Price Analysis 101, Session 1
How to write a FAR-compliant Price Analysis report
Welcome to SpendLogic. In this video, we’re going to cover the fundamentals of price analysis. The concepts that we cover here today will apply to all price analysis reports regardless of whether they’re completed within SpendLogic or not. It’s important that these basic concepts are well understood. This will help you understand what it is that SpendLogic is asking you to do.
At the end of the session today, you’ll know what is meant by fair and reasonable. You’ll know when a price reasonableness review is required. You’re going to understand the difference between cost and price analysis, and you’ll have a basic familiarity with some common pitfalls. Let’s get started. First of all, let’s start with the basic question of why? Why are price reasonableness reviews required?
To start with, it’s good business. Companies rely on their purchasing department to make sound spending decisions every day. Reviewing price for reasonableness is what ensures that this actually happens. Furthermore, your ensuring that taxpayers’ money is not wasted, not just your companies. Reviewing price protects both your company and your supplier.
Consider a case where a supplier signs a contract to deliver an item, but accidentally leaves out half the price in their quote. By expending the effort to determine whether the price is reasonable in this case, you can ensure that your supplier isn’t going to default on the contract based on a simple pricing mistake. Last, by keeping an eye on cost over time, you motivate your sellers to stay competitive. If you’re not pushing them to improve, they may not be making the effort to do so on their own.
Here we have a basic purchasing process. Regardless of the product or service you’re buying, you’ll always follow these basic steps in placing the contract. What we’re concerned with today is the step called review pricing. What’s important to see here is that this step happens prior to negotiating and placing the contract. Another way to state this is to say that without conducting a price analysis, you won’t know what price you should be paying, and, therefore, you have no basis for starting price negotiations.
The point of price analysis is to determine a reasonable price so that you’re informed as you enter those discussions on price. We often hear that fair and reasonable is subjective. What might be expensive to one person, may seem cheap to another. This is actually true to a certain degree in that fair and reasonable is an array of prices, not one specific price. You can see this in something as simple as buying a gallon of milk at the grocery store.
Assume you have two brands of 2% organic milk. One is $6 and the other is $7. Which of these is fair and reasonable? The answer is that they’re both fair and reasonable. In conducting price analysis, we’re trying to define the upper boundary of an array of fair and reasonable prices, not just one particular price.
Our price analysis should set the maximum amount that we consider to be fair and reasonable based on what we know. The lowest price represents the lowest price we should expect. This will be your first offer in negotiations. But what counts as fair and reasonable? How do we define that array? This is actually one area in which the FAR does a pretty good job. Throughout the FAR, we’re given clues as to how fair and reasonable is defined.
Fair and reasonable costs does not exceed that which would be incurred by a prudent person in the conduct of a competitive business. You’ve probably heard some variant of the joke about the guy selling $1 million gumballs. His price is astronomical, but he responds to doubters that he just needs to sell one gumball to make it big. This is an example of a company that is not interested in conducting competitive business.
Next, the price should reflect fair market value of costs of a well-managed contractor, plus a reasonable profit. Consider the case of a company that has 50% of its buildings sitting idle. This is not a well-managed company, and the cost of maintaining those buildings is being added into the cost of the product you’re buying.
Lastly, the cost must be realistic and reflective of market conditions alternatives in any non-price factors. Let’s change gears and do a little exercise before we get into the different types of price reasonableness. This is a computing system that your company purchase previously. Last time you paid $175,000. This time, the suppliers quoted you $170,000 for the exact same item. A decrease of $5,000.
Is the price fair and reasonable? Ask yourself, is there anything else you need to know before making this decision? For one thing, you’ll want to know when the last time was that you purchased the system. A quick look at the invoice shows that the $175,000 was paid in 2009. This should raise flags for you.
Technology typically decreases in price relatively quickly. Therefore, you should expect that this system would cost significantly less than the previous purchase. Let’s try another one. Here you have a new car and the dealer has it listed on their published price list or their website at $16,995. Since it’s on a published price list, is this price fair and reasonable? You’re going to need a lot more information than that.
Just because it’s on a price list, doesn’t mean the price is reasonable. What’s important is knowing whether this price is what the market is willing to bear. Here you can see examples of different prices paid for the exact same car. There are two basic types of price, reasonableness reviews, price analysis, and cost analysis.
Price analysis involves taking a look at the total price, while cost analysis involves reviewing the separate elements of cost and profit. Using the milk example, price analysis would involve looking at the $7 per gallon that was proposed by the supplier. If this was a cost analysis, we would be working with that supplier to understand how the $7 breaks down into the cost of the cow, the milking equipment, milking labor, packaging, shipping, and profit.
So when is a cost or price analysis required? What you see here is a simplistic view of when the FAR says cost or the price analysis is required. Note that the FAR is written for contracting officers, so unless you work in the government, make sure that you follow the guidance set by your company’s policies and procedures not necessarily the FAR. Anything over the cost of pricing data threshold requires a cost analysis unless a FAR exception applies.
For products and services, under the certified cost of pricing threshold, a price analysis will suffice. Note that within price analysis, the higher the value, the more formal the analysis needs to be documented. For small purchases, specific analysis, rationale doesn’t necessarily need to even be written down. However, for large purchases, a documented report will need to be filed and may have to be approved prior to starting price negotiations.
Again, make sure you understand your company’s procedures in this particular area. We’re going to finish up here with a little quiz. I’m going to give you three scenarios and you can decide whether a price analysis is required or not. Scenario one, you had a competition and you received the bids that are shown on the screen. Do you need a price analysis?
Absolutely. You probably noticed that bidder two was significantly lower than bidders one and three. If you don’t conduct a price analysis, you could be placing a contract with a bidder that doesn’t fully understand the requirements. Scenario two, suppose a competition is not possible because there’s only one supplier in the whole world that can deliver what you need.
Do you need to conduct a price analysis? You bet. By conducting a price analysis, you’ll know that the price you’re being offered is fair and reasonable. Last, you have a supplier that responds they’re a small business and therefore exempt from CAS. Do you, therefore, need a price analysis?
Yes. Why would being a small business carry any weight related to price reasonableness? You’re required to analyze every supplier’s price for determination of fair and reasonable, regardless of size. This concludes Part 1 of Price Analysis Fundamentals. Go to spendlogic.com/help to view Part 2, which dives into how to write a successful price analysis report.