Purchasing Notes

Purchasing

Purchasing: Definition, Introduction, Objectives

• Purchasing is the "Process of buying" which involves all departments in a company.
• It is about obtaining the right material and the right quantity, with the right delivery (in terms of time & place) from the right source, at the right price, and in the right place.
• Inputs from Marketing, Engineering, and Manufacturing are crucial for Purchasing in selecting the material.
• Manufacturing Planning & Control (MPC) must decide when to order which material to meet market demand.
• The purchasing department is responsible for locating suitable sources of supply and for negotiating prices.
• Inputs are needed from other departments to find and evaluate sources of supply and to assist in price negotiation.

Introduction

• Purchasing is important to companies whose raw materials 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, & clerical activities.
  • Speeding up purchasing steps.
  • Allowing time for a more strategic view of the organization and increasing impact on profit.
• Three management influences that encourage improvement in supplier relationships:
  1. Viewing the supply chain as an integrated function.
  2. Outsourcing.
  3. Lean production.
• Latest Trend: Promote environmentally friendly purchasing activities (e.g., Apple product parts in China).

Introduction - Outsourcing

• Definition: "Process of having suppliers provide goods and services that were previously provided internally."
• Reasons: Technical advances in internet communication and efficient shipping methods make offshore sourcing very attractive in terms of cost, service, quality, and delivery.
• Trend: Many products and services are purchased rather than produced locally.
• Purchasing involvement: Increase responsibility of management of outside operations, development, and administration of contracts.

Purchasing as Profit Leverage

• Improve Pre-Tax Profit by 10% ($11 million).

• Method 1: To increase profit by 10% (from 10 to 11), the firm needs to increase sales revenue from 100 to 110.

  Sales Revenue (a) = 110

  Cost of Good Sold Purchases (50% of Sales) = 55

  Others (40% of Sales) = 44

  Sub Total: (b) = 99

  Profit before Tax (c) = 11

• Method 2: Reduce the purchasing cost by 2% from 50 to 49 million.

  Sales Revenue (a) = 100

  Cost of Good Sold Purchases (50% of Sales) = 49

  Other Expense = 40

  Sub Total: (b) = 89

  Profit before Tax (c) = 11

Objectives

• Five objectives of Purchasing: Obtain goods and services:
  1. 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, suppliers 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 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 analyze purchase requisitions

1. Purchasing requisition starts with the ultimate user.
2. A planner releases a planned order authorizing the purchasing department to go ahead and process a purchase order.
3. A purchase requisition contains at least:
   i. Originator identity, signed approval, account to which the cost is assigned.
   ii. Material specification
   iii. Quantity and unit of measure
   iv. Required delivery date and place
   v. Any other supplemental information needed.

2. Select Suppliers

i. Find potential suppliers
* For routine purchases - Lists of approved suppliers
* Search for new suppliers
ii. Issuing requests for quotation
* Written inquiry sent to potential suppliers
* To ensure receipts of competitive and reliable quotations
* NOT a sales order
iii. 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 trade-off between PRICE and technical suitability.
iv. Selecting the right supplier

3. Determine the Right Price

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

4. Issuing a Purchase Order

i. Purchase order is a legal offer to purchase.
ii. Legal contract for the delivery of goods according to the terms and conditions specified in the purchase agreement.
iii. Copies to: Supplier, originator, accounting, receiving, and purchasing file (Communication & records)

5. Follow Up and Delivery

i. Purchasing MUST ensure suppliers deliver goods and services on time
* Expediting transportation, alternate sources of supply, resolving supplier problems, rescheduling production
ii. Work with suppliers
* Changes in delivery requirements, expediting, or delaying delivery when demand changes
* Buyer communicates true requirements to suppliers, so that suppliers are able to provide products and services according to the requirements

6. Receiving and Accepting Goods

i. Normal process
* Inspect goods for correct quantity, no damage
* Accept goods using purchase order & bill of lading supplied by the carrier
* If goods were accepted, receiving would inform purchasing department and close out receiving information.
ii. Exceptions:
* Discrepancy or variance - receiving department communicates to buyer and supplier on variance, quality, or damage information to buyer and pending decision
* Work with the supplier: change in delivery requirement, expediting, or delaying delivery when damage

7. Approving Supplier’s Invoice for Payment

i. After invoice received, must agree on 3 pieces of information.
* Purchase order, Receiving report, invoice
ii. All information must be the same
* The item, Quantity, Price
iii. Check against invoice (Purchasing department responsibility)
* Discounts and terms of original purchase order
* Check against discrepancy, resolve any difference
iv. Once approved, sent to account payable

Establishing Specification

Introduction

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

Quality and Functional Specification

• Functional specifications should define the quality level of products and services (quality characteristics) from the 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

Quality

• Determine what Product & Services to market (through market studies)

• What market segment to be served.

• Product feature, quality, price, and expected sales volume.

• Build the product’s expected quality, performance, appearance, price, sales volume into general design specification.

• Manufacturing conforms to specification or requirement defined by the designer

• If purchase – ensure suppliers can provide the expected quality.

• User expectation of how the product should perform.

Value Analysis

• 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.
• It reduces cost and improves overall part functionality.
• Example: Glass Milk bottle to carton

Describe Functional Specifications

• Can be described individually or a combination of the following:
  1. By Brand
  2. By Engineering drawings
  3. By Specification
     i. Physical and chemical characteristics,
     ii. material and method of production, and
     iii. performance
  4. Miscellaneous

1. By Brand

• Customers rely on the reputation and integrity of suppliers that maintain and guarantee product quality. Apply under such circumstances:
  i. Items are patented; or process is secret
  ii. Supplier has expertise that the buyer does not have.
  iii. Quantity is so small that it is not worth the buyer to develop the specification
  iv. 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
    *   Hot and cold-rolled steels
3.  Performance
    *   Concern with product performance
    *   Example: water pump – liters per hours

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 a 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, e.g., ENGINE Oil standard SAE10W30, electrical wire
    *   Advantages:
        *   Widely known and accepted
        *   Lower price due to
        *   Adapt 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 exact part required.

Supplier Selection

• The selected supplier must have the technology and capacity to provide goods 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, the risk of discontinuity of supplying material.
2. Multiple sourcing (more than 1 supplier)
   • Advantages are competition will help to lower price, provide better service, will be a continuity of supply
   • Disadvantage: the tendency toward an adversarial relationship between supplier and customer.
3. Single sourcing (Partnership with 1 supplier)
   i. Objective is to develop a long-term partnership with the supplier; lower cost and improve quality through partnership
   ii. Supplier has stable management and is sincere in partnership agreement.
   iii. Minimum danger of breaching organization’s secret
   iv. Supplier shares the 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 the 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, supplier relationship

Identifying Suppliers

• The purchasing department must continue to search for available sources of supply through these channels:
  • Salesperson of suppliers
  • Internet
  • Catalogues
  • Trade magazines
  • Trade directories
  • Information obtained by salespeople 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 in 2.)
4. Rank the suppliers by
   a) Multiply weightage (from 2.) with supplier rating (from 3.).
   b) Tally all the score.
5. Determine the best supplier based on the best score.

Supplier Selection Ranking Example

• Step 1: Determine the criteria or factors for supplier selection
• Step 2: assign a weightage for each factor in relationship to other factors. For example, rank 1 to 9.
• Step 3: Rate the supplier based on their ability to meet the factor. (Not associate with Weight.)
• Step 4: Multiply weight (A) x rating (B)
• Step 5: Rank according to the overall score.

Supplier Selection

• Advantages

  • It attempts to quantify factors that are not quantified by nature.
  • It forces the 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.

• Supply 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) Breakeven

1. A fair price is one that 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
• 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
  • $X = 588.2 => 589$ unit (round up)
  • Revenue = 589 x 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
• $0 = (Price * Unit) - (Variable Cost * Unit) - Fixed Cost$
• $0 = (P * X) - (VC * X) - FC$
• $0 = (P-VC)*X - FC$
• $0 = CM * X - FC$
• $CM * X = FC$
• $X = frac{FC}{CM}$

Example – CM Methods

• Fixed Cost = $5,000
• Variable Cost = $6.50 / unit
• Selling Price = $15 per unit
• Average Cost = 5,000 ÷ 1000 + $6.50 = $11.50 per unit
• To find the Break-Even Units
• $Break Even Point = frac{5000}{15 - 6.5} = 588 approx 589$

(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

A. The price can be negotiated if the buyer has the knowledge and clout (high versus low volume) to do so.
B. Through negotiation, the buyer and seller resolve conditions of purchase to the mutual benefits of both parties.
C. For a successful negotiation, potential profit must justify the expenses of careful planning, time, and efforts in negotiation.
D. Different negotiation approaches for different product categories
1. Commodities - negotiation concern with future market; the price is set based on demand and supply ( copper, coal, wheat)
2. Standard products – provided by many suppliers, thus prices are set based on published prize; limited negotiation except large quantity.
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. Product is made to order.

Impacts 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 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, minimize work-in-process inventory, and maintaining desire customer service.

Buyer / Planner Concept

• Production activity control
  • Controls the flow of work through the plant
  • Schedules need for components
• Purchasing
  • 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 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
• Buyer can delay actual ordering

Impact of MRP on purchasing

• Two types of purchasing activities
  1. Procurement
     • it includes functions of establishing specification, selecting suppliers, price determination, and negotiation
  2. Supplier scheduling and follow-up
     • release order to suppliers, work with suppliers to schedule delivery, and follow up
     • Supplier scheduling is the same as production activities control:
       • Execute master production schedule, MRP, effective use of resources, minimize work-in-process inventory, maintaining desire 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)

• EDI in sharing customers and suppliers information
  • Speedy information sharing and reduce waste (paperless)

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, Reuse, and Recycle

• Reduce (most important), reuse, and recycle
  • Purchasing has first-hand knowledge of the price trend of the waste product.
  • Purchasing internal and external contacts
  • Purchasing is familiar with internal needs and external registration