3CHAPTER THREE-purchasing
3CHAPTER THREE-purchasing
3CHAPTER THREE-purchasing
PURCHASING
3.1 Meaning of Purchasing
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 – price, quality, contractual term, time, source,
material, mode of transportation and attitude for all organizations (big or small, business or non
business, public or private) depend on varying degrees for materials and sources acquired
through a group of activities known as procurement.
There are two basic types of purchasing in business
i. Purchasing for sale is performed primarily by merchants.
ii. Purchasing for consumption or conversion are called industrial buyers or
purchasers. This term includes buyers for
a. Manufacturing firms
b. Service businesses
c. Institutions (school, hospitals, etc._
d. Government agencies
Is purchasing involved in your personal life? Explain how or why not
3.2 Objectives of purchasing
The overall objectives of purchasing function is ensuring the 6Rs (obtaining the right material
(meeting quality requirements), in the right quality, for delivery at the right time and to the right
place, from the right source at a right condition).
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1. General managerial level:
From their prospective, relates to the 6 rights the managements expects the purchasing
department to achieve:
Note. It is the combination of buying competitively and buying wisely that typically
contribute most to the profitability of the firm.
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d. 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 the
level of inventory required for supporting operations and cost of carrying the
inventory.
- JIT (Just-in-time) production inventory system helps considerably in achieving their
objective.
- Through proper buying, handling, storing, it is possible to minimize losses that can
occur.
e. 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
their suppliers.
f. To develop good relationship with supplier community and good continuing relationship
with active suppliers.
g. 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.
h. To hand the purchasing functions proactively in a professional and cost effective manner.
i. 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.
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There are two approaches of placing purchasing function;
I. Centralized II. Decentralized
I. Centralized Purchasing
Centralization exists when the entire purchasing function is made the responsibility of a single
unit. This unit 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 cost savings can be realized by the consolidation of orders and delivery
schedules.
Develops purchase specialists
Suppliers are able to offer better prices and better service because their sales personnel’s’
duplication of selling effort is minimized.
- have fewer people to call on, - fewer invoices to prepare
- fewer shipments to make - fewer financial records
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.
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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.
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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
Date___________________ Sl.NO________________
Date by which material is required_______
Department___________
____________ _______________
Inventor Authorized by
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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.
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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 important variable. Example, quality, schedule and
services are also variables of equal importance
Repetitive and routine purchase
Items of low value
Single/few suppliers
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
delivery time and
at lower cost
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5. Insurance 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
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
We should have the systems which show that, the date at which delivery check should be made.
a) Vendor files and review: This is filling orders concerning on the general correspondence,
delivery schedules, supply progress sheets, follow-up letter in respect of the supplier concerned.
If the delivery of a supplier is behind schedule or a delay regarding any point is not
given, supplier can be contacted personally, by telephone, letter.
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A remainder letter will be sent indicating the quantity received in the previous
month, quantity outstanding, the quantity now urgently required, fresh orders
placed.
b) Signal method: - used for single item orders. The signals are placed against the “date scale”
on stock control card, corresponding to the period on which supplier will be expected to arrive.
The scale may be divided into four week1, 2, 3, and 4 or into dates 1, 8, 15, 22 and 29 for each
month.
If the material arrive in time, the signal is removed if it doesn’t a remainder will be
sent to the supplier and the signal will be placed further to coincide with the next
anticipated arrival date and so on until all the materials are received.
c) Purchase record card and review: - A card which shows the total no. of items covered By the
SPR, details of PO and details of purchase receipts
The cards should be reviewed once a week /fort might and take action where necessary.
d) Method:- Useful in cases of multi-item purchase requisition files. In the filer all maters
including the order no. which is to be followed up will be noted down.
Expediting: It is speeding up or accelerating the receipt of the item before the agreed upon time.
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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
Seizing the delivery notice presented by the carrier
Identify and record all incoming materials
Report their receipt to the purchasing department
Make prompt dispersion of the goods to the appropriate department
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.
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Receiving report
Inspection report
Any notes /correspondence inventorying to the order.
The completed order file thus, constitutes records of all activities encompassing the total
purchasing cycle.
A firm has two categories of suppliers; the firm itself and Outside suppliers.
There are four stages in selection process of right supplier;
I. Survey Stage
All possible sources are explored to obtain information about available suppliers and searching
for all likely suppliers. Potential sources to a buyer in establishing a list of potential suppliers
include;
- Supplier information file - Trade journals
- Trade exhibits - Company personnel
- Other purchasing depts. - Personal contacts
II. Inquiry Stage
Inquiry stage involves prequalification of potential sources which narrows the filed sources from
possible sources to acceptable sources.
Factors to be considered:
Location
services, which include arrangement of transport, insurance, after sale service-
installation, maintenance, repair warranty, discounts, convenient packaging, on time
delivery, purchase reforms.
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III. Selection and Negotiation
This leads to the issuance of Purchase order and both subjective (qualitative) approach and
quantitative approach can be used.
IV. Experience Stage
This stage involves follow up activities to ensure that the supplier(s) meet the terms and
conditions of the contract and rating and evaluating supplier performance.
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Required: Rank the suppliers and select one
Solution:
Suppliers Quality Delivery CRs rating Price/rating Comparison
rating rating rating
A 0.9x40=36 0.8x30=24 0.2x20 =4 1x10=10 74
B 0.8x40=32 0.9x30=27 0.2x20=4 0.8x10=8 71
C 0.7x40=28 1x30=30 0.6x20=12 0.67x10=6.7 76.7
2. The Cost ratio method: - When using this method, the buying firm identifies the additional cost
it incurs when doing business with a given supplier. These are separated as cost associated with the
quality, service and price elements of supplier performance. Each of these costs are converted to
cost ratio which expresses the additional cost as a percent the buyer’s total dollar purchase from
that supplier. It will be totaled to get the supplier’s overall additional cost ratio. For purpose of
analysis the supplier’s price adjusted by applying its overall cost ratio. The higher is the ratio of
the cost the lower is the rating and therefore lower chance for being selected.
Note:
Total quality cost
x 100
1. Quality – cost ration (QCR) = Total purchase
Total delivery cost
x 100
2. Delivery cost ration (DCR) = Total purchase
Total lowest price
x 100
3. Price ratio = Actual price
4. Service cost ratio (SCR)
In this case we need to establish a norm or standard service requirements and then we can
evaluate the supplier to see whether they fall above or below the standard. Finally we should
relate to the quoted price.
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Example: Suppose you are the purchaser of a company and you want to select among supplies
A, B, C and D based on the performance of the suppliers during the year just ended and forward
your proposal to the higher management based on cost ratio method. The records were given
below:
Deliver costs (in birr)
A B C D
Telephone call 400 100 200 300
Telegrams 475 275 425 200
Expediting 875 300 975 750
Premium shipment 750 225 900 950
Miscellaneous 500 300 700 600
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Service rating (service in points)
Factors Max pt A B C D
Financial stability 20 20 18 15 15
Filed service 25 20 21 15 12
Labor relation 10 8 10 10 8
Geographic location 15 10 15 6 0
Flexibility 5 5 5 3 5
Expansion capacity 10 10 8 7 9
Warranty 10 8 10 8 0
Miscellaneous 5 3 4 0 0
- Assume that the service rating is 60 points and the maximum value of service package is
20% of price.
The total value of shipments (purchase) and the quoted prices are given as follows.
Supplier Total value purchase (Birr) Quoted price
A 100,000 85
B 120,00 86
C 80,000 82
D 140,000 83
Required: which supplier is the best based on the cost ratio-method
Solution
Step1. Summary of the costs
Delivery(Birr) Quantity (Birr) Service
Suppliers
A 3000 1000 84
B 1200 3600 91
C 3200 3200 64
D 2800 2800 49
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Step 2. Delivery Cost ratio
Supplier DCR
3,000
x 100 =3%
A 100,000
1,200
x 100 =1%
B 120,000
3,200
x 100 =4%
C 80 ,000
2,800
x 100 =2%
D 140,000
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Step 4. Service Cost Rating - SCR
Supplier SCR
A
( )
84
60
x 100 − 100 =40 % x 0.2 = 8%
B
(60 x 100) − 100 =51% x 0.2 = 10.3%
91
C
(6460 x 100) − 100 =6.67 % x 0. 2 = 1.33 %
D
(6049 x 100) − 100 = −18.3% x 0.2 = −3.67 %
Note: 1st determine the percentage by which the rated supplier is above or below the
Acceptable norm.
2nd Apply this percentage to the total value of the service package to determine
SCR.
Step 5. Cost ratio summary
Supplier DCR QCR SCR Total
A 3 1 -8 -4
B 1 3 -10.3 -6.7
C 4 4 -1.33 6.67
D 2 2 +3.67 7.67
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Rank 1st -B 3rd - C
2nd -A 4th - D
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When other companies hold trade secrets or patents on a required material so that it is not
possible to make it
Qualitative 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
an to buy
Total Cost of Make = Total Cost of Buy
TVC + TFC = TCB
6 x + 8000 = 8x
2x = 8000
X = 4000 units
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For volume below 4000 units buy
For volume 4000 units make
Example
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
1.4x = 5880
X = 4200 units
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3.7 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.
Value analysis /value engineering Tools
The basic conceptual tools in the operation of VA value analysis are
1. Design analysis of the required product, part or material
Design analysis involves a methodical step-by-step study of all phases of the design of a given
item in relation to the function if performs. Analysis of each component/part in this fashion
attempts to answer the three basic Questions:
a) Can any part be eliminated without impairing the operation of the complete unit?
b) Can the design of the part be simplified to reduce its basic cost
c) Can the design of the part be changed to permit the use of simplified or less costly
production method?
Common design analysis approaches:
a) Value analysis check list
b) Functional cost approach
c) Brainstorming
d) Use of suppliers
2. Cost analysis
Cost analysis involves the investigation of supplier’s probable costs of producing a given product
To get selling price of supplier
Construct estimated elemental costs for labor, material, overhead and general over head
and total these costs
Make a reasonable margin and arrive at selling price
Cost analysis plays two major roles
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a) Cost Analysis is conducted for currently purchased items whose cost appears excessive.
b) Cost Analysis also served as a means of locating high-cost parts which should be
subjected to design analysis.
3.8 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.
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:
a. The labor costs in the producing country may be substantially lower
b. The exchange rate may favor buying foreign.
c. The equipment and processes used by the foreign vendor may be more efficient.
d. The foreign vendor may be concentrating on certain products and pricing.
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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.
a. 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.
b. 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.
c. Counter Trade
The term “counter trade” refers to any trasaction in which payment is made partially or fully
with goods instead of many. Counter trade links two normally unrelated transaction; 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.
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I. 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.
II. Lead/Deliver Time – There can be uncertainties on the lead – time required since
transporting the materials may demand longer period.
III. 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.
V. 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.
VIII. Quality
Because locations being distant, it may not be easy to reconcile understandings on the
quality specifications.
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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.
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