The Purchasing Function

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.

Businesses Providing Services

• Businesses like accountancy firms provide services but still need to purchase items like stationery, refreshments, cleaning products, printing machines, and computers to remain operational.

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 and purchase transport for incoming materials
3. Negotiate prices
4. Determine quantity needed for each material, product, or service
5. Ensure the right quality of material, product, or service
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 and stock on hand. If sales are slower than stock levels, it could lead to cash-flow problems.
• Profit is linked to Expenditure and Income.
• 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 and Supply Chain Cost

• Walmart aims to cut supply chain costs by combining store purchasing across national frontiers.
• Increase the proportion of goods bought directly from manufacturers, rather than through third-party procurement companies or suppliers.

Managing the Purchasing Function

• Revisiting the management tasks/functions.

Key Functions of Management

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

Managing the Purchasing Function: PLANNING

• Overall business objectives should be supported by the purchasing objectives
• Consult with other functions:
  • Marketing = Seasons and consumer needs.
  • Finances = Budget.
  • Operations = Raw materials and machines required + when are certain garments planned to be made to ensure that they are available in shops?

Examples

• Business Objective of Mr Price = LOW cost and NEW trends

• Purchasing Objective= Reduce number of suppliers and seek new items.

• Availability of products relates to PURCHASING.

• Informing people about the products relates to MARKETING.

• Availability of cash relates to FINANCE.

• Garments should be ordered in January to be on the shelves in May.

Managing the Purchasing Function: ORGANISATION

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

Centralised Purchasing Function (PF)

• Done by 1 purchasing department
• Products of one kind are purchased from a supplier
• Benefit:
  • Standardization= cost advantages
  • Supplier relations

Decentralised Purchasing Function (PF)

• Each branch/ unit performs their own purchasing
• Geographic spread- local suppliers/ different activities
• Benefit:
  • Closer contact with consumers and suppliers

Combination Purchasing Function

• Centralised or decentralised basis for purchasing
• Maximises BOTH sets of benefits Example:
  • Game’s head office (Purchasing Manager) will do the purchases and then send to other Game stores (like Bloemfontein)
  • A butchery would try and source its own produce as close as possible to the butchery itself.
  • 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 are often bought from local farmers in Bloemfontein (not from Jhb head office)

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 Examples

• 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.

Types of Inventory

• Unique Inventory Needs per Industry
  • Manufacturing Industry
  • Retail Industry
  • Service Industry

Classifications of Inventory: Manufacturing

• Raw and supplementary materials
  • Needed to manufacture the finished products
  • Examples: Aluminium, wood, plastic…

Classifications of Inventory: Manufacturing

• Semi- finished goods
  • In the process of being manufactured, but not yet completed

Classifications of Inventory: Manufacturing

• Finished Goods
  • Been through the full manufacturing and production cycle
  • Ready to be sold and used

Classifications of Inventory: Retail Industry

• Deal only with the FINISHED GOODS
• Buy goods from manufacturers and suppliers
• Offer goods in a CONVENIENT way

Classifications of Inventory: Service Industry

• CANNOT be acquired, stored and sold as physical inventory
• Labour hours of different levels

Purchasing Activities

• Purchasing activities are performed in logical steps, forming a cycle.
• This cycle is known as the elements of the purchasing process or as the purchasing procedure.
• Some of these activities can be performed together
• A manual or computerized system will use the same steps.

The Purchasing 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.

Defining Quality

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

• Quality of purchased goods

Methods to Determine Quality

1. Specifications
   • Most general method of describing quality
   • A specification is 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.
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 because:
  • Marketing and operational budgets are only ESTIMATES.
  • Supply of material is UNRELIABLE regarding delivery and quality.

Need to consider:

• THEREFORE business aim for: Optimal Level of Inventory
• Too much inventory, money is tied up.
• Too little inventory, shelves are empty.

How to achieve an Optimal Level of Inventory

• Inventory control
• Determining inventory quantities
• Inventory control systems

1. 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.
2. 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.
3. Inventory control systems
   • We will look at 2 systems, namely the fixed-order quantity system and the cyclical ordering system

Determining Inventory Quantities: 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 utilised 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.
• Total costs line indicate sum total of carrying costs and ordering costs

Determining Economic Order Quantity

• 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

Fixed-Order-Quantity System

• 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.
• Economic Order Quantity (EOQ) determination:
  • It will be the difference between the maximum amount and the minimum amount.
    $EOQ = Maximum - Minimum$
    $EOQ = 160 – 10 = 150$

Cyclical Ordering Systems

Break-Even Analysis

• A technique that managers can use to determine inventory levels.
• Break-even analysis is a technique for determining the volume where:
  • Total revenues (income) = Total cost (expenses)
  • Total cost to produce = The total cost to buy.

Break-even Point Formula

$Q = \frac{F}{(P-C)}$
Where:

• $Q$ = Quantity/Amount
• $F$ = Fixed Costs
• $P$ = Selling Price
• $C$ = Purchasing Cost

Break-even Analysis 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?

$Q = \frac{30000}{(5-3.5)} = 20000$

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. Evaluate Performance -- POOR GOOD
3. Shortlist
4. Seek new supplier
5. Select a specific 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 -> Integrated Information, BUT REMEMBER… Therefore, physical stocktaking is important to 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

1. Focusing on critical inventory
2. Spot checks
3. Chaos vs. order
4. 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 to 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 store rooms
• 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.