Contract price modelling versus an old-fashioned “back of the envelope” pricing of a contract

Gone are the days when important commercial contracts were agreed upon on the “back on an envelope”. The genesis of the spreadsheet has ushered in a more robust, accountable and best practice approach to the modelling of commercial contracts.

There are a number of reasons why the introduction of a best practice financial model into the preliminary pricing and analysis of a commercial contract is unparalleled.

Unlike a “back of the envelope” approach, a pricing model will deliver a robust, best practice financial model. It will garner further value with the introduction of scenario and sensitivity analysis, as well as the inclusion of the summarised dashboard outputs.

Value-add #1 – A Best practice financial model

Ad-hoc spreadsheets or scribbled projected numbers on a piece of paper outlining the return on a contract based on price, are simply not good enough in this commercial age of heightened corporate governance and sophisticated financial reporting of forecasts and budgets.

The best practice financial model clearly conveys a contract’s price, direct and indirect costs, and its rate of return; which can be circulated efficiently with commercial managers, financial accountants/controllers and executive management – where necessary.

It ensures there is a clear approach to the approval of all contracts based on price. This clear approach will be reinforced by a company applying a uniform, template version of the pricing tool across all its commercial contracts. This epitomises the importance of corporate governance across all functions of a company; including the pricing and approval of all contracts in controlling “the future direction of the company”.

Value-add #2 – Scenario and sensitivity analysis

Contracts approved based on price and other parameters, and agreed to on a piece of paper or ad-hoc spreadsheet will never enjoy the added rigour of a best practice, contract pricing model that offers seamless scenario and sensitivity analysis.

Either form of analysis helps to conceptualise how to improve income streams, optimise costs via improved operational efficiencies, smooth out the lumpiness of cash flow, and endeavour for improved profit margins for a specific commercial contract.

It enables stakeholders of a contract to play around with any parameter of a contract – but without compromising or changing the underlying computed numbers, which may have been tentatively agreed upon in a company.

Value-add #3 – Dashboards

As discussed in “The value-add of Dashboards in Strategic Planning”, dashboard functionality delivers a “visual snapshot of the detailed financial projections” for such a financial analysis, as the one undertake to price a commercial contract.

A dynamic dashboard will permit contract stakeholders to further comprehend the myriad of drivers, which drive the rate of return of a contract, based on assumed parameters of volume, unit price and cost.

Similarly to the addition of dashboard in strategic plans, it provides contract stakeholders with a visual snapshot or high-level view of the computed returns modelled in the respective contract being analysed.

In Summary

The advent of the computer, but particularly the spreadsheet, has changed the approach to pricing and analysing commercial contracts. Unlike the old fashioned way of agreeing to a price on the “back of the envelope”, a best practice financial model will deliver superior financial forecasting and analysis of the potent contract. It will provide advanced conceptual analysis via scenario and sensitivity analysis, and dynamic dashboard features to deliver a high-level or visual snapshot of forecasted return from the contract.