Price vs. Total Cost vs. Value

PurchTips edition #316

 

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By Charles Dominick, SPSM, SPSM2, SPSM3

Picture of Charles Dominick, SPSM, SPSM2, SPSM3

Do You Know The Difference Between Price And Cost?

Once focused strictly on price, today's leading procurement departments also focus on total cost and value. In this edition of PurchTips, we'll explore the difference between price, total cost, and value.

Price – Price is simply the amount of money an organization pays to a supplier for a product or service. When price is the focus, procurement departments work intensely to pay less than they had in the past for goods and services. If particular goods or services were not purchased in the past, procurement departments will work intensely to pay lower prices than initially proposed by suppliers. When price-oriented procurement departments report their performance, they only take into account the effect they had on prices paid.

Total Cost – While seeking lower prices is noble, it shouldn't be done without considering factors that could make costs go up. For example, let's say that you've begun buying a lower-priced component for a manufactured item. The price reduction has caused your company to spend $10,000 less per year for that component. However, the lower-priced component is of a lower quality than the previously purchased component. As a result of a higher defect rate, your company has incurred $20,000 per year in new costs for repairs, tech support, etc. That's obviously a bad outcome.A total cost focus assesses expenses that a price-only focus ignores. Total cost includes all expenses associated with the acquisition, receipt, storage, use, maintenance, and disposal of purchased products and services. When total cost-oriented procurement departments report their performance, they take into account all components of cost.

Value – Simplified, improving business performance means increasing revenues and/or reducing costs. Historically, the procurement function has been associated exclusively with cost reduction. But modern procurement departments can also help to increase revenues. For example, imagine that you implemented a program with a supplier that gave your company a unique advantage over competitors and, as a result, increased your company's market share and revenue. You may not have reduced the price or cost of the product purchased. But your work delivered a financial benefit to thecompany in the form of higher sales. "Value" is the word used to describe any type of financial benefit, whether it is a reduction in price, reduction in total cost, or an increase in revenue.

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