CHAPTER THREE

PURCHASING

3.1. Introduction

Purchasing function comprises the essential activities associated with the acquisition of material
used in the operation of an organization. Because all organization requires supplies of materials,
purchasing functions is common in almost all organizations.
Purchasing can be defined as ensuring right quality, quantity, contractual term, time, price,
source, material, and mode of transportation.

3.2. Objectives of purchasing

The standard statement of the overall objectives of purchasing function is obtaining the right
material (meeting quality requirements), in the right quantity, for delivery at the right time and to
the right place, from the right source at a right condition.
The objectives of purchasing can be viewed from:
I. a very general managerial level
II. more specific operational level
I. General managerial level:
From their prospective, relates to the five rights the managements expects the purchasing
department to achieve:
 The right quality
 The right quantity
 From the right supplier
 At the right time
 At the right price
II. Functional level
 To support company operations with uninterrupted flow of materials
- this is the most fundamental of all purchasing objectives
- in a logical sense this is a key reason for the existence of the department
 To buy competitively- Buying competitively involves:

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 - keeping abreast(side by side) of the forces of supply and demand that regulate prices
and availability of materials in the market place
- Understanding of suppliers cost structure computed with an ability to help improve
the cost structure.
Note. A buyer who pays significantly more than his/her competitor does for a given material is
not buying competitively
 To buy wisely: buying wisely involves
- A continued search for better values that yield the best combination of quality service
and price. This in turn involves coordination with users. In users needs and
reconciling users needs with suppliers capabilities
Example: A firm that purchases high-grade bond paper for use in internal office
communications that could be performed as well with less expensive softer stock paper
usually in not buying wise.
Note. It is the combination of buying competitively and buying wisely that typically
contribute most to the profitability of the firm.
 To keep inventory investment and inventory losses at a practical minimum.
- Although maintaining a large inventory is one way to achieve objectives, it is also
costly. Hence, the purchasing department job is to achieve a reasonable balance
because the level of inventory required supporting operations and cost of carrying the
inventory.
- JIT (Just-in-time) production inventory system helps considerably in achieving their
objective.
- Though proper buying, handling, storing, if is also the department is responsible to
minimize losses that occur.
 To develop effective and reliable source of supply.
- It involves the identification, investigation, selection and development of competent
and responsive suppliers.
- Progressive buyers tend increasingly to “buy suppliers’ as opposed to simply “buying
products” which may lead to develop partnering arrangements/strategic alliance with
the suppliers.

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  To develop good relationship with supplier community and good continuing relationship
with active suppliers.
 To achieve maximum integration with other departments of the firm.
- understand material needs of user department
- Support user department in actions like material standardization, forecasting future
prices, performing more or by analysis.
 To hand the purchasing functions proactively. In a professional, cost effective manner.
 To develop policies and procedures which permit accomplishment of the stated
objectives
Note. These objectives apply in principle to all categories of industrial buying.

3.3. Purchasing Policies

Policies are general statements, understanding, and guidelines in making operating decisions that
channel actions toward achievement of the objectives. Policies are areas within which a decision
is to be made and assure that the decision will be consistent and contribute to objectives clarity
and improve relationship with other functions. Purchasing polices are aids for purchasing
decisions. Purchasing policy may be written or not.
There are two approaches of placing purchasing function;
1. Centralized 2. Decentralized
1. Centralized Purchasing
Centralization exists when the entire purchasing function is made the responsibility of a single
person. This person is held accountable for performance of purchasing activities.
Advantage
 Duplication of effort and random practices are minimized by central coordination of a
firms purchase.
 Quantity discounts are made possible by consolidating all company’s orders for the same
and similar materials.
 A firm is able to develop and implement a unified purchasing policy, enabling it to speak
with a single voice to its suppliers.
 Transportation savings can be realized by the consolidation of orders and delivery
schedules.

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  Develops purchase specialists
 Suppliers are able to offer better prices and better service because their sales personnel:
Duplication of selling effort is minimized.
- have fewer people to call on, - fewer invoices to prepare
- fewer shipments to make - fewer financial records to
 Responsibility for the performance of the purchasing function is fixed with a single
department head, there by facilitating management control.
Disadvantage
 Slow decision making
 May not satisfy local interest
 Does not spread risk
Factors affecting feasibility and desirability of centralization
 Similarity of the classes of materials used in each of the departments /plants.
 Size of each individual plant purchasing department when a firm’s individual plant
purchasing department is not large in size, centralization would be advantageous.
 Distance separating individual plants or geographic dispersion of plants the closer a
firm’s plants are situated geographically, the more feasible centralization becomes,
conversely the wider the plants are dispersed, the more serious disadvantageous of
centralization become.

2. Decentralized purchase

Decentralization of purchasing occurs when personnel from other functional areas-operation

marketing, finance, HRM, and so on decide unilaterally on sources of supply or negotiate with
suppliers directly for major purchases.
Advantage
 Speed of operation: there is a possibility of response more quickly to user’s needs and
time delay can be improved.
 Effective use of local resources/local interest
 Plant/department autonomy
Disadvantage
 Losing control

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  Difficulty of obtaining discounts
 Duplication of effort

Factors that favor decentralized purchase

 Single natural raw materials – knowledge of these materials is important

 Technically-oriented firms that are heavily evolved in research

3.4. Purchasing Cycle/ Process/Procedures

A procedure outlines in detail the specifications to be taken to accomplish a given task, within
the guideline of any applicable policies. In short, it establishes the way of doing things.
Purchasing procedure/purchasing cycle/purchasing process comprises the following basic steps.
1. Recognize, define and describe the need (purchase requisition)
2. Verification of purchase requisition
3. Request for Quotation (Bids, price quotation)
4. Evaluation and selection of suppliers
5. Issuance of purchase order
6. Follow up and expediting
7. Receipt, and inspection of materials
8. Checking of invoices and bill payment
9. Completion of the records and files
10. Evaluation of the purchase process

1. Recognition, Definition and Description of need Purchase Requisition (PR)

The need for purchase typically originates in one of a firm’s operating department or in its
inventory control section.
The purchasing department is usually notified of the need by one of the three basic methods;
a. Standard Purchase Requisition (SPR)
b. Material Requirements Planning (MRP)
c. Bill of Materials (BOM)

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 A. Standard Purchase Requisition (SPR)
It is an internal document numbers serially for requests originating in the operating departments.
SPR is used for materials that have to be ordered from suppliers.
This Requisition form includes;
 Material name/code identification
 The amount needed
 Desired delivery date
SPR formats vary widely because each company designs its format to simplify its own
Communication problem. A typical SPR is given below.

Date___________________ Sl.NO________________
Date by which material is required_______
Department___________

Item No Description Qty.

____________ _______________
Inventor Authorized by

The user department generally makes a minimum of two copies-one copy is sent to purchasing,
the other is retained in the using department’s file.
Note. SPR is used
 To ask for materials those are in regular use in the plant and carried out as the stock. This
requisition goes directly to the stores department and the requirements are supplied from
there.
 For items of a repetitive nature and
 For items in which purchases are normally made to replenish (refill) stocks.

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 B. Material requirement Plan (MRP)
MRP is a technique for determining the quantity and timing for the requisition of dependant
demanded items.
C. Bill of Materials (BOM)
It is a complete list of all items incorporated in to a finished product with specifications and
quantity required of each item of materials.

2. Verification of Purchase Requisition

It involves the purchasing department responsibility for

 Checking the document for accuracy and completeness
 Determining that the need has adequately defined
 Ensuring that the appropriate method of description has been used.
3. Request for Quotation (Bids, price quotation)
A request for quotation is a process of initiating potential suppliers that are willing to compete to
supply the required material. The request depends on the type of materials because some
materials need “Request for quotation” and others not.
 Competitive bidding is dictated by five criteria.
i. The dollar value of the specific purchase must be large enough to justify expense to
both buyer and seller.
ii. The market must consist of an adequate number of sellers.
iii. The sellers that make up the market must be technically qualified and willing to
compete.
iv. The specification/description is clear to both the buyer and seller
v. The time available must be sufficient for using competitive bidding
 Competitive bidding should not be used:
 When it is impossible to estimate costs with a high degree of certainty.
 When price are not the only importance variable. Example, quality, schedule and
service also variables of equal importance
 Repetitive and routine purchase
 Items of low value
 Single/few suppliers

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 Invitation For Bids (IFB) or Request For Proposal (RFP) or Request For Quotation (REQ)
includes:
 Purchase description /specification
 Delivery schedule (timing and mode)
 Special terms/conditions
 Eligibility of suppliers
 Bid security (Bid bond and Performance bond)
 Any amendments
 Address for further information
 Purchasing company
 Term of payment
 Last date of submitting bids
 Time, date and place of opening the bid

4. Evaluation and Selection of suppliers

There are two primary supplier sources:

 Internal
 External.
The internal source: - is the company itself.
The external sources: - are the outside suppliers and the market place.
Thus, when evaluating and selecting a supplier, a buyer should try to find a supplier who would
meet the needs of the quality, quantity and delivery time (purchase description and specification)
at lower cost

5. Issuance of purchase order (PO)

Once a supplier has been selected, the purchasing department prepares and issues a serially
numbered purchase orders. Purchase order (PO) is the instrument by which goods are procured
to fill a requirement. Once accepted, it has the legal force of a binding contract.
 The essential information in every purchase order includes.
 Name and address of purchasing company
 Identifying order number

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  Date, number and address of the vendor
 General instructions
 Delivery date required
 Shipping instructions
 Descriptions of materials ordered and the quantity
 Price and discounts
 Terms and conditions (also called boiler plate)
 Signature
 Most companies prepare PO on multipart forms. These multipart forms provide enough
copies of the order to satisfy both internal and external common needs.

6. Follow-up and Expediting

The objective of follow up is to see that the right quality and quantity of materials is received at
the right place and time. This means ensuring that
 Quotations are received on time
 Replies are received on time from suppliers.
 The supplier(s) acknowledge the order and accept the delivery schedule
given.
 Materials are received according to the delivery schedule
Expediting: It is speeding up or accelerating the receipt of the item before the agreed upon time.

7. Receipt and Inspection of Orders

This procedure involves the following activities:

 Unpacking and checking the materials
 Completing the receiving report and distribute to each departments.
 Receive incoming goods
 Sizing the delivery notice presented by the carrier
 Identify and record all incoming materials
 Report their receipt to the purchasing department
 Make prompt desperation of the goods to the appropriate department

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Inspection:
Whenever it is necessary to take technical inspection, we may make sample/all inspection. This
depends on the nature of material and/or the description of those materials.

8. Checking of invoices and Bill payment:

A simultaneous check and review of purchase order the receiving report and the invoices.
 By checking the receipt report against the purchase order the purchaser determines
whether the quantity and type of ordered is received.
 Comparing the invoice with the purchase order and receiving report the firm verifier that
the supplier’s bill is correctly priced and that if covers the proper quantity of acceptable
material
Note. Theoretically, the purchasing department job is completed when the material covered by
the purchase order has been received. Thus, invoice auditing can be handled by accounting
personnel.

9. Completion of the records and files (Closing the order)

Closing the order simply entails a consolidation of all documents and correspondence relevant to
the order.
The completed order is filled in the close order file. In most forms, a completed order consists of:
 The purchase requisition (PR)
 Copy of the purchase order (PO)
 Acknowledgment
 Receiving report
 Inspection report
 Any notes and any notes/correspondence inventorying to the order
The completed order file thus, constitutes records of all activities encompassing the total
purchasing cycle.

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 10. Evaluation of the purchase process
This stage refers to the evaluation of the purchase process against the objective and requirement
of the overall organizational system.

3.5. Make or Buy Decisions

An organization may be in need of different raw materials, parts, components or products which
are processed and/or assembled into a finished product. In sourcing a part or product, it either
purchases from an outside source or the firm may seek to undertake production. Accordingly any
firm has the following three basic alternatives.
i. Buy the parts or products completely from an outside source
ii. Make all the parts or products within the firm
iii. Buy some materials or products and make the remaining.
 Factors influencing make-or-buy decisions
Two factors stand out above all other when considering the make or buy decisions; Cost and
availability of production capacity. There are also certain factors on which make or buy
decisions can be based. Quantity, quality, availability and flexibility of supply, control of trade
secret and patents, research and development, and alternative sources of supply are the important
factors.
 Considerations which favor making
 When the cost to make is substantially lower or less than the cost to buy
 When the suppliers are unable to meet specification in terms of quality and performance
 When the company has idle capacity like idle space, skilled human resource, equipment
 Need to exert direct control over production and/or quality
 Design secrecy required or trade secrets,
 When the experience is well suited to make
 Consideration which favor buying
 When the cost to buy is substantially lower or less than the cost to make
 Suppliers research and specialized know-how
 Small volume requirements

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  Limited production facilities
 Desire to maintain a multiple-source policy
 When other companies hold trade secrets or patents on a required material so that it is not
possible to make it

iii.5.1.Quantitative Analysis of Make-or Buy decision

Example 1: ABC Machine Company produces parts that are shipped nationwide. It has an
opportunity to produce plastic packaging cases which are currently purchased at 8 Birr each.
Annual demand for the product depends largely on economic conditions and this has been
estimated at 37,500.
If the company produces the cases itself, it must renovate an existing work area and purchase a
molding machine which will result in annual fixed costs of Birr 8,000. Variable costs for labor,
materials and per head are estimated as Birr 6 per case.
Required:
a) Should the company make or buy the cases?
b) At what volume of production is it more profitable to produce in-house rather
than purchase from an outside supplier?
Solution:
Total cost of buying TCB = Price x Demand
= Birr 8x37, 500
= Birr 300,000
Total cost of making, TCM = TVC(D) + TFC
= variable cost/unit* x + TFC
= 6 x 37,500 + 8000
= Birr 233,000
Decision  to make (produce) & Amount saved  Birr. 300,000 – 233,000 = Birr 67,000
B. The breakeven point is the volume of production where the total costs to make equal the total
cost to buy
Total Cost of Make = Total Cost of Buy
TVC + TFC = TCB
6 x + 8000 = 8x

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 2x = 8000
X = 4000 units
 For volume below 4000 units  buy
 For volume above 4000 units  make
Example 2
Company produces a cash machine, which uses punch keys. The legs are currently purchased at
Birr 4.2 each. The company is considering producing in house. The labor, materials and
overhead costs are estimated as Birr 2.8 per key and fixed costs would be Birr 5,880. Demand is
estimated as shown:
Demand Probability
D P(D)
2000 0.05
3000 0.10
4000 0.30
5000 0.40
6000 0.15
Required
a) Should the company produce the keys?
b) How much is saved by the division?
c) What is the break even volume where it becomes profitable to produce them rather
than buy from a supplier?
a) Demand, D =2000 x 0.05 + 3000 x 0.10 + 4000 x 0.3 +5000 x 0.4 + 6000 x 0.15
= 4500 units
Cost to buy: Birr 4.2 x 45000 = Birr 18,900
Cost to make: TVC + TFC
= 2.8 x 4500 + 5880 = Birr 18,480
Decision: to make
b) Saved amount: 18,900 – 18,480 = Birr 420
c) TCM = TCB
2.8x + 5880 = 4.2x
4.2x – 2.8x = 5880

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 1.4x = 5880
X = 4200 units

iii.6. Value Analysis

Value analysis is concerned with study of the design function and cost of any
product/material/service with the objective of reducing the design material specification by
modification. The purpose of value analysis is to bring together the combined talent of
purchasers, engineers, and other operating personnel to review the components of material usual
in making the product.

iii.7.Global Sourcing

In connection with the flow of goods and services in the international market, as stated by R.
Jerry Bake(1993 p.2), “boundaries are shrinking and disappearing, and what’s becoming
apparent is that global purchasing and domestic purchasing are flowing, blending, and
converging in to one stream.” The inter dependence of countries is increasingly growing,
however, their advantages may not be of equal terms, and in fact with big gaps, particularly,
between the developed and developing countries.
The reason for sourcing abroad are many and actually vary with the specific commodity needed,
however, the underlying principal and governing reason for using foreign vendor is that better
value is perceived to be available from that source than from a domestic vendor.
Purchasing goods and services of foreign origin can be highly challenging. International sourcing
requires additional efforts when compared with domestic sourcing, though may be with higher
rewards. One of the complexities of buying goods and services of foreign origin is the wide
variability among the production countries in characteristics such as quality, service, and
dependability. With this perception in mind, however, there are common reasons for purchasing
goods and services from international sources as highlighted below.
 Quality: The key reason forwarded by purchasing managers for international sourcing is to
obtain the required level of quality. This is not to imply that there are higher quality products
in the international market than in domestic markets.

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 Price: It actually observed in the international trade additional costs, import duties, and
transportation expenses are required on international sourcing. But, several factors can
influence the issue and be reasons for the specific commodity, such as:
 The labor costs in the producing country may be substantially lower
 The exchange rate may favor buying foreign.
 The equipment and processes used by the foreign vendor may be more efficient.
 The foreign vendor may be concentrating on certain products and pricing.
 Product and Process Technologies: International sources in some industrial products
are more advanced technologically than their domestic counter parts.
 Unavailability of Items Domestically: Some items may only be available in foreign
sources. In such situations there may not be option than depending on foreign purchase.
 Faster delivery and continuity of supply: Because of limited capacity of the domestic
sources, foreign vendor can deliver faster than the domestic supplier. The foreign supplier
may even maintain an inventory of products. In related connection professional buyers
want to develop and maintain an adequate supply base for required materials. It may be
necessary to develop international suppliers in order to have a completive supply base.
 Better Technical Service: If the foreign vendor has a well – organized distribution
network in various areas; better supply of parts, warranty service, and technical advice
may be available than from domestic suppliers.
 Counter Trade: The term “counter trade” refers to any transaction in which payment is
made partially or fully with goods instead of many. Counter trade links two normally
unrelated transactions; the sale of a product in to a foreign country and the sale of goods
out of that country. Under such arrangement countries require their domestic suppliers to
purchase materials in their country as part of the sales transactions, which commonly are
called barter, offsets, or counter trade.
 Tie in with Foreign Subsidiaries: Firms can consciously be made to operate in foreign
countries to support the local, foreign economy by purchasing there and for export to own
country.

Having stated as above, the reasons for the need to undertake international purchasing, the
process is with many challenges and problems. Such problems include:

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o Source location and evaluation – this refers to the costs required to have adequate
information and evaluation on suppliers located abroad, which may be thousands of
miles away.
o Lead/Deliver Time – There can be uncertainties on the lead – time required since
transporting the materials may demand longer period.
o Expediting – additional efforts and resources in terms of financial and personnel may
be needed to know supplier’s personnel and assuring that they are responsive.
o Political and labor problems: There can be a risk of supply interruption due to
governmental problems, say change in government or labor strikes. So the buyer may
need to establish some systems to monitor such concerns.
o Currency fluctuation: Changes in the exchange rates can take place while the
purchasing process in undergoing and payments are incomplete. There can be a need to
be conscious and make arrangements to reduce the effects to the fluctuation.
o Payment terms and conditions: Terms of payments and conditions may substantially
differ from those made with domestic sources. The arrangement may not be easy and
can be with many affecting consequences.
o Culture and communication: Cultural differences can impede purchasing processes
and language difference poses difficulties in communication process.
o Quality: Because locations being distant, it may not be easy to reconcile
understandings on the quality specifications.
o Tariffs and duties: A tariff is a schedule of duties (changes) imposed on the value of
the good imported in to a country, where the rates can differ from country to country
and depending on the type of commodity. The buyer should therefore have the
knowledge on all the different aspects linked with tariffs and duties.
o Higher costs of doing business: The need for translators, communication problems,
the distances involved in making distant sit visits, and others expenses add to the costs
of doing business with international suppliers.
o Legal problems: How to settle disputes in case of failure of either of the parties to
comply with agreements is one problem. The law to be applied should be clearly
specified a head. Different arrangements may be needed and clauses included in the

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agreements. Performance bond may be required; or, a bank guaranty providing for
payment in case of failure to perform according to specified agreements.

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