Purchasing Notes

Purchasing

Definition, Introduction, Objectives

Definition

Purchasing is the process of buying, involving all departments in a company. It focuses on obtaining the right material in the right quantity, with the right delivery (time & place) from the right source, at the right price, and in the right place.

• Inputs from Marketing, Engineering, and Manufacturing guide purchasing in material selection.
• Manufacturing Planning & Control (MPC) determines when to order materials to meet market demand.
• Purchasing is responsible for locating suitable sources of supply and negotiating prices.
• Inputs are needed from other departments to find and evaluate sources and help in price negotiation.

Introduction

• Purchasing is critical for companies dealing with raw materials that are difficult or precious to obtain.
• The goal is to get the right product at the right time and at the best price.
• The Internet and technology impact purchasing by:
  • Reducing routine, manual, and clerical activities.
  • Speeding up purchasing steps.
  • Allowing more time for strategic organizational views and increasing impact on profit.
• Three management influences encourage improvement in supplier relationships:
  1. Viewing the supply chain as an integrated function.
  2. Outsourcing.
  3. Lean production.
• Latest Trend: Promoting environmentally friendly purchasing activities.

Outsourcing

Outsourcing is the process of having suppliers provide goods and services that were previously provided internally.

• Reasons for outsourcing include technical advances in internet communication and efficient shipping methods, making offshore sourcing attractive in terms of cost, service, quality, and delivery.
• Trend: Many products and services are purchased rather than produced locally.
• Purchasing involvement: Increased responsibility for managing outside operations, development, and administration of contracts.

Purchasing as Profit Leverage

• Improving Pre-Tax Profit by 10%:

Method 1: Increase sales revenue from $100$ to $110$ million.

*Sales Revenue (a):* $110$
*Cost of Goods Sold (Purchases - 50% of Sales):* $55$
*Others (40% of Sales):* $44$
*Sub Total (b):* $99$
*Profit before Tax (c):* $11$

Method 2: Reduce purchasing cost by 2%, from $50$ to $49$ million.

*Sales Revenue (a):* $100$
*Cost of Goods Sold (Purchases - 50% of Sales):* $49$
*Other Expense:* $40$
*Sub Total (b):* $89$
*Profit before Tax (c):* $11$

Objectives

Five objectives of Purchasing:

1. Obtain goods and services of required quantity and quality.
2. At the lowest possible cost.
3. At the best possible service and delivery.
4. While maintaining and developing suppliers.
5. That minimize impact on the environment.

• Purchasing is responsible for establishing the flow of material into the company, supplier follow-up, and expediting delivery.

Purchasing Functions and 7 Cycles

Purchasing Functions

To satisfy the objectives, purchasing needs to perform the following functions:

1. Determining purchasing specifications: right quality, quantity, delivery time, & delivery place.
2. Selecting a supplier: right source.
3. Negotiating terms and conditions: right price.
4. Issuing and administering purchase orders.

7 Purchasing Cycles

1. Receive & analyze purchase requisition.
2. Select & issue quotation.
3. Determine the right price.
4. Issue purchase order.
5. Follow up to ensure correct delivery.
6. Receiving & accepting goods.
7. Approving invoices.

1. Receive and Analyse Purchase Requisitions

• The purchase requisition starts with the ultimate user.
• The planner releases a planned order authorizing the purchasing department to process a purchase order.
• A purchase requisition contains:
  • Originator identity, signed approval, account to which cost is assigned.
  • Material specification.
  • Quantity and unit of measure.
  • Required delivery date and place.
  • Any other supplemental information needed.

2. Select Suppliers

• Find potential suppliers:
  • For routine purchases - Lists of approved suppliers
  • Search for new suppliers
• Issuing requests for quotation:
  • Written inquiry sent to potential suppliers
  • To ensure receipts of competitive and reliable quotation
  • NOT a sales order
• Receiving and analyzing quotations:
  • Clearly written specification: Price, compliance to specification, term and conditions of sale, delivery, and payment terms
  • Specification not clearly written: Include technical suitability evaluation; make a tradeoff between PRICE and technical suitability.
• Selecting the right supplier

3. Determine Right Price

Responsibility of purchasing and closely linked to the selection of suppliers.

4. Issuing a Purchase Order

• A purchase order is a legal offer to purchase.
• It's a legal contract for delivery of goods according to the terms and conditions specified in the purchase agreement.
• Copies are sent to: Supplier, originator, accounting, receiving, and purchasing file (Communication & records).

5. Follow Up and Delivery

• Purchasing MUST ensure suppliers deliver goods and services on time by:
  • Expediting transportation, finding alternate sources of supply, resolving supplier problems, or rescheduling production.
• Work with suppliers to manage changes in delivery requirements, expedite or delay delivery when demand changes.
• Buyers communicate true requirements to suppliers, so suppliers can provide products and services accordingly.

6. Receiving and Accepting Goods

• Normal process:
  • Inspects goods for correct quantity and to ensure there is no damage
  • Accept goods using purchase order & bill of lading supplied by the carrier
  • The Receiving department informs the purchasing department and closes out receiving information if goods were accepted.
• Exceptions:
  • Discrepancy or variance – receiving department communicates variance, quality, or damage information to buyer and supplier pending a decision
  • Work with supplier: change in delivery requirement, expediting, or delaying delivery when damage occurs

7. Approving Supplier’s Invoice for Payment

• After the invoice is received, it must agree on 3 pieces of information from:
  • Purchase order, Receiving report, Invoice
• All information must be the same regarding:
  • The Item, Quantity, Price
• Check against invoice (Purchasing department responsibility):
  • Discounts and term of original purchase order
  • Check against discrepancy, resolve any difference
• Once approved, sent to account payable

Establishing Specification

Based on 3 categories of requirements:

1. Quantity
   • Establish based on market demand
     • Low demand - design with low or least cost
     • High demand - taking advantage of economies of scale
2. Price
   • Is an economic value users put on the product based on use and anticipated selling price of a product
     • lower price product: manufacturer tends to use low cost components in establishing specification
3. Function (most important & difficult to define)
   • Concern with end use and real need or purpose of an item and what the item is expected to do.
   • The real need has both practical and aesthetic elements

Quality and Functional Specification

• Functional specification should define quality level of products and services (quality characteristics) from end users (customer standpoint) perspective.
• Quality is centered on user satisfaction.
• 4 phases of providing user satisfaction:
  1. Quality and product planning
  2. Quality and product design
  3. Quality and manufacturing
  4. Quality and use

Functional Specification & Quality

4 phases of providing product quality:

1. Product Planning
   *Determine what Product & Services to market (through market studies)
   *What market segment to be served
   *Product feature, quality, price and expected sales volume
2. Product Design
   *Build the product’s expected quality, performance, appearance, price,sales volume into general design specification.
3. Purchase/Manufacturing
   *Manufacturing conforms to specification or requirement defined by designer
   *If purchase – ensure suppliers can provide the expected quality.
4. Use
   *User expectation of how the product should perform.

Value Analysis

Value Analysis is a systematic use of techniques that:

1. Identify a required function
2. Establish the value for the function
3. Provide the function at the lowest possible cost.

A team of engineers, users, production personnel, and suppliers analyzes current specifications and identifies redundant or unnecessary features to reduce costs and improve overall part functionality.

Example: Glass milk bottle to carton.

Describe Functional Specifications

Functional Specifications can be described individually or in combination using the following:

1. By Brand
2. By engineering drawings
3. By specification
   • Physical and chemical characteristics
   • Material and method of production
   • Performance
4. Miscellaneous

1. By Brand

• Customers rely on the reputation and integrity of a supplier that maintains and guarantees product quality. Apply under such circumstances:
  • Items are patented, or the process is secret.
  • The Supplier has expertise that the buyer does not have.
  • The quantity is so small that it is not worth the buyer's time to develop the specification.
  • The supplier has created buyer preference through branding (marketing effort).
• Disadvantages
  • Higher cost, restricted number of suppliers, and reduces competition

2. By Specification

A. Methods of describing product specification:

1. Physical and chemical characteristics:
   Examples: Petroleum products, pharmaceuticals, and paints.
2. Material and method of production:
   Examples: Hot and cold-rolled steels.
3. Performance:
   Concern: With product performance.
   Example: Water pump – liters per hour.

B. Characteristics of Description by specification:

1. Carefully designed.
2. Must allow multiple sourcing and competitive bidding.
3. May not be 100% inclusive.
4. May be more expensive than supplier with standard products.
5. Expensive if set by buyer due to lack of enough volume to take advantages of economies of scale in production.

C. Sources of Specifications:

1. Buyer specification – not a preferred method
   • Usually expensive and time-consuming
2. Standard specification
   Set by government or non-governmental agency after much study; apply to raw and semi-finished products.
   Examples: ENGINE Oil standard SAE10W30, electrical wire –
   Advantages:
   * Widely known and accepted
   * Lower price due to economies of scale
   * Adapted from the needs of many purchasers

3. By Engineering Drawing and other

• Engineering Drawings
  • Developed by the engineering department when no standard part is available.
  • Describe in detail the exact configuration or parts and assembly and other details.
  • A major method of specifying what is wanted
  • Expensive to produce but give the exact part required.

Supplier Selection

Selected supplier must have the technology and capacity to provide good and services to the required quantity and with a competitive price.

A. Sourcing of suppliers

B. Factors to be considered

C. Identify suppliers

D. Final selection of suppliers - Ranking

Sourcing – 3 types

1. Sole sourcing – 1 supplier only
   • Only 1 supplier is available due to patents, technical specifications, raw material, location, etc.
   • Disadvantage: more expensive due to less competition, risk of discontinuity of supplying material.
2. Multiple sourcing (more than 1 supplier)
   • Advantages: competition will help to lower the price, provide better service, will be a continuity of supply
   • Disadvantage: tendency toward an adversarial relationship between supplier and customer.
3. Single sourcing (Partnership with 1 supplier)
   • Objective is to develop a long-term partnership with the supplier; lower cost and improve quality through partnership
   • The supplier has stable management and is sincere in partnership agreement.
   • Minimum danger of breaching organization’s secret
   • Supplier shares a vision of customer satisfaction and delighting customers.

Factors (Selecting suppliers)

1. Technical ability
   *Able to make/supply product, to provide product development and improvement.
2. Manufacturing capability
   *Ability to meet specification (quality), and quantity
3. Reliability
   *Reputable, stable, financially strong.
4. After sales service
   *Good inventory of service parts and good service organization; comprehensive technical support capability
5. Supplier location
   *Near buyer or maintain inventory locally/near factory/manufacturing locations (good response time)
6. JIT or LEAN capabilities
   *Able to supply inventory in smaller quantity to meet production need (reduce inventory carrying cost and prevent part obsolete)
7. Price
   *Competitive pricing (not necessary the lowest price); Overall cost rather than individual cost
8. Other Factors
   *Credit term, reciprocal business, willing to hold inventory on behalf of, supplier relationship

Identifying suppliers

• The purchasing department must continue to search for available sources of supply through these channels:
  • Salespersons of suppliers
  • Internet
  • Catalogs
  • Trade magazines
  • Trade directories
  • Information obtained by salespersons of the buyer firm

Final Supplier Selection – Ranking Method

1. Determine supplier selection factors
2. Assign a weight to each factor (from 1 to 10)
3. Rate the suppliers for each factor based on their ability to meet the requirements of the factor (not associated with weight)
4. Rank the suppliers by:
   • Multiply weightage with supplier rating.
   • Tally all the scores.
5. Determine the best supplier based on the best score.

Example: Supplier Selection Ranking

Supplier Selection Advantages

• Attempts to quantify factors that are not quantified by nature.
• Forces buying company to consider the relative importance of various factors.
• Agreement on final selection will be improved when the input of many users has been considered.
• Methods: Eliminate the bottom-ranking suppliers and select top-ranking suppliers for top management consideration.
• Based on the example shown in the table above:
  • Supplier Z: It ranks 4th, the lowest of the 4 suppliers, with the difference of 250-213 = 37 points from supplier Y. May consider dropping the supplier Z from the lists.
  • Supplier W and X: Their total scores are very close. Select both suppliers for top management consideration.

Price Determinations

1. Fair price and breakeven analysis:
   • Breakeven analysis calculation
2. Competitive bidding
3. Price negotiation

1. Fair Price and Breakeven Analysis

1. A fair price is competitive, gives the seller a profit, and allows the buyer to sell at a profit.
2. The buyer sets the UPPER limit – willingness to pay – Based on perception of demand/supply, need.
3. The seller sets the lower limit – profit expectation, manufacturing cost.

Use breakeven analysis for price determination.

Break-Even Point - Example

Fixed Cost = $5,000

Variable Cost = $6.50 / unit

Selling Price = $15 per unit

The average cost can be calculated as follows:

Average Cost = $5,000 ÷ 1000 + $6.50 = $11.50 per unit

To find the Break-Even Point, let X = Number of Units:

$\$15X = \$5,000 + \$6.50X$

$\$8.50X = \$5,000$

$X = 588.2 => 589 units (round up)$

$Revenue = 589 \times 15 = \$8,835$

The volume must exceed 589 units to make a profit.

Breakeven – Contribution Margin Method

For breakeven analysis: Set net profit = 0, calculate the breakeven unit

$0 = Total Revenue - Total Variable Costs - Fixed Cost$

Example – CM Methods

Fixed Cost = $5,000

Variable Cost = $6.50 / unit

Selling Price = $15 per unit

The average cost can be calculated as follows:

Average Cost = $5,000 ÷ 1000 + $6.50 = $11.50 per unit

To find the Break-Even Units:

$0 = 15 \times Units - 6.5 \times Units - 5000$

2. Competitive Bidding

• Definition:
  • The buyer compares prices from various suppliers and chooses the lowest price.
• Methods:
  • Sending out quotations and analyzing the results, or Comparing catalog or advertised prices
• Conditions or requirements to adopt
  • A number of sources must be available (at least 3 sources)
  • Must have sufficient time
  • The product is well specified and widely available.
• Examples: Nuts and bolts, bread, milk, gasoline

3. Price Negotiation

• Price can be negotiated if the buyer has the knowledge and clout (high versus low volume) to do so.
• Through negotiation, the buyer and seller resolve conditions of purchase to the mutual benefits of both parties.
• For a successful negotiation, potential profit must justify the expenses of careful planning, time, and efforts in negotiation.
• Different negotiation approaches for different product categories:
  1. Commodities
     *Negotiation concerns with the future market; price is set based on demand and supply (copper, coal, wheat)
  2. Standard products
     *Provided by many suppliers, thus prices are set based on the published prize; limited negotiation except for large quantities
  3. Items of small value
     *Purchase in small quantity, price negotiation is of little value. The objective of negotiation is to keep the ordering cost low
  4. Made-to-order items
     *Is negotiable. The product is made to order

Impacts of MRP on Purchasing

Two types of purchasing activities:

1. Procurement
   • Includes functions of establishing specification, selecting supplier, price determination, and negotiation.
2. Supplier scheduling and follow-up
   • Concerns with the release of orders to suppliers, working with suppliers to schedule delivery, and follow-up.
   • The goals of supplier scheduling are the same as those of production activity control (PAC).
   • PAC goals include MPS and MRP implementation, effective use of resources, minimizing work-in-process inventory, and maintaining desired customer service.

Buyer / Planner Concept

• Production activity control coordinates the flow of goods from suppliers.
• responsibility of planning and buying
• Works with the Master Scheduler and other Planner/Buyers
• Handles fewer components
• Smoother flow of information
  • Knowledge of factory needs
  • Matches material requirements with supplier capabilities

Plans are going to change!

Planner / Buyer Responsibilities

• Determining material requirements
• Developing schedules
• Issuing shop orders
• Issuing material releases to suppliers
• Establishing delivery priorities
• Controlling orders in the factory and to suppliers
• Handling all the activities associated with the buying and the production scheduling
• Maintaining close contact with suppliers

Contract Buying

• Long-term contract with a supplier for small volume items
  • Authorize releases against the contract when goods are needed
• The supplier may be given a copy of the material requirements plan
• Requires close coordination
• Works best with the Buyer/Planner concept

Benefits of Contract Buying

• Assures the supplier of a certain amount of business
• Suppliers are more responsive to the buyer’s needs
• Assures buyer that capacity will be available when needed
• The buyer can delay actual ordering

Impact of MRP on purchasing

• Two types of purchasing activities:
  1. Procurement
     • Includes functions of establishing specification, selecting suppliers, price determination, and negotiation
  2. Supplier scheduling and follow-up
     • Release orders to suppliers, work with suppliers to schedule delivery, and follow up
     • Supplier scheduling are the same as production activities control:
       • Execute master production schedule, MRP, effective use of resources, minimizing work-in-process inventory, maintaining desired customer service.

Latest Trend

A. Supplier responsiveness and reliability

B. Close relationship with suppliers

C. Supply Chain Management organizational implication

D. Use Electronic data exchange

E. Vendor Managed Inventory

F. Environmentally friendly Effort – 3Rs – Reduce, Reuse, Recycle

A. Supplier Responsiveness and Reliability

• Material requirements often change
• Suppliers must be able to react to change
• Flexibility in volume and products needed
• Reliable in delivery promises

B. Close Relationship with Suppliers

• The need to understand each other's capabilities and constraints
• Cooperation and teamwork
• Very frequent communications
• Between the buyer/planner and the supplier’s production planner

C. Supply Chain Management (SCM) Organizational Implications

D. Electronic Data Interchange (EDI)

Sharing customers' and suppliers' information, speeds up information sharing and reduces waste (paperless).

Traditional Fax Flow vs. EDI:

Fax:
*Prepare document
*Fax to customer
*Verify and re-enter data into IT system

EDI:
*Cut short of all the re-entering data steps to streamline efficiency.

E. Vendor Managed Inventory

The vendor maintains inventory at the customer's factory, and the customer only pays for the inventory when it is used.

F. Reduce (most important), Reuse, and Recycle

• Purchasing has first hand knowledge of price trend of the waste product.
• Purchasing internal and external contacts
• Purchasing is familiar with internal needs and external registration