LUSAKA BUSINESS AND TECHNICAL COLLEGE

DEPARTMENT OF BUSINESS AND EDUCATION STUDIES

PURCHASING AND SUPPLY (ZIPS) - LEVEL ONE

Lecture notes  UNIT THREE (4)

COURSE: principles of procurement and supply

SUB TOPIC: PROCEDURE FOR PROCURING CAPITAL GOODS

(10%)
LECTURER:        Mr. Mukanda

Introduction
This will ensure that you have the knowledge and skill to procure capital goods.

Upon completion of this unit you will be able to:

 Categorise capital goods;

 Undertaking procurement of capital goods;
 Verify availability of funds;
 Recommend procurement of capital goods; and
 Administer a contract.
Capital goods: Capital in the form of fixed assets used
to produce goods, such as plant,
equipment, rolling stock.
Capital All expenditure that is expected to
expenditure: produce benefit to the
firm over a period longer than the
accounting period in which the
expenditure was incurred.
Leasing: A process by which a firm can obtain
the use of a certain fixed assets for
which it must pay a series of
 contractual, periodic, tax deductible
payments.
Hire Purchase: A purchase in which the buyer agrees to
pay for goods in parts or a percentage at
a time.
Outright The purchase where the buying
Purchase: organisation to pay the full price to the
seller.
CATEGORISING CAPITAL GOODS
Definitions
Capital equipment is defined as: One of the subclasses of the fixed
asset category and includes industrial and office machines and tools, transportation
equipment, furniture and fixtures and others. As such, these item: are
properly chargeable to a capital account rather than to expense.
Alternative terms include 'capital goods', 'capital assets' and 'capital
expenditure' which can be defined as follows:
Capital goods
Capital in the form of fixed assets used to produce goods, such as plant, equipment,
rolling stock

Capital assets
Assets used to generate revenues on cost savings by providing production,
distribution service capabilities for more than one year."
Capital expenditure
An expenditure on acquisition of tangible productive assets which yield continuous
service beyond the accounting period in which they are purchased.
All expenditure that is expected to produce benefit to the firm over a period longer
than the accounting period in which the expenditure was incurred.
The definition of Capital Expenditure emphasizes the three important
characteristics of capital equipment, namely:
 Tangibility- capital equipment can be physically touched or handled;
 Productivity - capital equipment is used to produce goods or services; and
 Durability - capital equipment has a life longer than one year.
From the accountancy standpoint, expenditure on capital equipment results in the
acquisition of fixed rather than current assets
Characteristics of capital expenditure

Expenditure on capital equipment differs from that on materials and components

in many ways, including the following:
 the cost per item is usually greater;
 the items bought are used up gradually to facilitate production rather than as
a part of the end product;
 capital expenditure is financed long-term capital or appropriations of profit
rather than from working capital or charges against profit;

 ax considerations, such as capital allowances and investment grants, have

an important bearing on whether or not to purchase capital equipment and
the timing of such purchases
 government financial assistance towards the cost of capital equipment
may be available, such as where a manufacturing organisation is located
in a development area;
 the purchase of capital equipment is often postponable, at least in the
short term
 the decision to buy capital equipment often results in consequential
decisions relating to sales, output and labour - in the latter case,
consultations with the appropriate unions may be necessary.
 It is probable that the terms and conditions of purchase will have to be
tailored to meet the circumstances arising from the acquisition of capital
equipment.

All of these things mean that the purchase of capital equipment is usually more
complicated than that of materials and components, a large proportion of which
can be handled using repeat

Classes of capital goods

There are a number of classification and categorizations for Industrial products:
The following are the six types of Industrial equipment that can be distinguished:
Buildings - permanent constructions on a site to house or enclose equipment and
personnel employed in industrial, institutional or commercial activities.

Installation equipment: (capital equipment, plant) - essential plant, machinery or

other major equipment used directly in producing the goods and services.

Accessory equipment- durable major equipment used to facilitate the

production of goods and services or enhance the operations of organisations.
Installation and accessory equipment often coincide, but there is a distinction.
Aircraft purchased by an airline, for example, would be installation
equipment; aircraft purchased by a manufacturing organisation to facilitate the
movement of executive personnel would be accessory equipment.

Operating equipment- semi-durable minor equipment that is movable and

used in, but not generally essential to, the production of goods and services,
such as special footwear, goggles, brushes and brooms.
Tools and instruments - semi-durable or durable portable minor equipment and
instruments required for producing, measuring, calculating and so on, associated
with the production of goods and services, such as word processors, all tools,
surgical instruments, timing devices, cash registers and other such items.

Furnishings and fittings- all goods and materials employed to fit buildings for
their organisational purposes, such as carpets, floor coverings, draperies,
furniture, shelving, counters, benches and so on, but not that equipment used
specifically in production.

1.4.2 UNDERTAKING PROCUREMENT OF CAPITAL GOODS

Role of buyer in the acquisition of capital equipment

Purchasing capital equipment requires extensive liaison between procurement,

technical specialists and finance to ensure that when a purchase is made the
company/organisation is completely satisfied. So far as procurement is concerned
the following considerations are important:

 It is likely to be a one-off procurement event for which there is no technical

or commercial precedent;
  The specification must reflect the performance required, with sufficient
allowance for the total capacity that may be required;
 The detail to be included in the contract must be established. Some facets of
the contract include: the right to reject for failure to meet the specification;
damages for late delivery; provision of drawings; provision of spare parts
and their cost;
 The price and payment terms (including foreign currency considerations)
must be thought out;
 The lifecycle cost of the equipment must be calculated;
 Supply market research should be conducted to identify potential suppliers;
and
 Disposal of displaced assets should follow a defined process.

Factors to consider when acquiring capital goods

Apart from the mode of purchase, finance and the return on the investment
made, the following factors should be considered when buying capital
equipment.

Purpose - what is the prime purpose of the equipment?

 Flexibility - how versatiûe is the equipment? Can it be used for purposes
other than those for which it is primarily being acquired? –
 Spares - cost, lead times, initial purchase of essential spares, Escrow for
drawings and length of time spares will be provided.
 Standardisation - is the equipment standardised with any already
installed, thus reducing the cost of holding spares?
 Compatibility with existing equipment.
 Life - this usually refers to the period before the equipment will have to
be written off due to depreciation or obsolescence. It is, however, not
necessarily linked to the total lifespan of the item if it is intended that the
asset will be disposed of before it is obsolete or unusable.
 Reliability - breakdowns mean greater costs, loss of goodwill due to
delayed deliveries and possibly a high investment in spares.
 Durability - is the equipment sufficiently robust for its intended use?
  Product quality - defective output proportionately increases the cost per
unit of output. Cost of operation - costs of fuel, power and maintenance.
Will special labour or additional labour costs be incurred? Is
consultation with the trade unions advisable?
 Cost of installation - does the price include the cost of installation,
commissioning and training of operators?
 Cost of maintenance - can the equipment be maintained by your own
staff or will special service support agreements with the vendor be
necessary? What estimates of maintenance costs can be provided before
purchase? How reliable are these?
 Miscellaneous - these include appearance, space requirements, quietness
of operation (decibel level), safety and aspects of ergonomics affecting
the performance of the operator.
 Intellectual progeny rights - who owns the design? Will the 'as built'
drawings be provided?

Acquisition options- New/Used capital goods

Various aspects of new and used equipment and their respective advantages and
disadvantages are examined below.

Used equipment may be either rebuilt or reconditioned. With the former, the
equipment will usually have been stripped down and built up again from the base.
Worn and broken parts will have been replaced and worn surfaces reground and
realigned to meet the original tolerances. The rebuilt machine will also have been
thoroughly tested and will carry a limited warranty. Such machines will typically
cost between 50 and 70 per cent of the cost of a new counterpart.

Reconditioned machines will not have been as thoroughly overhauled as rebuilt

machines. They will, nevertheless, have been cleaned and had all broken or worn
parts replaced and been repainted to look like new. However, the guarantee or
warranty may be less inclusive than for rebuilt equipment. Reconditioned items
generally sell at between 40 and 50 per cent of the cost of new items.
Factors to consider when buying new and used equipment
New Equipment Used Equipment
 Likely to incorporate the most  Less likely to provide
up-to-date technology state of the art
 Will provide maximum capital technology
allowances  Capital allowances
 Will probably provide lower
will be based on
maintenance costs, fewer
problems and better warranties lower acquisition cost
 Procurement Wilf be more
 Maintenance
straightforward, requiring
problems will only
fewer tests and investigations
reveal themselves
 Availability of spares may be when the equipment
better
IS operating
Should be environmentally more
 Manufacturers'
efficient
warranties may not be
 Should incorporate the latest available
safety features  Much used
equipment is sold, as
seen. To avoid
expensive mistakes,
all potential
purchases should be
vetted by an expert
 Difficulties in
obtaining spares may
be encountered

Advantages and disadvantages of used equipment

Advantages Disadvantages
Acquisition costs often significantly lower Equipment may be old, with a
than for new • equipment and may
high risk of early obsolescence
therefore offer a better return on
investment and ratio
Low cost of equipment may be
Equipment may be thoroughly run in and offset by lower productivity,
v

the teething resulting in increased

production costs
troublés associated with néw equipment
eliminated Used equipment may be
available immediately, thus obviating
the time required for the acquisition of
new equipment
Maintenance records should be available
for inspection
Warranties may not be given even when
available
decide whether to buy new or used equipment
New Equipment
New equipment should be bought
When relative efficiency is great
enough
to be important
When the guarantee is better
When better essential service is
provided
When better credit terms are
stated
When longer life is anticipated
When less maintenance is
required
When government finance is
available
When it•is desirable to
strengthen vendor relationships
When repair parts on used
equipment may not be
available
maintenance (not production) departments For better delivery time
when time is essential
When a used machine can be easily modernised or is the latest model
Warranties are generally short and
maintenance costs relatively high
Maintenance records require careful
investigation. Who did the
maintenance? Have any patts been
replaced? Why were they replaced
and when
Used Equipment
Purchase of used equipment
should be considered
When price is important,
either because the
differential between new and
used is vital or the
buyer's funds are low
For use with pilot or
experimental plant
For use with a special or
temporary order over which
the total cost can be amortized
When the machine will be idle
for a substantial
amount of time
For use by learners or
apprentices
For
 When labour costs are unduly
high

Precautions to take when buying used equipment

Although protection is given by the Sale of Goods, Trades
Description and Misrepresentation Acts, the purchaser of used
equipment should work on the principle of caveat emptor - 'let the
buyer beware'. Some questions that a prospective buyer of used
equipment should ask include the following.

Is the history of the equipment available?

Is there any indication of age, such as a serial number?
 How well has the equipment been maintained?
Are spares readily available? Will they continue to be?
How does the price asked for used equipment compare with the cost of buying
new?
Is the vendor well established? Has the vendor got a sound reputation?
What special contractual terms and conditions, if any, apply to the purchase?
Do any guarantees or warranties supersede the protection given under the Sale of
Goods Act?
What trials, test or approval period will the vendor allow?

Will the vendor permit an inspection by an independent assessor?

What will be the cost, where appropriate, of dismantling, transporting and re-
erecting?
Installing equipment?
Financing the acquisition of capital equipment
The acquisition of new or capital equipment may be financed by:

Outright purchase;
Hire purchase; and + 1 Leasing.

Outright purchase

The most obvious acquisition strategy for the purchase of equipment is for
the buying organisation to pay the full price to the seller. The relative
advantages and disadvantages of this strategy are shown below. The effect of
an outright purchase is to increase fixed (equipment) and reduce current
(cash) assets.
The capital cost of acquisition and the revenue cost of maintenance may
adversely affect the working capital of an enterprise and so must, in the long
term, be expected to create a positive
return on the investment. Equipment may have a

Advantages residual or second-hand

value User has total
The total cost, particularly in comparison control over the
to rental, is low
equipment (there may,
 however, be maintenance and Investment in fixed capital
software constraints) Capital' resources Wilf reduce— liquidity
allowances (normally 25 per cent Obsolescence or market
annually on the reducing balance) changes may drastically reduce
may be set against tax residual or second-hand market
expectations Long-term-
commitment to maintenance
and software may be necessary
to protect the capital equipment
investment
Equipment may rapidly become
obsolete and the costs of
Disadvantages upgrading by means of sale,
trade-in or, leasing may be
expensive

Hire purchase
With a hire purchase (HP) agreement, when all the payments have been made,
the business customer becomes the owner of the equipment. This ownership is
transferred either automatically or on payment of an option to purchase fee.

For tax purposes, from the beginning of the agreement the business customer is
treated as the owner of the equipment and can therefore claim capital
allowance. This can be a significant tax incentive to invest in new plant and
machinery.
HP agreements are different from ordinary credit agreements. With an HP
agreement there are certain rules which apply including:
you may not sell the goods until the money's paid off creditors may
ask you to return the goods if you don't make regular payments.
The relative advantages and disadvantages of hire purchase of
equipment are shown below

Advantages Disadvantages
 Provides a compromise between  Financing arrangements
 straight purchase and leasing. Hire impose more restrictions
purchase agreements are easily than when equipment is
negotiated and available
 Subject to such factors as interest purchased outright
rates and the user's rate of return,  Interest rates and the
hire purchase may be more user's rate of return may
financially effective than outright
purchase or leasing make hire purchase a
 The most up-to-date technology tess financially effective
may be hired and used to increase method than outright
the company's productivity and
efficiency purchase or leasing
 After all the payments have been  There will, in general, be
made, the user no opportunity to
upgrade
The disadvantages of
outright purchase as
stated above
 For tax purposes, the
user is, from the
start, regarded as the
owner of the
equipment- and can
claim capital
allowance and VAT
on the equipment
Leasing
Leasing is a contract between the leasing company - the lessor - and the customer,
the lessee.
The leasing company buys and owns the asset that the lessee requires.
The customer hires the asset from the leasing company and pays rental over a
predetermined period for the use of the asset.
There are two types of leases: finance leases and operating leases.

i. Finance lease ii. Operating {eases

The rental covers virtual {y atl the costs of the asset The lease will not
run for the full life of the asset and
 therefore, the value of the asset is
equal to or greater than
90 per cent of the cost of the asset
The leasing company claims
written own allowances whereas
the customer can claim both tax
relief and VAT on rentals
Leasing has both advantages and disadvantages, as listed in table
above.
the lease will not be liable for
its full value
The lessor or the original
manufacturer or supplier will
assume the residual risk
This type of lease is usual for
equipment where there is a
well- established second-hand
market, such as cars or
construction equipment

Other advantages of leasing include easier replacement decisions.

Ownership of an asset sometimes has the psychological effect of
locking the owner into the use of an asset that should be replaced by
a more efficient item of equipment. Leasing is also a hedge against
inflation. The use of the asset is obtained immediately. The payments
are met out of future earnings and are made in real money terms with
the real costs falling over the years.

6
0
Advantages and disadvantages of leasing equipment
Advantages Disadvantages
 Costs are known in advance and cannot be  Fixed obligation to pay
amended without agreement once the rental may create an
lease has been signed embarrassment in
depressed conditions
 Reduced need to tie up capital in fixed  Does not provide the
assets. Use of an asset can be obtained prestige or flexibility of
without capital outlay
ownership
 Leasing is concerned only with rentals
 Large organisations may be
and not with grants, allowances, able to obtain capital or
depreciation or other calculations equal terms with lessors and,
because of a steady flow of
  Leasing provides a hedge against the risk taxable profit, be able •to
of obsolescence obtain the use of capital
allowances for themselves

 The flexibility to
dispose
of obsolete equipment
before the end of the
lease may be reduced

Leasing or buying
In practice, the decision to lease or buy is complicated,
depending on operating, legal and financial considerations.

 Operating factors relate to the advantages of a trial period

before purchase, the immediate availability of cost-saving
equipment, the period for which the assets are required and
the hedges provided against obsolescence and inflation.
 Legal factors are important as the leasing agreements are
one-sided in that most risks are
transferred to the lessee. The lessee should therefore
carefully examine the terms and conditions of the contract,
especially with regard to such aspects as limitations on the
use of the equipment and responsibilities for its insurance,
maintenance and so on. Where possible, improved terms
should be negotiated.

 Financial factors are usually crucial in deciding whether to lease or buy.

These include:
 The opportunity cost of capital- that is, what the purchase price of the
equipment would earn if used for other purposes or invested elsewhere
 The discounted cost of meeting the periodical rental payments over the
period of the lease - note that 'flat' interest rates, calculated on the initial
 amount owing rather than on the average amount owed, can be misleading.
Unit summary
In this unit you learned about categories of capital goods, methods of procurement
of capital goods and financing the acquisition of capital goods.

LUSAKA BUSINESS AND TECHNICAL

COLLEGE
DEPARTMENT OF BUSINESS AND EDUCATION STUDIES
PURCHASING AND SUPPLY (ZIPS) - LEVEL ONE

UNIT THREE (4)

 COURSE: principles of procurement and supply

End of Unit 4 Assignment

Q1. Explain the following terms
i.Capital equipment [4marks]
ii.Capital goods [4marks]
iii.Capital assets [4marks]
vi.Capital expenditure [4marks]
v. Operations expenditure [4marks]
(20 Marks)
Q.2. (a)TK College of Business Management is in the process of being set up.
Explain any Five (5) Classess of capital equipment they need to secure
before they start operations. Give at least one example in each case

(10marks)
(b). Apart from the model of purchase, finance and return on the investment
made. Explain any Five (5) factors that should be considered when buying
capital equipment

10marks)
[Total 20
marks]

Q3. (a). List THREE (3) environment and THREE ethical that a buyer
organisation can consider when evaluation suppliers.
(6 marks)
(b). Describe the following methods of finance capital equipment.
i. Finance lease
(3marks)
ii. Hire purchase
(3marks)
 (c). For each method in (b) above, discuss TWO (2) advantages (8
marks)
[Total 20
marks]
Q4.(a) Explain any FIVE (5) precautions you need to take when making a
decision to procure used equipment
(10 marks)
(b) With the AID of the Kraljic model, explain how supplier can be
categories
(10
marks)

[Total 20 marks)
Q5. (a)Determine any Three (3) methods of acquiring Capital goods
[6marks]
(b). State Three (3) advantages and Five (5) disadvantages of purchasing
used equipment
[8marks]
(c). Analyse Four (4) opportunities where the procurement function can
add value in the procurement of capital equipment [6
marks]
[Total 20
marks)

[Total 100 marks)

Due date:
Lecturer: Mr. Mukanda
Mcips, Mzips – Maven