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Purchasing

As already emphasized, all organizations require supplies of materials and services from outside sources. Therefore, purchasing and procurement are common functions in almost all organizations. Purchasing implies the act of exchange of goods and services for money, whereas procurement is a generic term with a wider connotation for the total responsibility of acquiring goods and services. Purchased parts and materials inventories have to be planned, procured and delivered when needed. The real problem, however, is to determine the inventory level which ensures a high rate of return on invested capital as well as satisfy the demands of operating and user departments. In other words, it is always the question of the right quantity. What is the right quantity under a given situation is, however, not easy to answer considering the many problems involved. Consider, for example, the following factors of input storage and output, wherein costs at each of the stages enter into consideration (see Fig. 5.1(a)). This can be more clearly seen from an analogous situation of maintaining an optimum level' of water in a water-cistern when controlled through an 'inlet' and an 'outlet' valve (see Fig. 5.1(b)). The flow of water is controlled in such a manner as to maintain the desired level so that at no time do we run out of water while at the same time ensuring that water does not overflow through greater input, when consumption or output falls. In a production system, what we really do is 'decoupling' of one function from the other in order to see that there is no wastage through overstocking at one unit stock-point as well as that the operation does not stop due to lack of stock. It must, however, be remembered that stock of water is an end in itself, whereas stock of materials inventories is always a means to a given end. Here, we are faced with the problem of estimating the future demand. Although, in doing so, we can very easily know from our past experience, the average value and the limits within which it will, in all probability, fall, yet this may not be an accurate estimate due to many factors which behave in an erratic manner. The problem is: this might hold true for materials which are constantly needed. We have to always have them in stock. When demands are constant and the lead time is also known, the setting up of an optimum inventory level is not difficult. But when this is not so, what is the right quantity is difficult to answer. No straight answer can be given to this question. The present difficulty is that the purchase department might not have any idea what the production is going to plan and produce in future months. Materials Management is almost always concerned with economic decision problems where there are two opposite forces at work. Often two different kinds of costs will have to be balanced, one against the other, if a particular problem is to be solved. For example, Materials Management deciding on optimal level of inventory has to balance the re-order cost against the inventory carrying cost. If it asks for big deliveries of any item which goes into stock, this will reduce the

number of deliveries and so will reduce the re-order cost. However, big deliveries of any item will increase the amount of that item held in stock on an average, and, therefore, will raise the cost of holding or carrying that item in inventory. The optimum level of inventory, therefore, depends on the size and behaviour of one kind of cost as compared to the other. If, on the other hand, smaller inventory leads to shorter production runs, and so to increased production costs, the result of reducing the size of inventories might be to increase overall cost of production. More about these when we come to inventory control, a vexed problem in Materials Management. It must be borne in mind; however, that purchasing is not an end in itself. Materials and supplies are purchased or procured for use in other departments and purchasing department's role is to satisfy their needs within the framework of organizational policy, procedures and objectives. It is primarily a service function, though the modern concept is that its role should be to coordinate one with other phases of the Materials Management operations so as to best serve the common goal. This is quite in consonance with the Materials Management concept, since it stresses the service aspects and recognizes its contributions, and also gives due weight age to the improved performance and methods for implementation of the Materials Management policies of the organization. Therefore, Purchasing is deeply involved in the management of materials flow right from the outside sources down to production through to the inventory pipeline. Basically, purchasing authority is a conferred authority along with a delegation of responsibility. The general principle is that authority should be commensurate with responsibility. Both these criteria are appraised and decided by the management as thought appropriate to the functional responsibility. Purchasing department rarely has any difficulty in exercising its authority and increasing its scope of responsibility in serving other facets of Materials Management. Thus, constant liaison with production, engineering, stores, inspection and quality control, inventory control, traffic, distribution, sales and accounting are all important features of this service aspect. Purchasing is both a science and and art. It is a science because there are certain basic principles of purchasing. The application of these principles, when put into practice, makes the art of purchasing an interesting job. Every purchaser should, therefore, acquaint himself with these basic principles and apply them to his job. PURCHASING PRINCIPLES, PROCEDURES AND PRACTICES Be it either a small-scale industry, medium-scale one or a large-scale industry, purchasing is thought to be one of the most important functions. But, it is a supportive function to production and other user departments. Therefore, it follows that it must provide the service efficiently and economically. Industrial purchasing is, however, entirely different from personal buying practices. Here, there is no room for personal likes or dislikes. All businesses consist of the following ingredients and by coordinating and integrating these, the desired results are achieved. 1. Creation-the idea or product-concept, which is a design function;

2.Capital-financing the operations, that is, resource planning for investment in plant, equipment and other factors of production; 3. Personnel-recruitment of human resources and retaining them; 4. Purchasing-buying of plant, machinery and equipment, materials and services; 5. Conversion-manufacturing process to produce economic goods to satisfy human needs; and 6. Distribution-selling and marketing of goods to ultimate consumers. It has been observed that without successful purchasing at some stage or the other, it is impossible to achieve results for which the business exists. But purchasing practices may vary according to the policy of management, and the size and type of industry. Yet, there are some broad well-recognized principles of scientific buying. Principles and Procedures Basic principles may be enumerated as follows: 1. Buying the right quality 2. Buying the right quantity 3. Buying at the right price 4. Buying from the right source 5. Buying at the right time and place. Accordingly, certain procedures have to be followed, although actual practices may vary according to time and place. Right quality. First and foremost, quality must be properly defined. No general description of the character of the material or desired attributes will be sufficient, like 'high quality' or 'poor or low quality', etc. The definition must be in greater detail and this must be described in the purchase order. This description then becomes the essence of the purchase order. Significant elements like, dimension, physical, chemical and other properties, suitability and purpose must all be clearly stated. Right quantity. This is also one of the basic considerations. It has a special meaning in this context, that is to say, what quantity should be purchased at a time. Since quantity is a mathematical measure, there have been many attempts to determine the optimum quantity which is most economical. Besides this, there are many other considerations which have to be taken into account. However, this will be dealt in further detail in a later chapter. Right price~ Price is not just one of the terms and conditions of the purchase order, but is an important economic consideration which is a guiding factor. A most common equation used in this connection is: Quality /Value = Price This is not just a mathematical formula, but expresses an axiomatic truth that value varies in direct proportion to quality and inversely to the price paid. But

where quality is defined in a specification, it is a constant and the comparison of value can be made in terms of price alone. It follows, therefore, that the lower the price, the greater the value. Right source. Source selection is also an important factor. Besides the factors mentioned earlier, reliability and timely delivery have to be seriously reckoned with. Actually, there are four stages of source selection: 1. Survey stage 2. Enquiry stage 3. Negotiation stage 4. Experience stage. In purchasing, the starting point is the recognition of the need for a material or a product. Though the exact specifications mayor may not be fixed, its general nature and purpose are known. What is available in the market? Who makes such a product? Or, who can make it or supply it most economically or satisfactorily? All these questions must be answered before a supply order is placed. Right time. Right time implies that in order to be effective, purchases should be made, in such a way that stores and materials are made available in time when needed, it being purchasing department's duty to see that the delivery schedule is honoured. As such, timing is an important element in every purchase order, except when such purchases are made for stock purposes. Even then, in order to get some price advantage when some seasonal purchases are resorted to, timing plays its due role. Right place. Right place means right place of delivery. Every purchase contract, in addition to time of delivery, must clearly state the place of delivery and such other terms like free delivery or ex-factory delivery. Generally, F.O.B. (Free on Board), F.O.R. (Free on Rail), CLF. (Cost, insurance and freight) paid terms are part of the price agreement. From these basic principles, fundamental objectives of purchasing follow. FUNDAMENTAL OBJECTIVES OF PURCHASING Fundamental Objectives of Purchasing may be enumerated as follows: 1. to maintain continuity of supply to support production schedules, 2.in doing so, minimum investment in stores and materials inventory must be ensured, consistent with safety and economy, 3.duplication of purchases, wastes, obsolescence and costly delays must be avoided, 4. Proper quality standards based on suitability criteria, must be maintained, 5. Materials must be procured at lowest possible cost, consistent with quality and service requirements, and 6. It must maintain, in so far as materials costs are concerned, company's competitive position in the market.

SCOPE, RESPONSIBILITY AND L1MITATI9NS As stated already, purchasing is a supportive function and, thus, all purchases require authorization-either formal or informal. Sometimes, it may be only in the form of a manufacturing quota for a given period. The purchasing man is informed of this quota, and all that is required is to use his discretion. At other times, it is expressed in a purchase requisition. For standard items in common and repetitive use, he is generally given considerable latitude to exercise his judgment for stocking in advance. His decisions are generally based on experience, rate of usage, sales estimates, etc. In a government department or public institution, purchases are generally governed by the annual budget. Purchases of capital equipment are strictly limited and controlled by special authorization or committee action. In Centralized' Purchases, purchasing responsibility, as all other operating responsibilities, is generally delegated to a specific person or department. This system of purchasing is known as centralized buying. The advantages and disadvantages of centralized buying may thus be summarized in the following sections. Advantages of centralized buying. 1. This ensures better control, since one person or department is responsible, and records pertaining to purchase transactions, commitments, expenditure are also easily available. 2. It develops specialized knowledge, skills and efficiency for economical purchasing. 3.Better performance can be expected from other departments when they are relieved of purchasing responsibility. 4.It diverts influence or domination by other departments and, thus, makes a greater 5.Contribution to profitability and productivity. Disadvantages of centralized buying. 1. It is somewhat slow when different plants require immediate supplies, which due to geographical and locational reasons cannot be affected. 2. Due to such barriers, local purchases are often resorted to and any problem relating to a particular material can be settled on the spot, which is not often possible in a centralized system. SOURCES OF SUPPLY AND SUPPLIER SELECTION This is one of the basic duties of buying personnel, it being the essence of the buying process. It is, however, imperative that final authority should lie with the purchasing department. Procedure involved is to Prepare an exhaustive list of suppliers and then to decide on the most suitable parties. In preparing the list, the following steps should be taken to elicit information.

1. Past" experience with the supplier 2. Interview with salesmen 3. Technical and descriptive catalogues 4. Trade directories and trade journals 5. Visits to trade fairs 6. Consulting trade agencies 7. Open and limited tenders for quotations 8. Periodical advertisements in the Press. PURCHASING POLICY AND PROCEDURES Purchasing policy is largely determined by the finances available, but every organization has its own policy, whether they are put into writing or not. However, an established policy eliminates the necessity of making a fresh decision every time when a comparable situation arises. A written policy ensures that decisions and actions will be consistent and such an approved policy statement gives authority to the purchasing people. Policy must be stated clearly and in unambiguous terms so that it can be easily understood by all. There should be a clear policy regarding the supply sources-whether preference should be given to local suppliers. Policy of maintaining multi-source is almost universal since this overcomes the difficulty in case a particular supplier fails. In some companies reciprocal buying is resorted to as a matter of business policy, though this may sometimes prove uneconomical. Purchasing people, therefore, view reciprocal buying as unscientific. Government policy to purchase from government departments is an example. In order to foster growth and free them from competition from large-scale industries, government policy is also to buy from small-scale and village industries, as far as practicable. Procedure means the manner in which a purchase proposal is carried into effect. Therefore, it involves the functions to be performed by purchasing people from inception to the conclusion of the deal. These functions are briefly enumerated now: 1. ascertaining the need and recognition of it; 2. Accurate statement of specifications, character, quality and quantity requirements with full description; On receipt of the purchase requisition, the buyer obtains quotations and, in many cases, according to the importance of the item, invites tenders or special tenders by advertisement in the press for the supply of the materials required. No purchases are permitted without duly authorized purchase requisitions. In case of materials which are regularly needed in large quantities, generally forward contracts are made in consultation with and approval of higher management. When such contracts are made, a record of orders issued against them and deliveries made has to be kept. These are called open-end purchase orders or blanket purchase orders. Repetitive orders go directly to the supplier

without being processed by the purchase department. The contracts are negotiated for a fixed period with delivery dates, quantities and prices open. In other cases, necessary formalities have to be carried out and processed, like the invitation of quotations, tenders, etc. A good plan is to prepare a schedule of quotations to facilitate comparison and then to decide on a supplier to place the order. Apart from price, due weight age has to be given to such factors as quality and specifications, conditions of delivery (time, place, etc.) and other conditions including terms of payment and trade-discounts. A purchase order form is then written in triplicate. In many cases, details of the general terms like shortages, breakages, spoilages, including suppliers' warranties needed, damages in cases of supply failures, are printed on the back-side of the purchase order. The original one is sent to the supplier, a duplicate copy is sent to the receiving storekeeper, and the third one is retained by the purchase department for reference. Sometimes, it is prepared in quadruplicate or more according to the necessity, and one copy is sent to the inspection department for post-delivery inspection. Three specimen of Purchase Order Forms for stock items, non-stock items and special materials respectively are given here (see Forms A, B and C). Purchase Order For !! (A) is a standardized one and is used only for open-end or blanket purchase orders for bulk purchases on forward contract basis; otherwise, it is similar to (B). Thus, it is seen that a purchase requisition fully describes the needed item(s) and forms the legal basis for a purchase action. As already said, the multicopy form signed by the requisitioned (generally the storekeeper) with authorized signature avoids unnecessary expenditure. Although, the originator may also be a user of the operating department, most of the organizations use a standardized format for the purpose of communication. The two most common forms have been described, a third one needs to be mentioned. It is a traveling purchases requisition, which is used to procure currently needed materials and standard parts that originate either from the stores or from the inventory control section. It is in the form of a card maintained for stocked item. When the stock level of an item drops to the reorder or replenishment level, the card is sent to the purchase department which contains the detailed information of the item, such as, potential supplier, usage rate, order quantities, etc., from which, purchase section makes out the order and then sends it back to the stores section with a colored signal (generally a clip). Upon receipt of the order this colored signal is removed, and the cycle starts again. Product specification. Specifications are detailed descriptions of the characteristics, attributes and other features of a material. They serve the following purposes: 1. They describe the item on the purchase order; 2. They let the supplier know what exactly is required; and 3. They help in verification of the ordered item upon receipt.

There are many types of specifications used to describe a material. Some common types are:

Blueprint. A blueprint or engineering drawing will generally accompany a purchase order where closer tolerance limit or mechanical perfection is required. Market grades. Market grades are used to describe and specify qualities of goods which are generally traded in commodity markets and/or exchanges, e.g. rice, wheat, jute, cotton, cereals, tobacco, etc. Brand or trade names. Brand or trade names are also in vogue in many cases. It depends upon the reputation and reliability of the manufacturer and in such a case, quality and other features are not separately described. Commercial standards. These are developed for a wide range of items above commodity level, such as, bolts, nuts, pipes, fittings and many other electrical and mechanical items. Generally, some standardized specifications and sizes are available in the market. They have the sanction of the government or the semi-government autonomous institutions like the BIS (Bureau of Indian Standards) in India, trade associations or engineering societies which leads to their wide acceptance. Evidently, without such commercial standards massproduction is not possible. Material specifications. These outline the desirable physical or chemical properties of items, such as, metals, basic drugs, paints and varnishes, oils and lubricants, etc. Performance characteristics. When other criteria are not suitable to describe an item, performance specifications are prescribed. This means that the supplier is told what function the product is desired to perform. The performance in service is stressed rather than passing the tests. However, product specifications are generally determined from (a) individual standards developed by the buying organization, (b) private agencies, and (c) government or the national agencies like the BIS. Resource limitations. As already stated, management policy and resource limitations seriously affect purchasing activities. Resources here mean availability of finance. Again, this means that purchasing must operate within the limits of working capital and cash flow position of the company. As such, the right time to buy does not always mean buying on cheaper prices, but the buyer must also take into account availability of funds and credit terms allowed. Often, purchase orders are placed to take advantage of the low prices, neglecting the financial situation, which could subvert the organizational goals. Other resource limitations are: manpower

shortage, shortage of storage space, non availability of handling equipment, etc. Purchasing Outputs Purchasing outputs are not just to select a supplier to award a contract. Rather, they are very much related to policies, data and procedures for future purchases. Each purchase provides some additional information that is useful for future purchases. As such, for improving future purchasing activity, proper records should be maintained, such as: 1. a list of supply sources, 2. a scientific appraisal of supplier performance, 3. cost and price data, 4. a database for make/buy or lease decisions, and 5. a proper evaluation of purchasing performance. Supply sources. There are two primary supply sources, viz. internal and external. The internal source is the company itself and the external sources are the outside suppliers and the market place. A make-or-buy decision is essentially a game between internal versus external supply sources for some specific advantages. This involves many factors, but a major factor is an incremental cost-advantage. However, when a major buying decision is taken by the top-management, outside suppliers become the major source of supply. Outside suppliers are 'shops' of the purchasing department and their products are bought as input materials. If these are not properly available, costs escalate and profits decline. Thus, when selecting a supplier, a buyer should try to find one who would meet the needs of quality, quantity and delivery-time at lowest cost. As already mentioned, supplier selection is a major purchasing activity, and shortages of many basic raw and other materials in the market can create a serious situation which could affect the smooth operation of an organization. Under such circumstances, maintaining good sources of supply has special importance and good vendor relationship needs to be nourished. Market conditions. As is wellknown, short-term situations are strongly influenced by the supply and demand conditions in the market. Thus, during shortages of strategic items in the national economy, it may be more prudent to rely on the availability factor, with price not being a paramount factor in purchasing the item. It may also be noted that purchase procedure depends upon the type of demand for the material. For example, high volume and continuous requirements with high frequency and other factors have to be considered. Different treatments are necessary for items having the necessity for large-volume single order, or for items of small value purchases and normal purchases. Price determination. Obviously, prices vary according to the demand and supply conditions in the market. This again depends upon whether the market is dominated by competitive conditions, monopoly, duopoly or oligopoly. Most of the suppliers set

their prices on cost-plus-profit or market-price basis. Whatever the basis and approach, fair prices should be paid which ensures that supplies will be continuous, in proper quantity and quality. Although, the basic objective of purchasing is to pay the lowest possible price, if fair prices are not paid to suppliers to have sufficient profit margin, suppliers will not show continuing interest in the long run. Published prices in the price-lists, competitive bidding and price negotiations are typical examples of price determination. Many products are sold on the market for which prices are established and pre-determined through manufacturers' or suppliers' price lists. Often, these cannot be questioned. For other items several suppliers are asked to quote the price and the lowest bid is accepted. Normally, at least three competitive bids are obtained to award a purchase contract on the basis of the lowest bid. But, if other factors matter, the lowest bid offer is often superseded. Negotiation is another method commonly used for price determination. Most often the buyer analyzes the cost, profit and price, and then negotiates for a fair price. A good knowledge of the market plus a thorough understanding of the strengths and weaknesses of the other party's position in the market-place is likely to give the buyer an edge. There are three distinct phases of price negotiations. In the first phase, the issue involved is presented. In the second phase, some factors are clarified with reference to the particular purchase deal. In the third phase, an agreement is reached. For successful price negotiations, a buyer must have the necessary skill to negotiate and may often be required to search for another source, which makes the sole source to yield rather than willing to negotiate for a better price. Discounts. Another aspect, which often leads to price-reduction (often through negotiation) are discounts offered and the buyer should be familiar with this. There are many types of discounts, such as, trade, quantity, cash and seasonal, which are offered for many items. A good buyer should take due advantage of such discounts, and securing the best discount means a cost-reduction which may not be a negligible sum when large quantity purchases are made. Often, it is found that list-prices are much higher than the actual selling price and discounts are allowed on the basis of cash payments, trade customs and volumes. Purchase decisions. Thus taking into account many factors like market constraints, organizational restrains, demand factors, etc., a buyer makes a host of purchase decisions which have an impact on the whole operation, finance and other functional areas. It is, therefore, a good practice to see that such important decisions are made to serve the organizational goals of productivity and profitability. Buying locally and reciprocal buying. Even many large organizations buy a substantial number of items locally, since a local supplier is a more dependable supply source than a distant one. Apart from the fact that there are certain definite advantages from the view-point of freight cost, prompt delivery and better after-sales service, buying locally generates good public relations. However, it must also be remembered that while local buying has some social merit, it also restricts the buyer's choice to obtain the

best price, even though it shortens the suppliers' lead time, lowers the re-order point and the quantity of safety stock. Reciprocity in buying is a practice followed by many firms. This is essentially buying from a company which is also a potential buyer of the buyer company's products. Although this is perfectly legal so long as it does not restrain trade unreasonably, it restricts the buyer's freedom of choice, and hence, tends to be uneconomical. Many buyers are, therefore, opposed to this policy, but some top-management tends to like this. But, when it becomes mandatory, it leads to wastes and proves to be an inefficient practice. Delivery terms. The cost of stores and supplies are not always solely determined by the price paid for them. The cost of transportation, handling and delivery charges, etc. is often a substantial part. These are again often sources of legal disputes. If goods are lost in transit, someone must bear the loss and pay for it. Therefore, insurance charges are also included. Moreover, when goods arrive much before they are required, storage and warehousing charges have to be paid. We are always inclined to impute a cost for delayed delivery, but it must be realized that early delivery also increases storage and carrying cost to the organization. Generally, therefore, delivery terms are to be clearly stated in the purchase order mentioning the time, place, etc. There are some common terms which are used in this connection. These are: 1. FO.R. (Free on Rail) 2. F.O.B. (Free on Board) 3. CLF. (Cost, Insurance, Freight Paid) 4. F.A.S. (Free Alongside Ship) 5. F.O.R. seller's plant means that the buyer has to take the risk for loss or damage in transit and the seller's responsibility to deliver. the goods in good condition and at right time ceases after they are handed over to the common carrier, in this case the Railways. The ownership title of the goods also passes to the buyer at the same time.

FO.B. is a shipping term, and generally when it is the seller's plant, the goods are delivered to the loading dock, with the supplier paying the transportation charges and freight. The legal liability is same as in F.O.R. CLF. and F.A.S. contracts are commonly used in international trade.

CLF. Contract price includes cost of materials, insurance and freight and the foreign supplier is responsible for the goods and all charges until the goods arrive at the port of destination. With F.A.S. terms, the buyer designates port, berth and vessel and the foreign supplier is responsible for getting the goods to the ship and the buyer takes the responsibility thereafter.
Timing of purchases.

Timing of purchases is also an important ingredient, as this determines largely the economy in the purchasing operation. A buyer is generally interested in obtaining the best price consistent with quality and delivery requirements. When market conditions are stable, this does not pose any problem to him. But, when it is unstable and market prices fluctuate considerably from day-to-day and month-to-month, the time of purchase becomes critically important. Although the purchaser does not usually control the market, nevertheless he can exert some influence on the market by varying his purchasing operations in response to market conditions. There are different types of purchasing which need to be mentioned in this connection. These can be divided under four heads: 1. Hand-to-mouth buying 2. Averaging down on the market 3. Speculative buying 4. Forward buying. The first type refers to purchases in which only items of immediate requirements are purchased. Purchases which do not relate to shortterm immediate requirements are usually deferred. It is generally preferable when prices are expected to drop. But when other costs are considered, this policy may not be a very prudent one. In the second type the stocks are accumulated when prices are low, and this discourages buying when prices are high. In this way, the buyer averages out a price change. Speculative buying is a term that means just what it says. It is generally followed in order to make some profit arising out of an anticipated price rise. Forward buying is done to obtain favourable prices in excess of current requirements, but not beyond actual requirements in the foreseeable future when prices are expected to be relatively stable. It is generally done in commodity markets. Hedging. To negate the effect of fluctuations of prices in the market, a buyer can resort to hedging. As he is not expected to be right all the times, he enters intp two transactions, one for the present and the other for the future. He pays cash for the former transaction, taking possession of the goods physically, and in the latter case, he enters into a future contract with promised delivery at a specified future date. Should the