Factors influencing the cost of an item

Factors influencing the cost of an item

The term ‘item’ here can be multi-component equipment, a unit consisting of several equipments, or a project. The term ‘cost’ here means the total amount which the purchaser spends for the procurement of the item. The cost includes the amount paid to the seller through the contract entered with him and the additional expenditure incurred by the purchaser outside the contract for the procurement of the item. The contractual price is the amount which the purchaser pays to the supplier for fulfilling his obligations under the contract. While entering into a contract between the purchaser and the seller, the purchaser wants to pay the minimum price to keep his cost under control while the seller wants a price which can give him a decent profit after taking care of all the expenditure which he has to incur for the production and selling of the item.

Often it may appear that the purchaser is paying a higher/lower price to the seller when compared to the price paid by another purchaser for the same item. This type of comparison is not advisable though very frequently it is being done by the purchasers, auditors and many other peoples.  In two contacts of purchase/sale of the same base item, though the supply of the base equipment can remain the same in the two contracts still the terms and conditions of the contract can differ a lot between the two contracts to influence the contractual price. For understanding the reasons for the difference in the price paid by the two purchasers for the so called same base item, it is necessary to understand the factors which are influencing the cost. These factors are (i) base date of the contract, (ii) scope of work, (iii) delivery terms, (iv) implication of tax, (v) payment terms, (vi) financing arrangement, (vii) inflation rate, and (viii) statutory regulations.  These factors are given in Fig 1 and are described below.

Fig 1 Factors influencing the cost

Base date of the contract

Different countries have different rates of inflation. Further the inflation rate fluctuates with time. Hence the base date of the contract is an important data to be considered when the estimates for the price of the base equipment are being worked out by the purchaser.

Scope of work

When the item is same, normally it appears to everyone that the scope is same. But this does not happen in reality. Scope covered under the contract for the same item can vary very widely between the two purchasers. Several items of the contract have strong influence in the scope. Major of these items are described below.

  • Type of fittings – Fittings included in the contract depends on the choice of the purchaser. All the fittings included in the contract have a cost element in it. Take the example of an automobile; tubeless tyres have different cost than the tyres with tubes.
  • Add-ons included with the base equipment – There are several components/equipment which the purchaser normally includes in the contract when the base item is being procured. These add-ons normally differ from purchaser to purchaser. These add-ons can also differ if the same purchaser may order the same base equipment on the same supplier after a period of time.
  • Bought out items – Some purchasers leave the choice of the sub-suppliers of the bought out items to the supplier while some other purchasers put restrictions on the supplier to procure the bought out items from the short listed sub-suppliers. This restriction has a price implication in the contract.
  • Peripheral facilities and equipment – Some purchaser prefer to procure these from the supplier to avoid the co-ordination involved in procurement from different supplier while in the case of other purchaser, these are not included in the supplier’s scope.
  • Standardization of component – Certain purchasers desires to standardize some components of the equipment so as to reduce the overall inventory of these components within their plant. This standardization of components has price implication since it disturbs the standard practice followed by the supplier in his manufacturing plant.
  • Approval of manufacturing drawings – Some purchaser insists that before the manufacture of the equipment starts the GA (general arrangement) drawings are to be approved by the purchaser or his consultant while the other purchaser does not put this condition in the contract. To get the drawing approved by the purchaser has a price implication which gets reflected in the contract.
  • Indigenous manufacture – in some of the procurement contract, the place of the manufacture of the all the components of the equipment is left to choice of the supplier, while in other contract, the contractual term can include certain percent of equipment to be manufactured indigenously within the country. Further, in some cases of the part equipment being manufactured in the country, the purchaser may ask the supplier to provide the manufacturing drawings while in other case purchaser may ask the supplier to get the indigenous manufacture of the equipment under his supervision. Each of these alternatives has price implication.
  • Warranty – In some of the contracts, purchaser is satisfied with the standard warranty offered by the supplier, while in some other case, the purchaser may ask for extended warranty either for the complete equipment or for the critical components of the equipment. In both the cases there are price implications.
  • Stage inspection – Some of the purchaser may ask for the stage inspection at the manufacturing works of the supplier before further manufacture can be taken up, while other purchaser can show complete confidence in the production system of the supplier and hence he does not insist on the stage inspection. Stage inspection has price implementation.
  • Supplies of spares – Some of the purchaser is satisfied with the standard commissioning spares included in the supplies with the base equipment by the supplier while other purchaser may ask the supplier based on his experience to either increase/decrease the quantities or ask the supplier to include some additional spares as commissioning spares or ask the supplier to remove some of the offered commissioning spars from the contract. Each of these alternatives has price implication in the contract.
  • Supplies of operational spares and insurance spares – Some purchaser include in the contract because of which the supplier gets committed to supply two years operational spares as well as insurance spares as per mutually agreed list along with the main equipment, while the other purchaser may not order these spares in the contract. These spares have a big price implication in the contractual value.
  • Supplies of change parts – Some parts of equipment have limited life. Examples of such parts are rolls, guides and chocks in case of rolling mills, copper moulds in case of continuous casting machines, and copper tuyeres in case of blast furnace etc.  Purchaser when ordering the base equipment normally orders a number of sets of these change parts. Number of sets included in the contract has its implication on the value of the contract.
  • Performance guarantee test – Different purchaser specify this test in different ways. But normally this need to be conducted within six months of the commissioning by running the equipment continuously for 72 hours during which supplier is show the capability of the equipment with respect to equipment productivity, specific consumptions of materials and utilities, and product quality. The strictness and the number of the parameters for the performance guarantee test has implication on the price of the contract.
  • Volume of the contract – If a purchaser orders a large number of base equipment in one go then the purchaser gets quantity discount which is not available to the purchaser who orders only the single piece of the base equipment.
  • Training – Some of the purchasers may desire to train a number of people in the operation and maintenance of the equipment which the supplier has to arrange while some other purchasers may have their own facilities and may not ask for it. The training of the purchaser personnel has impact on the contractual price.
  • Erection and commissioning – Erection and commissioning of the equipment can be included or excluded from the scope of the supplier. In case it is excluded then the supplier or the purchaser or both may still want the supplier to provide the supervision of erection and commissioning. All these alternatives affect the contractual price.

Delivery terms

Delivery term has big influence on the price. Some purchaser takes delivery of the equipment at the supplier’s works and bears the further expenditure of transport while the other purchasers want equipment to be delivered at their site and the responsibility of equipment remains with the supplier till then. In case of overseas supplies normally ‘International Commercial Terms (Inco terms)’ are used for the delivery of the equipment. Under the ‘Inco terms’ the responsibilities of the supplier and the purchaser have been specified for different mode of deliveries. Adoption of different modes has an impact on the contract value. International Commercial Terms are available in the article having the link ‘ ‘.

Equipment delivery period also impacts the contract value. There can be three alternatives with respect to the equipment delivery. In the first alternative, the purchaser accepts the normal delivery period offered by the supplier. In the second alternative, the purchaser wants the delivery to be advanced while in the third alternative, the purchaser desires delaying of the delivery. Each of these three alternatives has impact on the contractual price.

Implication of tax

Generally in every contract the usual practice is that all the taxes are to be paid in the country of the supplier by the supplier and all the taxes are to be paid in the purchaser country is to be paid by the purchaser. But there are exceptions to this in many contracts. Sometimes the purchaser asks the supplier to take care of the part of the tax burden in the purchaser country especially when the supplier is to deliver the equipment at the purchaser site. Purchasers normally do it to avoid the co-ordination work needed to be done at the time of delivery of the equipment. When the supplier bears the tax burden especially for the long lead item then he makes a guess of how the taxes will move during the period of the contract and then multiply by a risk factor to arrive at the figure which he includes in the value of the contract to take care of this.

Payment terms

Payment terms have maximum influence on the contract price after the scope of work.  Generally the supplier desires during the initial period of the contact higher percentage of payments so that he can procure raw materials and bought out items from the payment received against the contract and need not allocate funds for these activities from other resources. On the other hand purchaser does not want to pay heavy amounts to the supplier in the initial stages of the contract. The purchaser always desire to pay during the contract as per the progress of work.

The most followed payment terms in a contract consist of 10 % payment as advance payment immediately after signing of the contract, 80 % payment in several stages as per the progress of work and balance 10 % just after the conductance of the performance guarantee test. In a long drawn out contract, the value of money goes on reducing as the contract progresses. In such contracts, the supplier pads up the prices to take into account this factor, while in short delivery contracts supplier is not bothered about this factor.

Financing arrangement

Most of the high value contracts are covered by financing arrangements. The price of such contracts is guided by the type of the financing arrangement accepted in the contract. The financing arrangement can vary from contract to contract. Finances can be arranged either by the supplier, or by the purchaser through the banking channels in their respective countries, or can be arranged by the governments of the respective countries. The contractual prices are greatly influenced by the interest rates applicable and other clauses of the accepted financial arrangements.

Inflation rate

Inflation rate in the supplier’s country as well as in the purchaser’s country also normally influence the price of the contract though the effect of it is more visible in the case of long drawn out contracts.

Statutory regulations

The design of the item being purchased is to satisfy the statutory regulations enforced in the country of the suppler as well as in the country of purchaser. In case if the purchaser belongs to a country where very strict statutory regulations are there, then the supplier is required to make modification in his standard designs to satisfy this requirement. This has a price implication.

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