + Factory overhead* 2,500 = Manufacturing cost $10,000 + General, administrative, and selling cost 1,500 = Total cost $11,500 + Profit 920 = Selling price $12,420 *Factory overhead consists of all indirect factory costs, both fixed and variable. Costs can be defined as dollars and cents per unit based on an average cost for raw material over a period of time, direct labor costs, and an estimated volume of production over a period of time on which the distribution of overhead is based. Cost of services or cost of revenue includes all expenses that occur only when services are sold or expenses that increase or decrease as sales of the service increase or decrease. Expenses commonly included in the cost of services are sales commissions, fees or wages for professionals and contract labor paid by projects, transportation costs to deliver services, and rental costs for equipment or tools that occur only when services are sold. If this definition of cost is acceptable, then a logical question is: Whose cost? Some manufacturers are more efficient than others. Usually all sell the same item at about the same price. But should this price be high enough to cover only the most efficient supplier’s costs, or should it cover the costs of all suppliers? Furthermore, cost does not necessarily determine market price. A seller’s insistence that a price must be a given amount because of costs is not justified. Goods are worth and will sell for what the market will pay. page 269 Moreover, no seller is entitled to a price that yields a profit merely because the supplier is in business or assumes risk. If so, every business automatically would be entitled to a profit regardless of costs, quality, or service. A seller that cannot efficiently supply a market with goods that are needed and desired by users is not entitled to get a price that even covers costs. HOW SUPPLIERS ESTABLISH PRICE Depending on the commodity and industry, the market may vary from almost pure competition to oligopoly and monopoly. Pricing varies accordingly. For competitive reasons, most firms will not disclose how prices are set, but the two traditional methods are the cost approach and the market approach. The Cost Approach The cost approach means that price is a certain amount over direct costs, allowing for sufficient contribution to cover indirect costs and overhead and leaving a certain margin for profit. This provides the purchaser with opportunities to seek lower-cost suppliers, to suggest lower- cost manufacturing or service alternatives, and to question the size of the margin over direct costs. Negotiation, used with cost-analysis techniques, is a particularly useful tool. The Market Approach The market approach implies that prices are set in the marketplace and may not be directly related to cost. If demand is high relative to supply, prices are expected to rise; when demand is low relative to supply, prices should decline. This, too, is an oversimplification. Some economists hold that large multinational, multiproduct firms have such a grip on the marketplace that pure competition does not exist and that prices will not drop even though supply exceeds demand. In the market approach, the purchaser either lives with prevailing market prices or finds ways around them. If nothing can be done to attack the price structure directly, it still may be possible to select suppliers willing to offer nonprice incentives, such as holding inventory, technical and design service, guaranteeing specific people as part of a service contract, superior quality, excellent delivery, transportation concessions, and early warning of impending price and product changes. Negotiation, therefore, may center on items other than price. Many economists hold that substitution of like but not identical materials or products is one of the most powerful forces preventing a completely monopolistic or oligopolistic grip on a market. For example, aluminum and copper may be interchanged in a number of applications. The aluminum and copper markets, therefore, are not independent of one another. The purchaser’s ability to recognize these trade-offs and to effect design and use changes to take advantage of substitution is one determinant of flexibility. Make or buy (or outsource or insource) is another option. If access to the raw materials, technological process, and labor skills is not severely restricted, one alternative may be for an organization to make its own requirements to avoid excess market prices. When buying services, substitutability of one service provider for another may hinge on the perceived value of the service provider’s expertise. page 270 Sometimes purchasers use long-term contracts to induce the supplier to ignore market conditions. This may be successful in certain instances, but suppliers normally find ways around such commitments once it becomes obvious that the prevailing market price is substantially above that paid by their long-term customers. GOVERNMENT INFLUENCE ON PRICING The government’s role in establishing price has changed dramatically. The role of government has been twofold. The government can have an active role in determining prices by establishing production and import quotas and regulating the ways that buyers and sellers are allowed to behave in agreeing on prices. Because other governments are active in price control and have, in a number of situations such as natural gas prices in Russia, created dual pricing for domestic use and exports, it is difficult to see how the U.S. and Canadian governments will be able to ignore their position. Prices may be determined by review or control boards or by strong moral suasion. They are likely to be augmented by governmental controls such as quotas, tariffs, and export permits. Governments influence prices of utilities that offer common services, such as electricity and water, and set prices on licenses and goods and services provided by government-run organizations, such as postal services. Energy deregulation is still in its infancy but will be an interesting and challenging area for purchasers to watch. The U.S. Postal Service, a quasi-governmental organization, also is undergoing changes as it forges alliances with private-industry competitors such as FedEx and UPS. Despite receiving no tax dollars for operating expenses, key decisions, including prices and fees charged, services offered, and the pension coverage calculation, are made by various government entities while the Postal Service relies on the sale of postage, products, and services to fund its operations. Other nations have taken various steps to introduce competition into their national postal service. For example, Germany privatized Deutsche Post in 2000, and now DHL is part of the world’s leading postal and logistics Group, Deutsche Post DHL. What these changes will mean in terms of pricing and negotiation opportunities remains to be seen. Legislation Affecting Price Determination While there are differences in United States and Canadian laws related to pricing, both federal governments have taken an active interest in how a buyer and seller agree on a price. United States The government has largely played a protective role by preventing the stronger party from imposing too onerous conditions on the weaker one or preventing collusion so that competition is maintained. The two most important federal laws affecting competition and pricing practices are the Sherman Antitrust and Robinson-Patman acts. The Sherman Antitrust Act of 1890 states that any combination, conspiracy, or collusion with the intent of restricting trade in interstate commerce is illegal. It is illegal for suppliers to get together to set prices (price fixing) or determine the terms and conditions under which they will sell. For example, following a three-year investigation by the U.S. Department of Justice Antitrust Division, 26 Japanese companies in the automotive parts industry pleaded guilty of bid rigging and price-fixing. By February 2014, the companies had agreed to pay criminal fines of over $2 billion. Twenty-eight individuals were also charged.1 Buyers cannot get together to set the prices they will pay. page 271 Over 120 countries have antitrust laws of some sort to protect competition. There is increasing cooperation in investigating international cartels, and many multinational mergers are reviewed by antitrust agencies. The Robinson-Patman Act (Federal Anti-Price Discrimination Act of 1936) says that a supplier must sell the same item, in the same quantity, to all customers at the same price. It is known as the “one-price law.” Some exceptions are permitted, such as a lower price (1) for a larger purchase quantity, providing the seller can cost justify the lower price through cost accounting data; (2) for moving distress or obsolete merchandise; or (3) for meeting the lower price of local competition in a particular geographic area. It is also illegal for a buyer to knowingly induce or accept a discriminatory price. However, the courts have held that it is the buyer’s job to get the best possible price, and as long as a buyer does not intentionally mislead the seller into giving a more favorable price than is available to other buyers of the same item, the law is not being violated. A buyer can file a charge detailing the alleged violation to the Federal Trade Commission (FTC), which investigates alleged improprieties. Bringing a seller’s actions to the government’s attention has few advantages for a buyer. Typically, the government’s reaction is relatively slow; the need for the item may be gone and conditions may be substantially changed by the time the complaint is decided. Most sellers view a complaint as an unfriendly act, making it difficult to maintain a reasonable future relationship with that particular supplier. For this reason, complaints are not common, and most are lodged by public buying agencies rather than corporations. Canada Canadian federal pricing legislation differs from U.S. legislation, but it has essentially the same intent. It prohibits certain pricing practices in an attempt to maintain competition in the marketplace and applies to both buyers and sellers. Violation of the statute is a criminal offense. Suppliers or buyers may not “conspire, combine, agree, or arrange with another person” to raise prices unreasonably or to otherwise restrain competition. It does not prevent the exchange of data within a trade or professional association, providing it does not lessen price competition. Bid rigging is a per se violation, which means that the prosecution need only establish the existence of an agreement to gain a conviction; there is no requirement to prove that the agreement unduly affected competition. It is also illegal for a supplier to grant a price concession to one buyer that is not available to all other buyers (similar to the U.S. Robinson-Patman Act). Quantity discounts are permitted, as are one-time price cuts to clear out inventory. As in the United States, the Canadian buyer who knowingly is on the receiving end of price discrimination also has violated the law. With regard to price maintenance and the purchase of goods for resale, it requires that a supplier should not, by threat or promise, attempt to influence how the firms that buy from it then price their products for resale. TYPES OF PURCHASES page 272 Analysis of suppliers’ costs is by no means the only basis for price determination. What other means can be used? Much depends on the type of product being bought. As discussed in Chapter 6, there are seven general classes: 1. Raw and semiprocessed materials. This includes sensitive commodities, such as copper, wheat, and crude petroleum, but also steel, cement, and so forth. The Wedlock Engineered Products case at the end of this chapter provides an example of a supplier selection decision that involves raw material. 2. Parts, components, and packaging. This includes nuts and bolts, many forms of commercial steel, valves, and tubing, whose prices are fairly stable and are quoted on a basis of “list price with some discount.” 3. Maintenance, repair, and operating (MRO) supplies and small-value purchases (SVP). Some organizations require a huge variety and number of MRO and SVP items. Effort to check price prior to purchase is not justified. 4. Capital assets. Capital assets are long-term assets that are not bought or sold in the regular course of business, have an ongoing effect on the organization’s operations, have an expected use of more than one year, involve large sums of money, and generally are depreciated. Assets may be tangible or intangible. Historically, tangible assets (land, buildings, and equipment) have been the primary focus of managerial attention because they were the key drivers of wealth. Today, intangible assets (patents, copyrights, ideas, knowledge, and people) are important generators of wealth. Intangible assets are especially challenging because traditional accounting procedures do not include valuation methods for intangibles. 5. Services. This category is broad and includes many types of services, such as advertising, auditing, consulting, architectural design, legal, insurance, personnel travel, copying, security, and waste removal. 6. Resale. This category can be subdivided into two groups: a. Items that formerly were manufactured in-house but have been outsourced to a manufacturing supplier. For example, a major appliance maker markets a microwave oven but, instead of manufacturing the product, buys it under its own brand name. The decision process for these items is the same as presented in this book. b. Items sold in the retail sector, such as clothing sold in general-line department stores; food sold through supermarkets; tools sold in hardware stores; and tires, batteries, and accessories sold in gasoline/filling stations.      The dollar amount involved in the purchase of these resale items is tremendous. The people who buy these items, merchandise  managers, make their buying decisions based on the forecast of consumer demand. There is no detailed coverage of merchandise buying in this text, although many of the same supply principles and practices apply. 7. Other. This includes custom-ordered items and materials that are special to the organization’s product line. page 273 Raw and Semiprocessed Materials Raw materials and commodities are normally quoted at market prices, which fluctuate daily. The price at any particular moment probably is less important than the trend of the price movement. The price can be determined readily in most instances because many of these commodities are bought and sold on well-organized markets. Prices are reported regularly online and in print in many of the trade and business journals and on websites, such as American Metal Market (amm.com), ICIS, the world’s largest petrochemical market information provider (icis.com), Bloomberg.com, and The Wall Street Journal (wsj.com). These quoted market prices can be useful in developing prices-paid evaluation systems and price indexes for use in price escalator clauses. To the extent that quoted prices are a fair reflection of market conditions, the current cash price is known and is substantially uniform for a given grade. Such published market quotations usually are on the high side, and the astute buyer probably can get a lower price. A company’s requirements for these commodities usually are sufficiently adjustable that purchase can be postponed if there is a downward price trend. While the price trend is of importance in the purchase of any commodity, it is particularly important for this group. Insofar as “careful and studious timing” is essential to getting the right price, both the type of information required as a basis for such timing and the sources from which the information can be obtained differ from those necessary in dealing with other groups of items. Commodity study research, discussed in Chapter 17, is particularly useful in buying these items. Parts, Components, and Packaging The prices of parts, components, and packaging are comparatively stable and likely to be quoted on a basis of list-less-certain-discounts. This includes a range of items commonly obtainable from multiple sources. The inventory problems are largely routine. Changes in price do occur, but they are moderate and far less frequent than with raw materials. Prices usually are obtained from online or hard-copy catalogs or similar publications of suppliers, supplemented by periodic discount sheets. Still price quotes should be examined carefully because annual dollar volume may be high and price per unit may be worth attention. If the material has been regularly or recently purchased, an up-to-date price record and catalog file give information about potential and current suppliers and prices paid. This enables the buyer to order without extended investigation. However, if the buyer thinks the information is incomplete, a list of available suppliers can be assembled from supplier files, catalogs, the Internet, and other sources and quotation requests issued. Online auctions (seller initiated) or reverse auctions (buyer initiated) are also used by some organizations to more efficiently purchase standard items (see Chapter 4). Sales representatives are good sources for current prices and discounts. Few manufacturers rely wholly on catalogs (online or hard copy) for sales, but follow up such material with visits by their salespersons. A sales representative may quote the buyer a price while in the buyer’s office, and the buyer may accept by issuing a purchase order (PO). There likely will be no problem, although legally the salesperson probably does not have agency authority, and the offer made by the salesperson does not legally commit the selling company until it has been accepted by an officer of the selling company. If the buyer wishes to accept such an offer, and to know that the offer is legally binding, he or she should ask the salesperson to furnish a letter, signed by an officer of the selling company, stating that the salesperson possesses the authority of a sales agent (see Chapter 15). page 274 Maintenance, Repair, and Operating Supplies (MRO) and Small-Value Purchases (SVPs) MRO includes items of small comparative value, and prices are typically competitive so no special effort is required to analyze price. Every supply department buys MRO items, yet they do not justify a catalog file, even when such catalogs are available, nor do they represent enough money to warrant requests for quotations. The pricing problem is handled in a variety of ways; the following constitutes an excellent summary of these procedures. As discussed in Chapter 4, MRO items may be procured through e-procurement systems. While the actual transaction is handled electronically, most of the advantages come from applying good supply practices, such as consolidating and standardizing requirements and reducing the number of suppliers. Other common practices include sending out unpriced orders and indicating on the order the last price paid, or buying on a cost-plus basis with suppliers who have the materials in inventory and then conducting price checks. Procurement cards allow internal customers to purchase small-value items from designated suppliers. Perhaps a more effective way to buy items of small value, such as those included in the MRO group, is to use the systems-contracting, vendor-managed inventory (VMI), and third-party supplier techniques described in Chapters 4 and 8. Typically, sources of supply for small-value items are local, and current prices often are obtained online or by telephone or fax. Prices are included on the purchase order so they become a part of the agreement. The most common practice is to rely on the integrity of the suppliers and omit detailed price checking. The supply manager’s goal when purchasing small-value items is to minimize the cost of acquisition, that is, the ordering process costs. Spot-checking is often used to control prices for small-dollar items. Discovery of unfair or improper prices is a reason for discontinuing the source of supply. Similar to the small-value purchase problem is the emergency requirement. For example, with equipment breakdown, time may be of much greater value than money, and the buyer may wish to get the supplier started immediately even though price has not been determined. The buyer may decide merely to say “start” or “ship” and issue an unpriced purchase order. If the price charged on the invoice is out of line, it can be challenged before payment. Capital Assets As addressed in Chapter 6, “Need Identification and Specification,” capital assets include equipment, IT, real estate, and construction. Because of the high-dollar amount and the long-term consequences of many capital projects, purchase price is often a small percentage of total cost of ownership. The application of tools and techniques such as enterprisewide spend analysis; standardization of equipment, including hardware and software; globalization of processes; and cost visibility are important. Price determination tools range from request for proposals (RFP) to competitive bidding to negotiation. page 275 Services Pricing in services may be fixed or variable, by the job or by the hour, day, or week. Prices may be obtained by competitive bid if the size of the contract warrants it; enough competitors are available; and adequate, specific, consistent specifications can be prepared. Negotiation is commonly used to establish prices and may be the only option in sole-source situations. Volume and size can be used effectively as leverage by the knowledgeable supply manager. Understanding the cost structure of the service is helpful in revealing negotiation opportunities. For example, if a service provider has offshored high-paid service providers such as research analysts, engineers, or animators to lower-labor-cost countries, how does this change the service provider’s cost structure? Depending on the relative strength of each party, the changed cost structure might be a negotiating point. It is not unusual to estimate professional time required without committing to a specific figure. Most supply managers probably would prefer such contracts to have a “not to exceed” limit. Some professionals, such as architects, may quote their fee based on a percentage of the total job cost. But from a supply standpoint, this removes the incentive for the architect to seek the best value for the total job. Resale Merchandise managers must determine a fair price to pay for resale items that allows both the supplier and the merchandiser to make a profit. As discussed in Chapter 6, the largest single cost for a reseller who takes ownership of the goods it resells is what it paid for the goods or services. Although resale is not covered specifically in this text, many of the concepts and practices of price and cost management apply. Other Other items include the large variety of purchased parts or special materials peculiar to the organization’s end product or service. Make or buy is always a significant consideration because of the proprietary nature of these items. Prices normally are obtained by quotation because published price lists are unavailable. Subcontracts are common, and the availability of compatible or special equipment, skilled labor, and capacity may be significant factors in determining price. Because large differences may exist between suppliers in terms of these factors and their desire for business, prices may vary substantially. Each product is unique and may need special attention. A diligent search for suppliers willing and able to handle such special requirements, including an advantageous price, may pay off handsomely. THE USE OF QUOTATIONS AND COMPETITIVE BIDDING Quotations normally are secured when the size of the proposed commitment exceeds some minimum dollar amount, for example, $1,000. Governmental purchases commonly must be on a bid basis; here the law requires that the award be made to the lowest responsible and responsive bidder. In the private sector, organizations may solicit quotations and negotiate the final price. The use of competitive bidding for price determination varies widely. It is a common practice for buyers of routine supplies, purchased from the same sources time after time, to issue unpriced orders or to order automatically through an e-procurement system. The same thing occasionally happens in a very strong seller’s market for some critical items when prices are rising so rapidly that the supplier refuses to quote a fixed price. Whenever possible, however, price should be indicated on the purchase order. In fact, from a legal point of view, a purchase order must contain either a price or a method of its determination for the contract to be binding. With competitive bids, the following are required: a careful initial selection of dependable, potential sources; an accurate wording of the request to bid; submission of bid requests to a sufficient number of suppliers to ensure a truly competitive price; proper treatment of quotations; and a careful analysis prior to award. page 276 Steps in the Bidding Process The first step is to screen sources of supply and select potential suppliers from whom quotations will be solicited. It is assumed that the bidders must (1) be qualified to make the item or provide the service in accordance with the buyer’s specifications and to deliver it by the desired date, (2) be sufficiently reliable, (3) be numerous enough to ensure a truly competitive price, but (4) not be more numerous than necessary. The first two issues were considered in our discussion of sources. The number of suppliers to whom inquiries are sent is largely a matter of the buyer’s judgment. Ordinarily, at least two suppliers are invited to bid. More often, three or four are. Multiple bidders do not ensure a competitive price, although under ordinary circumstances it is an important factor if bidders are comparable, each is sufficiently reliable, and the buyer would purchase from them. The buyer normally will exclude from the bid list those firms with whom it is unlikely to place an order even though their prices are low. Sometimes bids are solicited solely for the purpose of price checking or for inventory-pricing purposes. It costs a company to submit a bid. Suppliers should not be asked to bear this cost without good reason. Moreover, the receipt of a request to bid is an encouragement to the supplier and implies that an order is possible. Therefore, purchasers should not solicit quotations unless placement of a purchase order is a possibility. Off-line Process After selecting the companies to be invited to bid, the purchaser in an off-line process sends a general inquiry that includes a complete description of the item(s), the delivery date, and the due date for bids. A telephone inquiry may be substituted for a formal request to bid. Between mailing an inquiry and awarding the contract, bidders want to know how their quotations compare with competitors. Because sealed bids, used in governmental/public purchasing, are not commonly used in private industry, the purchaser is in a position to know how the bids, as they are received, compare with one another. However, if the bids are examined on receipt, it is important that this information be treated in strictest confidence. Indeed, some buyers deliberately keep quotations secret until they are ready to analyze the bids; thus, they are in a position to tell any inquiring bidder truthfully that they do not know how the bid prices compare. Even after the award is made, it probably is the better policy not to reveal to unsuccessful bidders the amount by which they failed to meet the successful bid. Electronic Process In both the public and private sectors, the entire bid process may be automated. For example, the federal governments in the United States and Canada (http://www.tpsgc-pwgsc.gc.ca) have well-established electronic procurement systems. On the U.S. FedBizOpps site (fbo.gov), more than 20,000 active federal opportunities were listed in early 2014. page 277 Beginning in 2009, the Mexican government modernized its procurement methods, eliminated obsolete regulations, built in methods for transparency, and created an online platform to ensure transparency and ease of access. This reduced execution time by 95 percent. Within three years, small and medium enterprises increased their participation in the federal procurement system by 36 percent, and the government saved $1 billion USD. Bid packages and specifications are made available online, bidders submit their bid and proposals online, and the bid opening and award are communicated electronically. The cycle time reductions and other cost savings can be great if the automated process is efficient. This process is similar to an online bid. In an online auction, the potential sources are prequalified and invited to participate. The auction, or event, is set for a specific date and time period much like the deadline and bid opening deadlines in an off-line process. Auction success depends on the quality of the bid specifications and the ability of the person and process to prequalify suppliers. Bidders can see, online, the actual bid amounts but not who the bidders are (see Chapter 4). Firm Bidding Bid price information is treated confidentially because buyers often face “firm bidding.” Most organizations have a policy of notifying suppliers that original bids must be final (firm) and that revisions will not be permitted under any circumstances. Exceptions are made only in the case of obvious error. When prices are falling and suppliers need orders, suppliers try to ensure that their bids will be the lowest. Frequently, suppliers are encouraged by purchasers who have acceded to requests that revisions be allowed. Unfortunately, it is also true that there are buyers who deliberately play one bidder against another and who even seek to secure lower prices by relating imaginary bids to prospective suppliers. The responsibility for deviations from a policy of firm bidding lies with the purchaser as well as the supplier. A policy of firm bidding is sound and should be deviated from only under the most unusual circumstances. This is the practice followed in many organizations. The advantage of firm bidding as a general policy is that it is the fairest possible means of treating all suppliers alike. It tends to stress the quality and service elements in the transaction instead of the price factor. Assuming that bids are solicited only from honest and dependable suppliers and that the buyer is not obligated to place the order with the lowest bidder, it removes from suppliers the temptation to try to use inferior materials or workmanship once their bid has been accepted. It saves the purchaser time by removing the necessity for constant bargaining with suppliers over price. An exception to the firm bidding approach is one in which the buyer wants both parties (seller and buyer) to have the flexibility to clarify and define specifications and prices further after the initial bids are received. The buyer will notify all the sellers in the bid request that, after the initial bids are received, the buyer may enter into discussions with one or more of the bidders, and then request best and final offers (BAFOs). Some public buying agencies also use this approach. Occasionally the buyer may notify bidders that all bids are being rejected and another bid request is being issued, or that the item will be bought through a means other than competitive bidding. This is done if it is obvious that the bidders did not fully understand the specifications, if collusion on the part of the bidders is suspected, or if it is felt that all prices quoted are unrealistically high. page 278 Determination of Most Advantageous Bid Typically, a bid analysis arrays the bids or they are viewed electronically in real time during an online auction. The lowest bid customarily is accepted. The objective of securing bids from various sources is to obtain the lowest price, and the purpose of supplying detailed specifications and statements of requirements is to ensure receipt of the same items or services from any bidder. Governmental contracts must be awarded to the lowest bidder unless very special reasons can be shown for not doing so.  Sometimes the lowest bidder may not receive the order. This occurs when the buyer discovers that the lowest bidder is unreliable, the lowest bid is higher than the buyer believes justifiable, or there is reason to believe bidders colluded. Also, users such as plant management, engineering, or marketing may prefer a certain supplier’s product or service. A slight difference in price may not compensate for the confidence in a particular supplier’s product or service, or satisfaction with a long-term supplier. Yet the bid process may be essential in ensuring proper price treatment. Selecting the supplier is not a simple matter of listing the bidders and picking out the one whose price is apparently low, because the obvious price comparisons may be misleading. Of two apparently identical bids, one actually may be higher than the other. One supplier’s installation costs may be lower than another’s. If prices quoted are FOB origin (buyer pays freight charges), the transportation charges may be markedly different. One supplier’s price may be much lower because it is trying to break into a new market or is trying to force its only real competitor out of business. One supplier’s product may require tooling that must be amortized. One supplier may quote a fixed price; another may insist on an escalator clause that could push the price above a competitor’s firm bid. These and other factors render a snap judgment on comparative price a mistake. The Coral Drugs case at the end of this chapter and the Carson Manor case in Chapter 12 are examples of organizations facing complex supplier selection decisions following a bidding process. Collusive Bidding A buyer also may reject all bids if it is suspected that the suppliers are acting in collusion with one another. The proper policy is often difficult to determine, but there are various possibilities. Legal action is possible but seldom feasible because of the expense, delay, and uncertainty of the outcome. Often, unfortunately, the only apparent solution is to accept the situation because there is nothing the buyer can do about it anyway. Another possibility is to seek new sources of supply either inside or outside the area in which the buyer customarily has purchased materials or services. Using substitute materials, temporarily or permanently, may be an effective solution. Another possibility is to reject all the bids and then try to negotiate with one supplier to reduce the price. If negotiation is the most feasible alternative, a question of ethics is involved. Some supply managers believe that supplier collusion means it is ethical for them to attempt to force down prices by means that ordinarily would not be adopted. page 279 Public-Sector Bidding The process for bidding in the public sector is similar to the private sector, but there are a few important differences. Public statutes normally provide that the award of purchase contracts should be made on the basis of open, competitive bidding. The goal is to ensure that all qualified suppliers who are taxpayers, or who employ personnel who are taxpayers, have an equal opportunity to compete for the sale of products or services needed to operate government. Since bids are open to public inspection, it is difficult for the public buyer to show favoritism to any one supplier. This system tends to put a heavy weight on price as the basis for supplier selection because it might be difficult for the buyer to defend selecting a higher-priced supplier. Providing a list of weighted criteria for bid evaluations in the invitation to bid allows the buyer to consider nonprice factors (see Chapter 13). Either by law, statute, or regulation or as a matter of normal operating policy, public purchasers in North America and Europe are required to advertise upcoming purchases in specified publications and/or online. The advertisement informs interested suppliers how to access or receive a request for bid for a particular requirement. The buyer then determines whether the supplier meets the minimum supplier qualifications. Advertising improves transparency of the purchasing process. The public buyer generally must be willing to consider any supplier who requests to be put on the bid list if the supplier meets the minimum standards for a responsible bidder in measurable terms. However, public purchasers should be aggressive in ferreting out new potential supply sources. Public purchasers are required to award contracts to the lowest “responsible” and “responsive” bidder. A responsible bidder is fully capable and willing to perform the work; a responsive bidder submits a bid that conforms to the invitation for bid. In some public agencies, a purchase award cannot be made unless at least some minimum number of bids (often three) have been received. If the minimum number is not received, the requirement must be rebid, or the buyer must justify that the nature of the requirement is such that it is impossible to obtain bids from more suppliers. Use of Bid Bonds and Deposits There may be a legal or policy requirement for bidders to submit a bond at the time of the bid, especially for large-dollar bids or construction. Or the bidders are required to submit a certified check or money order in a fixed percentage amount of the bid. If the selected bidder does not agree to sign the final purchase contract or does not perform according to the terms of the bid, this amount is retained as liquidated damages for nonperformance. The bid bond or bid deposit is designed to discourage irresponsible bidders from competing. In high-risk situations, the extra cost of the bid bond, which in some way will be passed back as an extra cost to the buyer, is warranted; in the purchase of standard, stock items available from several sources, the use of a bond is questionable. There are three general types of bonds. Most bidders purchase each, for a dollar premium, from an insurance company, thus effectively transferring some of the risk to the insurance carrier: 1. The bid (or surety) bond guarantees that if the bidder wins it will accept the purchase contract. If the supplier refuses, the extra costs to the buyer of going to an alternative source are borne by the insurer. page 280 2. The performance bond guarantees work will be done according to specifications and in the time specified. If another supplier does rework or completes the order, purchasing is indemnified for these extra costs. 3. The payment bond protects the buyer against liens that might be granted to suppliers of material and labor to the bidder, in the event the  bidder does not make proper payment to its suppliers. In a multiple-year contract or one with high initial costs, the purchaser may want to break the performance bond into periods or stages of completion to avoid having the surety write the bond too high and increase the cost of the contract too much. Bid Opening, Evaluation, and Award In an off-line system, at the hour and date specified in the bid instructions, the buyer opens and records all bids. Usually, any interested party can attend the bid opening and examine any of the bids. The original bids are retained for later inspection by any interested party for a specified time period (often 12 months). In an e-procurement system, these steps are done electronically. For example, many U.S. government opportunities and awards are processed through fedbizopps.gov. Most U.S. states and Canadian provinces have a similar e-procurement system. After the bid opening, the buyer analyzes the bids for conformance to bid requirements and prepares a recommended purchase action. Large-dollar purchases may require council approval in a municipality or cabinet approval for a federal, state, or provincial procurement. If multiple bid criteria apply and if two or more responsible bidders meet the specifications and conditions, the supplier with the best rating is selected. Other actions by the buyer must be justified. If identical low bids are received, and the buyer has no evidence or indication of collusion or other bid irregularities, then the buyer must find an acceptable way of resolving this issue. The public buyer has no obligation to notify unsuccessful bidders because the bid opening was a public event and the bid and award documents are retained and may be viewed. In an e-procurement system, bidders can access the information online. Bid Errors If the successful low bidder notifies the buyer of an error after the bid has been submitted, but before the award of the purchase order has been made, normally the bid may be withdrawn. However, the buyer makes note of this, since it reflects on the responsibility of the bidder. A much more serious problem arises if the bidder, claiming a bid error, attempts to withdraw the bid after it has been awarded. A bid bond helps protect the buyer. If no bid bond exists, the buyer must decide on court action to force performance, collect damages, go to the closest other successful bidder (who now may no longer be interested), or go through the bid process again. Legally, if the mistake was mechanical in nature, a mathematical error, the courts probably will side with the supplier. However, if it was an error in judgment—for example, the supplier misjudged the rate of escalation in material prices—then the courts generally will not permit relief to the supplier. Also, for the supplier to gain relief in the courts, the supplier must show that once the error was discovered, the buying agency was notified promptly. If the buyer receives a bid that common sense and knowledge of the market indicates is unrealistic, the bid should be rechecked and the bidder requested to reaffirm that it is a bona fide bid. In the long run, such action likely will be cheaper than a protracted legal battle with an uncertain outcome. page 281 Competition Concerns Since public purchasers share bid information with each other, they are in a unique position to watch for illegal trade practices by suppliers. Collusion may be evident from artificially high prices, identical prices, unwillingness to bid, the rotation of a low bidder among a small group of bidders, the apparent favoring of a particular bidder on a specific requirement area, and so on. Every country has an agency or bureau that investigates anticompetitive practices and prosecutes perpetrators. The antitrust division of the U.S. Department of Justice and the Competition Bureau in Canada perform these tasks. The Problem of Identical Prices It is not unusual to receive identical bids from various sources. This may indicate intensive competition or discrimination or collusion. Identical or parallel prices are suspect when: 1. Identical pricing marks a novel break in the historical pattern of price behavior. 2. There is evidence of communication between sellers or buyers regarding prices. 3. There is an “artificial” standardization of the product. 4. Identical prices are submitted in bids to buyers on complex, detailed, or novel specifications. 5. Deviations from uniform prices become the matter of industrywide concern—the subject of meetings and even organized sanctions. There are four types of action to discourage identical pricing. First, encourage small sellers who form the nonconformist group in an industry and are anxious to grow. Second, allow bids on parts of large contracts if bidders feel the total contract is too large. Third, encourage firm bidding without revision. Fourth, choose award criteria that discourage future identical bids. If identical bids are received, the buyer can reject all bids and then either call for new bids or negotiate directly with one or more specific suppliers. If the contract is going to be awarded, it may be given to: 1. The smallest supplier. 2. The one with the largest domestic content. 3. The most distant firm, forcing it to absorb the largest freight portion. 4. The firm with the smallest market share. 5. The firm most likely to grant nonprice concessions. 6. The firm whose past performance has been best.  Competitive bidding is used to obtain a fair price; the forces of competition are used to bring the price down to a level at which the efficient supplier will be able to cover only production and distribution costs, plus make a minimum profit. If a supplier wants the order, that supplier will review and improve the offer and give the buyer an attractive quote. This places a good deal of pressure on the supplier. page 282 Several conditions are necessary for the bid process to work efficiently: (1) there must be at least two, and preferably several, qualified suppliers; (2) the suppliers must want the business (competitive bidding works best in a buyer’s market); (3) the specifications must be clear, so that each bidder knows precisely what it is bidding on, and so that the buyer can easily compare quotes; and (4) there must be honest bidding and the absence of collusion. When any of these conditions is absent—that is, a sole-source situation, a seller’s market, specifications that are not complete or subject to varying interpretations, or suspected supplier collusion—then negotiation is the preferred method of price determination (see Chapter 11). DISCOUNTS Discounts represent a legitimate and effective means of reducing prices. The most commonly used types of discounts are cash discounts, multiple discounts, quantity discounts, and cumulative or volume discounts. They may be offered by suppliers or negotiated by purchasers. Cash Discounts Cash discounts are granted by virtually every seller of industrial goods. The actual discount terms are determined by individual trade custom and vary considerably. The purpose of a cash discount is to secure the prompt payment of an account. For example, a 2/10 net 30 cash discount means a discount of 2 percent if payment is made within 10 days, with the gross amount due in 30 days. This is the equivalent of earning an annual interest rate of approximately 36 percent. If the buying company does not pay within the 10- day discount period but instead pays 20 days later, the effective cost for the use of that money for the 20 days is 2 percent (the lost discount). Because there are approximately eighteen 20-day periods in a year, 2% × 18 = 36%, the effective annual interest rate. Most sellers expect buyers to take the cash discount. The net price is commonly fixed at a point that will yield a fair profit to the supplier and is the price the supplier expects most customers to pay. Those who do not pay within the time limit are penalized and are expected to pay the gross price. However, variations in cash discount amounts frequently are used merely as another means of varying prices. If a buyer secures a cash discount not commonly granted in the past, the net result is merely a reduction in the price. A reduction in the size of the cash discount is, in effect, an increase in the price. Cash discounts sometimes raise difficult questions about price policy. If the same terms and practices are granted to all buyers, then the supply department’s major interest in cash discounts is bringing them to the attention of financial managers. The purchaser ordinarily cannot be held responsible for a failure to take cash discounts because this depends on the financial resources of the organization and is, therefore, a matter of financial rather than supply policy. The purchaser should, however, be very careful to secure such cash discounts as customarily are granted. The buyer is responsible for ensuring prompt inspection and acceptance and expeditious document handling so discounts may be taken. The exact date by which payment must be mailed or electronically transferred to take the discount must be established. Some purchase orders specify that “determination of the cash discount payment period will be calculated from either the date of delivery of acceptable goods, or the receipt of a properly prepared invoice, whichever date is later.” page 283 Some customers will take the cash discount even when they are paying after the discount date. Part of the buyer’s responsibility is to ensure that his or her organization lives up to the terms and conditions of the contract. This means working with other functional areas to ensure that payment is made in a timely manner. Trade Discounts Trade discounts are granted by a manufacturer to a particular type of distributor or user. They aim to protect the distributor by making it more profitable for a purchaser to buy from the distributor than directly from the manufacturer. Manufacturers use distributors in territories where the distributors can sell more cheaply than the manufacturer. The distributor is granted a trade discount approximating the cost of doing business to move goods through the channel. Trade discounts may be used improperly when protection is granted to distributors not entitled to it, because the services they provide to manufacturers and customers are not commensurate with the discount. Generally speaking, buyers dealing in small quantities who secure a great variety of items from a single source or who depend on frequent and very prompt deliveries are more likely to obtain their supplies from wholesalers and other distributors receiving trade discounts. Manufacturers are more likely to sell directly to large accounts, even though they may reserve the smaller accounts in the same territory for the wholesalers. Some manufacturers refuse to sell to accounts below a stipulated minimum annual volume. Discounts often are available to a buyer who also purchases aftermarket requirements (replacement parts for units already sold). The supplier may put the buyer who wishes to buy items that will be sold to the aftermarket into one of several price classifications: (1) an OEM (original equipment manufacturer) class, (2) a class with its distributors, or (3) a separate OEM aftermarket class. Aftermarket suppliers often do special packaging, part numbering, or stocking, which may justify a special price schedule. The buyer needs to know what price classifications the supplier uses and the qualifications for placing the buyer in a particular classification. Multiple Discounts In some industries and trades, prices are quoted on a multiple discount basis. For example, 10, 10, and 10 means that, for an item listed at $100, the actual price to be paid by the purchaser is ($100 − 10%) − 10%($100 − 10%) − 10%[($100 − 10%) − 10%($100 − 10%)] = $100 − $10 − $9 − $8.10 = $72.90. The 10, 10, and 10 is, therefore, equivalent to a discount of 27.1 percent. Tables are available listing the most common multiple discount combinations and their equivalent discount. Quantity Discounts Quantity discounts apply to particular quantities and vary roughly in proportion to the amount purchased. Sellers grant such discounts because volume purchases result in savings to the seller, enabling a lower price to the buyer. These savings may be marketing or distribution expense or production expense. Marketing or distribution savings occur because it may be no more costly to sell a large order than a small one; the billing expense is the same; and the increased cost of packing, crating, and shipping is not proportional. A direct quantity discount not exceeding the difference in cost of handling the small and the large order is justified. Transport savings (e.g., truckload [TL] versus less-than-truckload [LTL]) is a classical example of quantity discounts. page 284 Production cost savings occur because setup costs may be the same for a large order as a small one or material costs may be lower per unit. For the buyer, quantity discounts are intimately connected with inventory policy. Larger order sizes may mean lower unit prices, but carrying charges on larger inventory are more costly. Hence, the savings on the size of the order must be compared against the increased inventory costs. The Price-Discount Problem Accepting a price discount for ordering larger quantities leads to higher levels of anticipation inventory. Marginally, the question is: Should we increase the size of our inventory so that we obtain the benefits of the lower price? This can be analyzed as a return on investment (ROI) decision. The simple EOQ model is not of much assistance here because it cannot account for the purchase price differential directly. It is possible to use the EOQ model to eliminate some alternatives, however, and to check the final solution (see Chapter 8). Total cost calculations are required to find the optimal point. The following problem is illustrative of the calculation: R = 900 units (annual demand) S = $50 (order cost) K = 0.25 or 25 percent (annual carrying cost) * Not feasible. C = $45 for 0–199 units per order         $43 for 200–399 units per order         $41.50 for 400–799 units per order         $40 for 800 and more units per order A simple marginal analysis shows that in moving from 100 per order to 200, the additional average investment is $4,300 − $2,250 = $2,050. The saving in price is $40,500 − $38,700 = $1,800, and the order cost saving is $450 − $225 = $225. For an additional investment of $2,050, the savings are $2,025, which is almost a 100 percent return and is well in excess of the 25 percent carrying cost. In going from 400 to 800, the additional investment is $7,700 for a total price and order savings of $1,406.25. This falls below the 25 percent carrying cost and would not be a desirable result. The total cost numbers show that the optimal purchase quantity is at the 400 level. The largest single saving occurs at the first price break at the 200 level. page 285 The EOQs with an asterisk are not feasible because the price range and the volume do not match. For example, the price for the second EOQ of 92 is $45. Yet for the 200-to-400 range, the actual price is $43. The EOQ may be used, however, in the following way. In going from  right to left on the table (from the lowest unit price to the highest price), proceed until the first valid EOQ is obtained. This is 89 for the 0-to- 199 price range. Then the order quantity at each price discount around this EOQ is checked to see whether total costs at the higher order quantity are lower or higher than at the EOQ. Doing this for the example shown gives us a total cost at the valid EOQ level of 89 of: Total annual price paid $40,500 Carrying cost 500 Order cost 500 Total cost $41,500 Because this total cost at the feasible EOQ of 89 units is above the total cost at the 200 order quantity level and the 400 and 800 order levels as well, the proper order quantity is 400, which gives the lowest total cost of all options. The discussion so far has assumed that the quantity discount offered is based on orders of the full amount, forcing the purchaser to carry substantial inventories. The buyer prefers to take delivery in smaller quantities, but still get the discounted price. This might be negotiated through annual contracts, cumulative discounts, or blanket orders. This type of analysis also can identify what extra price differential the purchaser might be willing to pay to avoid carrying substantial stocks. Quantity Discounts and Source Selection The quantity discount question is also of interest because all quantity discounts, and especially those of the cumulative type, tend to restrict the number of suppliers, thereby affecting the choice of source. The buyer should obtain discounts whenever possible. Ordinarily they come through the pressure of competition among sellers. Furthermore, an argument may be advanced that such discounts are a matter of right. The buyer is purchasing goods or merchandise, not crating or packing materials or transportation. The seller presumably should expect to earn a profit, not from those wholly auxiliary services, but rather from manufacturing and selling the merchandise processed. These auxiliary services are necessary, they must be performed, they must be paid for, and it is natural to expect the buyer to pay for them. But the buyer should not be expected to pay more than the actual cost of these auxiliary services. When quantity discounts are justified because they contribute to reduced production costs by providing a volume of business large enough to reduce overhead expenses, more cautious reasoning is necessary. It is true that in some lines of business the larger the output, the lower the overhead cost per unit of product. It also may be true that without the volume from the large customers, the average cost of production would be higher. However, the small-volume buyers may place a greater total proportion of the seller’s business than do the large-volume ones. For production costs, therefore, the small-volume buyers may contribute even more toward that volume so essential to the per-unit production cost than does the larger buyer. page 286 Large customers may contend that ordering early in the season or prior to actual production justifies higher discounts because their orders keep the facility in production. While early season ordering may justify a lower price than later ordering, it should be granted to every order regardless of its size. This would properly be called a time discount, not a quantity discount. Cumulative or Volume Discounts A cumulative discount varies in proportion to the quantity purchased. It is based on the quantity purchased over a period of time not on the size of any one order. It is an incentive for continued patronage and the concentration of orders with a single supplier. Typically, distributing one’s orders over many sources is uneconomical and costly. The supplier may pay more attention to the buyer’s requirements if it is getting the larger portion of the purchaser’s business. The use of cumulative discounts must meet the same cost justification rules under the Robinson-Patman Act as other quantity discounts. However, as long as the buyer is not knowingly accepting or inducing discriminatory quantity discounts, the responsibility for justification rests solely with the seller. Cumulative discounts, if provided in the form of a payment by the supplier after the specified contract date, can provide tangible evidence of purchasing savings, especially if the discounts were not included in budgets or standard costing systems. It may be easier for a supplier to provide a discount to a purchaser than a lower price. This allows the supplier to keep established list prices unchanged and distinguish between various classes of purchasers. CONTRACT OPTIONS FOR PRICING Four contract options for pricing are firm-fixed-price (FFP), cost-plus-fixed-fee (CPFF), cost-no-fee (CNF), and cost-plus-incentive-fee (CPIF). Firm-Fixed-Price (FFP) Contract The price set is not subject to change, under any circumstances. Buyers prefer this type of contract, but if the delivery date is some months or years away and if there is substantial chance of price escalation, a supplier may feel that there is far too much risk of loss to agree to sell under an FFP contract. In services, it is often difficult to agree on a firm fixed price because of the historical practice of hourly billing and the fear that scope creep will erode the margin built into the fixed price. A detailed scope of work includes customers’ responsibilities as well as supplier’s, time lines, progress payment schedule, and how work outside the scope will be handled. Cost-Plus-Fixed-Fee (CPFF) Contract If it is unreasonable to expect a supplier to sell at a firm fixed price, the CPFF contract can be used. This occurs if the item is experimental and the specifications are not firm, or if costs in the future cannot be predicted. The buyer agrees to reimburse the supplier for all reasonable costs incurred (under a set of definite policies under which “reasonable” is determined) in doing the job or producing the required item, plus a specified dollar amount of profit. A maximum amount may be specified for the cost. This contract type is far superior to the old “cost-plus- percentage” type, which encouraged the supplier to run the costs up as high as possible to increase the base on which the profit is figured. While the supplier bears little risk under the CPFF, since costs will be reimbursed, the supplier’s profit percentage declines as the costs increase, giving some incentive to the supplier to control costs. page 287 Cost-No-Fee (CNF) Contract If the buyer can argue persuasively that there will be enough subsidiary benefits to the supplier from doing a particular job, then the supplier may be willing to do it provided only the costs are reimbursed. For example, the supplier may be willing to do the research and produce some new product if only the costs are returned, because doing the job may give the supplier some new technological or product knowledge, which then may be used to make large profits in some commercial market. Cost-Plus-Incentive-Fee (CPIF) Contract Both buyer and seller agree on a target cost figure, a fixed fee, and a formula under which any cost over- or underruns are shared. For example, assume the agreed-on target cost is $100,000, the fixed fee is $10,000, and the incentive-sharing formula is 50/50. If actual costs are $120,000, the $20,000 cost overrun would be shared equally between buyer and seller, based on the 50/50 sharing formula, and the seller’s profit would be reduced by $10,000, or to zero in this example. On the other hand, if total costs are only $90,000, then the seller’s share of the $10,000 cost underrun would be $5,000. Total profit then would be $10,000 + $5,000, or $15,000. This motivates the supplier to be efficient because the benefits of greater efficiency (or the penalties of inefficiency) accrue in part, based on the sharing formula, to the supplier. Provision for Price Changes Many long-term contracts contain provisions for price changes. The contract normally provides for no price changes for a fixed period of time, after which a price change may become possible with a minimum notice period. There are several options for price changes. Guarantee against Price Decline For recurring purchases and for raw materials, the contract may be written at the price in effect at the time the contract is negotiated. Provision is made for a reduction during a subsequent period if there is a downward marketplace price movement. The contract specifies how a price change is determined, typically by a specific business or trade publication or website. Buyers prefer this provision when it overcomes their reluctance to buy because of fear that prices are likely to drop still further. Price Protection Clause In a long-term contract for raw materials or other key purchased items with one or more suppliers, the buyer may want to keep open the option of taking advantage of a lower price offered by a different supplier. This might be done by either buying from the noncontract supplier or forcing the contract supplier(s) to meet the lower price available from the noncontract suppliers. A price protection clause may be incorporated into the contract specifying that “If the buyer is offered material of equal quality in similar quantities under like terms from a responsible supplier, at a lower delivered cost to the buyer than specified in this contract, the seller on being furnished written evidence of this offer shall either meet the lower delivered price or allow the buyer to purchase from the other supplier at the lower delivered price and deduct the quantity purchased from the quantity specified in this contract.” page 288 Escalator Clauses The actual wording of many escalator clauses provides for either an increase or decrease in price if costs change. Escalator clauses came into common use during the hyperinflation years in the 1970s when suppliers believed that the uncertainty of future costs made firm quotation either impossible or, if covering all probable risks, so high as to make it unattractive, and perhaps unfair, to the buyer. There are several general and many specific problems with escalator clauses. These include determining the proportion of the total price subject to adjustment; the particular measures of prices and wage rates to be used in making the adjustment; the methods to be followed in applying these averages to the base price; the limitations, if any, on the amount of adjustment; and the methods for making payment. When prices are stable, escalation usually is reserved for long-term contracts in which certain costs may rise and the seller has no appreciable control over this rise. When prices are unstable—with inflation, shortages, and sellers’ markets—escalation becomes common on even short-term contracts as sellers attempt to ensure the opportunity to raise prices and preserve contribution margins. Changes in material and direct labor costs generally are tied to one of the published price and cost indexes, such as those of the Bureau of Labor Statistics or one of the trade publications, such as American Metal Market (amm.com) or ICIS for chemical, energy, and fertilizer prices. It can be a problem finding a meaningful index to use. Because most escalation is automatic, it is important to carefully determine the index, the portion of the contract subject to escalation, the frequency of revision, and the length of contract. The following is an illustrative escalator clause: Labor Adjustment with respect to labor costs shall be made on the basis of monthly average hourly earnings for the (Durable Goods Industry, subclass Machinery), as furnished by the Bureau of Labor Statistics (hereafter called the Labor Index). Adjustments shall be calculated with respect to each calendar quarter up to the completion date specified in contract. The percentage increase or decrease in the quarterly index (obtained by averaging the Labor Index for each month of the calendar quarter) shall be obtained by comparison with the Labor Index for the base month. The base month shall be ____ 20____. The labor adjustment for each calendar quarter as thus determined shall be obtained by applying such percentage of increase or decrease to the total amount expended by the contractor for direct labor during such quarter. Materials Adjustment with respect to materials shall be made on the basis of the materials index for Group VI (Metals and Metal Products), as furnished by the Bureau of Labor Statistics (hereafter called the Materials Index). Adjustments shall be determined with respect to each calendar quarter up to the completion date specified in the contract. The percentage of increase or decrease in the quarterly index (obtained by averaging the Materials Index for each month of the calendar quarter) shall be obtained by comparison with the Materials Index for the base month. The base month shall be ____ 20____. The material adjustment for each calendar quarter shall be obtained by applying to the contract material cost the percentage of increase or decrease shown by the Materials Index for that quarter. page 289 A buyer who uses escalator clauses must remember that one legal essential to any enforceable purchase contract is that it contains either a definite price or the means of arriving at one. No contract for future delivery can be enforced if the price of the item is conditioned entirely on the will of one of the parties. The clauses cited earlier would appear to be adequate. So too are clauses authorizing the seller to change price as costs of production change, provided that these costs can be reasonably determined from the supplier’s accounting records. The Suman case in Chapter 2 provides an example of contract proposals from suppliers that include price escalation clauses for energy, labor, and material. Most-Favored-Customer Clause Another price protection clause (sometimes referred to as a “most-favored-nation clause”) specifies that the supplier, over the duration of the contract, will not offer a lower price to other buyers, or if a lower price is offered to others, it will apply to this contract as well. Contract Cancellation Cancellations usually occur during a period of falling prices. At such times, some buyers find loopholes and technicalities in the purchase order or sales agreement to reject merchandise. One can have sympathy for the buyer with a contract at a price higher than the market price. There is little justification, however, for the purchaser who follows a cancellation policy under this situation. A contract should be considered a binding obligation. Canceling a contract because of falling market prices is not justified. Sometimes the buyer knows when the purchase order is placed that the customer for whose job the materials are being bought may unexpectedly cancel the order, thus forcing cancellation of purchase orders for materials planned for the job. This is a common risk when purchasing materials for use on a government contract, for appropriation changes often force the government to cancel its order, which results in the cancellation of a great many purchase orders by firms that were to have been suppliers to the government under the now-canceled government contract. Or severe changes in the business cycle may trigger purchase-order cancellations. If cancellation is a possibility, the basis and terms of cancellation should be agreed on and included in the contract terms and conditions. Problems such as how to value and what is an appropriate payment for partially completed work on a now- canceled purchase order are best settled before the situation arises. FORWARD BUYING AND COMMODITIES Forward buying is the commitment of purchases in anticipation of future requirements beyond current lead times. An organization may buy ahead because of anticipated shortages, strikes, or price increases. As the time between procurement commitment and actual use of the requirement grows, uncertainties also increase. One common uncertainty is whether the actual need will be realized. A second concern is with price. How can the purchaser ascertain that the price currently committed is reasonable compared to the actual price that would have been paid had the forward buy not been made? page 290 Commodities represent a special class of purchases frequently associated with forward buying. Almost all organizations purchase commodities in a variety of processed forms. For example, an electrical equipment manufacturer may buy a substantial amount of wire, the cost of which is significantly affected by the price of copper. Many organizations buy commodities for further processing or for resale. For them, the way they buy and the prices they pay for commodities may be the single most important factor in success. Prices for selected commodities are reported daily in The Wall Street Journal, Bloomberg.com, and many other sources. Managing Risk with Production and Marketing Contracts Marketing and production contracts in agriculture are substitutes for spot market (cash) sales. Marketing contracts outline the terms of  exchange, including the product to be delivered; the quantity, location, and time window for delivery; and a price or pricing formula. Production contracts govern an entire production process—farmers are paid a fee to grow an animal or crop for a contractor who provides some production inputs and who removes the product from the farm for processing or marketing at the close of the production cycle. Contracts can help farmers manage price and production risks, they can elicit the production of products with specific quality attributes by tying prices to those attributes, and they can smooth flows of commodities to processing plants, thus encouraging more efficient use of farm and processing capacities. The downsides of contracts include introducing new and unexpected risks for farmers—in some circumstances, they can extend a buyer’s market power—and they can effect fundamental changes in how farming is organized and carried out. The attractiveness of contracts depends on multiple factors, including government farm programs, price behavior of noncontract agricultural commodities, and the specificity of buyers’ quality requirements. Thus, farmers turn to contracts when they perceive the efficacy of spot markets to be inadequate in handling their risks, and processors turn to contracts as a way to encourage farmers to produce specific products at desired times. In 2016, the USDA reported that production and marketing contracts covered 36 percent of the value of U.S. agricultural production, up from 28 percent in 1991 and 12 percent in 1969. Contract use is more common on large farms and the use has stabilized in recent years. Marketing contracts are reached prior to crop harvest and production contracts before the completion phase for livestock. Contracts are now the primary method of handling sales of many livestock commodities, including milk, hogs and broilers, and of major crops such as sugar beets, fruits, and tomato processing. Farms with $1 million or more in sales have more than half their production under contract.2 Forward Buying versus Speculation All forward buying involves some risk. In forward buying, purchases are confined to actually known requirements or to carefully estimated requirements for a limited period of time in advance. The essential controlling factor is need. Even when the organization uses order points and order quantities, the amount to be bought may be increased or decreased in accordance both with probable use and with the price trend, rather than automatically reordering a given amount. Temporarily, no order may be placed at all. page 291 This may be true even when purchases have to be made many months in advance, such as seasonal products like wheat, or those that must be obtained abroad, such as cocoa or coffee. The price risk increases as the lead time grows longer, but the basic reasons for these forward commitments are assurance of supply to meet requirements and price. Speculation seeks to take advantage of price movements. At times of rising prices, commitments for quantities beyond anticipated needs would be called speculation. At times of falling prices, speculation would consist of withholding purchases or reducing quantities purchased below the safety limits, thereby risking stockouts as well as rush orders at high prices, if the anticipated price decline did not materialize. At best, any speculation, in the accepted meaning of the term, is a risky business, but speculation with other people’s money has been cataloged as a crime. It is supply’s responsibility to provide for the known needs to the best advantage possible at the time and to keep the investment in unused materials at the lowest point consistent with safety of operation. Purchasers can buy forward, but should not speculate or gamble. Organizing for Forward Buying The organization’s size, financial strength, and the percentage of total cost represented by volatile commodities influences how the company organizes to determine and execute policy on long-term commodity commitments. In some instances, the CEO exercises complete control, based almost wholly on personal judgment. In other cases, although the CEO assumes direct responsibility, a committee provides assistance. Some organizations designate a person, other than the supply manager, whose sole responsibility is price-sensitive materials and who reports directly to top management. Often, the supply manager controls the commodity inventory, or an outside agency specializing in speculative commodities executes policy. The soundest practice for most organizations appears to be to place responsibility for policy in the hands of a committee consisting of the top executive or general manager, an economist, a risk manager, and the supply manager. Actual execution of the broad policy should rest with the supply department. Control of Forward Buying Safeguards should be set up to ensure that commodity commitments will be kept within proper bounds. For example, a leather company established the following safeguards: (1) Forward buying must be confined to those hides that are used in the production either of several different leathers or of the leathers for which there is a stable demand. (2) Daily conferences are held among the president, treasurer, sales manager, and hide buyer. (3) Orders for future delivery of leather are varied in some measure in accordance with the company’s need for protection on hide holdings. Because the leather buyer is willing to place orders for future delivery of leather when prices are satisfactory, this company follows the practice of using unfilled orders as a partial hedge of its hide holdings. In general, the policy is to have approximately 50 percent of the total hides the company owns covered by sales contracts for future production of leather. (4) A further check is provided by an operating budget that controls the physical volume of hides rather than the financial expenditures, and that is brought up for reconsideration whenever it is felt necessary. (5) There is a final check that consists of the use of adequate and reliable information, statistical and otherwise, as a basis for judging price and market trends. page 292 This particular company does not follow the practice of hedging on an organized commodity exchange as a means of avoiding undue risk, though many companies do. Nor does this company use any of the special accounting procedures, such as last-in, first-out, or reproduction- cost-of-sales, in connection with its forward purchases.  These various control devices, regarded as a unit rather than as unrelated checks, should prove effective. They are not foolproof, nor do they ensure absolutely against the dangers inherent in buying well in advance. However, flexibility in the administration of any policy is essential, and, for this one company at least, their procedure combines reasonable protection with flexibility. In organizations requiring large quantities of commodities whose prices fluctuate widely, the risks involved in buying ahead, under some circumstances, may be substantially minimized through the use of the commodity exchanges. The Commodity Exchanges The prime function of an organized commodity exchange is to furnish an established marketplace where the forces of supply and demand may operate freely as buyers and sellers carry on their trading. An exchange that has facilities for both cash and futures trading also can be used for hedging operations. The rules governing the operation of an exchange are concerned primarily with procedures for the orderly handling of the transactions negotiated on the exchange, providing, among other things, terms and time of payment, time of delivery, grades of products traded, and methods of settling disputes. In general, the purposes of a commodity exchange will be served best if the following conditions are present: 1. The products traded are capable of reasonably accurate grading. 2. There are a large enough number of sellers and buyers and a large enough volume of business so that no one buyer or seller can significantly influence the market. In order for a commodity exchange to be useful for hedging operations, the following conditions also should be present: 1. Trading in “futures”—the buying or selling of the commodity for delivery at a specified future date. 2. A fairly close correlation between “basis” and other grades. 3. A reasonable but not necessarily consistent correlation between “spot” and “future” prices. All of these conditions usually are present on the major grain and cotton exchanges, and in varying degrees on the minor exchanges, such as those on which hides, silk, metals, rubber, coffee, and sugar are traded. Financial futures also permit a firm to hedge against interest rate fluctuations, which are one of the strongest factors affecting exchange rate fluctuations. One of the most easily accessed sources of information about futures and options prices is the commodities section of Bloomberg.com and the Wall Street Journal (wsj.com). They report prices from the major exchanges, from North/Latin America (e.g., Chicago Board of Trade [CBOT], ICE Futures Canada [formerly the Winnipeg Commodity Exchange], Mexico Bolsa [MEXBOL], and Brazil BOVESPA); Europe/Africa (e.g., NYSE Euronext, NYSE Liffe [formerly the London International Financial Futures Exchange], South Africa Futures Exchange [SAFEX]); and Asia/Pacific (e.g., Tokyo Commodity Exchange [TOCOM], Hong Kong Exchanges and Clearing [HKFE], and the Australian Securities Exchange [ASX]). Each of the major commodity trading exchanges has a website that provides real-time information for quotes, charts and historical data, and news. page 293 The commodities traded on the exchanges vary; if the volume is not large enough, a given commodity will drop off the exchange either temporarily or permanently. However, the following agricultural items, metals, petroleum products, and currencies normally are among those listed on any given day: corn, oats, soybeans, soybean oil, wheat, canola, cattle, hogs, pork bellies, cocoa, coffee, sugar, cotton, orange juice, copper, gold, platinum, silver, crude oil, heating oil, gasoline, natural gas, Japanese yen, Euro, Canadian dollar, British pound, Swiss franc, Australian dollar, U.S. dollar, and Mexican peso. In most cases, the prices quoted on the exchanges and the record of transactions completed furnish some clue, at least, to the current market price and to the extent of the trading in those commodities. They offer an opportunity, some to a greater extent than others, of protecting the buyer against basic price risks through hedging. Limitations of the Exchanges There are limitations to these exchanges as a source of physical supply for the buyer. In spite of a reasonable attempt to define the market grades, the grading often is not sufficiently accurate for manufacturing purposes. The cotton requirements of a textile manufacturer are likely to be so exacting that even the comparatively narrow limits of any specific exchange grade are too broad. Moreover, the rules of the exchange are such that the actual deliveries of cotton do not have to be of a specific grade but may be of any grade above or below basic cotton, provided, of course, that the essential financial adjustment is made. This also holds true for wheat. Millers who sell patented blended flours must have specific types and grades of wheat, which normally are purchased by use of a sample. There are other reasons why these exchanges are not satisfactory for the buyer endeavoring to meet actual physical commodity requirements. On some of the exchanges, no spot market exists. On others there is a lack of confidence in the validity of the prices quoted. Crude rubber, for example, is purchased primarily by tire manufacturers, a small group of very large buyers. On the hide exchange, on the other hand, a majority of hides sold are by-products of the packing industry, offered by a limited number of sellers. An increase or a decrease in the price of hides, however, does not have the same effect on supply that such changes might have on some other commodities. It is not asserted that these sellers use their position to manipulate the market artificially any more than it is asserted that the buyers of rubber manipulate the market to their advantage. In these two cases, however, the prices quoted might not properly reflect supply an