BUS 315 Week 1 Part 2: Pricing Concepts Slide Topic # 1 Intro 2 Topics Narration Welcome to Cost and Price Analysis. In this lesson, we will cover fair and reasonable price, how it is established and price and cost analysis. Please go to the next slide. The following topics will be covered in this lesson: Fair and reasonable price; Market and cost-based prices; Price and cost analysis; and Adequate price competition. 3 Cost, Profit and Price Please go to the next slide. Price is the sum of the two component parts of cost and profit. So, any definition of price must first deal with these two terms. Cost is defined as the expenses a contractor will incur in performing contract work. Unfortunately, even in government publications, the term, cost can sometimes be mixed up with the term, price. However, individuals with previous contracting experience are already accustomed to the definition of cost. For example, they know about cost reimbursement contracts and heir general meaning. The government says it will reimburse the holder of a cost-reimbursement contract for its costs expended to do the work as long as they are allowable, reasonable, and properly allocable to the contract. Business profit is whatever monies are left after all costs have been paid. When talking about a particular contract, profit is the additional amount a contractor receives above out-of-pocket costs. So, profit is the reward for undertaking the contract task in the first place. The government fully understands that profit is a basic motivation for all private businesses. Government pricing policy provides for contractors to receive a fair and reasonable profit. Price is the financial outlay, which is made to pay for a product or service. A reasonable price is the sum of reasonable costs to do the work and a reasonable profit. The government policy is to pay a fair and reasonable price for whatever it buys. The government knows well that a failure to pay reasonable prices will result in contractors selling their outputs in the private sector where they will be treated more fairly. But on the other hand, if the government pays excessive prices, it is waste of taxpayer money. When excessive prices have already been paid, it is not possible for the government to recover overpayments except in very limited circumstances. Almost all companies decide on the price to charge for their products or services by determining the cost to make or provide the product or service and then adding a profit. Any firm that manufactures products uses certain specifications and standards for making its products. These specifications may be formal or informal but whatever they are the company must know its costs to perform its work. For example, a company that manufactures electric appliances follows detailed drawing specifications and standards for making or buying various parts for the appliances and for assembling them into finished products. It can then calculate what it costs to produce each product and establish a price by adding a profit figure to the cost. 4 What is a Fair and Reasonable Price? Please go to the next slide. A fair and reasonable price is different things to different people. The term is difficult to define because whether or not a price is reasonable depends on a great many factors, and it is simply not possible to define the term in a few words. However, two generalizations are possible: First, the government prefers market-based pricing over cost-based pricing to judge fair and reasonable price. Second, cost based pricing is appropriate only when the forces of the marketplace cannot judge fair and reasonable price. There are five means normally identified to establish a fair and reasonable price. The first four rely on the marketplace to determine a fair and reasonable price. They are competitive offers, established catalog price, established market price, established by law or regulation. However, when there are no competing sources or the competing sources are ineffective, the marketplace cannot be relied on to produce a fair and reasonable price. So, cost based pricing serves as a surrogate to the market in determining a fair and reasonable price. 5 Product and Price Implications Please go to the next slide. Primary manufacturers of commercial products will, for the most part, use the cost-plus-profit approach to arrive at prices for their products. Most of these primary manufacturers provide their products to the marketplace through distributors who in turn sell to retailers. Heavy users of commercial items prefer to find ways to avoid the effects of pyramiding of costs and profits through the manufacturer-distributor-retailer chain. The government and most private companies solicit bids or proposals when their requirements are a high-dollar amount or for large quantities or both. Retailers are not generally in a position to compete with manufacturers or distributors in these circumstances and so the government and private companies achieve price savings. There are many methods of price setting including adapting to established prices, product differentiation, and price leadership. Adapting to established prices is the approach commonly seen for commercial items and services. The supplier who sells products or services essentially the same as those sold by other sellers in the same marketing area is generally forced to conform to established prices. In product differentiation, large companies are able to convince some buyers that their particular product or service is worth the extra price. But such efforts generally require heavy advertising and selling expenses, which add to the cost of the product being sold. Price leadership is practiced by very large firms such as Microsoft. In this method, the company takes initiative by setting prices for their own products. If they raise or lower prices, other companies have little choice but to follow suit. 6 What is a Fair and Reasonable Price? (cont) Please go to the next slide. Suppliers do not always price their outputs based on their total costs for the products or services plus a profit. For example, a supplier may have slow-moving items in its inventory and may choose to sell them at cost or at cost plus a less-than normal profit level. A similar type of pricing occurs when a firm’s business is temporarily down. The firm may not be getting enough work to keep it going at its usual profit level. Under these circumstances, some business is better than no business. If the company can get work that recovers its variable costs to do the work plus make a contribution to other costs, it is generally better to take the work. For example, consider that a company can accept a job that would cost thirty nine thousand dollars. Normally, they would try to make eleven thousand in profit on top of that and charge fifty thousand dollars, but if a customer offers a small bit on top of the thirty nine thousand, the company might consider taking the job so at least it will have a small amount to contribute towards other expenses. 7 Price and Cost Analysis Please go to the next slide. Price analysis is a set of methods for determining whether an asking price is reasonable without examining the details of the cost or profit included in the price. Every time we make a purchase, we consciously or unconsciously make a price analysis, which satisfies us that what we are paying is reasonable. The government does a significant amount of contracting based on getting a price alone, with no information on how much cost and profit is included in the price. Such contracting will result in the award of a fixed-price type contract. Cost analysis is a set of procedures used to determine the reasonableness of proposed costs to do contract work. Under certain conditions, the government is entitled to receive complete details on the estimated cost and profit built into a bottom line asking price. The government can then determine if the asking price is realistic for the firm in question. Over time, the term cost analysis has come to mean the government’s analysis of proposed costs and profits. The government relies on adequate price competition to get fair and reasonable prices. The concept is that if the offers are competing against each other to get the work based on lowest price, the pressures of the competition itself will result in a reasonable price. But this concept is correct and true only if actual adequate price competition exists. Some points that require emphasis here are as follows. First, the customarily heard phrase, at least two offers, does not in itself guarantee that adequate price competition exists. There are other conditions that need to be met. Second, the offers must have competed independently. Third, there must be at least two offers that can actually satisfy the requirement and they must be responsive. Fourth, adequate price competition does not exist if one or a few offers have a lock on the job. 8 What is a Fair and Reasonable Price? (cont) Please go to the next slide. What does the government do if it receives only one offer but the price is reasonable? Federal regulations say that an offer tendering an offer in ignorance of the absence of competition is tendering a competitive offer. Federal regulations require a Certificate of Independent Price Determination in all solicitations when the government anticipates the award of either a firm-fixed-price contract or fixed-price a contract with economic price adjustment. The offer is required to certify a number of things including that no attempt has been made to influence any offer or competitor to submit or not submit an offer. A buy-in is one of several improper business practices. The offer engaging in a buy-in submits a below-cost offer just to get the contract and plans on making up the shortfall after award by unnecessary or overpriced change orders or by receiving followon contracts at artificially high prices. Federal acquisition regulations state that the government should minimize the possibilities for buy ins by seeking price commitments for as much of a total program as is practical. In practice, however, it is often difficult to know whether an offer is engaging in a buy in or exercising its right to provide a good faith below cost offer. The receipt of a known below cost offer raises several questions including: Is it a below cost offer caused by failure to understand fully the work to be done? Please go to the next slide. 9 10 11 Check Your Understanding Additional Resources Summary We have reached the end of this lesson. Let’s take a look at what we’ve covered. First, we defined price to be the sum of components cost and profit. Then we went on to define and explain these two components. Next, we explained how fair and reasonable price is established and that the government prefers market-based pricing over costbased pricing. We also explained the five ways to establish fair and reasonable prices. Then, we covered the cost-plus-profit approach, which is used by many manufacturers. Then we talked about various ways of price setting, including adapting to established prices, product differentiation, and price leadership. Finally, we defined cost and price analysis. Finally, we talked about how a single offer, in the ignorance of absence of competition is considered a competitive offer, and how buy-in is an improper business practice. This completes this lesson.
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