In principle, linking the price paid by a customer to its supplier’s cost has certain advantages. First, there is a benefit to a customer in ensuring the profitability of its suppliers because by doing so the customer’s supply chain will remain stable and secure.
Second, by linking price directly to cost, a customer will automatically benefit should the supplier’s own costs fall.
The evidence is that there is a considerable lag in the time it takes for any decline in supplier costs to be passed on to customers.
Ultimately, any system of pricing will be supplier cost related.
By expressly linking the two, the inefficiencies resulting from price adjustment delay are eliminated.
Third, a cost–based approach is more transparent. Fourth, suppliers must necessarily build a hedge against the risk of adverse price fluctuation into any fixed price. If the risk of such a fluctuation is eliminated then the hedge may be removed from the price.
Despite these theoretical advantages, there are a number of features that make a cost-base price system unattractive to most purchasers.
In practice, any contract that permits the supplier to recover the entirety of its cost plus a profit margin presents risk to the customer.
To be effective, a cost related pricing system must be properly policed by the customer and the reality is that most purchasers do not have the time to keep track of the suppliers input costs on an outgoing basis.
Moreover, to understand the price implications of changes in input costs, the customer would need to know a great deal about the operations of the supplier, and, in practice, it is rare for them to possess such knowledge.
Financial management also suffers from a cost–based pricing system.
Sound financial management requires predictability.
Under a cost-based arrangement, the customer takes all the risk associated with production. Moreover, there is also a risk that costs unassociated with that customer will be applied to the customer’s account.
Although the use of such a contract may be essential in a crisis, the audit process is essential. The method of calculating cost should be clearly specified.
An audit mechanism should be put into place for every project.
Where costs are found to have been misapplied to the account of the customer, some form of penalty should be built into the system.
Contracts that provide for the payment of cost plus a percentage present the greatest level of risk, because the greater the cost, the greater the profit.
Prudence dictates an upward limit must always be set on the extent of the municipality’s exposure.
The payment of cost-plus a fixed fee mitigates the risk to some extent.
However, a better option is for the contract to provide an incentive to the supplier to keep its costs down.
For instance, a contract might provide for a payment of cost plus a fee of $100,000 if the total amount payable is less than $1 million, but for a fee of only $50,000 if the total amount payable exceeds this amount.
Under such an approach, the supplier has a strong incentive to manage its costs, even though it is still entitled to recover the full amount of its cost.
Having said that, cost-plus contracts are easier to manage if all the checks and balances are in place to be able to audit the numbers.
Standard form sale and other supply contracts frequently contain provisions that shift an acceptable amount of risk to a municipal customer.
Many of these provisions were drafted solely with a view toward sales to commercial customers.
Accordingly, a municipal buyer should be aware of those risks and seek to contract around them where practical.
Stephen Bauld is a government procurement expert and can be reached at firstname.lastname@example.org. Some of his columns may contain excerpts from The Municipal Procurement Handbook published by Butterworths.