Indirect Costs, Marginal Cost, Marginal Revenue, and Quantity Discounts – Supplier & Buyer Views

Earnout Agreements - Link Between the Buyer and Seller | Smythe Advisory

In retail, one of the most common negotiations between a buyer and a seller would be something like: If you want the price to be lower by x%, you need to pick up y% more stock right now. Where is this coming from? What does this even mean at a deeper level? We have seen indirect costs (overheads and G&A) in my previous post. In this post, we will understand how does it affect the overall costing for a manufacturer and how does it come into play when you negotiate with suppliers as a buyer.

For manufacturers, indirect costs (overheads and G&A) are costs that they anyways incur. Yes, they do vary with production but still they don’t go down significantly when the factory is running at only 50% capacity due to lack of orders(demand). So, in such a case, the best way to maximize return out of them is by having the factory run at maximum production efficiency. In India, even efficient factories, especially in fabric and furniture run at 85% of the maximum output. In off-seasons, the factories might be operating at 70% of the maximum output. So, as the owner of the manufacturing unit, you should be careful with how you will manage your indirect and direct expenses and how you will especially cover the indirect expenses. Similarly, as a buyer, you should understand how is the manufacturer arriving at certain costs and how much of the total indirect costs is getting allocated to your product and why.

Manufacturers typically look at the costing of a particular product by the direct costs that are going into it and the indirect costs that are to be allocated to the specific buyer. If manufacturers have their own retail channels in which they sell goods, they might even allocate lower percentage of the total indirect costs to the products in their own retail channel and allocate higher percentage of indirect costs to your (buyer) goods. Basis my experience, almost all manufacturers do this if as a buyer you don’t dig into it.

As a buyer, one should not only visit the headquarters but one should always insist to visit the factory. It gives a strong understanding of the brand or the manufacturer. On the manufacturing floor, you will understand the below insights:

  • Products getting manufactured for different buyers (you will learn about other buyers)
  • Products getting manufactured for different channels (you can learn about new channels)
  • Products white-labelled (which the Business Head may not have mentioned to you)
  • You can talk to the factory manager and you can ask them about hourly productivity and take a mental note of it (once you come back, you can do the monthly volume calculations)
  • You can look around and talk to the factory manager of the number of labor working on the floor, inside factory offices, factory sq.ft. area, own factory or rented, labor union is there or not there, quality of the premises, number of different machines (import cost of machines), labor is paid as salaried or per unit basis payment or daily wages, understand the import cost of raw-materials from databases like Zauba etc.

The above questions along with the business overview of the brand or manufacturer and the competition will give you a good sense of the total actual turnover and indirect costs of the factory. Most buyers do have a good idea of the direct costs of their products through competitive quotes, competition, own imports or own buying of raw-materials. So, you can tie them all up together and do your own bottom-up costing and understand the supplier margins and if the supplier if ripping you off or not. Personally, bottom up break down costing is my favorite.

Supplier View of Quantity Discounts

Suppliers know that usually their fixed indirect costs won’t go up significantly even if there is more output produced in the factory (within the max efficiency). So, they would like the buyer to buy more stocks. This will not only increase the revenue but it will also increase the profit because usually the marginal cost required to manufacture that additional number of units is lower.

If the additional cost involved in manufacturing the unit is only the direct material and direct labor, then:  the marginal cost to manufacture those additional units = direct material + direct labor. The direct material cost could actually be lower now because of bulk buying of raw-materials. Similarly, there could be advantages in direct labor too basis if they are salaried labor. Marginal cost includes the additional costs that the supplier has to incur for only manufacturing the additional number of units, it usually includes only the variable costs.

If the additional cost involved in manufacturing the unit requires some machine batch loading of raw-materials, reset of machine configuration, other costs then: the marginal cost to manufacture those additional units = direct material + direct labor + cost of machine reset, cost of loading, cost of machine reset, and other variable costs coming caused only because of this additional output.

Nevertheless, the supplier knows that the marginal revenue that he can make is more than the marginal costing. And therefore, he will make more profit in selling more of these units. Theoretically, it is taught that you should manufacture that additional unit if the marginal revenue is higher or equal to the marginal cost.

Buyer View of Quantity Discounts

The buyer knows that the supplier is getting a range of benefits in terms of spread of indirect costs, optimization of cost of sales, marketing, inventory carrying costs, and a lot many other costs. So, the buyer expects a discount on bulk buying. Also, buying doesn’t mean you give that money in one shot to the supplier (giving back cash is a different negotiation with the supplier that the buyer will always keep it for the last so that the supplier doesn’t have that information pre-hand and pre-calculate his cost of capital and inject that into product costs).

So, buyer would always come and first ask for discounts on account of buying more atleast to the extent of his cost of capital. For example, if I as a buyer regularly buy 100 units per month of a product (basis my demand) and if the supplier is asking you to buy 200 units at a certain discount. The first thing is to calculate your cost of capital for the additional months of inventory. Say, if your cost of capital is 18% (annual) then it comes to 1.5% per month. Since you’re buying for one additional month of inventory, as a first step you will ask 1.5% discount on the product. Wait, you’re not done. Like, this is not even a discount in the actual terms. You are just covering for your cost of capital.

Then as a buyer you would ask for discount on the sales costs that are getting saved (per unit sale/per customer sale  of this volume). Each sales channel unit has a certain sales waterfall discount model at various units (which doesn’t include the indirect costs benefit yet, it only includes the cost benefits of sales). The cost of sale per customer in the case of selling 30,000 recliners to 10 customers is lower than in the case of selling 30,000 recliners to 50 customers. This is the benefit that the buyer expects the supplier to pass.

Then, the buyer expects the benefit of spreading the indirect fixed and overhead costs across a larger number of units. The buyer knows that the supplier will pocket the profit, but atleast expects a certain share.

Then, the buyer expects the benefit of discount in raw-materials that the supplier enjoys on account of buying more raw-material basis your purchase orders at the end of the day. Also, the transport cost optimization in doing the same. In India, if you transport in a 22 feet vehicle because of a low order, you can transport 60 to 65 tonnes of material and it costs you about Rs.X per km. But, if you use a 32 feet container, you can transport 110-120 tonnes of material (almost double) and it costs you about Rs.1.2X per km. So, there is a huge benefit in transporting in bulk quantities. Most manufacturers and buyers anyways do that irrespective of your purchase orders and sales to optimize the transport costs. In case of low quantities, they will share the vehicle with other suppliers and buyers to still pay for the same share of truck.

Anyways, coming back to the negotiation, by this time the supplier will say I don’t have more money to give any discounts. You can look at cash discounts at that time. Cash discount means giving the cash for this buy on receipt of goods instead of the 60 day credit period. And you can get an additional 3% (for two months) discount. Obviously, this can happen only if your company is okay doing this and has no big qualms regarding working capital. Again, cash discount in reality is not a discount on the product. You are just using your money power over the supplier.

As a buyer, you can also optimize on dispatching to locations basis aggregation. You can look at optimizing costs by bringing all stocks to one central location and then cross-dock from there to different locations in partial load trucks at cheaper prices too. This again can give some benefits to you or the supplier basis who is providing the transport.

Using the above levers, both supplier and buyer will mutually discuss a certain annual business plan in terms of volume of buying/selling, conditions of buying, marketing support, sales support, etc. This will again enable the buyer to get the product cost lower and will enable the supplier to increase his turnover and profitability and lock the sale.

Basis the above variables, the buyer should always go into a negotiation with a BATNA, the price beyond which you will not buy, the price below which the supplier will most probably not go (this is a guess basis other competitive quotes and prices and market and material understanding). I will say that the buyer should always push the supplier to the maximum extent, to the extent saying I am not going to buy. Also taking diplomatically additional time in making the decision helps too. The suppliers often try to bring out a sense of urgency in the buyer saying, there is a special discount if you buy 500 units in the next 3 days. This applies especially to end of life (EOL) models that they want to liquidate. Sometimes, these deals are really good and sometimes they may be just trash. This comes with experience. But, suppliers should take time and buy time and use various top management to buy more time and get more discounts after doing all the above at their individual levels. I say this not to rip off the suppliers. I say this because suppliers will never sell without making profit. Always remember as a buyer that even when a supplier is saying I am not making any money, they are still making money. If not, they will not be doing this business.

You can refer to the below pdf for Marginal Costing details. I found it pretty informative with examples.

Typically, you don’t incur significant additional cost of carrying inventory, etc. as a buyer in buying more inventory (as against the risk of not selling it) because usually inventory carrying and handling costs are very low per unit. But, if it is a relevant cost in your industry, you can ask a discount to the supplier to cover the cost of additional cost of carrying and handling inventory. Normally, this is a very small cost, and hence most suppliers will laugh at you saying “abhi khoon bhi lelo humara” – “take our blood too”, with all the discounts you’ve already taken.

Hope this is useful! Happy Buying and Selling!!

Other related posts by me:

Prime Costs and Conversion Costs, Fixed and Variable Indirect Costs