Chapter Three
Purchasing
Learning Objectives
You should be able to:
– Describe the role of purchasing and understand its
impact on an organization’s competitive
advantage.
– Identify and describe the various steps of the
purchasing process.
– Describe Sourcing Decisions: The Make-or-Buy
Decision
– Describe centralized, decentralized, and hybrid
purchasing organizations and their advantages.
– Supplier selection and Value analysis
2
Introduction
Purchasing-
Obtaining merchandise, capital equipment; raw materials, services, or
maintenance, repair, and operating (MRO) supplies in exchange for money or its
equivalent.
Purchasing –
The activities associated with identifying needs, locating and selecting suppliers,
negotiating terms, and following up to ensure supplier performance
PURCHASING is defined as acquisition of required materials, services and
equipment.
Merchant Buyers-
wholesalers and retailers who purchase for resale.
Industrial Buyers-
purchase raw materials for conversion, services, capital equipment, & MRO
supplies.
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The Role of Purchasing in an
Organization
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
The goals of purchasing are:
1. Ensure uninterrupted flows of raw materials at the lowest total cost,
2. Improve quality of the finished goods produced, and
3. Optimize customer satisfaction.
4. To buy competitively and wisely
5. To keep inventory losses (due to deterioration, obsolescence and theft)
at a Practical minimum level
6. To develop good vendor (seller) relationships and good continuing
supplier Relationships
7. To achieve maximum integration with the other departments of the
firm.
.
4
The Purchasing Process /PURCHASING
PROCEDURES
Needs identification
Description
No
Is there a preferred supplier?
Supplier identification Yes
and evaluation
Supplier selection & contracting
Purchase order preparation
Follow up and expediting
Order
Receipt and inspection cycle
Settlement & payments
Records maintenance
The Purchasing Process
[Link] Identification
Needs identification • Purchase requisition –
An internal document completed by a user that
informs purchasing of a specific need
• Reorder point system –
A method used to initiate the purchase of routine
items. Typically, each item has a predetermined order
point and order quantity
• Statement of Work/Scope of Work (SOW)
–
Terms and conditions for a purchased service.
Includes how supplier will be evaluated
The Purchasing Process
2. Description
The communication of a user’s needs to
Description
potential suppliers in the most efficient and
accurate way possible
• Specification may be Functional, Technical and
Performance
• Description by market grade/industry standard
• Description by brand
• Description by specification
• Description by performance characteristics
• Description by prototypes or samples
The Purchasing Process
3. Supplier Identification and Evaluation - I
The amount of effort increases as:
• The complexity of the product
or service increases
Supplier identification
and evaluation • The amount of money that is
committed increases
• The length of the proposed
buyer-supplier relationship
increases
Objective:
Build the best supply team ever!!!
Supplier Selection
A Four-Step Process
• Supplier Identification Universe of Potential Suppliers
• Supplier Evaluation Not all supply
relationships are
created equal!!!
• Approved List
• Supplier Performance Monitoring Suppliers of Choice
Universe of Potential Suppliers
Supplier Identification
Where to begin? “Suppliers of Choice”
Sources of Information:
• Current Suppliers
• Buyer's Previous Experience
• Purchasing Database
• Internal Contacts
• External Contacts
• Purchasing Consortiums
• Directories
• chamber of commerce
• Trade Publications
• Trade Associations & Trade Shows
• The Web
Universe of Potential Suppliers
Supplier Evaluation
What issues should be evaluated?
How can information be obtained? “Suppliers of Choice”
How can suppliers be compared?
Evaluation Criteria:
• TOP Performance
• Management Capability Information Gathering:
• Workforce Capabilities • Supplier Database
• Cost Structure • Other Buyer’s Experience
• Quality Systems • Benchmarking Data
• Process Control Capabilities • RFI
• Technological Capabilities • Supplier Survey
• Financial Stability • Facility Visit/Audit
• Information Systems Capability
• E-commerce Readiness Comparison Approaches:
• Upstream Management Capabilities • Intuition
• Long-term Partner Viability • Weighted-factor Model
• Environmental regulation compliance • Expert System
The Purchasing Process
Supplier Selection/Approved purchasing Methods
• Competitive bidding/open Tender
• Limited Tendering
• Two-stage Tendering
• Request for proposal
• Request for quotation
• Single source procurement
• Negotiation
• Contracting
Cont…
Competitive bidding is most effective when:
• The buying firm can provide qualified suppliers with clear
descriptions of the items or services
• Volume is high enough to justify the cost and effort
• The firm does not have a preferred supplier
Negotiation is most effective when:
• The item is new or technically complex with only vague
specifications
• The purchase requires agreement about a wide range of
performance factors
• The supplier must participate in the development effort
• The supplier cannot determine risks and costs without input
from the buyer
Cont…..
Contracting is most effective when:
• There is a large amount of money involved
• The business needs specific requirements that need to be put
into writing such as quality levels, delivery times
• Two basic types of contracts:
• Fixed-price – price does not change for life of contract
• Cost-based – price tied to cost of selected key input or
economic factor
Universe of Potential Suppliers
Supplier Evaluation
Method
Weighted-Factor Analysis “Suppliers of Choice”
Factor Weight Saturn
Apollo Artemis Athena Hermes
Supplier Score 1.00
Example. 1
Factors WEIGHTS MEASUREMENT
Quality 40 Number of acceptable lots
Total lost received
Service 25 Lots received as promised
Total lots received
Price 35 lowest net price
Net Price
VENDOR A VENDOR B
Shipped 58 lots/2 rejected Shipped 34 lots/4 rejected
Price $1.07/unit Price = $0.93/unit *
55 lots received as promised 29 lots received as promised
Cont…..
Solution
Performance Vender A Vender B
rating
Percentage of good lots 56/58 X 100% = 96.5% 30/34 X100% =88.23%
(Quality rating) = 96.5% x 40 = 38.6 =88.23% X 40 =35.29
A's price performance 0.93/$1.07 x 100% 0.93/0.93 X100%
Price rating 86.9% =100%
= 86.9% x 35 = 30.4 100%X35=35
Service = 55/58 x 100% =94.8% 29/34X100%=85.29%
Service rating 94.8% x 25 = 23.7 85.29%X25=21.32
Total score 92.7 91.612
Accordingly vender A is the one w/c will be selected as a best
supplier
Approved List
How Many Suppliers Do You Need?
Single Source: Multiple Source:
• Greater responsiveness • Competition leads to . . .
• Higher quality . . . lower prices
• Improved/faster product design . . . better service
• Greater economies of scale • Reduced risk of shortages
• Reduced inspection costs • Meet local content rules
• Reduced administrative costs • Hedge technological risk
• Asset specificity dictates • Learn from different suppliers
Universe of Potential Supp
Factors Influencing the Decision:
• Purchasing philosophy of the buyer
• Technological sophistication of item
• Characteristics of the market
• Supplier capabilities “Suppliers of Choice”
The Purchasing Process
The Order Cycle
• Purchase order preparation
74% of firms currently have electronic
data interchange (EDI) with some part of
their supply base
Purchase order preparation
• Follow-up and expediting
Follow-up and expediting • Receipt and inspection
Receipt and inspection • Invoice clearance and payment
Settlement and payment • Records maintenance
Records maintenance
IMPORTANT ISSUES IN PURCHASING
Sourcing Decisions: The Make-or-Buy Decision
• Outsourcing -buying materials and components from suppliers
instead of making them in-house. The trend has moved toward outsourcing.
• Backward integration refers to acquiring sources of supply
• Forward integration refers to acquiring customer’s operations.
The Make or Buy decision is a strategic
decision.
Sourcing Decisions: The Make-or-Buy
Decision- Cont.
Reasons for Buying or Outsourcing
• Cost advantage: Especially for components that are non-vital to the
organization’s operations.
• Insufficient capacity: A firm may be at or near capacity.
• Lack of expertise: Firm may not have the necessary technology and
expertise.
• Quality: Suppliers have better technology, process, skilled labor, and the
advantage of economy of scale.
Sourcing Decisions: The Make-or-Buy
Decision- Cont.
Reasons for Making
• Protect proprietary technology
• No competent supplier
• Better quality control
• Use existing idle capacity
• Control of logistics- lead-time transportation, and
warehousing cost
• Lower cost
Sourcing Decisions: The Make-or-Buy
Decision- Cont.
Reasons for Buying
• When the cost to buy is substantially lower or less than the
cost to make the item.
• When the demand for the product is fluctuating, creating
production problem.
• When the quantities of item required is small.
• When other companies hold trade secret or patents on a
required product so that it is not possible to make it.
• When obsolescence makes machine worthless or
substantially reduce their value.
• 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
• ABC metal work company produces parts that are shipped nation wide.
It has an opportunity to produce plastic packing cases which are
currently purchase at 0.70 Br. each. Annual demand for the product
depends largely on economic conditions & this has been estimated at
45,000 units. If the company produces the cases itself, it must re-
innovate on existing area & should purchase a molding machine which
will result in an annual fixed cost of 12,000 Br. Variable costs for labor,
material & factory overhead are estimated at 0.65 Br./case.
• Required:
• Should the company Make or Buy the cases.
• At what volume, it is more profitable to produce in house
rather than purchase from an outside suppliers.
Cont…..
Since the cost of buying is less than cost of making the company should buy
the cases because there is a cost saving of 9,750 Birr.
Cont…..
Therefore, it is more profitable to produce the items in house
rater than purchase at any volume of greater than 240,000 units.
The Make-or-Buy Break-Even Analysis
2. Organization of Purchasing
Centralized vs. Decentralized
Purchasing Organization dependent
on many factors, such as market
conditions & types of materials
required.
– Centralized Purchasing- purchasing
department located at the firm’s
corporate office makes all the
purchasing decisions.
– Decentralized Purchasing-
individual, local purchasing
departments, such as plant level,
make their own purchasing decisions.
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Purchasing: Centralized vs.
Decentralized
Advantages- Centralization Advantages- Decentralization
– Concentrated volume- leveraging – Closer knowledge of requirements
purchase volume – Local sourcing
– Avoid duplication – Less bureaucracy
– Specialization
– Lower transportation costs
– No competition within units
– Common supply base
A hybrid purchasing organization- both decentralized at the
corporate level and centralized at the business unit level may be
warranted.
3. Who will determine Quality?
• Quality description performs three main purposes.
– It makes it possible to describe the items listed on the
Purchasing Order.
– It makes the supplier know exactly what type of
material, and
– It serves as a basis of inspection
• Methods of Quality Description
– Market Grades
– Trade/Brand names
– Commercial Standards
– Physical/Chemical Specification
– Performance Specification
Cont…..
• Chemical specifications. Explain the nature of
material and how it reacts in relation to another
materials and environment.
• Physical specification. Explain the size and
dimension of the materials such as length, weight,
thickness etc.
• Material specification. Explain from what materials
the product is made such as wood, plastic, steel etc.
• Method specification. It explains the method used
to in making a product i.e. manual, mechanical etc.
• Blue prints. These are special types of specifications
used for construction. Blue prints are usually
diagrams and illustrating of building and other
construction items.
Type of Purchasing
• There are four time based types of purchasing
1. Hand to mouth
2. Current Requirement
3. Forward buying
4. Speculative buying
Cont…
1. Hand –to-mouth buying
• It is not a recommended policy for normal
operations of the typical buying firm
• The policy seems appropriate whenever there are
plenty of supplies and the price of he item in
question is likely to decline larger purchases are ten
postponed until the price level is lower and a saving
occurs.
• Hand-to-mouth buying policy can be more effective
and facilitated through speedy communications,
rapid transportation, and an increasing degree of
decentralization of production facilities.
Cont….
2. Buying According to Current Known Requirements
• This is a purchasing schedule strictly based on the volume
of the firm’s current needs and disregarders the behavior
of the market in which the purchase is made.
• It is designed to cover only the buying firm’s materials
requirements that are definitely known, it is considered
by many firms to be the best approach when dealing with
a market involving price risks.
• Firms’ scheduler purchases by forecasting production. It
is most frequently used by most firms when there is
relative price stability and in buying important
production materials
• Although the time coverage varies form firm to firm, a
period of 1-3 months is the common practice.
Cont….
3. Forward Buying
This is the practice of buying materials in a quantity
exceeding specified current known requirements
but not beyond the actual foreseeable
requirements.
[Link] Buying
• This is buying an item at a price with the intention
of profiting on the transaction by selling it at a
higher price.
• The distinction between forward buying and
speculative buying lies in the reason for making the
advance purchases.
Cont…
• Times Covering in Months
– Hand – to- Mouth buying policy (takes 0-1 months)
– Buying to requirements policy (takes 1-2 months)
– Forward buying policy (takes 3-12 months)
– Speculative buying policy (takes more than one year)
• The selection of buying policies depends largely
on:
– The General economic conditions,
– The buying firms probable needs,
– The decision maker’s and his assistant skill in
forecasting, etc.
Discount in Purchasing
I. Cash Discount
II. Quantity Discounts
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
Original seller of the product
IV. Seasonal Discounts
VALUE ANALYSIS
• Value Analysis is an effective tool for cost
reduction and the results
• 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.