Purchasing Management

MS 491
Chapter 2 - Lecture 5

Umar Farooq
Department of Management Sciences
GIK Institute
 Background
• Every organization, buys materials, and supplies from
outside suppliers to support its operations.
• As a functional area within a firm, purchasing and supply
management grappled with the stigma of being labeled a
clerical function.
• During the next decade, the supply management function
is likely to contribute to profits more than any other
function in the company.
 Background

• For manufacturing, about 60 percent of the cost of

finished goods comes from purchased parts and
materials.
• For retail and wholesale companies, sometimes
this percentage exceeds 90 percent.
 PURCHASING
Purchasing
Obtaining merchandise, capital equipment; raw materials,
services, in exchange for money or its equivalent.
• Purchasers can be classified into two categories;
Merchant Buyers-
wholesalers and retailers who purchase for resale.
e.g. Retailer, wholesaler
Industrial Buyers-
– Purchasing raw materials for conversion, services, capital
equipment and MRO supplies.
e.g. Manufacturer

• Acquisition of services is widely called contracting.

 The Role of Purchasing in an
Organization
Basic Procurement Objectives or Key purchasing Variable
 The Role of Purchasing in an
Organization
The primary 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.

Purchasing contributes to these objectives by:

 Actively seeking better materials and reliable suppliers,
 Work closely with strategic suppliers to improve
quality of materials, and
 Involving suppliers and purchasing personnel in new
product design and development efforts.
 The Role of Purchasing in an
Organization

• Purchasing
• Obtaining a purchase requisition
• Requesting proposals and quotations
• Evaluating quotations and supplier selection
• Dispatching official purchase orders
• Receiving products and services
• Checking the quality of delivered items
• Payment to vendors
 Procurement
• Term “Supply Management/Procurement” is used in a
broader concept than of purchasing.
• The procurement function can be broken into five main
activity categories:
1. Purchasing
2. Consumption Management
3. Vendor Selection
4. Contract Negotiation
5. Contract Management
 The Role of Purchasing in an Organization
Procurement is an umbrella term
o Spotting internal needs/Need Identification
o Surveying the market
o Find potential suppliers
o Creating an approved list of Suppliers/vendors
o Creating a purchase order
o Requesting proposals and evaluating quotations
o Selecting the right supplier and negotiating effectively
o Receiving goods and performing quality checks
o Developing and managing contracts
o Obtaining invoice approvals and fulfilling payment
terms
o Establishing a good supplier relationship
 Purchasers: Target
• Choose the appropriate suppliers

• Determine the best value

• Get best quality of supplies

• Negotiate the best price

• Award contracts that ensure that the correct amount of

the product or service is received at the appropriate
time.
 Purchasers/Buyers Qualities
• Purchasing managers, buyers, and agents must
become experts on the services, materials, and
products they purchase.

• Evaluate suppliers on the basis of price, quality,

service support, availability, reliability, and
selection.

• Orders are placed and contracts are awarded to

those suppliers who meet the purchaser’s needs.
 Pull and Push Strategy
• What instigates the movement of the work in the system?

• In Push systems, work release is based on downstream demand

forecasts
• Keeps inventory to meet actual demand
• Acts proactively
• e.g. Making generic job application resumes today
• In Pull systems, work release is based on actual demand or the
actual status of the downstream customers
• May cause long delivery lead times
• Acts reactively
• e.g. Making a specific resume for a company after talking to
the recruiter
 Ratios Of Materials Related Costs
• The cost of acquiring, storing, and moving materials is an
increasingly large portion of the cost of goods sold.

• Example: The following are ratios of materials-related costs in

fabrication or assembly industries, for example.
 Cost of purchase = 80 percent of sales
 Cost of marketing (sales) = 10 percent of sales
 Cost of transportation = 10 percent of sales
 The Financial Significance of Supply
Management
Profit-Leverage Effect
• Measures the impact of a change in purchase spend on a firm’s profit
before taxes.
– Purchase spend is the money a firm spends on the purchase of goods and
services.
• The measure is commonly used to demonstrate that a dollar decrease
in purchase spend directly increases profits before taxes by the same
amount.
• But, a decrease in purchase spend must be achieved through better
purchasing strategy that acquire materials of similar or better quality.
• Three options to increase profit
 Increase sales
 Reduce COG (Cost of Goods)
 Cut Operating cost
 The Financial Significance of Supply
Management cont….
• Example:
• Gross sales/revenue = $100 $100
• Cost of Goods(COG) = $50 $40
• Gross Profit = $50 $60
• Fixed cost (20%) = $20 $20
• Total Profit before tax = $30 $40

Cost of Goods(Material + Manufacturing Cost)

 The Financial Significance of Supply
Management
Profit-Leverage Effect
 Increase sales,
 Reduce COG (Cost of Goods)
 Cut Operating cost
• Every dollar saved in purchasing goes straight to the bottom line
(profit)
• Your material purchasing cost is 80% of COG
• 42428 x 80% = $33942
How much 8%
Sales $84167 100% reduction in purchasing
cost will impact our
Cost of Goods Sold(COGS) $42428 50.4%
profit?
Gross Profit $41739 49.6%
Operating Expenses $26950 32% $33942 x 8% = $2715
Income/Profit $14789 17.6%
 The Financial Significance of Supply
Management
Profit-Leverage Effect
• Every dollar saved in purchasing goes straight to the bottom line
(profit)
How much 8% reduction in purchasing cost will
impact our profit?

$33942 x 8% = $2715

Sales $84167 100%

Cost of Goods Sold(COGS) $39713 47.2%
Gross Profit $44454 52.8%
Operating Expenses $26950 32%
Income/Profit $17504 20.8%

8% 18.4% 2715 / 14789 = 18.4%

 The Financial Significance of Supply
Management
Profit-Leverage Effect
Increase sales

How much does marketing needs to sell to get same increase in profit?

+15454

Which is more easier?

8% 18.4%

$2715/17.6 = $15454 Purchasing Sales

• Every dollar saved in purchasing goes straight to the bottom line
(profit)
The Financial Significance of Supply Management
• Return on Assets Effect (ROA)
• Return on assets (ROA) is an indicator of how profitable a
company is relative to its total assets.
• ROI is a ratio of a firm’s net income to its total assets.
• Total assets consist of current and fixed assets.
• Current assets include cash, accounts receivable and
inventory
• Fixed assets include equipment, buildings and real estate
• ROA indicates how efficiently management is using its total
assets to generate profits.
 The Financial Significance of Supply
Management cont….
• Example:
Gross sales/revenue = $100
Cost of Goods(COG) = $50
Gross Profit = $50
Fixed cost or expenses= $20
Total Profit before tax = $30

Total assets = $1000

ROA = Net Profit or Income ÷ Total assets
= 30 ÷ 1000
= 3%
The Financial Significance of Supply Management
• Inventory Turnover Effect
• Shows how many times a firm’s inventory is utilized and
replaced over an accounting period, such as a year.
• A low turnover implies weak sales and possibly excess
inventory.
• ITF = Cost of Goods (COG)/ Average Stock Cost

Gross sales/revenue = $100

Cost of Goods(COG) = $50
Gross Profit = $50
Fixed cost or expenses = $20
Total Profit before tax = $30

Average Stock Cost = 10 %

ITF = 50 ÷ 10 = 5 Times
 The Purchasing Process
• Manual Purchasing - slow system, prone to
duplication of effort and errors.

o Step 1-Material Requisition/Purchase Requisition- stating

product, quantity, and delivery due date are clearly.
Step 2- The Request for Quotation (RFQ) - Buyer
identifies suppliers & issues a request for quotation (RFQ).
o Step 3- Request for Proposal - allows suppliers to propose
new material and technology, thus enabling the firm to exploit
the technology and expertise of suppliers
o Step 4- The Purchase Order (PO)- The purchase order is
the buyer’s offer & becomes a binding contract when
accepted by supplier.
The Purchasing Process
 The Purchasing Process –
e-Procurement
• The rapid advent of Internet technology in the 1990s
spurred the growth of more flexible Internet-based e-
procurement systems
• Step 1- Material user inputs a materials requisition - Relevant
information such as quantity and date needed.

• Step 2- Materials requisition submitted to buyer - At purchasing

department (hardcopy or electronically).

• Step 3- Buyer assigns qualified suppliers to bid - Product

description, closing date, & conditions are given.

• Step 4- Buyer reviews closed bids & selects a supplier

The Purchasing Process
 The Purchasing Process
• Advantages of the e-Procurement System
o Time savings
o Cost savings
o Accuracy
o Real time- The system enables buyers to initiate bids
in real time on a 24/7 basis.
o Mobility- The buyer can submit, process and check
the status of bids regardless of the buyer’s
geographical location
o Trackability
o Benefits to the suppliers- lower barriers to entry and
transaction costs, access to more buyers and the
ability to instantly adjust to market conditions,
 Small Value Purchase Orders
• The administrative costs to process an order can be quite
substantial.
• The cost of placing an order using the manual purchasing system
could be as high as $175.
(Ohmae, K., “The Global Logic of Strategic Alliances,” Harvard Business Review, 143–152. )

• The purchase order value must not be less than small dollar value.
• Small dollar value depending on the size of the firm, $500 to
$1,000 can be considered a reasonable cutoff point.
• Cost to Profit ratio or cost to value ratio.
• Purchasing managers have various alternatives to deal with small
value purchases.
 Small Value Purchase Orders
• Procurement Credit Card/Corporate Purchasing Card (P-Cards) are
credit cards with a predetermined credit limit, issued to authorized personn
of the buying organization.
• e.g. American Express, Diners Club, MasterCard and Visa cards
• The card allows the material user to purchase the material directly from th
authorized suppliers, without going through purchasing.
• At the end of the month, an itemized statement is sent to purchasing, or
directly to the accounting department.
 Small Value Purchase Orders
• Blank Check Purchase Orders: a special purchase order with a
signed blank check attached, usually at the bottom of the purchase
order.
• Due to the potential for misuse, it is usually printed on the check
that it is not valid for over a certain amount, usually $500 or
$1,000.
• The supplier enters the amount on the check and cashes it after the
material is shipped.
• Phasing out blank check purchase orders with the use of
procurement credit cards.
 Small Value Purchase Orders
• Stockless Buying or System Contracting
• The supplier is required to maintain a minimum
inventory level to ensure that the required items
are readily available for the buyer.
• Stockless purchase is an arrangement in which a
supplier holds the items ordered by the customer
in its own warehouse, and releases them when
required by the customer. It is also known as just-
in-time.
• It is stockless buying from the buyer’s perspective
because the burden of keeping the inventory is on
the supplier
 Small Value Purchase Orders
• Petty Cash
• Petty cash is a small cash reserve maintained by a
mid-level manager or clerk.
• Petty cash is a small amount of cash on hand that is
used for paying small amounts owed, rather than
writing a check.
 paying the postal carrier the 17 cents.
 paying $14 for bakery goods delivered for a company's
early morning meeting.
• Material users buy the needed materials and then
claim the purchase against the petty cash by
submitting the receipt to the petty cashier.
 Small Value Purchase Orders
• Standardization and Simplification of Materials and Components
• These concepts can be effectively used in industry to minimize
unnecessary parts, reduce inventory costs, simplify controls and
improve product quality.
• Purchasing department should work with design and engineering
departments to standardize materials and components to increase the
usage of standardized items.
• e.g. Intel’s Systems Group reduced 20,000 active part numbers to 500
part types! Of 2,000 resistors, capacitors, and diodes, they reduced
2,000 to 35 values.
• Simplification refers to reduction of the number of components,
supplies or standard materials used in the product or process.
 Small Value Purchase Orders
• Accumulating Small Orders to Create a Large
Order
• Numerous small orders can be accumulated and mixed into a large
order, especially if the material request is not urgent.
• Purchasing can simply increase the order quantity if the ordering
cost exceeds the inventory holding cost.
• Larger orders also reduce the purchase price and unit transportation
cost.
 Small Value Purchase Orders
• Using a Fixed Order Interval
• Group materials and supplies into categories and
then set fixed order intervals for each category.
• Order intervals can be set to biweekly or monthly
depending on usage.
• This increases the dollar value and decreases the
number of small orders.
 Sourcing Decisions: The Make-or-Buy
• The Make or Buy decision is a strategic decision.
• Factors to be analyzed;
Evaluate whether outsourcing is right for your company;
Determine exactly what functions to outsource and the
performance expectations;
Use a well-defined professional selection process to evaluate
and select which provider(s) are right for the job.
 Sourcing Decisions: The Make-or-Buy

• Outsourcing -buying materials and components from

suppliers instead of making them in-house.
• Outsourcing is a practice used by different companies to
reduce costs by transferring portions of work to outside
suppliers rather than completing it internally.
• Traditionally firms preferred the make option by means of
backward or forward vertical integration
 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- Leadtime transportation, and
warehousing cost
• Lower cost
 Sourcing Decisions: The Make-or-Buy Decision
• Make-or-Buy Break-Even Analysis
 The make-or-buy decision is the action of deciding between
manufacturing an item internally (or in-house) or buying it from
an external supplier (also known as outsourcing).
 Break-even analysis is a tool for computing the cost-effectiveness
of sourcing decisions.
• Several assumptions must be consider for the analysis:
1. All costs involved can be classified as fixed or variable cost.
2. Fixed cost remains the same.
3. A linear relationship exists for variable cost and output.
4. Fixed cost of the make option is higher because of initial capital
investment in equipment.
5. Variable cost of the buy option is higher because of supplier
profits
 Sourcing Decisions: The Make-or-Buy
Decision…Cont
• Example:
• Consider a firm has the option to make or buy a
part. Its annual requirement is 15,000 units. A
supplier is able to supply the part at $7 per unit.
The firm estimates that it costs $500 to prepare
the contract with the supplier. To make the part,
the firm must invest $25,000 in equipment and
the firm estimates that it costs $5 per unit to
make the part.
 Sourcing Decisions: The Make-or-
Buy Decision…Cont
• Example:
• Requirement of parts = 15000 units
• Buy Option: Supplier is able to supply the part at $7 per unit.
The firm estimates that it costs $500 to prepare the contract
with the supplier.
• Make Option: To make the part, the firm must invest $25,000
in equipment and the firm estimates that it costs $5 per unit to
make the part
Sourcing Decisions: The Make-or-Buy
Decision…Cont
Sourcing Decisions: The Make-or-Buy Decision
• For the annual requirement of 15,000 units
Total Cost = Fixed Cost + Variable Cost
 Procurement Terms
• Arbitration – Third party dispute resolution, is a way to resolve disputes
outside the courts.
• Breach/Default – When a contract provision is not met
• Force Majeure – Riots, wars, weather, or other “Acts of God”.
• Unforeseeable circumstances that prevent someone from fulfilling a
contract
• Liquidated Damages – Estimated damages for specific types of
defaults as defined in the contract.
• These are the damages whose amount the parties designate
during the formation of a contract for the injured party to collect
as compensation upon a specific breach (late performance).
• Material Breach – A violation of the contract of sufficient
magnitude that the contract cannot be completed.
• Termination – Stopping the work before it is completed
• Waiver – Statements in the contract that indicate that rights
cannot be ignored or modified without written agreement
between the two parties
 Roles of Supply Base
Supply Base- list of suppliers that a firm uses to
acquire its materials, services, supplies, and
equipment.
• Firms emphasize long-term strategic supplier
alliances consolidating volume into one or fewer
suppliers, resulting in a smaller supply base.
 Preferred suppliers provide:
Early supplier involvement
Information on the latest trends in materials, processes, or
designs
Information on the supply market
Capacity for meeting unexpected demand
Cost efficiency due to economies of scale
 Supplier Selection
• Today the average U.S. manufacturer spends roughly
half of its revenue to purchase goods and services.
• The process of selecting competent suppliers for
important materials, is a complex one and should be
based on multiple criteria.
• A recent cross-industry survey of companies placed
companies’ average total spend per procurement at $115
million.
 Supplier Selection
• Supplier non-performance on even the most basic level can have
dire consequences for the buyer.

• Many product safety issues have been traced back to suppliers

failing to meet a buyer’s requirements.

• Production delays due to parts shortages and recalls of faulty

products have cost buyer firms millions of dollars through recalls,
warranty costs.

• Can severely damage their reputations and future sales potential

 Supplier Selection

Product and process Order System and cycle time

technologies Capacity
Willingness to share Communication capability
technologies and information Location
Quality Service
Cost
Reliability
 How Many Suppliers to use
• Single-sourcing- a risky proposition.
• Poor supplier performance will result in plant
shutdowns or poor quality finished products.
Sole sourcing and Single sourcing
• Sole sourcing typically refers to the situation
when the supplier is the only available source,
• Single sourcing refers to the practice of
concentrating purchases of an item with one
source from a pool of many potential suppliers.
 How Many Suppliers to use
 Reasons Favoring a Single Supplier
• To establish a good relationship
• Less quality variability
oVariability in the quality levels is less than if the parts are
purchased from multiple suppliers
• Lower cost
• Transportation economies
oSingle sourcing concentrates volume, the firm can take advantage
of truckload (TL) shipments.
• Proprietary product or process
oIf the supplier holds the patents to the product or process
• Volume too small to split
oIf the requirement is too small, it is not worthwhile to split the
order among many suppliers.
 How Many Suppliers to use
Reasons Favoring More than One Supplier
• Need capacity
o When demand exceeds the capacity of a single supplier
• Spread risk of supply interruption
o Due to a strike, quality problem, political instability
• Create competition
o Encourages competition to get best price and quality.
• Information
o Multiple suppliers usually have more information about market
conditions, new product developments and new process
technologies
• Dealing with special kinds of business
o The firms may need to give portions of their purchases to small,
local or women or minority-owned businesses, either
voluntarily or as required by law.
 Purchasing: Centralized vs. Decentralized

• Purchasing Organization depends 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.
 Purchasing: Centralized vs. Decentralized
Advantages- Centralization
• Concentrated volume
• The purchase volume to create quantity discounts,
less-costly volume shipments
• Suppliers are willing to give better terms and share
technology due to the higher volume.
• Avoid duplication
• Eliminates the duplication of job functions.
• Specialization
• Allow purchasing professionals to specialize in one
area
• Lower transportation costs
• Allows larger shipments to be made to take
advantage of truckload shipments
 Purchasing: Centralized vs. Decentralized
Advantages- Centralization

• No competition within units

• when different units Purchase the same material,
a situation may be created in which units are
competing among themselves.
• Common supply base
• A common supply base is used, thus making
it easier to manage and to negotiate
contracts.
Purchasing: Centralized vs. Decentralized
• Advantages of Decentralization
 Closer knowledge of requirements
• A buyer at the individual unit is more likely to know its
exact needs better than a central buyer at the home
office
 Local sourcing
• A local buyer will know more about local suppliers
 Less bureaucracy
• Allows quicker response, due to less bureaucracy and
closer contact between the user and the buyer
• Hybrid purchasing organization- both decentralized at the
corporate level and centralized at the business unit level may be
warranted.
 International Purchasing/Global
Sourcing
Global sourcing-
• Opportunity to improve quality, cost, and delivery
performance.
• Requires additional skills and knowledge to deal with
international suppliers, logistics, communication,
political environment, and other issues.
International Purchasing/Global Sourcing
• Various methods are employed for global sourcing.
• Import broker or sales agent- performs service/
transactions for a fee.
• Import merchant- buys and takes title to the goods, and
then resell them to the buyer.
• Trading company- imports & carries wide variety of goods.
• Tariff -is an official list or schedule showing the duties,
taxes or customs imposed by the host country on imports or
exports.
• Non-tariffs-are import quotas, licensing agreements,
embargoes, laws and other regulations imposed on imports
and exports.
 Reasons for Global Purchasing
• Firms expand their supply base to include foreign suppliers for many
reasons.
• Lower Price of Material: Many factors can contribute to cheaper
materials from overseas suppliers.
 Cheaper labor costs and raw materials,
 Favorable exchange rates,
 More efficient processes
 Intentional dumping of products by foreign suppliers
• Quality of Product: The quality of overseas products may be better
due to newer and better product and process technologies.
• Efficient Logistic System: deliver goods faster than domestic
suppliers due to a more efficient transportation and logistical system
 Challenges of Global Sourcing

• Language barriers-Suppliers may not be fluent in your

language, and they may not be comfortable asking for
explanations multiple times.
• It's not just a question of communication - make sure any labeling
or other printed materials are error-free.
• Quality expectations-If you rely solely on overseas suppliers
to determine that quality standards have been met, you won't know
about any problems until after orders arrive.
• One way to prevent that is to conduct quality inspections
• Duty you pay- Tax rate or duties for import and export can be
very high
 Countertrade
• Goods of domestic firms are exchanged for goods of
equal value from foreign firms.
• In countertrade transactions cash does not change hands
• It is used if there is a shortage of hard currency or as a
means to acquire technologies.
• The various forms of countertrade include barter
o No currency convertibility
o Weak reserves prohibit access to hard currency
o Structures an international sale when means of payment
are difficult, costly, or non-existent
 Types of Countertrade

• Counter purchase-is an arrangement whereby the

exporter agrees to sell goods or services to a foreign
importer and simultaneously agrees to buy specific goods
or services from the foreign importer.
• Barter- Barter is the complete exchange of goods or
services of equal value without the exchange of currency.
• Offset- is an exchange agreement for industrial goods or
services as a condition of military related export.
 Types of Countertrade
• Switch Trading : It involves at least three parties.
• This means a country may barter goods from another
country which may be of no use to itself so it sells the
goods to third country for hard cash.
o Brazil exported corn to East Germany (before Unification)
and received products in return. Germany did not use corn
so it sold the corn to other countries for hard cash
• Buyback:
• It occurs when a firm builds a plant in a country - or
supplies technology, equipment, training, or other
services to the country and agrees to take a certain
percentage of the plant's output as partial payment for
the contract.
o BOT contracts (Build, Operate and Transfer)
 Public Procurement
• Public procurement that is completed within
the context of not-for-profit organizations
(NFP’s).
• The procurement that occurs in this context is
typically government affiliated, which can be
central, state, or local.
• Private procurement that is completed within
the context of for-profit organizations (FP’s).
Private procurement happens within privately
owned companies.
 Public Procurement
• Private procurement is typically in FP (for-profit)
organizations, while public procurement functions to
support NFP’s (not-for-profit)
• Invitation to Tender (ITT): An invitation to third
parties to submit offers
• Tendering is the beginning of the contracting process
and serves as an ITT
• Bid/proposal submission and opening
• Requests for Proposals (RFP)
• Request for Quotations (RFQ)
• Bid/proposal evaluation
• Contract award recommendation
• Contract negotiations
• Contract Award (signing)