Price diffusion – How much are we actually paying for…?

For negotiations and strategic measures, such as benchmarking or the measurement of its success over time, purchasing departments require correct transparency regarding its own conditions. For the purchasing company, this transparency is also relevant in many other areas, as the actual expenditure must be considered in a series of decisions: in cost accounting and ultimately in its own assortment design, in decisions on investments and locations, in financial planning and the income statement – to name just a few.

Even if other strategic fields of action such as sustainability, security of supply, or a shortage of skilled labour are currently gaining in importance, most surveys and discussions with purchasing managers reveal that the management of purchase prices is and remains a core task of purchasing departments. Therefore, it should at least be known how much the purchasing department spends on purchased goods and services.

The degrees of hardness of the purchase price

The paid price is only the “hardest” answer to the question posed at the beginning. On the way to payment, however, the price passes through various stages in typical purchasing processes. These stages could be described as the “degrees of hardness of the purchase price” (DHPP) and could look something like this:

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Depending on whom you ask in the company, the answer to the question about the actual price can differ. The person responsible for tactical purchasing and negotiations might answer with the contractually agreed price (DHPP 3). The person involved in operational purchasing might respond with the price documented in DHPP 4 or 5. The finance department primarily sees DHPP 6 and 7 and will derive its answer from them, and even within finance, accounting and controlling could come up with different answers.

One could argue, that if the processes work properly and the documentation is done neatly, all these functions should come to the same results in all the different process phases. This may be absolutely correct in theory and in terms of the objective, but the reality is unfortunately different in many instances.

The ideal world and the reality

The fact is that prices can change at every step in the sequence shown above – sometimes intentionally from the perspective of the purchasing organization and very often unintentionally. For example, in the case of commercial negotiations, which ideally achieve an improvement in the form of a lower price from DHPP 1 to 2, changes are intentional. It can also be intentional that the accounting department deducts a financing discount (cash discount) from DHPP 6 to 7 by paying supplier invoices earlier.

However, there are also unintentional changes to the price – these changes are also unplanned. The causes of this “price diffusion” can be either external or internal in nature and they take place at the various stages of the process chain indicated above.

External factors for price diffusion

Externally caused factors, which are only controllable and plannable to a certain extent by the purchasing company include, in particular, changing or not at all foreseeable framework conditions that were not known at the time of negotiation. Examples of such framework conditions are: environmental factors such as raw material prices, inflation or regulations, quantity planning – in total or broken down into qualities and variants, which are later corrected – or even the performance promise of suppliers, whenever these change significantly later in the process.

Firstly, there is the difference between the commercial negotiation (from DHPP 1 to 2) and the detailed contract negotiation (from DHPP 2 to 3). Especially if different people are involved in these two negotiations and the subject of the negotiation is more complex, significant differences can arise.  It lies in the essence of the subject matter that simplification and reduction of complexity are more useful in commercial negotiations, but details play a more decisive role in the formulation of contract wording. Although these circumstances are theoretically foreseeable in practice, they are often not.

In addition, actual unforeseen factors occur when framework conditions that were assumed during negotiations change in the course of further processes. In principle, these diffusing factors can be of a temporal, spatial, factual, or personal nature. For many purchased goods, these can never be completely avoided.

Internal factors for price diffusion

There are even more causes for internal factors, even though these are much easier to control with suitable processes and rules. Since errors can occur at almost every working step in tactical and operational purchasing, a list of common and typical observations from practical experience will suffice to illustrate this:

• Different interpretation of more complex pricing modalities between buying and selling parties or between different purchasing organizational units, e.g. applicable dates in combination with index-linked prices – this can result in different absolute values compared to those calculated at the time of negotiation
• Negotiated prices are not properly communicated or documented from the person negotiating to the person ordering – as a result, they are not available during the ordering process
• Despite proper communication, the negotiated prices are erroneously not used, due to poor processes in operational purchasing – this would also result in incorrect prices being used for orders
• Handling of ancillary or additional costs such as logistics, packaging or quality assurance; hereby it should be noted that there are conflicting interests between the “cost accounting view”, which seeks to allocate all costs to the material to be purchased, and the “purchasing view”, which wants to record individual cost components separately in order to allocate them, for example, to different spend categories
• Errors in invoicing or in the invoice control, which do not necessarily have to be of malicious nature and again occur more frequently in more complex pricing models (e.g. energy purchasing) – as a result, the prices from invoicing can deviate from those in the agreement
• Discounts granted late in the process, that lead to an influence on the actual price – a classic example in German-speaking countries would be the discount for prompt payment, the “Skonto”

Creating awareness and using systems correctly

Therefore, it is important for all parties involved in purchasing processes – from management downwards – to know that there is often no single specific purchase price for a purchase item across time and location. This is particularly expected for purchased goods with complex pricing models and a high number of operational cases (many orders, many invoices).

It is interesting to analyze how large such a spread is and where it comes from. Purchasing and controlling departments should work together to develop a common language and common awareness and standards for transparency and for reporting to management.

For the purchasing management, which strives to eliminate especially avoidable and unwanted causes, a detailed process analysis of complex and high-frequency order items is recommended. In particular, the lack of suitable systems in tactical purchasing and the correct utilization of the ERP system (the complexity of which is often overly underestimated) after the transition to operational purchasing are hot candidates for potential sources of error.