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The best buyers know that it is better to have an objective of lower costs rather than lower prices only..." />

The Compound Effect of a Price Reduction

Date: 07/01/2010

The best buyers know that it is better to have an objective of lower costs rather than lower prices only. It is important to remember that lower costs can be achieved in various ways including price reductions. This publication has described the different ways that cost reductions can be achieved. Obtaining lower prices has been one of them.

There is a compounding effect when a supplier reduces prices. For example, assume that price increases are usually asked for periodically, a valid assumption during inflation.

Also, assume that you buy 10,000 pieces per year of item X based on a price of $10 each and that the supplier increases prices by 5% every year. At the end of five years the price then becomes $12.76. In other words over the five year period the increase has amounted to 27.6%.

However, if the buyer had negotiated a decrease of 5% instead of accepting an increase for the first year alone while accepting the increases for the following four years, the five year increase produces a price of $11.55 or 15.5% rather than the 27.6%. This is a saving of $55,260 over the five year period assuming a usage of 10,000 per year.

Naturally you will attempt to get reductions in the increase amounts requested each and every year, but during a period of high inflation that will be very difficult unless the prices received have been previously higher than they should have been.

Obtaining a price reduction has a compounding affect because many suppliers will not look closely at the price history and will base their request for an increase predominantly on the present prices only. Thus the requested increase will be from the lower base price that you negotiated.

Buyers have complained to their managers who want reductions every year claiming it is impossible to keep getting lower prices indefinitely. However, buyers can often obtain lower costs by product improvements or other methods as a worthwhile substitute for actual price reductions. They also can obtain significant savings by negotiating postponement of increases or maintaining present prices for an extended length of time. The savings are computed by subtracting the expected increase price based on the price index from the actual price paid.