Monitoring Price Increases with Economic Data: A Practical Approach

INTRODUCTION The bane of purchasing's existence has been, and probably always will be, price increases. The agitation among buyers is understandable, yet in many sectors of the economy, increasing prices are a way of life. Inflation has been a part of the American business scene for the past five decades. While higher prices should be used to cover unavoidable increases in costs of operation, they are often used to enrich margins or cover burgeoning overhead costs or inefficiencies in the operation. Also, there is always that temptation to "take advantage" of the situation when a plausible "scapegoat" can be found. The economic scene is resplendent with examples of the "government made me do it" or "we cannot absorb all the increases from our suppliers." A price increase can also be considered a test mechanism to gauge the price elasticity of the individual customer. At what point does the buyer "walk away" and seek another source of supply? How sensitive is the buyer to the price increase? The irritability of the buyer toward price increases can be quite pronounced since they often impact negatively on purchasing personnel. Many companies develop standard material costs at the beginning of their fiscal year. Price increases elevate the actual cost of material and lead to unfavorable material variances, reflecting badly on purchasing. Purchasing must either anticipate those increases and attempt to get them incorporated in the computation of the standard cost or face the embarrassment of unfavorable material variances over which they exercise little or no control. This places the buyer in a reactive position. When material prices increase, the buyer is limited in options. One option is to ask the supplier to justify the price increase and document the reasons, but the supplier is not legally obligated to respond to requests of this type by the buyer. Another option is moving the issue higher in the supplier's organization. The success of this option depends on the buyer's importance as a customer. More often than not, the final offer is an insinuated "take it or leave it." The best outcome that might be expected in this situation is some degree of warning or prediction that the increase is coming. While price increases occur with a fair degree of regularity, where they take place in the channel of distribution is important. A price increase provides the stimulus for the next seller in the channel to "pass along" the increase, creating a domino effect. The ultimate consumer pays for this price compounding in the channel. Price increases are compounded because most price increases are usually based on a percentage of the current price. Passing along a price increase is not done by simply adding on the increased cost from the supplier as a surcharge, but by raising the selling prices by the same percentage, although the increased cost is only on one part of the total cost structure. A five percent total price increase implies that every cost element increased by five percent. This may not be the case. Consider the example illustrated in Table I. The current price is $10.34 per unit and the supplier has suggested a price increase of 6 percent or $0.62 per unit. By using supplier price analysis tools, the product cost structure has been dissected into its major components.[1] The old elements total $10.34. While the new price is $0.62 higher, notice how each element would have to change if that element were the sole cause of the increase. These are one-at-a-time increases. TABLE I ALLOCATION OF INCREASE IN PRICE TO INDIVIDUAL COST ELEMENTS Cost Old Potential Percentage Element Value Increase New Value Increase Direct Labor $0.67 $0.62 $1.29 92.32% Direct Material $3.02 $0.62 $3.64 20.54% Overhead $2.62 $0.62 $3.24 23. …