Procurement and Contracts Management: Module 4
Welcome to module 4 of Procurement and Contracts management.
We know it is essential that we are clear about cost estimations before we try to negotiate. Before moving on to
contracts management, we will dedicate this module to looking at internal and external cost levers and how these will
impact budgeting and proof of concept design.
We will focus on the total acquisition cost, the total cost of ownership, and broad categories of costs associated with
the business and how these change with operational output.
We will see why open book analysis is so important and finally look at various terms and pricing strategies that we
come across in the tending process.
Slide 1
Understanding the Total Acquisition Cost (TAC) is fundamental to understanding the overall cost.
The total acquisition cost will vary for different products and services, it is not a fixed percentage, and there are many
components.
The total acquisition cost includes core costs, such as the cost of assembly, but we would also include the finance
costs, procurement costs, handling and storage, receipting and inspection, packaging, delivery, transport, logistics
and the cost of raising a purchase order.
You may feel that some of these are trivial, but you would also be surprised at how much it costs to raise a purchase
order. This is because it has to go through lots of people at the organisation, accumulating time as it goes.
Also included, is the cost of the system used and the cost of your time to do it. These can be fairly considerable
costs for an organisation.
The total cost of acquisition gives us clarity when we scope work out and when we baseline where we are in the
[Link] costs are what we can seek to improve, manage out or design out. To reduce the T.A.C, we often
need to take the supplier head-on and tell them that we are going to resist the asking price, and we want 10 or 20%
off. It’s in everyone's interest to look at the non value added costs that go into acquisition and ownership and work
together to eradicate those.
Slide 2
Everything stated in a proof of concept (POC) increases the cost, and a poor POC results in long term costs being
incurred.
In a previous module we mentioned budget airlines, where they give you a price to fly with them and there may be an
expectation in your mind about what’s included in that cost. You may think you can reserve your seat, receive a drink,
watch a movie, check in a suitcase at no extra charge. However, all these things come with an additional cost with a
budget airline.
This is the same with procurement. We need to ensure our expectations are realistic. We need to scrutinise every
detail, and check the fine print so that we are receiving what we think we should be getting in the price that is being
charged to us.
Slide 3
We are now going to look at cost estimation and the budget control process. We all need to be clear on the cost
estimation because it is a huge part of getting things right and clear before we try to negotiate.
We need to know our subject matter and all the details. If we adopt category management this is a core part. The
value we bring as a specialist to the supply chain is the understanding of how costs are made up. This is especially
true as we budget for forthcoming years. If we want to budget the business for the future it's worth knowing what
costs we are going to bear and potentially, where we can reduce some of those costs.
Sometimes in the cost estimations, we like to think that everything in the supply chain cost can be managed and
controlled. The following are things we should be controlling and focusing on.
Firstly the scope, this should detail what is included and what is not included. For example, if we were going to build
a new athletics or football stadium, we need to be clear as to what is included in that scope. We need to check, are
seats included? Is a roof that closes during inclement weather included? Is a car park included? Are turnstiles
included? Is turf for the pitch included? Is a running track to be included?
Next, we need to conduct a needs analysis. We need to think about what is actually included in the scope so we can
be clear when we set the requirements for the bid going out for the tendering process. We need to think about what
our needs are, we need to think about the different packages of work that we might bundle up and the different
scopes that surround that.
We should define proof of concepts and scope. This process becomes a proof of concept, when we start to
articulate what we are doing. We need to consult across the business as well as with our suppliers to gather all the
information and assurances we require.
We need to think about how we are going to manage it, the governance, process and structure we are going to set
up. This structure could be a steering group, a group of people working together across the business, people like
stakeholders, procurement experts and I.T. experts.
You may have something set up called a RACI which stands for Responsible, Accountable, Consulted and informed.
We need to know who our consultants are going to be. Are they going to be deep dive finance experts or I.T.
specialists?
When we think about some of the project management techniques that are wrapped around a piece of work that we
are going to tender, we may need to consult with other people and bring in specialist skills to assist us.
We also need to construct a budget setting and approval process. When we review the budgeting and the
approval process, who is it in the business that is approved under the RACI to sign off on various pieces of work or
various spending, who can approve various draw downs on the budget?
We need to think about the baseline cost of ownership. What is our current situation in terms of putting some
numbers to that? What definition do we have, so that we can measure how well we are doing when we change
things, so we can identify if the changes are for the better or worse.
For example, if a new manager comes into a football team and spends money on buying new players and maybe
building a training academy, if the team does not improve within six months, potentially the manager's job is in
jeopardy because the stakeholders are not seeing the results they expected for their investment.
The key performance indicators (KPI) that have been put into place against the business case to ensure
improvements are being made from the investment in new players, the new facilities and new salaries.
So when we are spending money and making changes we must be able to show in a clear way that we have made
improvements for the better.
Slide 4
We will now briefly look at the different types of cost and the nature of costs, as not all costs are the same. We’ll start
with Variable costs.
A variable cost is something that changes in line with the business needs and business activities. This could possibly
be the raw materials, things that we bring in to add to our process or assembly line or it may be services that we bring
in. Potentially, these are things that we can reduce or eliminate, bringing down our next forecast.
An example would be delivery and logistics services we use. We may require significantly more of these leading up to
the christmas period, but this cost may drop off immediately afterwards. This cost is directly related to our business
activity.
Labour can also be a variable cost, we mean any temporary or contract labour. We are not talking about our
permanent workforce, as this is a fixed cost.
We can also include energy associated with business operations, this means turning the lights and heating on or
running machinery. For example, maybe there is an office or section of the factory that we are not currently using, so
in these areas we could reduce the cost by reducing the heat to a minimum and leaving the lights off. So our energy
requirements can vary according to our business needs.
Marketing campaigns are often also a variable cost. These campaigns are often seasonal or in line with a big event.
The marketing costs will go up and down depending on the campaigns being run by the business. An increase in
spending should yield an increase in business activity, or at least hope to.
Slide 5
Now we are going to look at fixed costs, these occur irrespective of our business activity. These costs include salaries
for permanent staff, that are on our books, they are formally employed by us and pay national insurance.
It would also include what we pay for a building in rent. There may be some reduction or suspension of rates if we are
not active, but generally we would still pay rates if we’re named as the occupant of the building.
If we are not as active, then we may not need the same level of insurance for our vehicles, but usually we have paid
the insurance premium for the year regardless of the activity. The same inflexibility is true of other types of business
typically paid by a company although yearly premiums for things like liability insurance may be linked to revenue and
rise and fall in the long term.
Capital depreciation is another major fixed cost depending on the organisation. This applies to our working capital.
For example equipment, buildings etc.
Slide 6
One of the things that is often talked about is open book relationships with the supplier. This means finding out the
kind of costs that a supplier has. We want to know that the price we are paying is competitive, and the best price that
we can pay for our goods and services. Open book analysis is really important, we are trying to find out the details of
any hidden costs, operating costs across a company. Be careful because some costs differ with big companies by
region and country. There are also different accounting practices that may alter how you see these costs.
Not everyone is prepared to open their books, or they may not open the books you actually want to see. You can still
try to do some benchmarking, you can look at their last 3 or 5 years accounts and you can look online at Company’s
House. You can check their key ratios, you can try and identify if they are an efficient business or do they generate a
lot of rejected products? Therefore, identifying a problem with their quality
For example, in the automotive business, cars have been recalled because they have set alight due to faulty
electrical equipment. There are ways you can do some analysis by checking their balance sheets and looking at the
margins they are charging companies.
Some of the margins are more obvious; in certain sectors like professional services they usually have quite generous
margins whereas in other sectors like cleaning and security the margins are quite tight. You can do some of your
homework. However, if you do want to go deeper and want an open book with a supplier that is a negotiation in itself.
There are obvious advantages to seeing their books, as there is a transparency of the costs that they have. At this
point you can look at potentially reducing costs together. We are looking at ways of removing waste and poor quality
to reduce the end to end costs.
Slide 7
Now we are going to look at different pricing that we come across.
Retail less; this is when a supplier provides the buyer with a discount. They receive the recommended retail price
with a discount. Suppliers often have more than one retail price so buyers should ensure they understand which retail
price the discount applies to.
Often we hear about massive discounts, but what is that discount based on?
For example, with technology, this is an always changing, ever improving market place. So items can be rendered
worthless when the company releases an upgraded new product. What the product was worth yesterday is not the
same as what is worth today. So in reality it is not a massive saving, it can be misleading.
Cost plus; this is when a supplier adds an amount to their ‘cost’ price. When using the professional services sector,
we are paying for labour of a specialist, the additional costs are treated outside any profit. No markup or margin.
Fixed and firm; this is when a price is agreed and that price will not change for the duration of the contract. For
example, the buyer and the supplier have agreed to purchase item A for £10 each for a period of 3 years. The price
will stay at £10 for the contract duration. This could be linked to the commodity index. For example, if you have a
fixed rate mortgage you will pay more than if it is on a variable rate, this is because you are paying for the certainty
over a set period of time.
Schedule of rates; this is when a schedule is agreed that contains elements of work that the supplier will complete.
Each element has a price. The total price is the sum of the elements. Buyers can create their own schedules, or
utilise the numerous standard schedules that are available. These rates will differ depending if we are dealing with a
partner or an analyst.
Profit/Gain Share; this is when the supplier is paid based on how successful the supplier/product/service is. For
example, the supplier could develop a new product line with the support of the buyer. This development could be
done at the suppliers risk/cost. If the product line is successful the buyer may receive 10% of the supplier's selling
price. This is like a bonus payment within a contract.
Fixed; this is when the supplier price is fixed to/by something. For exa please an index of some description. These
are some of the pricing techniques and methods which we come across in the tendering and negotiation process.
This is the end of Module 4 of Procurement and Contract Management. Continue on to the final two sessions which
will be focused on contractual agreements for supply and using KPIs in contract management.