Nominal vs effective price: how effective price can be used to evaluate suppliers

In this short tutorial, we will compare nominal and effective prices. Then, we will use the concept of effective price to compare suppliers.

1. Nominal vs. effective price

Nominal price is the value of goods or services in terms of money. In other words, it is how much cash you pay for them, eventually. Nominal price, however, may not reflect the effective price of a good or service.

The term “effective price” has a different meaning across contexts, but in general, effective prices capture the long-term value of something to someone.  Because effective prices reflect long-term value, they are important in implementing strategy and achieving long-term goals.

One way to translate nominal prices into effective prices is to consider quality. Quality and price are both important to consumers but require a trade-off. Likewise, organizations are consumers of goods and services from other organizations and need to consider both price and quality of products and services purchased from third parties.

Quality can be used to adjust nominal prices for products or services purchased from suppliers. Nominal price adjusted for quality will be called effective price.

Let’s look at an example. A chemical company manufactures various products used in agriculture. Its best-selling product is GRWFST, a fertilizer. The company uses ammonia in its fertilizer. It purchases ammonia from two suppliers: Supplier A for $380 per ton and Supplier B for $395 per ton. The quality of ammonia differs between the two suppliers. The yield is 0.92 when using Supplier A’s product and 0.97 when using the Supplier B’s product.

To compare the two suppliers, we should not use the nominal prices (i.e., $380 vs $395). Instead, we should adjust the nominal prices for the product quality. We can use yields to calculate the effective price for raw materials:

Yield = Good Output ÷ Input

In our example, the effective prices are as follows:

Supplier A: $380 nominal price ÷ 0.92 yield = $413 effective price

Supplier B: $395 nominal price ÷ 0.97 yield = $407 effective price

As we can see in the example above, the ranking of suppliers will differ if we use effective prices rather than nominal prices. When using nominal prices, Supplier A sells ammonia that is cheaper than Supplier B’s ammonia: $380 < $395. But, when using effective prices (i.e., nominal prices adjusted for yield), Supplier B sells relatively cheaper ammonia (i.e., $407 < $413).

While it is important to manage cash flows (nominal prices), in the long run it is important to evaluate the value of products or services purchased from third parties. Effective prices can help organizations to better compare the value of products and services procured from suppliers.

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