Any manager who has been working in procurement for some time knows phrases like, “I can only offer this price if it stays absolutely confidential …” or “If other customers find out, I can close shop!” Often, sale side comments like these lead to a successful conclusion of the business, as the purchasers suspect to be offered the optimal price and can supposedly save themselves a costly comparison of competing suppliers. However, this “illusion of the best price” is one of the biggest obstacles faced in order to effectively optimize purchasing for medium-sized businesses.
It has been and still is the “best price illusion” that enables a good quality supplier with a well-trained sales force to continue to be successful in the marketplace. It is the same illusion that makes it difficult for companies to reassess their business internally and to optimize their purchasing practices effectively.
The „best“ price is a matter of opinion
A clear definition of the “best” price is difficult to give because the term can be viewed from multiple angles. In the following, four different of these angles are explained:
1) Theoretically, the “best” price is one that no other purchaser can achieve for the same value under the specified conditions. However, this is practically never measurable or provable and can therefore lead to an illusion.
2) For an operational purchaser, the optimal price is the price of the currently best offering supplier. Anyhow, according to this definition, the price can be significantly higher or lower than the actual production costs. So, it may be that even the best offer is far away from a good price. Therefore, if suppliers offer a price below manufacturing cost over a longer period, they will sooner or later experience problems and raise prices, reduce quality and service, or shut down. Such a short-term approach may therefore be dangerous for both companies, the supplier as well as the purchaser.
3) Psychologically, the “best” price is nothing more than the “comfortable zone” for the purchaser. Large purchasing volumes are often seen as a justification for the best price offer: “We make so much money with this supplier, with us he does not pay attention to the margin but only on his base turnover.” Purchasers of smaller volumes, in turn, often say: “Our order volumes are not that big, suppliers barely notice us and take care of larger customers.” In both cases, a clarification by the sales department is advisable whether large purchases always bring better prices and how many of their own customers must make any contribution margin.
4) Using cost accounting, a long-term “best” price, or rather an optimal price, can be defined. This consists of the full costs and a moderate contribution to the profit margin. In addition, a corridor that spans between the manufacturing costs and a maximum of twice the average profit margin of the supply industry could be called a “healthy price” (see Figure 1). Prices above favor the supplier at the expense of the procurement unduly and should be avoided or reduced.
Such a detailed cost analysis requires some effort as well as special expertise and is therefore not possible in the day-to-day business of an operationally driven procurement department. Therefore, many purchasers strive for a benchmark with the competition, whereby in addition to antitrust difficulties also technically and methodically some challenges must be considered. In order to get a realistic indication of the “best” price, almost the entire market would have to be surveyed – but that causes a lot of effort. For a smaller sample in turn, the participants of the benchmark need to screen the supplier market in depth, at best regularly. In a next step, the obtained price level should be hedged against commodity markets and other influences. A target set by management would also have to be ongoing cost optimization. All in all, it is very difficult to actually find the “best” price.
The „best“ price as a dead-end
However, there are (purchasing) managers who are aware of the illusion of the “best” price and therefore pursue a different goal: an “ever better price”, or more informative: ever lower overall costs. These corporate leaders honor ongoing optimization and reward their buyers according to strict KPIs, just as they themselves are rewarded through KPI checking. For them, the “best” price is therefore an unsatisfactory condition, a dead-end so to speak. These managers will not use the term “best price”. Their goal is to pay the optimal price under precisely defined requirements, at which the most suitable supplier can cover his costs in the long term and earn a moderate contribution to earnings. As long as this is not the case, the price will be further optimized; If this is already the case, they look to optimize costs in the company and the entire supply chain.
Patent remedy for optimal prices
At this point, illusions should be dispelled and not built up anew, so it would be presumptuous to reduce the guide for optimal prices to a few sentences. There are numerous approaches, measures or best practices for individual industries, products and services in literature and practice. Still, there are a few patent remedies to be used in small and middle enterprises: 1.) create even more intense competition, 2.) hedge against or fair splitting of commodity price fluctuations and risks and 3.) complete transparency of all price and cost components.
It has been and still is the “best price illusion” that enables a good quality supplier with a well-trained sales force to continue to be successful in the marketplace. It is the same illusion that makes it difficult for companies to reassess their business internally and to optimize their purchasing practices effectively