Chapter 3 : Purchasing Management

Introduction

The scarcity of raw materials has practically put the people in purchasing department in a very

tight positions. The purchasing department can be in a better position if the designer take a

little pain to consult the purchasing personnel about the technological capabilities of the

vendors. The main outset of company’s cash goes in material purchase thus purchasing people

should take greater responsibilities and should analyze the existing procurement policy and

should tune with the overall organizational objectives and policies.

The improvement in purchasing management by the help of standardization, value analysis,

material substitution, transport saving, cost reduction by packing modification and scrap

reclamation all can contribute to the profitability of an organization.

Definition

Purchasing in its narrow sense, refer merely to the act of buying an item at a price. A broader

meaning of purchasing makes it a managerial activity that goes beyond the simple act of buying

and includes the planning and policy activities, research and development, service selection

etc.

Purchasing is, therefore, the procurement of raw materials, supplies, machines, tools, and

services required for equipment, maintenance and operation of a manufacturing plant.

Purchasing function also involves procurement by purchase of the proper materials, machinery,

equipment and supplies for stores of used in the manufacture of a product adopted to marketing

in the proper quantity at the proper time and at the lowest price consistent with quality desired.

IMPORTANCE OF PURCHASING

Purchasing management best reflects the role of purchasing in corporate operation and

organization. There is a trend towards introducing materials mgt. in industry today, but to say

that it has superseded purchasing would be to anticipate the future more than we feel is
warranted. Purchasing is still a clearly identifiable function in most business organizations.

The term “Management” suggests that purchasing decision involve the weighting of alternative

possibilities, and many of these alternatives involve the influence of other functions on the

purchasing decisions. No organization can operate without materials, supplies and equipments.

The efficiency of any business activity is contingent up on having materials, supplies and

equipment available in proper quantity with proper quality at proper place and time, and at

proper price. Purchasing is a managerial activity that goes beyond the simple act of buying

and includes the planning and policy activities covering a wide range of related and

complementary activities such as research and development; proper section of materials and

sources from which those materials may be bought.

Purchasing objectives

The objectives of purchasing is to conduct purchase function so as to minimize or eliminate

disruption in production resulting from lack of any materials, equipment or supplies.

Furthermore, this objective must be achieved with a minimum investment ins reserve

inventories. Another objective of purchasing is the maintenance of adequate standards of

quality for items purchased. The purchasing objective is lowest ultimate cost rather than lowest

initial cost. Another objective of purchasing is the avoidance of duplication, waste and

obsolescence with respect to the various items purchased. The mission of purchasing

organization is the effective commitment of the company’s funds. Its objective is the economic

success of the business organization. In other words the objective of purchasing is not so much

to procure the raw materials at the lowest price but to reduce the cost of the final product.

According to A.G. Pearson the prime objective of purchasing organization is “Effective

Commitment of company’s fund” and having goods of the right quality, form right source at

right price and right quantity and time. These objectives of purchasing are known as 5R’s of

purchasing.

i. Right Quality
Cost and quality are critical dimensions. The interaction between the two is very complex. A

right quality is not necessarily best quality. To a large degree manufacture’s determine the

quality of goods by the desired quality of a product to make. The considerations are basic

materials, grades, size, design, colors, patterns and durability.

The quality must be described precisely so that vendors should understand what is exactly

needed. The exact specification of item should to be given, preferably interms of market

grades, brand or trade names, commercial standards, on blue prints or physical characteristics,

materials and method of manufacture.

ii. Right Quantity

Quantity to be purchased varies with the production strategy and planning. Right quantity is

the level of quantity which is not too much or too few. This can be made possible through the

techniques of E.O.Q (Economic Order Quantity), which save the producer from the danger of

stock outs as well as carrying cost of surplus inventory. Other strategical considerations in

determining quantities are combination of items to reduce transportation costs, anticipation of

market conditions both of raw materials/spares as well as the minimum quantity of finished

goods.

i. Right Source

The source of supplier is determined normally by calling quotations and the lowest bidder is

selected provided he has quoted as per the requirement of producer interms of quality and

period of delivery. But such ideal situations do not appear in all cases and selection of supplier

involves a strategic consideration of various factors. It is always prudent to select a

manufacturer in case of patented standard products even if it means a little extra transportation.

Secondly, the past records, financial capacity, technical ability and other resources play

important role in selection of supplier.

The purchasing department has to maintain a vocabulary of suppliers of different goods and

develop it further from the knowledge or data collection through journals, bulletins and news

papers, trade directory, and exchange of information through buying associations.

ii. Right Price

The right price is the worth interms of quality, time and adequacy of supply of an item obtained.

It is no doubt easy and safe to go for standard products at a higher price but one has to keep in

mind the utility of item in the ultimate worth of product.

iii. Right Time

The ideal time of purchase period would be the minimum time for which the goods remain

unconsumed. This could be achieved if the stockiest or manufacturer of raw materials supplies

the day-to-day requirements in regular installments. This would save the storage. But the

geographical and market conditions do not permit and it is where the ordering system comes

into existence. The timing policies will depend up on fluctuating prices as well as problems

arising out of monopolistic trade and sellers’ maturity.

RELATIONSHIP BETWEEN THE PURCHASING DEPARTMENT AND OTHER

FUNCTIONAL UNITS

All of an organizations department can have a relation with the purchasing department.

Engineering Department and Purchasing Department

It can stipulate technical specifications of the final product of the company and the technical

specification of materials to be used in the process of production. This technical specification

determines the prices of materials costs of assembly/fabrication and number of suppliers. From

this points we can say that what is economical to procure is also economical to fabricate.

Production Department and Purchasing Department

The production schedule is the starting point for the procurement schedule. The procurement

schedules could be workable when the production schedule arrives on time. If the production

of schedule is late due to various reasons the following risks are expected to occur.

1. Premium price (higher price)

2. Premium transportation costs and costly special production runs (over time work)

3. Production stoppage (shut down) – it may not be possible to get the materials required

for production purpose under the first two conditions, then the management will decide

to shut down the production process.

Good relationship between engineering and production and purchasing as well would avoid

minimize other above problems.

Marketing Department and Purchasing Department

Sales forecast is the bases for production schedule and thereby for purchasing. Purchasing

people can have frequent contacts with suppliers and gets information. And they should give

these information to sales personnel and the to the management as well.

Reciprocity – Purchasing materials from organizations that can buy finished products of the

company. Reciprocity should be accepted as far as it does not affect/discourage other suppliers.

Purchasing personnel could tell the sales personnel that which behavior or what things would

irritate purchasers, and sales people should consult purchasing people instead of going to the

library for further reading.

Finance Department and Purchasing Department

Purchasing schedule or any change in procurement should be communicated to finance

department inorder to get sufficient fund at hand when required.

PURCHASING PROCEDURES

Purchasing procedures refers to the way in which a purchase transaction is carried through from

its inception to its conclusion. Purchasing policies outline the broader objectives to be

accomplished and guidelines within the desired results. Procedures outline in detail the
function to be performed by the people involved in the purchasing operation. Forms and

records used to implement procedures and policies. Therefore, procedures are chronological

sequence of activities, wile rules are statements that do not require chronological sequence and

aside to perform it.

Object of Purchasing Procedures

► It should facilitate accomplishment of task with minimum effort and directive.

► It should facilitate accomplishment and coordination (should be in written)

► Responsibility must be assigned clearly for accomplishment of each stage of each

procedure. There should not be an assignment of more than one procedure to some one

to avoid overlap of responsibility.

► Procedure permit management by exception; management should give their attention if

clear procedures are forwarded to subordinates, managers, superiors can follow

these responsibilities easily.

Steps In The Purchasing Cycle

 Origination of Purchase Requisition.

 Verification of Authority and Budget.

 Request for Quotation or Bids.

 Evaluation of Bids and Selection of Suppliers.

 Placing the Purchase Order.

 Follow–up and Expediting.

 Receiving, Inspecting and Storing

 Closing the order

Each of these steps will be discussed as follows.

Origination of Purchase Requisition (PR)

Purchase Requisition is a document generated by the using department or by the store that

authorize material purchase. Here, if the policy of the organization states, “All the materials

have to be made available to using department through the Store.” then the store department is

the only one which is authorized to fill the Purchase Requisition. From this we can infer that

the need for purchase originates in the inventory control section or in the operating (using)

department. This need for purchase is transmitted to the purchasing department by Purchase

Requisition. This Purchase Requisition is a serially numbered internal document by which the

need for purchase is transmitted or communicated. It is prepared by a minimum of two copies.

Information that a Purchase Requisition contains include:

1. Description of the materials

2. Quantity

3. Date of requires

4. Date of issue

5. Estimated unit cost

6. Operating account to be charged

7. An authorized signature

 Verification of Authority and Budget

The responsibility of indenter (who fills the Purchase Requisition) is to incorporate of details

items with full descriptions. However, the responsibility of the buyer (who receive the

Purchase Requisition) is to check whether the PR is within the budget limit or not and also

checking the accuracy of the document. In addition, he/she checks the stock level and see if

cheaper material can equally do the same purpose,

 Request for Quotation or Bids /Price Quotation/

This refers to identification and analysis of possible soured of supply. A Quotation is a

statement (perform) acquired from potential suppliers. Requests for Quotation is a process of

initiating potential suppliers that are willing to compete to supply the required material. The
request depends on the type of materials because some materials need price quotations and

other not.

Items which are purchased repetitively, from known suppliers, with small quantity and with

low value doesn’t require price quotation.

There are two types of Bids.

1. Open Bid – It is a type of bid where all potential suppliers are invited through mass media

and advertising agents to participate in the bidding.

2. Closed Bid – In this case selected suppliers are approached (invited ) to participate in the

bid. Here, the invitation can be made through personal contact, telephone or formal letter.

Issuing of Enquires and Tender Collection

In the case of closed bid we use letters or printed enquiry form because we know the bidder.

But in the case of Open tender, we use mass media.

Preparation of the tender involves;

 Bidding Notice

 Bidder’s instruction

 Description of Materials

 Samples and blue prints (when required)

 Tender Documents

Inorder to give general description of the materials; delivery time and point, term of payment,

last date of submitting bids, general term and condition should be included.

In the process of collecting tenders we need to set up separate boxes & seal the boxes on the

due date & time. After collecting the tender, we need to open the tender. Tender opening

involves the following activities.

 Earnest money deposit

 Time, date & place should be specified

  Representatives of purchasing department, suppliers, finance and using department

should be present.

 These and other things should enter the tender opening register or minuted.

 The minute should contain price, delivery date, discount, delivery point, & others if

any.

Here suppliers that do not pay bid bonds should get back their letters unopened and bid letters

arriving between the closing date and the opening date should also be returned to the supplier

unopened.

 Evaluation of Bids & Selection of Suppliers

This is analysis of the potential suppler who fulfill the criteria of the organization. Suppliers

are evaluated /reviewed by the following factors or selection criteria.

► Interms of price proposed by the suppliers.

► Interms of discount they offer.

► Interms of the shipping terms.

► Interms of delivery date.

► Interms of reliability of the supplier by analyzing past performance.

► Interms of reciprocity (this refers to mutual interchange of favors, privileges in good sense)

► Interms of quality of work & other services

Here the lowest bidder usually wins the tender, but some times this bidder may be denied or

not awarded to supply. This happens because of the following reasons;

1. A higher bidder may provide better after sale service.

2. A higher bidder may have better plant facilities and be able to offer quality provided

than the low bidder.

3. The low bidder may not be reliable.

4. The reciprocity may favor some company other than the low bidder.

5. The low bidder may be located so far from the company.

 6. Exceptional goodwill may exist between higher bidder & the buyer.

7. The organization (buyer) may adhere to the policy of dealing with local suppliers.

 Issuing of Purchase Order

The Purchase Requisition gives the purchasing agent authority to order the materials described

in the requisitions. The purchasing agent should maintain or have access to an up-to-date list

of vendors, which includes price, available discounts, estimated delivery time, and any other

relevant information. From this list, the purchasing agent selects a vender form whom high

quality materials can be obtained when needed at competitive cost. Then the purchasing agent

then completes a Purchase Order which is a buyer’s documents that formalizes a purchase

transaction with the seller. So a Purchase Order is a serially numbered external document that

is used to make purchases.

The Purchase Order should contain the following information. (See figure 2-1)

1. Suppliers name and address.

2. Quotation reference and date.

3. Description of items.

4. Quantity Ordered.

5. Unit Price.

6. Terms of Payment.

7. Date of the order.

8. Delivery date and

9. Signature of the purchasing agent

General terms and Conditions are included in the purchase order as a legal protection for the

buyer. In addition, Engineering designs & other drawings shall accompany the purchase order.

Figure 2-1 Purchase Order (Prepared by Purchasing agent & sent to vendor to

order materials.)
PURCHASE ORDER

Order No. 1982

XYZ Company

To: ABC Corporation Mark order No. on invoice and on all package.

Nazreth,

Ethiopia

Date: Jan. 6, 2003

Term 3/10 eom n/60

Ship via Track / to arrive on Jan. 25,2003

Quantity Description Price

20,000 Gallon Adhesive Compound Br. 31,000

Grade A

By: Alem

Purchasing agent

The purchase order should be prepared in a multiple snap out format; most generally it has 7

copies.

First Copy
These two are sent to the supplier, one as an acknowledgment.
Second Copy

Third Copy: to accounting department to inform fund be available.

Fourth Copy: should be sent to the store to intimate that shipment is arriving soon.

Fifth Copy: to the using department to enable them act accordingly.

Sixth Copy These two copies are retained by the purchasing unit, of
which the 6th copy is used for follow-up of purchase.
Seventh Copy

After the purchase order is prepared and distributed, if adjustment is required a letter or printed

format called “Change Order” should be filled in the same copies as the purchase order and be

distributed accordingly.

 Follow-up and expediting the Order

Follow-up refers to reminding the supplier to insure the timely arrival of the Order. And

expediting is speeding up or accelerating the receipt of the item before the agreed-up on time.

The later requires good relationship between the purchasing unit & the supplier.

Here, we need to have the system which shows the date at which delivery check should be

made.

These systems could be:

A. Manual - We may use a calendar file. This is keeping the follow up order on the required

date when the next follow –up is scheduled. Or suppliers list. This is filling orders

alphabetically on the top we are going to use a number running from 1 to 30/31 and we put

a visible colored mark on the date the next follow-up is made.

B. Automated System - This is normally using a computerized system.

C. Communications - This may be through

 Letters or telephone

 Printed form & Pcs. for routine work

 People: Purchasing people or other people to follow these duties.

 Receiving, Inspecting and Storing

When the items are received, the following receiving procedures are usually adopted.

1. Unloading and checking the consignment /shipment. Compare the consignment with

the freight whether there is any damage or not.

 2. Unpacking and checking the material – Compare for the right material that the packing

ship contains with the materials received. Here, we need to check for the right quantity

and General Condition of the material.

3. Completing the receiving report and distribute this report to:

 First copy - to purchasing; if all orders are received the document will be closed

 Second copy- to accounting department for effective payment.

 Third copy-to the requesting department to intimate the items are received

 Fourth copy – it should be retained by the receiving department.

4. Delivery of materials: these materials may be handled to the using department to the

internal delivery system or to the Store. Finally, whoever is receiving the material will

sing on the receiving report.

Inspection Report: whenever it is necessary to take technical inspection, we may make

sample/all inspection. This depends on the nature of material and/or on the description of those

materials. Based on this technical report, if the material is not useful (partly or wholly) the

purchasing people will notify the supplier how to handle those items. In this case the possible

courses action would be:

1. Return the material to the supplier.

2. Keep some of the more acceptable material and return the rest.

3. Keep all and rework it to the point where it is acceptable.

When is Inspection Justified?

This depends on economies of scale, which is based on two basic costs.

1. Cost of Inspection

2. Costs resulting from defectiveness entering the production operation and/or reaching

customers.

Here the intention is to minimize the process average of these cots.

When P>CI/CD, 100% inspection is desired. Because total losts of inspection is less than

costs of no inspection.
 When P<CI/CD, 0% inspection is preferred.

Even though it is taken 100% inspection, there might be damages or unwanted items found,

and therefore, inspection ranges from 85-95% accurate. On the other hand when taking sample

inspection the summation of the sample average cost is taken in to account.

 Closing the Order

After making the necessary payment to the ventor, Closing an order simply entails a

consolidation of all documents and correspondence relevant to the order in filling them in

closed order file which include a purchase requisition, the open order file of the purchase order,

the acknowledgement, the receiving report, the inspection report and any note or

correspondence pertaining to the order.

Make or Buy decision

How a make or buy decision originates? This decision may originate in any one of the

following events.

i. When we are planning to produce a new product or modifying the existing product.

ii. When the current performance of supplier is unsatisfactory.

iii. Changing demand in the external environment. (increase or decrease of demand.)

Now before buying or making the parts the costs should be evaluated. The relevant costs of

buying are; purchase cost of the parts, transportation costs and receiving and inspection costs.

The cost of making includes; In general,

 Delivered raw material costs

 Direct labor costs

 Incremental managerial costs

 Inventory Carrying costs

 Costs of Capital and

 Opportunity Costs.
Inorder to make a sound managerial decision, we should have to consider the factors

specifically favoring the making or buying decisions.

Factors that specifically favor the making decisions

i. When the cost to make is substantially lower or less than the cost to buy.

ii. When the demand for the product is stable & at a higher value, so that the investment

in equipment can be returned.

iii. When the companies manufacturing experience & equipment are well suited to the

manufacturing of the product.

iv. When the suppliers are unable to meet specifications interms of quality & performance.

v. When the company has idle capacity like, idle space, skilled human resource,

equipment to be utilized in manufacturing the product.

vi. When transportation costs can be saved by gathering local materials to make the

products rather than having made at a distant plant.

vii. When research break through occurs & the company wants to maintain trade secrets

concerning the product, materials in it & the process involved.

Considerations that favor buying than making.

i. When the cost to buy is substantially lower or less than the cost to make the item.

ii. When the demand for the product is fluctuating, creating production problem.

iii. When the quantities of item required is small.

iv. When other companies hold trade secret or patents on a required product so that it is

not possible to make it.

v. When obsolescence makes machine worthless or substantially reduce their value.

vi. When high scrap or spoilage rates are inherent in the manufacture of the product and

when the company is assured of getting the same from suppliers.

Illustration on Buying & Making decision

Organization of Purchasing

The organization of purchasing is usually identified as centralized or decentralized purchasing.

i. Centralized Purchasing

This occurs when the authority and responsibility to handle the material needs of the

organization is given to one department.

Merits of centralized purchasing (Compared to decentralized organization) includes the

following

1. In centralized purchasing all orders goes to one office as a result a better control can be

achieved over purchasing and inventories. It can also take advantage of cash discount &

EOQ (which results in reduced carrying cost and ordering costs).

2. Since orders are consolidated a quantity discount can be taken. i.e.

Order by one
Large Quantity Reduced
department for
 Quantity  discount  Cost
the entire
order
organization
3. There is more opportunity for the purchaser to specialize and concentrate on few

products.

4. The quantity of orders processed in centralized purchasing may make electronic data

processing feasible which may not be profitable in smaller or decentralized purchasing

department.

5. More purchasing power is represented which enables the purchaser to have a better

negotiating position and purchasing power.

ii. Decentralized Purchasing

This occurs when the various departments in the organization are established to satisfy material

needs. It is usually used when branches are located in different parts of a country.
Merits include the following

1. It offers fast action since decision is made close to the using department.

2. It helps to satisfy the differing local needs.

3. Though negotiating with several suppliers has problems interms of quantity discount

and quality, this does considerate the risk and avoid it in case of breakdowns, strikes

and natural catastrophes which may cut-off one source of supplier.

4. Transportation cost may be lower by buying locally from suppliers which are near to

each of the branches.

5. Local goodwill may be generated when buying from suppliers located in the same

community.

iii. Combuterization Purchasing

This occurs when both the centralized and decentralized purchasing are operated in an

organization. Items of high value and those that require high technical analysis and knowledge

of experts are purchased under centralized purchasing. But those items of low value and of

routine use are purchased under decentralization.

Who will determine Quality?

The quality of product is usually determined by the engineering/production department and

purchasing department as follows.

Engineering/production people are responsible to specify the technical aspects of quality (in

collaboration with sales personnel) of material which is meant for production. And other

material using departments should also specify the quality/specification of materials they

require.

The purchasing department then also determine the economical aspect of these materials.
Here the right to challenge should be given or exercised by the purchasing department. This

can be the right to question all materials that are required, to reconsider (reevaluate) the

technical specification for economic reasons. This can be by giving information to the

concerned people which helps to revise the specification. On the other hand this challenge

with one department make the other department to be alert while preparing quality

specifications. Therefore, since the purchasing department personnel have an exposure to the

outside environment it is better to communicate with them while preparing specifications.

Methods of Quality Description

There are various methods of describing the quality of a product. Some of these are:

A) Market Grades:- Grades are a position in scale of qualities and the grade of a

commodity is determined by comparing that product with pre-established agreed upon

standards. (e.g. cotton, coffee, tobacco, hide, etc…)

B) Trade/Brand names:- A brand name is a pledge/promise to customer, because once a

customer can adapt to a particular product, he can not shift unless he found a change in

taste, and other things in it. Sales of a products under a trade/brand name is easy to

describe and is also easy to inspect. Therefore, inspection and description time will be

reduced.

C) Commercial Standards:- A Standard is uniform identification that is agreed upon.

Commercial standards are complete descriptions of a standardized materials.

D) Physical/Chemical Specification:- Specifications are detailed descriptions of the

general features/ characteristics of a particular items that are used to define a specific

product quality. These are listing of materials, components used in making a product.

It is verbal and/or quantitative description. It is one means of communication between

the buyer and the sellers.

 Type of Purchasing

This is the right time aspect of purchasing. The quality of materials affect the price and time

of purchase. Organizations should have time of purchase for their production process, because

materials could have increase/decrease in price seasonably depending on the circumstances.

Here based on time dimension, there are four time based types of purchasing. These are

1. Hand to mouth

2. Current Requirement

3. Forward buying

4. Speculative buying

1. Hand –to-mouth buying

Hand to mouth buying policy is a practice of buying materials to satisfy immediate operating

requirements smaller than those normally considered economical.

Some of the reasons for exercising this method are:

o When there is no enough cash - flow in the organization.

o When there is too much inventory & insufficient storage space.

o When a drop – in prices is expected in the future.

o When an engineering changes are expected in the future.

Advantages:
 It saves money when prices are dropping

 It prevents inventory losses that result due to technological change and

 It provides the firm required additional cash for operating purposes.

Limitations:
 It leads to higher buying and administrative expenses. (ordering costs, price discounts,

etc.)

 There is a risk of running out of stock.

2. Current –Requirement Buying

This is a buying practice in excess of a hand –to mouth quantity. This is the most common

method of buying to satisfy short range requirements. The method obtains the most economical

quantity by using EOQ models which balances the costs, quantity discount, inventory cost,

obsolescence cost… in to account.

3. Forward Buying

This is a buying practice in excess of current requirement by taking in to account the supply

and demand interaction of the operation. It does not include purchases with a view to make a

profit out of it.

Advantages:
 It helps to fulfill known needs at a best price, quantity discount, volume, freight rate etc.

 To achieve the expected profit level, if an organization has a contractual agreement to

supply its products for a specific period, it should have enough inventory inorder to get

constant profit level for its operation.

 It reduces the risk of stock outs.

Limitations:
 Price risk is involved, it may fall.

 Added inventory carrying change.

There are also various reasons for forward buying.

 To provide a margin of insurance for possible strikes from the side of the supplier or

similar developments like carrier interruptions.

 To take advantage of quantity discounts and favorable transportation rates by

consolidating shipments

 To protect the company against risk of forecasted shortage of materials.

 4. Speculative Buying

Strictly speaking speculative is buying materials with the intention of making a profit out of

the transaction by selling the material at higher price later. On the other hand it may also be

bought for own use believing that the foreseeable future need of this material arises.

Responsibilities of Speculative Buying

Buying and selling materials later at higher price is the major source of the company’s income,

and hence the responsibility should also be towards the top executive (GM), because the

survival of the company and the risk associated to these operations is based on such

speculations. On the other hand buying materials to use in the process at later times should be

the responsibility of the top executive depending on the time the material is to be used and the

risk associated to it. If the risk diminishes the lower level executive can have the responsibility,

as the risk increases the responsibility shifts to the higher executive.

Under all buying polices there is a speculation of price to rise, and look for future reduction of

price. In hand to mouth and forward buying we are speculating inorder to protect the company

from paying higher prices in the future, while in speculative buying we are expecting generate

profit out of it.

2.7.5 Discount in Purchasing

The other important factor which can influence the buyer in suppler selection or tender

evaluation is discount. A discount is a reduction allowed by a seller to a buyer when the buyer

meets certain stated condition in buying. The following part will provide the detail explanation

of the most commonly used types of discount in purchasing.

i. Cash Discount

These are given to purchaser who pays their bill on time. It is used as a means of encouraging

early payment before the expiration of the discount period. For example, if the cash discount
is 2/10,net 30. It means the buyer can get a 2% discount when he settles his bills within 10

days; if not he can settle the bills within 30 days without any discount.

ii. Quantity Discounts

This is given to a buyer for purchasing increasingly larger quantity of materials; these can be

obtained because of;

1. For purchasing a specific quantity of item at one time, or

2. For purchasing a specified birr total of any number of items at one time.

3. For purchasing a specified birr total of any number of items over an agreed –up on

time period. (Cumulative discount).

Here the purchaser should take the inventory purchasing policy in to consideration with the

quantity discount, because of the inventory carrying cost of large quantity.

iii. Trade Discounts

These are reduction from list price allowed to various classes of buyer and distributors to

compensate them for performing certain marketing function for the Orignal seller of the

product.

iv. Seasonal Discounts

This is granted for purchasing seasonal nature products during the off-season period. For

example, a winter discount may be given to all summer products.

2.7.6 Selecting the Source of Supply

The essence of purchasing process is the rational selection of sources of supply. In selecting

sources of supply the purchase officer makes decision that influence not only his firms

economic success but livelihood of the supplier and the efficiency of the entire economy.

After the list of possible supplier has been compiled the next step is to evaluate each suppliers

so that the list may narrowed be down the predetermined number with whom the buyer chooses
to place his business. This process of evaluation is conducted by comparing the supplier it

terms of their ability to provide the desired quality, quantity, price and service.

As selection is the essence of the purchasing process it is imperative that final authority rest

with the purchasing department. In some companies improper selection causing inferior goods

and services has resulted in authority being shared with the using department.

The procedure for source selection involves the preparation of an extensive test of prospective

supplier and the successive elimination from the list on various grounds until the number has

been reduced to one or few to be favored with the business. Some of the possible sources of

potential suppliers are. Sales man, trade journals, trade directories, the yellow pages, mail

advertisements, trade exhibitions, other purchasing department/people, supplier catalogues and

supplier information file/won record.

After identifying the prospective suppliers, the next step is selection and evaluation. Now we

can apply both qualitative (subjective) approach and quantitative approaches. The subjective

evaluation approach compares suppliers based on the suppliers ability to provide the desired

quality and quantity, price, and services of the suppliers.

The objective (quantitative) approach stats with identifying the evaluation criteria and

quantifying them. Here there are two methods of quantitative evaluation methods. These are:

A. Weighted Point method

B. Cost ratio method

A. The weighted point method;

In this method the number of factors such as the objectives of the organization, its product and

economic conditions of the organization are included. The relative worth of these factors as

compared to each other will give a composite performance index. The relative worth of these

factors vary form products to products, organization to organization.

The following are the maximum but average points for the best performance.
 Factor Average Points
A. Quality 35

B. Price 30

C. Delivery 20

D. Service 15

The points are allocated based on the nature of the products for example, for toys quantity is

less important but the attraction and price are of main considerations while for air craft

components quality aspect is more important as compared to price.

Note:
This method is used for suppliers who have past relations with the firm because it take past

records in to consideration.

B. The Cost – Ratio method

In this method a list of suppliers service is established in relation to the price. In this method

the objective is to evaluate the suppliers on the basis of proceeding considerations. Here the

highest the ratio of costs to the value of shipment, the lower is the chance of selection for the

supplier and the lower the rating for a suppler. The cost categories that may be used in the

evaluation process will depend upon the type of firm or products.

We should identify elements which express quality, delivery, service and price inorder to

evaluate supplier by finding the cost ratio of each factor. i.e.

1. Quality –cost ratio = Total Quality Cost x 100

Total Dollar of Purchase

2. Delivery cost ratio = Total Delivery Cost x 100

Total Shipment
 3. Price Ratio = Total lowest Price x 100
Actual Price

4. Service cost Ratio - In this case we need to establish a norm or standard of service

requirements and then we can evaluate the supplier to see

whether they fall above or below the standard. Finally we should

relate it to the quoted price.

How to integrate the service ratio to the cost-ratio method?

Inorder to integrate the service ratio to the cost ratio method we may apply the following

procedure;

1. Determine the important subjective service factors & assign numerical weights to each

factor according to its importance to the buying firm.

2. Establish a premium over quoted price that the total subject service package worth.

3. Determine an acceptable norm.

4. Rate the suppliers according to the service factors.

5. Determine by what percentage the supplier being rated is above or below the acceptable

norm.

6. Apply this percentage to the total value of the total service package to determine the

service-cost ratio.

Example:
Suppose you are a purchasing head of a company & you are required to select the best supplier

from among four suppliers named Mr. A, Mr. B, Mr. C & Mr. D by evaluating their last year

performance. Factors of analysis include quality, delivery, service & price. Given the

following data on supplier performance, forward your proposal to higher officials the cost-

ratio method.
Delivery Costs:

(Birr)
A B C D
Telephone Call 400 100 200 300
Telegrams 475 275 425 200
Expediting 875 300 975 750
Premium shipment 750 225 900 950
Miscellaneous 500 300 700 600
Total Delivery Cost 3000 1200 3200 2800

Data related to Quality

(Birr)
A B C D

Visite Vendor Plants 300 500 400 200

Sample approval 400 700 800 600

Incoming Inspection 100 275 250 225

Manufacturing Losses 0 100 325 700

Reworking Cost 0 425 450 400

Value of rejects parts 200 1600 975 675

Total Delivery Cost 10000 3600 3200 2800

Service Rating

(Service Point)
Factor of Evaluation Maximum Point A B C D

A. Financial Stability 20 20 18 15 15

B. Field Service 25 20 21 15 12

C. Labor Relation 10 8 10 10 8

D. Geographical Location 15 10 15 6 0

E. Flexibility in Providing the

 Item with in short period 5 5 5 3 5

F. Expansion Capacity of

the supplier 10 10 8 7 9

G. Warranty Provision 10 8 10 8 0

H. Miscellaneous 5 3 4 0 0

100 84 91 56 49

Assume that the service rating is 60 points and the maximum value of service package is 20%

of price.

Additional information

The total value of shipment (purchase) & the quoted prices are given as follows.

Vendor Total Value of Purchase Quoted Price

A 100,000 Br. 85

B 120,000 Br. 86

C 80,000 Br. 82

A 140,000 Br. 83

Given the above data, which supplier is the best based on the cost-Ratio method.

Solution:
1. Compute the Quality Cost Ratio (QCR) as

QCR = Total Quality Cost

Total Value of Shipment

Supplier QCR

A (1,000/100,000) x 100 1%

B (3,600/120,000) x 100 3%

C (3,200/80,000) x 100 4%

D (2,800/140,000) x 100 2%
 2. Compute Delivery Cost Ratio (DCR) as

DCR = Total Delivery Cost

Total Value of Shipment
Supplier DCR

A (3,000/100,000) x 100 3%

B (1,200/120,000) x 100 1%

C (3,200/80,000) x 100 4%

D (2,800/140,000) x 100 2%

3. Calculate the Service Cost - Ratio (SCR)

Supplier Present rating SCR (% rating x Value of Service)

A 84 (84/60)100 = 140-100 = 40% x20 = 8%

B 91 (91/60)100 = 151.6-100=51.6%x20 = 10.3%

C 56 (56/60)100 = 93.3-100 = -6.7%x20 = -1.33%

D 49 (49/60)100 = 81.6-100 = -18.3% x 20 = -3.67%

N.B. The acceptable service rating is 60 points & the service package is valued at 20% of

price. Inorder to calculate SCR, first determine the percentage by which the rated

supplier is above or below the acceptable norm. For example, for supplier A the

percentage is 40% which means the supplier A is 40% above the acceptable norm. Then

apply this percentage to the total value of the service package to determine the SCR.

A positive sign of SCR indicates advantages. i.e. they will reduce quoted price & a negative

sign indicates under performance. i.e. they will increase the quoted price.

Finally combine QCR, DCR SCR with the quoted price to determine the vendors Net Cost.

1 2 3 4
 Supplier QCR DCR SCR Total Quote Net adjusted price

% % % Cost d Price

adjusted

A 1 3 -8 -4 85 85+(85x.04) = 81.6

B 2 1 -10.33 -6.33 86 86+(86x-0.063)= 80.56

C 3 4 1.33 9.33 82 82+(82x0.0933)= 89.6

D 4 2 3.67 7.67 83 83+(83x0.0761)=89.37

Conclusion- The best candidate is B , Nest is A , 3rd D and 4th C.

VALUE ANALYSIS

This is an attempt to see any material or any component can be substituted or eliminated so as

to achieve the proper function at a lower cost. Value analysis is concerned with scrutiny of the

design function and cost of any product, material or service with the object of reducing cost by

modification of design material specification, more efficient process, change in source of

supply or possibly the elimination of an item or its incorporation in to a related item without

sacrificing reliability and quality.

The two basic conceptual tools in the operation of value analysis are:

1. Design analysis of the required material design analysis in tails a methodical step by

step study of all phases of the design of a given item in relation to the function it

performs. Decomposing on item to its parts so as to see and examine each parts in

relation to their function avoids or eliminate redundant or idle ones.

This can be examined by:

 Can any part be eliminated without impairing the operation of the other unit?

 Can the design of the part be simplified to reduce its basic cost?

 Can design of the parts be changed to permit the use of simplified and less costly

production method?
  Can less expensive, but equally satisfactory materials be used in the part?

2. Cost analysis of the required material cost analysis involves the investigation of the

supplier’s probable cost of producing a given materials.

To get actual selling price of a suppler.

 Construct estimated elemental cost for labor, material, manufacturing overhead and

general overhead.

 Total these cost, to arrive at approximate actual costs of producing for an efficient

producer.

 Make-up reasonable profit and arrive at selling price.

Possible procedure in value analysis

1. Select the material that is right for value analysis.

2. Gather information about the material which includes, drawings, costs, scrap rate etc.

3. Define the prime functions; prime function of a material can be defined using two

words; verb and noun.

Example: A barrel Contain fuel.

A drill makes hole.

4. Estimate the present cost of each function.

5. Generate alternatives, using brain storming-insist people to give new ideas.

6. Evaluate alternatives interms of cost, feasibility, undesirable consequence, etc…

7. Present proposals.

8. IF approval is secured implement the plan; translate the approved proposal to

engineering change order.

In sum, the purpose of value analysis is to bring together the combined talents of purchasers

and its vendors as well as engineers and other operating personnel to review the components

of materials used in the making of the product with the view to improve its function and lower

its cost.