Activity 14
Purchase-price cost analysis (PPCA)
Overview
PPCA is a popular tool initially developed by the accounting community in the 1970s and subsequently tailored by purchasing consultants in the 1980s. It is primarily used to identify the breakdown of costs involved in the production of a product. This in turn helps with further research in relation to pricing (e.g. the amount of profit retained by the supplier).
This technique is also referred to as cost-breakdown analysis or ‘teardown’ analysis, and it is considered that understanding such detail can be helpful when it comes to the implementation and negotiation stages of the category management process, as it helps the buying team to challenge quoted prices. It also helps form the foundation of open-book collaboration and supplier development processes. However, PPCA is not appropriate for all procurement scenarios (e.g. a monopoly market structure).
Elements
Obtaining precise information from suppliers can prove difficult; therefore, when operating the tool, assumptions are often made. There is an effort-reward equation about obtaining some cost information, which inevitably means that at best the output will only be an estimation of the breakdown of costs and profit. Where longer-term collaborative relationships exist in the supply base, it pays to take an iterative approach to PPCA and therefore hone in on a more accurate cost breakdown through subsequent revisions as new cost data are established.
The key elements of a PPCA are as follows:
- Material costs – These may include the raw materials to make a product and any other materials, such as semifinished goods, components or subassemblies used in the production process, plus packaging and waste.
- Labour costs – These may include contracted and subcontracted labour (full or part time) directly associated with the production of the finished goods.
- Production costs – These may include the operating costs of equipment, plus any associated repairs, maintenance, energy or utilities, but should not include depreciation on capital equipment or any duplication with overheads.
- Logistics costs – These may include materials handling, haulage, warehousing, freight and associated export costs.
- Overheads – These will include all indirect costs appropriately attributed to the finished product, possibly including shared service costs (HR and procurement), financing costs, sales and marketing, general management and so forth.
- Profits – This is the net operating profit.
- Selling Price – This is the price at which the product is to be sold.
Much of the information needed to complete the PPCA can be sourced from industry journals, supply contracts, annual accounts, sales contacts, external benchmarking clubs and so on. Once all of the costs have been pinpointed and classified, a profit calculation can be made by reviewing the differential between costs and selling price. Finished goods can be broken down using reverse-engineering techniques to establish the component parts and a cost breakdown estimate established.
So what?
Breaking down product costs will help the category team plan their category strategy. Even if the information is just a ‘rough guide’ estimate, it is still relevant and may offer some form of confidence when analysing and determining the supplier’s pricing expectations.
Obtaining the information in the first instance can be daunting, and it is recommended that category teams view the analysis as ‘basic but developable’, depending upon the amount of time and effort available. This undertaking is usually done in teams, so that a breadth of experience is drawn from and utilised in order to populate the PPCA template.
For longer-term purchases (especially in manufacturing and lean production environments), PPCA can be an incredibly powerful tool to establish the ‘should cost’ of a product. This gives the buyer significant insight and advantage during the category planning and supplier negotiation phases. It is also an essential leverage tool to support supplier development and continuous improvement programmes.
Category management application
- Supports the preparation and research stage of category management
- Provides insight into the supplier’s cost structure
- Can assist with any negotiation elements of the category management process
- Affords a basis for benchmarking and continuous improvement
- May provide the basis for open-book costing and collaboration in the long term
Limitations
Some authors of category management texts believe that buyers seem to ‘shy away’ from developing a PPCA, due to the potential complexity and enormity of the task. There also appears to be a commonly held misconception that to create a credible cost breakdown, the document owner needs to have financial expertise and access to accurate supplier data, opposed to attempting an estimated version, as described earlier. Many consultants will use these arguments to justify their involvement in the process.
Initially, PPCA as part of the category management process was only ever meant to be at a rudimentary level and not a detailed accounting exercise. However, this is also exactly the reason why some category teams decide not to deploy the practice, as the output is seen as merely a poor approximation and therefore a waste of valuable resources.
PPCA is highly applicable to products and finished goods, but it is a lot harder to apply to services. The principles are fully transferable but the associated cost breakdown for services is more difficult to establish accurately.
Finally, it is worth remembering that if the PPCA output is to be used to contest a supplier’s price, then as much factual evidence should be gathered as possible, as a failure to do this could mean that your credibility is undermined when negotiating or collaborating with suppliers in that category.
Template
The following template can be used to support the identification of supplier costs and profits:
- Template 14: Purchase-price cost analysis