Saturday, July 9, 2011

Establishing Competitive Price Benchmarks

There can be some situations where you may be locked into using a Supplier where you need to establish a benchmark for competitive pricing in the future that they must meet to retain the commitment. Who you use to set the benchmark and the approach you use to benchmark is important.  I want to share with you an example of how not to do it that I ran into.

As part of a divestiture of a business there was a commitment to purchase products and services back from the purchaser of the Business for a period of five (5) years.  The business person that structured the deal understood the need to have competitive pricing in the future.  What they didn’t do was to think through what they were agreeing to. They included a process where they would take bids from the Supplier and three other competitors and future pricing would then be based upon the average of the four. To them it made perfect sense. To me it was a recipe for a disaster. 

The problem was that since the Supplier could not lose the business during the five-year term, they would always bid high. In doing so they were able to drive the average price up.  They knew that for every dollar they increased their bid, it would increase the average that would be used in establishing the new price by twenty five cents.  What the business had done was to allow the Supplier to significantly impact the future price and in doing what they thought would provide them with competitive pricing, it really didn’t have the effect.

There are other approaches they could have used with more effective results. For example:
1.     Have the benchmark be based upon a number of suppliers other than the Supplier, so the Supplier can’t influence the benchmark average.
2.     Include a formula that allows the Supplier to quote, but throws out the high quote or both the high and low quotes to create the average of the remaining quotes (negating their ability to drive the average up).
3.     Include a formula where if Supplier’s price is X percent over the current price it won’t be included in the average (to limit how much they can effect it)
4.     Agree to use another form of external benchmark such as well respected industry cost sources

Whenever you use any type of formula in a contract, always check it using real numbers in a number of different scenarios to understand what the real impact of the words are.

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