7. Purchasing

Purchasing refers to a business or organization attempting for acquiring goods or services to accomplish the goals of the enterprise. Though there are several organizations that attempt to set standards in the purchasing process, processes can vary greatly between organizations. Typically the word “purchasing” is not used interchangeably with the word “procurement”, since procurement typically includes Expediting, Supplier Quality, and Traffic and Logistics (T&L) in addition to Purchasing.

Purchasing managers/directors, and procurement managers/directors guide the organization’s acquisition procedures and standards. Most organizations use a three-way check as the foundation of their purchasing programs. This involves three departments in the organization completing separate parts of the acquisition process. The three departments do not all report to the same senior manager to prevent unethical practices and lend credibility to the process. These departments can be purchasing, receiving; and accounts payable or engineering, purchasing and accounts payable; or a plant manager, purchasing and accounts payable. Combinations can vary significantly, but a purchasing department and accounts payable are usually two of the three departments involved.

When the receiving department is not involved, it's typically called a two-way check or two-way purchase order. In this situation, the purchasing department issues the purchase order receipt not required. When an invoice arrives against the order, the accounts payable department will then go directly to the requestor of the purchase order to verify that the goods or services were received. This is typically what is done for goods and services that will bypass the receiving department. A few examples are software delivered electronically, NRE work (non reoccurring engineering services), consulting hours, etc.

In oracle EBS another ferature is avaiable which four way matching which invoices purchasing, Receving, Quality/Inventory and payable departments.

Choosing the right material requires input from the marketing, engineering, manufacturing, and purchasing departments. Quantities and delivery of finished goods are established by the needs of the marketplace. However, manufacturing plan-fling and control (MPC) must decide when to order which raw materials so that marketplace demands can be satisfied. Purchasing is then responsible for placing the orders and for ensuring that the goods arrive on time.

The purchasing department has the major responsibility for locating suitable sources of supply and for negotiating prices. Input from other departments is required in finding and evaluating sources of supply and to help the purchasing department in price negotiation. Purchasing. in its broad sense, is everyone’s business.

Purchasing : Impact on Cost & Profit
Historically, the purchasing department issued purchase orders for supplies, services, equipment, and raw materials. Then, in an effort to decrease the administrative costs associated with the repetitive ordering of basic consumable items, "blanket" or "master" agreements were put into place. These types of agreements typically have a longer duration and increased scope to maximize the quantities of scale concept. When additional supplies were required, a simple release would be issued to the supplier to provide the goods or services.

Another method of decreasing administrative costs associated with repetitive contracts for common material, is the use of company credit cards, also known as "Purchasing Cards" or simply "P-Cards". P-card programs vary, but all of them have internal checks and audits to ensure appropriate use. Purchasing managers realized once contracts for the low dollar value consumables are in place, procurement can take a smaller role in the operation and use of the contracts. There is still oversight in the forms of audits and monthly statement reviews, but most of their time is now available to negotiate major purchases and setting up of other long term contracts. These contracts are typically renewable annually.

On the average, manufacturing firms spend about 50% of their sales dollar in the purchase of raw materials, components, and supplies. This gives the purchasing function tremendous potential to increase profits. As a simple example, suppose a firm spends 50% of its revenue on purchased goods and shows a net profit before taxes of 10%. For every $100 of sales, they receive $10 of profit and spend $50 on purchases. Other expenses are $40. For the moment, assume that all costs vary with sales. These figures are shown in the following as a simplified income statement:

Purchasing objectives
Missed deliveries can create havoc for manufacturing and sales, but purchasing can reduce problems for both areas, further adding to profit. The objectives of purchasing can be divided into 4 categories:

- Obtaining goods and services of the required quantity and quality,
- Obtaining goods and services at the lowest cost,
- Ensuring the best possible service and prompt delivery by the supplier,
- Developing and maintaining good supplier relations and developing potential suppliers.

To satisfy these objectives, some basic functions must be performed:
- Determining purchasing specifications: right quality, right quantity and right delivery (time and place);
- Selecting supplier (right source);
- Negotiating terms and conditions of purchase (right price);
- Issuing and administration of purchase orders.

Functional Specification Description

Functional specification can be described in the following ways or by a combination of them:

- By brand;
- By specification of physical and chemical characteristics, material and method of manufacture, and performance;
- By engineering drawings;
- Miscellaneous.

1. Description by Brand
The price specification represents the economic value that the buyer puts on the item—the amount the individual is willing to pay. If the item is to be sold at a low price, the manufacturer will not want to pay a high price for a component part. The economic value placed on the item must relate to the use of the item and its anticipated selling price.

Items are patented, or the process is secret.
The supplier has special expertise that the buyer does not have.
The quantity bought is so small that it is not worth the buyer’s effort to develop specifications.
The supplier, through advertising or direct sales effort, has created a preference on the Dart of the buyer’s customers or staff

When buying by brand, the customer is relying on the reputation and integrity of the supplier. The assumption is that the supplier wishes to maintain the brand’s reputation and will maintain and guarantee the quality of the product so repeat purchases will give the buyer the same satisfaction.

Most of the objections to purchasing by brand center on cost. Branded items, as a group, usually have price levels that are higher than nonbranded items. It may be less costly to develop specifications for generic products than to rely on brands. The other major disadvantage to specifying by brand is that it restricts the number of potential suppliers and reduces competition. Consequently, the usual practice, when specifying by brand, is to ask for the item by brand name or equivalent. In theory, this allows for competition.

2. Description by specification
Whatever method is used, description by specification depends on the buyer describing in detail exactly what is wanted:

- Physical and chemical characteristics,
- Material and method of manufacture,
- Performance.

Whatever the method of specification, there are several characteristics to description by specification:
- To be useful, specifications must be carefully designed. If they are too loosely drawn, they may not provide a satisfactory product. If they are too detailed and elaborate, they are costly to develop, are difficult to inspect and may discourage possible suppliers;
- Specifications must allow for multiple sources and for competitive bidding;
- They provide a standard for measuring and checking the material supplied;
- Not all items lend themselves to specification;
- An item described by specification may be more suitable and a great deal more expensive, than a supplier’s standard product;
- If the specifications are set by the buyer, they will be used only where there is sufficient volume of purchases to warrant the cost or where it is not possible to describe what the buyer wanted in any other way.

Sources of specifications. There are 2 major sources of specifications:
- Buyer specifications,
- Standard specifications.

Buyer specifications. Buyer-developed specifications are usually expensive and time-consuming to develop. Companies do not use this method unless there is no suitable standard specification available or unless the volume of work makes it
economical to do so.

Standard specifications. Standard specifications have been developed as a result of much study and effort by governmental and non-governmental agencies. They usually apply to raw or semi-finished products, component part or the composition of material.
There are several advantages to using standard specifications. First, they are widely known and accepted and, because of this, are readily available from most suppliers. Second, because they are widely accepted, manufactured and sold, they are
lower in price than non-standard items. Finally, because they have been developed with input from a broad range of producers and users, they are usually adaptable to the needs of many purchasers.

3. Engineering drawings
Drawings are a major method of specifying what is wanted and are widely used because often there is no other way to describe the configuration of parts or the way they are to fit together. They are produced by the engineering design department and are expensive to produce, but given an exact description of the part required.

4. Miscellaneous
The method of description is a communication with the supplier. How well it is done will affect the success of the purchase and sometimes the price paid.

Price Determination

Price is not the only factor in making purchasing decisions. However, all other things being equal, it is the most important. In the average manufacturing company, purchases account for about 50% of the cost of goods sold, and any savings made in purchase cost has a direct influence on profits.

However, remember that “you only get what you pay for.” The trick is to know what you want and not pay more than necessary. When a purchase is made, the buyer receives a package of function, quantity, service, and price characteristics that are suited to the individual’s needs. The idea of “best buy” is the mixture that serves the purpose best.

Basis for Pricing
The term “fair price” is sometimes used to describe what should be paid for an item. But what is a fair price? One answer is that it is the lowest price at which the item can be bought. However, there are other considerations, especially for repeat purchases where the buyer and seller want to establish a good working relationship. One definition of a fair price is one that is competitive, gives the seller a profit, and allows the buyer ultimately to sell at a profit. Sellers who charge too little to cover their costs will not stay in business. To survive, they may attempt to cut costs by reducing quality and service. In the end, both the buyer and seller must be satisfied.

Since we want to pay a fair price and no more, it is good to develop some basis for establishing what is a fair price.

Prices have an upper and a lower limit. The market decides the upper limit. What buyers are willing to pay is based on their perception of demand, supply, and their needs. The seller sets the lower limit. It is determined by the costs of manufacturing and selling the product and profit expectation. If buyers are to arrive at a fair price, they must develop an understanding of market demand and supply, competitive prices, and the methods of arriving at a cost.

One widely used method of analyzing costs is to break them down into fixed and variable costs. Fixed costs are costs incurred no matter the volume of sales. Examples are equipment depreciation, taxes, insurance, and administrative overhead. Variable costs are those directly associated with the amount produced or sold. Examples are direct labor, direct material, and commissions of the sales force.

Example To make a particular component requires an overhead (fixed) cost of $5000 and a variable unit cost of $6.50 per unit. What is the total cost and the average cost of producing a lot of 1000? If the selling price is $15 per unit, what is the break-even point?
Answer :
Total cost = $5000 + ($6.50 x $1000) = $11,500
Average cost = $11,500 ± 1000 = $11.50 per unit
Break-even point: Let X = number of units sold
$15X= $5000+ $6.5X
$8.50X = $5000
X = 588.2 units
Break-even occurs when 588.2 units are made and sold.

Price Negotiation
Prices can be negotiated if the buyer has the knowledge and the clout to do so. A small retailer probably has little of the latter, but a large buyer may have much. Through negotiation, the buyer and seller try to resolve conditions of purchase to the mutual benefit of both parties. Skill and careful planning are required for the negotiation to be successful. It also takes a great deal of time and effort, so the potential profit must justify the expense.

One important factor in the approach to negotiation is the type of product. There are four categories:
1. Commodities. Commodities are materials such as copper, coal, wheat, meat, and metals. Price is set by market supply and demand and can fluctuate widely. Negotiation is concerned with contracts for future prices.

2. Standard products. These items are provided by many suppliers. Since the items are standard and the choice of suppliers large, prices are determined on the basis of listed catalog prices. There is not much room for negotiation except for large purchases.

3. Items of small value. These are items such as maintenance or cleaning supplies and represent purchases of such small value that price negotiation is of little purpose. The prime objective should be to keep the cost of ordering low. Firms will negotiate a contract with a supplier that can supply many items and set up a simple ordering system that reduces the cost of ordering.

4. Made-to-order items. This category includes items made to specification or on which quotations from several sources are received. These can generally be negotiated. 

Purchase specification

Purchase specification is a detailed description of the measurable characteristics desired in an item to be purchased, such as quality, size, weight, performance parameters, safety requirements, etc.

The first concern of purchasing—what to buy—is not necessarily a simple decision. For example, someone deciding to buy a car should consider how the car will be used, how often, how much one is willing to pay, and so on. Only then can an individual specify the type of car needed to make the “best buy.” In purchasing an item or a service from a supplier, several factors are included in the package bought. These must be considered when specifications are being developed and can be divided into three broad categories:

Quantity requirements: Market demand first determines the quantities needed. The quantity is important because it will be a factor in the way the product is designed, specified, and manufactured. For example, if the demand was for only one item, it would be designed to be made at least cost, or a suitable standard item would be selected. However, if the demand were for several thousand, the item would be designed to take advantage of economies of scale, thus satisfying the functional needs at a better price

Price requirements: The price specification represents the economic value that the buyer puts on the item—the amount the individual is willing to pay. If the item is to be sold at a low price, the manufacturer will not want to pay a high price for a component part. The economic value placed on the item must relate to the use of the item and its anticipated selling price.

Functional requirements: Functional specifications are concerned with the end use of the item and what the item is expected to do. By their very nature, functional specifications are the most important of all categories and govern the others.

Functional specifications and Quality

In a sense, functional specifications are the most difficult to define. To be successful, they must satisfy the real need or purpose of an item. In many cases, the real need has both practical and aesthetic elements to it. A coat is meant to keep one warm, but under what circumstances does it do so and what other functions is it expected to perform? How cold must it get before one needs a coat? On what occasions will it be worn? Is it for working or dress wear? What color and style should it be? What emotional needs is it expected to fill? In the same way, we can ask what practical and aesthetic needs a door handle or side-view mirror on a car is expected to satisfy.

There are many definitions of quality, but they all center on the idea of user satisfaction. On this basis, it can be said that an item has the required quality if it satisfies the needs of the user.

There are four phases to providing user satisfaction:
Quality and product planning.
Quality and product design.
Quality and manufacturing.
Quality and use.

Product planning is involved with decisions about which products and services a company is to market. It must decide the market segment to be served, the product features and quality level expected by that market, the price, and the expected sales volume. The basic quality level is thus specified by senior management according to their understanding of the needs and wants of the marketplace. The success of the product depends on how well they do this.

The result of the firm’s market studies is a general specification of the product outlining the expected performance. appearance. price, and sales volume of the product. It is then the job of the product designer to build into the design of the product the quality level described in the general specification. If this is not properly done, the product may not be successful in the marketplace.

For manufactured products, it is the responsibility of manufacturing, as a minimum, to meet the specifications laid down by the product designer. If the item is bought, it is purchasing responsibility to make sure the supplier can provide the required quality level. For purchasing and manufacturing, quality means conforming to specifications or requirements.

To the final user, quality is related to his or her expectation of how the product should perform. Customers do not care why a product or service is defective. They expect satisfaction. If the product is what the customer wants, well designed, well made, and well serviced, the quality is satisfactory.

Functional specifications should define the quality level needed. They should describe all those characteristics of a product determined by its final use. Function, quantity, service, and price are interrelated. It is difficult to specify one without consideration of the others, indeed, the final specification is a compromise of them all, and the successful specification is the best combination of the lot. However, functional specifications ultimately are the ones that drive the others. If the product does not perform adequately for the price, it will not sell.

Value analysis is an approach to improving the value of a product or process by understanding its constituent components and their associated costs. It then seeks to find improvements to the components by either reducing their cost or increasing the value of the functions.

Value engineering (VE) is a systematic method to improve the "value" of goods or products and services by using an examination of function. Value, as defined, is the ratio of function to cost. Value can therefore be increased by either improving the function or reducing the cost. It is a primary tenet of value engineering that basic functions be preserved and not be reduced as a consequence of pursuing value improvements

Purchasing Cycle

Successful purchasing organizations follow a purchasing cycle or process to ensure that the important elements are not overlooked. Each material or service being procured will require a different level of activity and priority. The experienced purchaser will ensure that each of the ten steps is fully performed and executed.

The purchasing cycle consists of the following steps:

Receiving and analyzing purchase requisitions.
Selecting suppliers. Finding potential suppliers, issuing requests for quotations, receiving and analyzing quotations, and selecting the right supplier.
Determining the right price.
Issuing purchase orders.
Following up to assure delivery dates are met.
Receiving and accepting goods.
Approving supplier’s invoice for payment.

1. Receiving and analyzing purchase requisition
Purchase requisitions start with the department or person who will be the ultimate user. In the material requirements planning environment, the planner releases a planned order authorizing the purchasing department to go ahead and process a purchase order. At a minimum, the purchase requisition contains the following information:

Identity of originator, signed approval, and account to which cost is assigned.
Material specification.
Quantity and unit of measure.
Required delivery date and place.
Any other supplemental information needed

2. Selecting suppliers
Identifying and selecting suppliers are important responsibilities of the purchasing department. For routine items or those that have not been purchased before, a list of approved suppliers is kept. If the item has not been purchased before or there is no acceptable supplier on file, a search must be made. If the order is of small value or for standard items, a supplier can probably be found in a catalogue, trade journal, or directory.

2.1 Requesting quotations
For major items, it is usually desirable to issue a request for quotation. This is a written inquiry that is sent to enough suppliers to be sure competitive and reliable quotations are received. It is not a sales order After the suppliers have completed and returned the quotations to the buyer, the quotations are analyzed for price, compliance to specification, terms and conditions of sale, delivery, and payment terms. For items where specifications can be accurately written, the choice is probably made on price, delivery, and terms of sale. For items where specifications cannot be accurately written, the items quoted will vary. The quotations must be evaluated for technical suitability. The final choice is a compromise between technical factors and price. Usually both the issuing and purchasing departments are involved in the decision.

3. Determining the right price
This is the responsibility of the purchasing department and is closely tied to the selection of suppliers. The purchasing department is also responsible for price negotiation and will try to obtain the best price from the supplier.

4. Issuing a purchase order
A purchase order is a legal offer to purchase. Once accepted by the supplier, it becomes a legal contract for delivery of the goods according to the terms and conditions specified in the purchase agreement. The purchase order is prepared from the purchase requisition or the quotations and from any other additional information needed. A copy is sent to the supplier; copies are retained by purchasing and are also sent to other departments such as accounting, the originating department, and receiving.

5. Following up and delivery
The supplier is responsible for delivering the items ordered on time. The purchasing department is responsible for ensuring that suppliers do deliver on time. If there is doubt that delivery dates can be met, purchasing must find out in time to take corrective action. This might involve expediting transportation, alternate sources of supply, working with the supplier to solve its problems, or rescheduling production.
The purchasing department is also responsible for working with the supplier on any changes in delivery requirements. Demand for items changes with time, and it may he necessary to expedite certain items or push delivery back on some others. The buyer must keep the supplier informed of the true requirements so that the supplier is able to provide what is wanted and when.

6. Receiving and accepting goods
When the goods are received, the receiving department inspects the goods to be sure the correct ones have been sent, are in the right quantity, and have not been damaged in transit. Using their copy of the purchase order and the bill of lading supplied by the carrier, the receiving department then accepts the goods and writes up a receiving report noting any variance. If further inspection is required, such as by quality control, the goods are sent to quality control or held there for inspection. If the goods are received damaged. the receiving department will advise the purchasing department and hold the goods for further action. Provided the goods are in order and require no further inspection, they will be sent to the originating department or to inventory.

A copy of the receiving report is then sent to the purchasing department noting any variance or discrepancy from the purchase order. If the order is considered complete, the receiving department closes out its copy of the purchase order and advises the purchasing department. If it is not, the purchase order is held open awaiting completion. If the goods have also been inspected by the quality control department, they, too, will advise the purchasing department whether the goods have been accepted or not.

7. Approving supplier’s invoice for payment
When the supplier’s invoice is received, there are three pieces of information that should agree: the purchase order, the receiving report, and the invoice. The items and the quantities should be the same on all; the prices, and extensions to prices, should be the same on the purchase order and the invoice. All discounts and terms of the original purchase order must be checked against the invoice. It is the job of the purchasing department to verify these and to resolve any differences. Once approved, the invoice is sent to accounts payable for payment.

Selecting Supplier/Approved Supplier List

Once the decision is made about what to buy, the selection of the right supplier is the next most important purchasing decision. A good supplier is one that has technology to make the product to the required quality, has the capacity to make the quantity needed and can run the business well enough to make a profit and still sell a product competitively.

Multinational companies usually maintain a central procurement department. These departments maintain a list of approved suppliers for all the purchased item. Central procurement department activates includes - creating request for quotation, quotation analysis, selecting a vendor, price negotiations, long term contracts and agreement etc.

There are 4 types of sourcing: sole, single, dual & multiple.

- Sole sourcing implies that only one supplier is available because of patents, technical specifications, raw material, location and so forth.
- Single sourcing is a planned decision by the organization to select one supplier for an item when several sources are possible. It is intended to produce a long-term partnership.
- Dual sourcing implies that only two vendors for the inventory items.
- Multiple sourcing is the use of more than one supplier for an item. The potential advantages are that competition will result in lower price and better service and that there will be a continuity of supply. In practice there is a tendency toward a adversarial relationship between supplier and customer.

Factors in selecting suppliers
Function, quantity, service and price are what the supplier is expected to provide and are the basis for selection and evaluation. Considering this there are several factors in selecting a supplier.

Technical ability. The buyer will depend upon the supplier to provide product improvements that will enhance or reduce the cost of the buyer’s products. Sometimes the supplier can suggest changes in product specification that will improve the product and reduce the cost.

Manufacturing capability. Manufacturing must be able to meet the specifications for the product consistently while producing as few defect as possible. The supplier must have a good quality control program, competent and capable
manufacturing personnel and good manufacturing planning and control system to ensure timely delivery.

Reliability. If the relationship is to continue, there must be an atmosphere of mutual trust and assurance that the supplier is financially strong enough to stay in business.

After-sales service. If the product is of a technical nature or likely to need replacement parts or technical support, the supplier must have a good after-sales service. This should include a good service organization and inventory of service

Supplier location. Sometimes it is desirable that the supplier be located near the buyer, or at least maintain an inventory locally. A close location helps shorten delivery times and means emergency shortages can be delivered quickly.
Other considerations. Sometimes other factors such as credit terms, reciprocal business and willingness of the supplier to hold inventory for the buyer should be considered.

Price. The supplier should be able to provide competitive prices. In a modern business environment, the type of relationship between the supplier and the buyer is crucial to both. The supplier can rely on future business and the buyer will have an assured supply of quality product, technical support and product improvement. Both parties understand the problems of the other and can work together to solve problems to their mutual advantage.

Identifying suppliers
One major responsibility of the purchasing department is to continue to research all available source of supply. Some aids for identifying sources of supply follow:
- Salespersons of the supplier company,
- Catalogues,
- Trade magazines,
- Trade directories,
- Information obtained by the salespeople of the buyer firm.

Final Selection of Supplier
Some factors in evaluating potential suppliers arc quantitative, and a dollar value can he put on them. Price is the obvious example. Other factors are qualitative and demand some judgment to determine them. These are usually set out in a descriptive fashion. The supplier’s technical competence might be an example.

The challenge is finding some method of combining these two major factors that will enable a buyer to pick the best supplier. One method is the ranking method, described next.

1. Select those factors that must be considered in evaluating potential suppliers.

2. Assign a weight to each factor. This weight determines the importance of the factor in relation to the other factors. Usually a scale of one to ten is used. If one factor is assigned a weight of five and another factor a weight of ten, the second factor is considered twice as important as the first.

3. Rate the suppliers for each factor. This rating is not associated with the weight. Rather, suppliers are rated on their ability to meet the requirements of each factor. Again, usually a scale of one to ten is used.

4. Rank the suppliers. For each supplier, the weight of each factor is multiplied by the supplier rating for that factor.
For example, if a factor had a weight of 8 and a supplier was rated 3 for that factor, the ranking value for that factor would he 24. The supplier rankings are then added to produce a total ranking. The suppliers can then be listed by total ranking and the supplier with the highest ranking chosen.

The given figure shows an example of this method of selecting suppliers. Theoretically, supplier B, with the biggest total of 223, will be selected.

The ranking method is an attempt to quantify those things that are not quantified by nature. It attempts to put figures on subjective judgment. It is not a perfect method. but it forces the buying company to consider the relative importance of the various factors.