Purchasing Function Notes

Chapter 6: The Purchasing Function

Learning Outcomes

• Explain the role and importance of the purchasing function in a business.
• Relate each of the fundamental management functions to the purchasing function.
• Explain the centralisation and decentralisation issue in a business.
• Motivate why senior-level employees should perform the purchasing function in a business.
• Describe the key performance indicators (KPIs) that can be used to make purchasing activities more efficient.
• Illustrate and explain the steps in the purchasing cycle.
• Explain quality issues in the purchasing of materials and services.
• Explain the issue of purchasing quantities and the control of inventories in a business.
• Explain the selection process and the factors influencing the selection of suppliers.
• Briefly explain purchasing prices as part of the total value package and the principal methods of determining prices.
• Discuss the internal and external factors influencing the timing of purchases.
• Explain the importance of physical stocktaking and the ways in which stocktaking can be approached.
• Describe how the purchasing function interacts with the other business functions.

Consumers’ Needs in Terms of Purchasing

• Every day we make certain purchases to satisfy our living needs.
  • Short-term (usually smaller purchases) like food and clothes.
  • Longer-term needs (usually larger purchases) like houses, cars, etc.

Businesses’ Needs in Terms of Purchasing

• Businesses also need to make certain purchases in order to conduct business and produce products.
• Examples: What a coffee shop would need to make include items such as coffee beans, milk, sugar, cups, pastries, cleaning supplies, equipment (espresso machines, ovens), furniture, and packaging.

Businesses Which Provide Services

• Certain businesses (like an accountancy firm) delivers a service to its clients but does not sell any products (like a PnP, for example).
• However, the accountancy firm still needs to purchase items in order to remain operational and deliver the service, such as stationery, refreshments, cleaning products, printing machines, computers, etc.

Objectives of the Purchasing Function

• To buy materials:
  • Of the right quality
  • From the right source
  • Delivered to the right place
  • At the right time
  • At the right price

Activities of the Purchasing Function

1. Select Suppliers
2. Arrange + Purchase Transport for Incoming Materials
3. Prices Acceptable? Negotiate
4. How Much Needed of Each Material, Product, or Service?
5. Quality of Material, Product, or Service Right?
6. Expedite Delivery of Materials, Products, and Services
7. Control Inventory

Importance of the Purchasing Function

• Biggest Issue = Cash Flow Problems
• Just-In-Time Principle (JIT)
• Purchasing costs are the largest expense for most businesses.
• Important to keep a good balance between purchasing + stock on hand. If sales are slower than stock levels, it could lead to cash-flow problems.
• Profit is linked to Expenditure (how much money a business spends) and Income (how much money a business makes).
• The aim of any business is to ensure purchasing is done right so that the business makes a good profit.
• JIT = there should be enough material (right quantity, right quality + at the right time) to be able to manufacture products AND so that there is enough for customers to buy.
• Purchasing contributes to successful marketing: Final products will then be available in the right quantities, at competitive price, and at the right time to customers.

Walmart Example

• Walmart aims to cut supply chain costs to increase profits.
• Walmart plans to exploit its scale of buying power.
• Walmart is launching a drive to cut billions of dollars of costs from its supply chain by combining its store purchasing across national frontiers in a new stage in the globalisation of its business.
• The effort is part of plans by the world's largest retailer to increase the proportion of goods that it buys directly from manufacturers, rather than through third-party procurement companies or suppliers.
• Walmart planned on cutting out the “middle man” in the supply chain in order to increase profits.
• Since each “middle man” requires payment, it would make sense for Walmart to buy certain items directly from certain suppliers themselves.
• This would mean that Walmart would need to carefully consider all the suppliers (and whether there are sub- suppliers in the supply chain for that specific item) so that they can identify for which products they need to reconsider suppliers.

Managing the Purchasing Function

4 Key Functions of Management

1. Planning
2. Organising
3. Leading
4. Controlling

PLANNING + the Purchasing Function

• Overall business objectives should be supported by the purchasing objectives.
• Consult with other functions:
  • Marketing = Seasons and consumer needs (no use marketing winter jackets in the summer)
  • Finances = Budget (how much can be spent on materials?)
  • Operations = Raw materials and machines required + when are certain garments planned to be made to ensure that they are available in shops?
• Example:
  • Business Objective of Mr. Price = LOW cost and NEW trends
  • Purchasing Objective = Reduce the number of suppliers and seek new items.

Inter-departmental Dependencies and Considerations

• PURCHASE: Availability of products
• MARKETING: Inform people about the products
• FINANCE: Availability of cash
• If garments should be on the shelves in May, they should be ordered in January, for example.

ORGANISATION of the Purchasing Function

• Who buys what?
• Difference between small, medium, and large businesses
• Centralised + Decentralised

Centralisation vs Decentralisation

• Centralised purchasing means that the purchasing manager of one office/branch of a certain business buys products and then distributes them to the other branches.
• Decentralised purchasing means that each branch of a business does its own purchases in its own environment. In most cases, by anyone in the local branch/office.
• Combination of the two: Some items are bought centrally, while others are purchased by each branch/office.

Examples of Centralized, Decentralized and Combination Purchasing

• Centralised:
  • Game’s head office (Purchasing Manager) will do the purchases and then send them to other Game stores (like Bloemfontein).
• Decentralised:
  • A butchery would try and source its own produce as close as possible to the butchery itself.
• Combination:
  • Checkers stores across the country (Kimberley, Bloemfontein, etc.) get toys from the head office (Purchasing manager is responsible for buying), but fresh produce like flowers is often bought from local farmers in Bloemfontein (not from Jhb head office).

Centralised Purchasing

• Advantages of Centralised Purchasing: Standardisation of purchased materials and procedures (cost advantage if bought in bulk). Example: Same types of instant coffee available at all PnPs across South Africa and at the same price at all PnPs.

Advantages of Decentralised Purchasing

• Purchasers have close contact with customers (know what they want in that specific region) and local suppliers (good relationship).
• Reaction time is quicker.
• Shorter times between ordering and delivery (also cost advantage because of no additional transport costs).

Why Senior Level Employees Should Perform the Purchasing Function

• When the value of the purchased materials in relation to the total expenditure of the business is high, the contribution made by the purchasing function to the success of the business is high.
• When the supply market consists of only one supplier (a monopoly) or a few suppliers only, the purchasing function is performed by staff in higher, managerial positions. This is because it requires skill and experience to negotiate with a supplier in a market where there is little or no competition.
• The position of the purchaser is determined by the nature of the materials, products, or services purchased and by the specialised skills that a purchasing transaction demands of the purchaser. The more specialised the purchased items or services, for example special equipment or commodities such as agricultural products, the more skills and knowledge are required from a purchaser. He or she will be appointed on a managerial level.

Management and the Purchasing Function

• CONTROL: Determines whether objectives have been reached and performance improved.

Performance Evaluation

• Key Performance Indicators (KPI’s) are used to gauge the efficiency of the purchasing activities.
• Just In Time (JIT): RIGHT quantity, quality, place, time, etc.

KPIs

• Price: comparing actual prices with planned or market prices and the number and amount of discounts negotiated for a certain period.
• Supplier performance: determining the number of rejected orders, orders received late, and the number of times it was necessary to speed up orders.
• Timeliness: determining the number of orders indicated as urgent, the number of interruptions of operations, and the number of purchases lost owing to a lack of inventory.
• Cost savings: comparing costs with those of previous periods and expressing administrative purchasing costs as a percentage of the monetary value of purchases, for example.
• Inventory holding: calculating inventory turnover, inventory losses, and obsolescence of inventory.
• Relationship performance with suppliers: using a supplier survey or scrutiny of supplier turnover.
• Relationship with other functions in the business: monitoring the diligent execution of requests to the purchasing function.
• Workload: looking at the number of orders and requisitions, for example.

Purchasing Management (Summarised)

• Purchasing function should be managed
• Plan + set objectives
• Work with other functions
• Performed on different levels and places in the business
• Purchasing is a skilled position
• Purchasing should be monitored + controlled

Unique Inventory Needs per Industry

• Manufacturing Industry
• Retail Industry
• Service Industry

Classifications of Inventory

• Manufacturing (and related) industries
  • Raw and supplementary materials
    • Needed to manufacture the finished products
    • Examples: Aluminium, wood, plastic…
  • Semi-finished goods
    • In the process of being manufactured, but not yet completed
  • Finished Goods
    • Been through the full manufacturing and production cycle
    • Ready to be sold and used
• The Retail Industry
  • Deal only with the FINISHED GOODS
  • Buy goods from manufacturers and suppliers
  • Offer goods in a CONVENIENT way
• The Service Industry
  • CANNOT be acquired, stored, and sold as physical inventory
  • Labour hours of different levels

The Purchase Cycle

1. Determine the Need
2. Select Suppliers
3. Determine Price and Conditions
4. Place Order or Contract
5. Manage Expedite and Follow-Up
6. Receive Goods
7. Handle Errors
8. Pay Suppliers
9. Close Order

Quality of Purchased Goods

• The main decisions in each purchasing transaction are quality, quantity, delivery, and the price-service package offered by the supplier.
• What is Quality?
  • All the features & characteristics of a product that satisfies a particular need.
• What is the RIGHT quality?
  • Quality that is purchased at the lowest price which satisfies a specific need and performs the function for which it was purchased.
• Direct Impact on marketing and operations

Methods to Use to Determine the Quality of Purchased Goods

1. Specifications
   • Most general method of describing quality
   • A specification is a description of non-standard materials that can perform certain functions
   • Dimensions/ physical features like tolerances, workability, uniformity, and chemical composition can be used to draw up specifications.
2. Standardisation
   • It is the process of making materials, methods, practices, and techniques uniform
   • Standardisation implies that the characteristics of items have to comply with a specific minimum acceptable standard, but at the same time, the types, sizes, and grades of an item are limited.
   • Examples:
     • Lightbulbs of a specific model (e.g., 60-watt Incandescent, 14-watt CFL, or 12-watt LED) will be the same.
     • Bread: All Albany D'light bread should weigh 500g.
3. Other forms of quality definition
   • Market grades, brands, SABS, samples etc.

Purchasing Quantities and Inventory Costs

• Should a business hold Inventory?
  • YES! Inventory holding is necessary.
    • Marketing and operational budgets are only ESTIMATES.
    • Supply of material is UNRELIABLE regarding delivery and quality.
• Need to consider:
  • Too much inventory, money is tied up.
  • Too little inventory, shelves are empty.
• THEREFORE business aim for: Optimal Level of Inventory

How Does a Business Achieve an Optimal Level of Inventory?

1. Inventory control
2. Determining inventory quantities
3. Inventory control systems

Inventory Control

• Objectives:
  • A scientific, factual method to simplify purchases (by using mathematical models) needs to be created.
  • There should be a reduction in possible losses as a result of obsolescence and incorrect or excessive purchases should be.
  • Dead or slow-moving inventory should be identified.
  • Inventory control must serve as a source of information for management decisions.
  • Losses should be prevented by controlling all incoming inventory with regard to quality, quantity, and the requirements as determined in the purchase order. This is important, since it impacts directly on the quality of the finished product.
  • Excessive variety should be avoided.
  • Production should never be delayed because of a shortage of a certain inventory item. Such delays make an extremely bad impression on the customer.
  • Ordering the most economical quantities through an effective control system is essential.

Determine Inventory Quantities

• NB!!! To HOLD inventory
  • Acquisition, alteration, storage, marketing & sales costs will be part of the business = UNAVOIDABLE
• Need Efficient and Effective inventory management
• Determine ECONOMIC ORDERING QUANTITY
• Right quantity at the right price & best carrying costs.
  • Ordering Costs
  • Carrying Costs

Economic Order Quantity (EOQ)

The figure displays where the economic order quantity (EOQ) lies.

• Carrying costs: Inventory ties up capital (less capital to spend on other things) and this is known as carrying costs.
  • Carrying cost can be divided into:
    1. Direct inventory-carrying cost
       • The two direct-cost components are capital cost (interest or opportunity cost) and holding cost.
       • Holding cost refers to the cost involved in renting storage facilities, warehouse equipment, electricity, insurance, security, handling, bookkeeping, warehousing labour and damage.
    2. Indirect inventory-carrying cost
       • These are the costs attached to obsolescence, record-keeping, physical stocktaking, inventory planning, and control by management.
       • Other hidden cost elements are the cost of production floor space utilized for work in process, scrap and rework, as well as the cost involved in handling and containerisation.
• The higher the number of units per order and delivery, the higher the carrying cost.
• Ordering costs:
  • Cost incurred to place an order.
  • An item may be ordered twice, three times or more per year – even daily in Just-in-Time (JIT) systems.
  • Examples of ordering costs: telephone calls, paperwork, transportation costs, time and effort in checking and receiving ordered inventory.
• Higher frequency of ordering (the more times you order within a certain time period) = higher ordering cost.
• Lower frequency of ordering = lower ordering costs.
  • Example: If you own a coffee shop and you know that it costs you a R50 admin + delivery fee each time you order your special coffee beans, you would not be wise to have coffee beans delivered daily. You would rather plan your orders carefully so that you do not spend unnecessarily on delivery and rather order every second week (lower frequency of ordering = lower ordering costs).
• Total costs:
  • Total cost indicates the balance between the advantages and disadvantages of having too much inventory and having too little inventory (inventory- carrying costs) and the balance between the advantages and disadvantages of a high or low frequency of ordering and receiving inventory.
• The point (the dot displayed in the figure) where the two cost lines (inventory- ordering costs and inventory-carrying costs) intersect, given the minimum total costs, is where the economic order quantity exists.

Inventory Control Systems

We will look at 2 systems, namely the fixed-order quantity system and the cyclical ordering system:

• Fixed-Order-Quantity System

  • According to the fixed-order-quantity system, an optimum level for each item in inventory is determined.
  • A fixed order point (at a certain level of inventory) and a fixed quantity to be ordered are determined for each item according to a formula known as the Economic Order Quantity, or EOQ.
  • The business uses or sells the inventory items and the inventory levels drop.
  • When this level or point is reached (points B, E and H), a fixed quantity of items, the EOQ, are purchased (EOQ = CD = FG = IJ).
  • After the order has been made, the business keeps on using or selling units of the specific item and the inventory level drops further (from B to C, E to F and H to I).
  • If the EOQ was calculated correctly, the ordered material will reach the business before or when the minimum inventory level is reached. Inventory will then be replenished to more or less the maximum inventory level.

• Fixed-order-quantity system – Let’s use an example

  • A stationery shop decided to keep a maximum of 160 boxes and a minimum of 10 boxes of photocopy paper. The management team decided as soon as they have 100 boxes in inventory left (order point B) they will have to place an order to ensure sufficient inventory is available. How many boxes will be indicated on the order form (in other words what is the Economic Order Quantity (EOQ)? Step 1: Draw the figure and indicate all the amounts provided on the figure

  • Step 2: Determine the EOQ… It will be the difference between the maximum amount and the minimum amount. = $160 – 10 = 150$

  • This means that before they have 10 boxes left (minimum inventory level) they expect to receive the 150 boxes that will replenish the stock of paper to more or less the maximum level.

• Cyclical Ordering Systems

  • With this ordering system, each item of inventory is checked at fixed intervals (for example weekly or monthly) and an order is placed to replenish the inventory level to its maximum level.
  • The order times are, therefore, fixed, but the order quantity varies (BC, DE, FG, HI and JK differ).
  • The system is suitable for seasonal materials used on an irregular basis, where the purchasing of such materials can be planned far in advance on the basis of forecast, for example clothing manufacturers or shops.
  • This system is used in grocery stores, where, at the end of a period (for example every week), stocktaking is done for the specific item on the shelves and the order quantities adjusted according to the quantity left on the shelves.
  • For example, more tins of soup are ordered with every order cycle in the winter than in the summer.

• Break-Even Analysis

  • Except for the two above-mentioned systems, there is also a technique that managers can use to determine inventory levels. This technique is called break-even analysis.
  • Break-even analysis is a technique for determining the volume where:
    • Total revenues (income) = Total cost (expenses)
    • Or Total cost to produce = The total cost to buy.

• How do we calculate the break-even point?

  • We use the following formula:
    • $Q = F / (P-C)$
    • Q = Quantity/Amount
    • F = Fixed Costs
    • P = Selling Price
    • C = Purchasing Cost

• Break-even Analysis – Let’s do an example

  • Dairy Donkey produces milky ice-cream lollies and sells it to consumers at R5 per lolly. The fixed cost per year is R 30 000 and the purchasing cost is R3.50. How many milky ice-cream lollies should Dairy Donkey sell, in order to break even?
  • Use the formula on the previous page and substitute the letters with the numbers in the information provided:
    • Q =F / (P-C)
    • Q = $30 000 / (5 – 3.5) = 20000$

Selection of Suppliers

• Selection of the RIGHT Suppliers
• Long-term relationships - right prices, quality and good after-sales support

Selection Process

1. Compile a list of possible suppliers
2. Shortlist
3. Select a specific supplier
4. Evaluate Performance
   • POOR
   • GOOD
5. Seek new supplier

Purchasing Prices

• Price should be regarded as only one of the components of the total value package, together with quality, delivery, and cost of use.

Sources of Pricing Information for Purchasing

• Price lists, brochures, etc. = Standard product
• Quotations= Non-standard products/large quantities
• Tenders= Construction
• Negotiations

Timing of Purchases

• The aims of purchasing at the right time is to ensure:

  • The business is supplied on an ongoing basis with materials, products, and services required for it to operate without interruptions.
  • To keep inventory holding at an optimum level.

• Internal factors influencing the timing of purchases

  • Availability of funds
  • Marketing and operations plans and strategies
  • Physical facilities, such as storage space,

• 3 Types of internal policies also determine the scheduling of purchases.

  1. Scheduling purchases according to needs
     • Purchase materials when the business needs them, regardless of the price and market conditions
  2. Advance purchasing
     • Involves the purchase of more materials than required, the aim being to ensure future availability.
  3. Minimum purchases
     • Schedule purchases to ensure that inventory is only available for the immediate needs of the business. Inventory is kept to a minimum and no buffer inventory is held.

• External factors influencing the timing of purchases

  • Market conditions (for example, availability, recessions, booms and exchange rates)
  • Government regulations
  • Seasons.
  • Lead time (particularly important in the case of imported goods)
  • Reliability of suppliers.

The Importance of Physical Stocktaking

• Everything changed after computer technology – now we have Integrated Information

  • Therefore, physical stocktaking is so IMPORTANT

  • Evaluate EFFICIENCY and EFFECTIVENESS of business

  • Rubbish in – Rubbish out

• Several ways to do stocktaking=

  • PHYSICAL VALIDATION of quantity and value of stock

  • (At least ONCE a year)

4 Approaches

• Focusing on critical inventory

• Spot checks

• Chaos vs. order

• Sound Admin and effective cost-accounting

• Focusing on critical inventory items

  • Inventory can be divided as follows:
    • Different values of unit costs
    • Top, average and poor sellers
    • Focus more effort on high unit cost items
    • Pareto Principle (80/20 principle)
    • 20% of stock, contributes to 80% of sales/profit

• Doing spot checks during interim periods.

  • Compare physical inventory to “administrative” stock numbers
  • Assist in detecting serious errors and/or irregularities in admin and security systems
  • Eliminate a standard repeatable system
    • Avoid predictability

• Choosing between chaos and order

  • Untidy stock areas causing confusion and irritation.
  • Problems:
    • Lack of coding, lack of product identification
    • Untidy shelves and storerooms
  • Solution:
    • Keep products neat and orderly by:
      • Type by Type
      • Size by Size
      • Age by Age
      • Supplier by Supplier

• Sound administration and effective cost- accounting practices.

  • Are product’s purchase prices indicated on the shelves?
    • Needed in order to determine value.