 PSM 205: INTRODUCTION TO PURCHASING & SUPPLY CHAIN 1.

 PURCHASING AND SUPPLY CHAIN

 Doesn’t everyone know the meaning of Purchasing? Well, we all do it everyday:
purchasing food, newspapers, clothes, petrol, transport services and a thousand other
things.
 There is a big difference between doing something in everyday life and doing it as a
professional .And there is even a difference between doing something as a professional
and understanding it in the way that professional education requires. Organizational
purchasing is a professional discipline based on a foundation of study and research, and
proceeding according to systematic guidelines on the best practice.
 Purchasing

 The activity of acquiring goods or services to accomplish the goals of an organization.

 Purchasing can be defined in various ways, depending on perspective:

 The Purchasing Function of an organization involves the acquisition of supplies or inputs

(raw materials, components, goods and services) to the organization’s activities
(conversion, consumption or resale).
 In some organizations, there is a purchasing department or unit which has responsibility
for carrying out this function, while in others, it may be carried out by individuals and
teams in other departments(such as finance or production) or as part of a larger, more
intergrated cross- functional(organization-wide) structure such as materials
management, logistics management or supply chain management.
 The basic objective or purpose of purchasing is ‘’to buy materials of the right quality, in
the right quantity delivered to the right place at the right time at the right price. These
are sometimes known as the five rights

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 Supply
 It may be defined simply as the act (or process) of providing something or making
something available, often in response to buyer’s or customers’ requirements. It
involves the transfer or flow of goods, services and information from one party (a
supplier) to another (a customer)

 Supply chain management (SCM) is the management of the flow of goods and services. It
includes the movement and storage of raw materials, work-in-process inventory, and
finished goods from point of origin to point of consumption. Interconnected or
interlinked networks, channels and node businesses are involved in the provision of
products and services required by end customers in a supply chain. Supply chain
management has been defined as the "design, planning, execution, control, and
monitoring of supply chain activities with the objective of creating net value, building a
competitive infrastructure, leveraging worldwide logistics, synchronizing supply with
demand and measuring performance globally.

 Procurement
 Procurement is a wider term than Purchasing. Procurement may be defined as the
process of obtaining goods or services in anyway including purchasing, hiring, leasing
and borrowing.
 Procurement, on the other hand, generally includes activities prior to the act purchase,
such as identification and definition of a business need, surveying the market to identify
potential suppliers and gather intelligence (eg on availability, price and technology
developments); sourcing (identifying and selecting suppliers); and the negotiation and
development of contracts. It also includes activities after purchase, including ongoing

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 contract management (ensuring that both parties fulfil their obligation under contract),
supplier relationship management, dispute resolution, contract review and so on.

Procurement process

 The procurement process incorporates both:

 Pre- Contract Award Stages, including identification and definition of need, procurement
planning, development of the contract, market survey and engagement, appraisal and
selection of suppliers, receipt and evaluation of offers and contract award.
 Post –Contract Award stages, including activities such as expediting, payment, contract
or supplier management, ongoing asset management and post contract lesson learning.

The Scope of purchasing

1. To supply the organization with flow of materials and services to meet its needs
2. To ensure continuity of supply by maintaining effective relationship with existing
sources and by developing other sources of supply either as alternatives or to meet
emerging or planned needs.
3. To buy efficiently and wisely, obtaining by ethical means the best value for every
amount spent
4. To maintain sound co-operation relationships with other departments, providing
information and advice as necessary to ensure the effective operation of the
organization as a whole.
5. To develop staff, polices, procedures and organization to ensure the achievement of
these objectives.

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Operational Objectives of Purchasing
 To select the best suppliers in the market
 To help generate the effective development of new products
 To prote ct the company’s cost structure
 To maintain the correct quality/value balance
 To monitor supply market treads
 To negotiate effectively in order to work with suppliers who will seek mutual benefit
through economically superior performance
 To adopt environmentally responsible supply management.

The Purchasing Process (Purchasing Cycle)

The purchasing process is a set of stages or a chain of events, required to make a purchase or
acquisition on behalf of the organization. The main stages in the purchasing process has been
summarized as
 Recognition of need
 Specification
 Make or Buy Decision
 Source Identification
 Source Selection
 Contracting
 Contract Management
 Receipt, Possibly Inspection
 Payment
 Fulfilment of the need.

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  The Five Rights
 RIGHT  DESCRIPTION
  Obtaining goods which are of
satisfactory quality and fit for their
purpose(suited to internal and
external customer’s needs) by
 Accurate specification of
 Quality requirement and quality
standards
 Supplier and buyer-side quality
management
  Obtaining goods in sufficient
quantity to meet demand and
maintain service levels while
 Quantity minimizing excess stock holding
(which incurs costs and risks) by
 Demand forecasting
 Inventory management
 Stock replenishment systems
 IMPORTANCE
 If not achieved:
 Stock may have to be rejected or
scrapped
 Production machinery may be
damaged
 Finished products may be
defective and have to scrapped or
re-worked
 Defective products may reach
customers, resulting in recalls,
returns, compensation claims, lost
goodwill, damaged reputation
 The firm will incur high costs
 If not achieved
 Insufficient stock may be held to
meet demand; stockout may be
cause bottlenecks or shutdowns in
production: idle time, lost
credibility, goodwill and sales.
 Excess stock may be ordered and
/or held tying up capital in idle
stock, wasting storage space etc.
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 Place  Having goods delivered to the
appropriate delivery point,
packaged and transported in such
a way as to secure their safe
arrival in good condition by
 Distribution planning
 Transport planning
 packaging
 Time  Securing delivery of goods at the
right time to meet demand, but
not so early as to incur
unnecessary inventory costs by
 Demand management
 Supplier cost analysis
 Price  Securing all of the above at a price
which reasonable ,fair,
competitive and affordable,
Ideally, minimizing procurement
costs in order to maximize profit
by
 Price analysis
 If not achieved
 Goods may be delivered to the
wrong place, creating delay and
correction costs
 Goods may be subject to
unnecessary transport and
handling( and related costs)
 Goods may be damaged,
contaminated or stolen in transit
 Transport may cause unnecessary
environmental damage
 If not achieved
 Goods may be too late causing
production bottlenecks(and
associated costs) and delays in
delivery to customers( with costs
of damages, lost business)
 Goods may be too early causing
undue risks and costs of holding
inventory)
 If not achieved
 Supplier will be free to charge
what they like without check
 Supplier profit margins will be
squeezed unfairly, leading to
insecurity of supply
 Materials and supply costs will rise
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  Supplier cost analysis  There will be less profit to
 Competitive pricing and motivate shareholders and
negotiation reinvest in the business
 Profits will fall- or prices charged
to customers will have to rise
(losing sales)

 Table 1

Classification of Purchasing Goods

 Van Weele (2010) grouped purchased materials and services into the following
categories:

 Raw material. Raw materials are materials which have undergone no transformation or
minimal transformation, and they serve as the basic materials for a production process.
 Supplementary materials. These are materials which are not absorbed physically into
the end product. They are used or consumed during the production process. Examples
of this type of product are lubricating oil, cooling water, polishing materials etc.
 Semi-manufactured product. These products have already been processed once or
more, and they will be processed further at a later stage. They are physically present in
the end product. Examples are steel plate, plastic foils etc.
 Components. Components are manufactured goods which will not undergo additional
physical changes, but will be incorporated in a system with which there are is a
functional relationship by joining it with other component. They are built in an end
product. Examples are lamp units, batteries, engine parts, electronic parts etc.

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 Finished or trade product. These encompass all products which are purchased to be
sold, after negligible added value, either together with other finished product and/or
manufactured products. Examples of this product category are accessories which are
supplied by a car manufacturers, such as navigation systems, car stereo systems and
alloy wheels and tires. The manufacturers does not produce these products, but obtains
them from specialized suppliers.
 Investment goods or Capital equipment. These are the products which are not
consumed immediately, but whose purchasing value is depreciated over a period of
time. In general the book value is stated on the balance sheet annually. Investment
goods can be machines used in production, but they also include computers and
buildings.
 Maintenance, Repair and Operating Materials (MRO items). These product sometimes
referred to as indirect materials or consumables items, represent materials, which are
necessary for keeping the organization running in general and for support activities in
particular. These products are often supplied from stock; examples are office supplies,
cleaning materials and copy paper but also maintenance materials and spare parts.
 Services. Services are activities which are executed by third parties (supplier,
contractors, engineering firms) or other business units of the company, on a contract
basis. Service can range from providing cleaning services and hiring temporary labour
etc.

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

 Peter Kraljic(1973) developed a tool of analysis that seeks to map two factors
 The importance of the organization of the item being purchased( related to factors such as
the organization’s annual expenditure on the item, and its profit potential through
enabling revenue earning or cost reductions)
 The complexity of the supply market (related to factors such as the difficulty of sourcing
the item, the vulnerability of the buyer to supply or supplier failure, and the relative
power of buyer and supplier the market)
 The matrix Kraljic defines the following types of items:
 (Routine or Non-critical Products) components that have a low impact on the company
and that are found in abundance and / or low-risk markets. For these types of components
typically you choose the delegation of management.

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 With multiplier effects (leverage Products): important for the company but located in
markets with low-risk and offer abundant. As the name implies, the optimal management
of these categories of purchase is necessary to ensure a satisfactory business result; for
these types of components, the company tends to make the most of their bargaining
power and abundance of supply with frequent negotiations.
 Subject to bottlenecks (bottleneck): with a low business impact in economic terms but
where continuity of supply is at risk. The management of these components is aimed at
creating partnerships in the medium to long-term customer and supplier to ensure the
provision, with less emphasis on the cost.
 Strategic: important for the company both in terms of economic impact for the
conditions of supply of complex markets and / or risky. In this field, the horizon is the
medium to long term with a continuous monitoring of the economic situation of the
market, technical development, evaluation of " make or buy ", creation of alternatives and
the development of stable relations and full cooperation with the supplier

 TYPES OF PURCHASE

 According to CIPS, there are three basic types of purchase;

 Straight re –buy
 If a purchase is a straight re-buy of items already sourced from a supplier:
 The buyer may already have a preferred supplier and perhaps a standing purchase
agreement or call- off contract enabling stock replenishment orders without further
investigation or negotiation
 It will not be necessary to establish a specification, or to survey and source the market,
and it may not be necessary to invite quotations or select a new supplier

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  Modified re- buy

 If a purchase is a modified re-buy, in that some of the requirement has changed;

 It may be necessary to re-specify the need or re-negotiate the contract, while using the
same supplier( or vice versa: the specification may stay the same, but a new supplier will
be sought, in order to provide more innovative or better value solutions)
 Modification of the requirement may represent an opportunity to revisit specifications
or contracts, in order to seek to meet business needs more efficiently or effectively.

 New Purchase

 If a purchase is a new buy, which has not been specified or sourced before:
 Purchasing activity is more likely to conform to the full, systematic procurement process
 New identification and specification of requirements represents a key opportunity to
build in business benefits at the product, service or project development stage.

THERE ARE FOUR TYPES OF PURCHASING SYSTEMS:

 Purchase made as per requirement: No purchase is made in advance. Purchase is done

as need arises. Method usually applied for emergency requirement or infrequent goods.
 Contract Purchasing: Contract of material is given to an agency. It has an advantage that
low price of those materials whose cost fluctuates highly.
 Market Purchase: Purchase is made from the market to take advantage of price
fluctuations.
 Schedule Purchasing: It is a cyclic purchase model. A schedule of purchase is made and It
is used for those commodities whose price do not fluctuate.

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 ORGANISATION OF PURCHASING

 Centralized purchasing
 means buying and managing purchases from one location for allocations within an
organization. This can also be run by a central location buying in to a distribution
warehouse that feeds smaller warehouses. This is called a hub and spoke system. The
responsibility and authority to purchase, lease, or rent materials, supplies, goods,
equipment, or services are placed with the Division of Finance and Operations,
Purchasing and Stores Department.

 Purchasing is centralized to:

 •realize economy, efficiency, and effectiveness in the procurement function;
• pursue quality assurance and standardization;
 •maintain the highest standards of ethics;

 The control by a central department of all the purchasing undertaken within an

organization. In a large organization centralized purchasing is often located in the
headquarters. Centralization has the advantages of reducing duplication of effort,
pooling volume purchases for discounts, enabling more effective inventory control,
consolidating transport loads to achieve lower costs, increasing skills development in
purchasing personnel, and enhancing relationships with suppliers.

 Advantages of Centralized Purchasing

 •Volume purchasing – When the district is able to purchase a single item in mass,
vendors are often willing to provide a discount. Purchasing in mass to take advantage of
discounts is called volume purchasing.

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 •Warehouse – In order to take advantage of volume pricing, the district purchases items
in bulk. Vendors typically require that the district take delivery of the items in mass.
These bulk purchases are stored in the warehouse until the items are requested by the
sites.

 •Save time in researching products – Individuals spend hours to research the products
and to find best price. The purchasing department has resources to help reduce the
time to research products.

 Disadvantages of Centralized Purchasing

 •Good processes are not without their shortcomings. Listed below are some of the
challenges of buying and suggestions on how to help the Purchasing department
minimize their effects.

 •Extended procurement time – One problem that is commonly associated with

centralized purchasing is the perception “it takes too long”. In reality, the purchasing
department processes vendor requisitions typically within one (1) day. Typically the
delay in the request is either: time spent to research the product, funding sources
(account code check and budget approval), vendor stock status, and shipping.

 Decentralized purchasing
 is the opposite where each plant or office buys what it needs. This operation allows any
employee to buy what he needs. You can also run this operation with a designated
buyer assigned to the site to do the buying. The more decentralized an operation is, the
less control the home office has. You have a duplication of effort in buying and less
buyer specialization. You lose discounts on quantity buys. You lose freight options based

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 on dollars or weight. Also some support is lost from the supplier as there is no single
contact for the supplier to deal with. Volume buying may not be calculated for all your
sites.

Advantages of decentralized purchasing

 Advocates of decentralization claim that local management has the incentive to control
cost when the local operation is set up as a profit center. Many companies operate with
a mixed system. The central operation may buy major commodities but allow local
operations to buy all MRO supplies. It is difficult to change from decentralized
purchasing to centralized purchasing. Employees feel their privileges are being taken
away. They feel they are losing control of their site. Some will refuse to really cooperate
in the changes in hopes to making the program look unsuccessful.

 Advantages of Decentralized Purchasing

- Materials can be purchased by each department locally as and when
required.
- Materials are purchased in right quantity of right quality for each
department easily.
- No heavy investment is required initially.
- Purchase orders can be placed quickly
 The replacement of defective materials takes little time.

 Disadvantages of Decentralized Purchasing

- Organization losses the benefit of a bulk purchase

- Specialized knowledge may be lacking in purchasing staff.
- There is a chance of over and under-purchasing of materials.
- Fewer chances of effective control of materials.

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 - Lack of proper co-operation and co-ordination among various
departments.

PURCHASED PRICE DETERMINATION.

 Price is what a seller charges for a package of benefits to a buyer.

 Cost is what the buying organization pays to acquire the goods or services purchased. As
we will see, this may be much more than just the purchase price paid to the seller: it will
also include a range of acquisition, installation, maintenance, operating, insurance and
disposal costs. It is also worth noting that the seller also has costs: the finance and
resources it expends in producing and providing goods and services. And a buyer cannot
routinely expect the (purchase) price of goods to be the same as their cost (of
production)-otherwise, the supplier would not make a profit and would be unlikely to
survive.

 Obtaining Prices from Suppliers

There are various methods by which suppliers can communicate prices to buyers or by
which buyers can ascertain the goods they are interested in
 Suppliers may have a standard price list or price schedule available in printed form or
posted online or published within a catalogue. This is common with standard articles
and industrial components. Discounts on list price are often available for bulk purchase
or prompt or early payment.
 Prices may be quoted on request: based on an internal price list (not seen by buyers) or
on specially prepared estimates for the proposed contract. Quotation may be included

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 in a sealed bid or tender by the supplier as part of a competitive bidding process.
Historical data on past quotations (and the price bases and discounts used to calculate
them) should be retained as the basis for future price estimates and comparisons
 Prices may be arrived at through negotiation between the supplier and the buyer based
on price and cost analysis.
 Prices may be determined by competition in an auction( where buyers bid for goods
offered for sale and the highest bid wins) or reverse auction( where suppliers bid to
supply bid to supply goods advertised as wanted and the lowest bid wins). Historical
data on the value of past winning bids may be available as a guide to the price of similar
goods and contracts.
 Prices may be determined by the market eg for commodities and other materials which
are traded in market exchanges: market prices are published on the exchange and in the
national press and trade journals. Historical data will help to identify trends and
fluctuations in market prices which can be used( with caution) to extrapolate future
prices
 Economic indices are published for various price data (including commodity prices) and
cost data (labour costs) indicating changes and trends in average data over time.

Price and Cost Research

A number of sources of market data may be consulted to gather information on market prices
and average costs and factors and trends affecting prices and costs.

Primary data are data collected especially for a particular purpose, directly from the relevant
source: the horse’s mouth, whoever that may be (eg supply chain partners or industry analysts).
Primary research is usually “field research; involving surveys, interviews, questionnaires or
observations. Here are some primary sources of market data on costs and prices.

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  Communication with suppliers: via requests for information or price enquiries; “Meet
the buyer’ events; online supplier/buyer forums; networking at trade conferences and
exhibitions and so on.
 The buyer’s database of market data, including historical records of supplier prices and
cost schedules; market price movement; competitor and industry analysis; price trends
analysis; spend analyses and so on.
 The marketing communications of suppliers: advertising, brochures and catalogues,
visits from sales representatives, websites and so on.
 Online market exchanges, auction sites and supplier/buyer forums, which may also
allow the posting of requests for quotation and other exchanges.
 Advisory and Information Services, including relevant professional institution( such as
CIPS)
 Trade fairs, exhibitions and conferences which may provide opportunities for visitors to
meet supplier representatives, gather relevant catalogues and hear expert industry
analysis and reports.
 Informal networking and information exchange with colleagues, other purchasing
professionals and suppliers.

Secondary data are data which have already been gathered and gathered and assembled for
other purposes, general reference or publication. Here are some secondary sources of data on costs
and prices.
 Financial and trade or industry press( newspapers, magazines, journals ) and specialist
procurement journals( such as Supply Management or procurement Professional) which
may carry market analysis, statistical digests on cost/price trends etc.
 Published economic indices such as the retail price index (RPI), the labour market index
and various commodity price indices.
 Published Statistical Surveys compiled by the government such as

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 - Economic and labour Market Review (monthly)

- Consumer/producer price indices by Ghana Statistical Service

 Price listing and price Comparison websites which allow the gauging of market prices.
In some cases (eg for commodities) market prices will be directly quoted on market
exchanges such as Ghana Stock Exchange.

FACTORS IN SUPPLIER PRICING DECISIONS

 EXTERNAL FACTORS  INTERNAL FACTORS

 Prices charged by competitors: the need to  Costs of production and Sales which must
stay competitive to win business- while be matched by sales revenue in order to
avoiding potentially damaging price wars earn profits

 Extent of competition( market structure) with
little competition, the supplier can charge what
it likes with lots of undifferentiated
competition the market decides the price
 The nature of competition in the market which
may (or may not) be based on price
 Market conditions: levels of demand and
supply, dictating the price that the market will
bear. If demand exceed supply, prices rise; if
supply exceeds demand , price fall
 Customer perception of value: different
 How badly the supplier needs the business
at a particular time( eg to cover fixed costs,
cover the costs of research and
development of a new product, gain
cashflow, reassure shareholder)
 Risk management: eg making provision in
the price to cover unforeseen costs or
changes
 How attractive a particular customer is to
the supplier; pricing low to win or retain
good customers, or high to penalize
unattractive ( eg late- paying, low –
volume) customers.
 Financial position and product portfolio,

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 perceptions of value for money; willingness to
pay a premium for quality and so on.
 Price elasticity of demand: the extent to which
market demand rises or falls with changes in
price
which may (or may not) allow the supplier
to accept occasional losses to secure
business
 Where the product is in its lifecycle eg new
products need higher prices to cover the
costs of research and development

 What a particular( desirable, powerful)  Shareholders’ expectations and managerial

customer is prepared to pay objectives in regard to profit margins

FACTORS IN BUYER’S DECISIONS IN PRICE

 The buying organization’s relative bargaining power in the market and relationship. ( A
monopoly supplier may have power to set prices as it wishes- but if a buyer represents a
large proportion of a supplier’s business, he will be in a strong position to negotiate
favourable prices)
 The number of suppliers in the market and the possibility of substitute products (
enabling the buyer to exploit competition to force prices down)
 The types of purchases: for non-critical or routine products for example , a buyer will
want to secure best price by competitive purchasing while for critical or strategic
products, he may pay more for service and security of supply
 The prices paid by competitors (if this information is available), so that the buyer keeps
his materials costs competitive.
 The total package of benefits offered for the price and whether ‘Value’ is better at a
higher price (given the need for quality, delivery, supplier relationship etc)

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  What the buyer can afford, given the quantities likely to be involved over a given period
 What is a reasonable price based on price analysis
 What is a fair price (ethical and sustainable) price from the buyer’s and supplier’s point
of view.

PRICE AND COST ANALYSIS

When considering the prices quoted by a supplier or offered in negotiation, there are two basic
approaches that a buyer can use to decide whether the price is right.
o Price Analysis
o Cost Analysis

Price Analysissimply seeks to determine whether the price offered is a fair and appropriate
price for the goods. The right price in this sense may be one which is advantageous or
reasonable compared to: the prices offered by other suppliers (competitive tenders or
quotations); the prices previously paid by the buyer for the same goods or services; the market
or going rate; and /or the price of any alternative or substitute goods.

Cost Analysis is a more specialized technique, often used to support price negotiations where
the supplier justifies its price by the need to cover its costs. Cost analysis looks specifically at
how the quoted price relates to the supplier’s cost of production.
Suppliers may be asked to include cost breakdowns with their price quotations, so that:
 Differences between the supplier’s cost breakdown and the buyer’s own analysis or
estimate of the supplier’s costs can be examined to arrive at an agreed cost figure

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  Buyers can identify when suppliers are claiming higher than average or unjustifiable
profit margins
 Buyers can calculate a target price or price range for use in negotiation (based on
suppliers covering their costs plus a reasonable profit margin)

ACCESSING SUPPLIER COST INFORMATION

In a close, long time supply relationship, there may be a policy of:
 Open Book Costing, where suppliers provide information about their costs to buyers, in
order to reassure them that they are getting value for money. In principle, such an
approach is helpful in agreeing cost based prices, and can enable the buyer to help the
supplier to identify potential for cost savings. In practice, however, it is unlikely to
appeal much to suppliers, because the flow of information is all one way- and to the
buyer’s advantage.
 Cost transparency, where both buyer and supplier share cost information, in order to
collaborate in joint cost reduction initiatives. This is arguably a fairer and more mutually
advantageous approach than open book costing- but it does demand a high level trust,
which may only exist within long- term partnership relationships.

UNDERSTANDING COSTS

COMPONENTS OF THE COST BASE

There are three major areas in which a manufacturing business incurs costs.
 Raw materials( and / or components, subassemblies and consumables): inputs to the
manufacturing process
 Labour: the wages or salaries of workers employed by the organization
 Overheads: expenditure which cannot be directly identified with the output of any
particular production item, but is associated with keeping business processes up and
running. Overheads may be sub-divided into production or manufacturing overheads
(electricity, maintenance and set up costs); administration overheads (office expenses

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 and management costs); and selling and distribution overheads (eg marketing,
advertising and sales force costs and storage, transport and logistics costs).

DIRECT AND INDIRECT COSTS

One common way of classifying costs is to distinguish between direct and indirect costs
 Direct Costs are costs which can be directly identified with a specific saleable unit of
output. So, for example, the direct costs of producing the textbook you are reading
include: direct materials( such as paper, ink and glue);direct labour ( wages paid to
employees working on the production of the book) and direct expenses(eg costs of
royalties payable to the author of the book, on a per- copy basis)
 Indirect Costs (or overhead) are expenditures on labour, materials or other items which
cannot be identified with a specific saleable unit of output. For example, the indirect
materials costs of this book might include the oil used to lubricate the printing press;
and indirect labour costs might include the salaries of the shift supervisor and sales
staff.( These costs contribute to all jobs performed by the printing press-not just this
one) such costs are often classified as production overheads, administration overheads
and selling and distribution overheads.

FIXED AND VARIABLE

Cost behavior is the way in which the costs of output are affected by fluctuations in the level of
activity: the volume of production, say or the level of the sales.
 Some costs do not vary at all as the volume of sales or production changes. If an
organization is paying rent on a factory, or paying employees a salary( not based on
output), it will have to pay the same amount for a given period, whether the operating
or not, and however much it is producing. This type of cost is called a fixed cost.
 Some costs vary as the volume of sales or production increases. If an organization uses
raw materials to produce textbooks, say at a cost of Gh¢ 0.40 per textbook, production
of 10,000 textbooks costs it Gh¢ 4,000 but production of 20,000 textbooks costs it Gh¢
8,000. This type of cost is called a variable cost.

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Understanding fixed and variable costs can help the procurement function in various ways.

 Calculating a supplier’s cost structure can help to determine the parameters for
negotiation on price( and other issues, such as cost reduction targets or supplier
development)
 Establishing cost per unit can help in making direct comparisons between different
suppliers
 Understanding variable costs can help to determine economic order quantities,
minimum order units and potential for economies of scale.
 Understanding variable costs can also help a buyer to assess the reasonableness of a
supplier’s proposed price increase( eg on the basis of raw material cost rises)
 Understanding fixed costs can helps in understanding the supplier’s resistance points
and walk-away position in negotiation, because of the supplier’s need to cover fixed
costs.

PROFIT
Profit is the difference between the selling price of a product (or the total revenue earned from
selling a product) and the cost of producing the product. In other words, it is the gain or surplus
left over after the manufacturer or service provider has paid all its costs. Profitability is the
primary objective of most businesses.
Both buyers and suppliers seeks to makes a profit for a number of reasons.
 Profit means that the business has covered its costs and is not ‘bleeding’ money in
losses. This is important for the business to survive in the long term.
 Profit belongs to the owners or shareholders of the business as a return on their
investment: a share of profits is paid to them in the form of a dividend on their shares.
Strong and consistent profits are therefore important to encourage shareholders to
continue to invest in the company, and to maintain the share capital of the company
through a high share price (reflecting market demand for the shares)

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  Profits which are not paid to shareholders (retained profits) are available for
reinvestment in the development of the business, enabling the business to acquire
assets, meet long term borrowings, update plants and equipment and build reserves for
future contingencies- without the cost and risk of borrowing funds for these purposes.

While a buyer will want to maximize its profits for all these reasons, it is also important to allow
suppliers to make a reasonable profit:
 In order to protect the security of supply: not creating financial instability for suppliers,
or driving them out of business by squeezing their profit margins.
 In order to protect the quality of supply: allowing suppliers the revenue and retained
profits they require to maintain quality and develop their business (potentially, to the
benefit of their customers)
 In the interests of corporate social responsibility (CSR) and sustainability: allowing
suppliers reasonable profits in order to protect employment and supplier diversity etc.

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