Price is a policy and cost is a fact!

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5 Ways Companies Set Price

This is a credo that I have followed since the early 1990s, so this headline in the Wall Street Journal “House Committee Taps Mylan for More Information on EpiPen Price Figures” caught my attention. Suppliers price their products in many ways and it is important for buyers to understand the pricing method as well as develop a should cost model to understand the supplier’s likely margin.

Some of the key methods used to price product are:

  1. What the market will bear – In markets where there is little or no competition, companies can employ a pricing strategy that optimizes profits. This pricing strategy is developed to achieve the maximum price point that will be supported by customers. The supplier justifies this as a way to quickly recoup high R&D or capital costs. Unfortunately, once recovered, the pricing model remains in place until competition is introduced.
  2. Pricing in line with competition – Suppliers typically use market and competition to set pricing levels. While competition works to set pricing levels, savvy purchasers know that in some industries a few of players can work to balance capacity and demand. Industries where there is significant competition use this pricing model.
  3. Value Pricing – This pricing method is typically used in the services industry and is based on the perceived value of the service to the service being offered.
  4. Market penetration pricing – This method artificially sets pricing levels at the lowest profit level possible to build volume and capture market share. In some cases, the supplier may use marginal pricing which reduces the fixed cost burden of the product to stimulate volume. While penetration price is attractive, it is a very short term pricing method.
  5. Cost based pricing – This methodology calculates the cost and adds a sufficient margin to the product. The reality is that only about 25% of the companies use this method.

The key to sourcing success is to be able to understand the manufacturing process or service being sourced, visit the supplier location and synthesize the cost. This is a process where the sourcing professional builds a should cost model by estimating the inputs of the goods or service being procured. Capturing the materials, labor and overhead costs provide a framework to challenge supplier pricing models. I have worked with sourcing teams who have seen as much as 180% margins and others that have validated supplier losses on their products.

It’s essential that every sourcing professional have cost analysis and cost modeling as a core skill set. Without this skill, the individual is working in the dark. I really like presenting the cost model and challenging supplier price. If I am wrong, suppliers will correct me. It is easier to present the cost model and force the supplier to negotiate it up than it is to take the supplier’s price and try to negotiate the price down.

Will you be working with a fact base on pricing?

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