IE 420 : SUPPLY CHAIN MANAGEMENT

CHAPTER 2 : PURCHASING
ORGANIZATIONS IN THE ENTERPRISE

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 Learning Outcomes
 Describe the role of procurement in the supply chain
 Identify the differences between traditional purchasing and contemporary purchasing
 Identify and define the four stages of purchasing sophistication
 Describe the critical success factors (CSFs) needed in the purchasing function
 Describe how purchasing is a key participant in integrating the members of a supply chain
 Identify the key functions of purchasing
 Describe differences between the make-or-buy decision and the outsourcing decision
 Identify how the performance of the purchasing function can be measured
 Recognize and describe the types of purchasing strategies
 Construct a vendor rating system when making an important purchase
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 ► This chapter deals with the purchasing of goods and services by various customers in the
supply chain—manufacturers, wholesalers, and retail companies. This is an important
function, because purchased materials and services represent over half of the product costs
in most manufacturing industries and are even higher for wholesale and retail companies,
sometimes exceeding 90% (Joyce 2006).
► As more manufacturing companies move to a core competency strategy, they will outsource
more of their component manufacturing to suppliers and become primarily an assembly
operation. In some cases, they have moved even further by outsourcing the entire
manufacturing function to concentrate on product and brand development and marketing
that product.
► Purchasing is also important in the service sectors of supply chains, including wholesale and
retail operations. In both areas, the value of purchased goods and services is even higher, as
a percentage of the sales dollar, than in manufacturing operations..

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 Role of Procurement in the Supply Chain
• The business functions of procurement planning,
Procurement purchasing, inventory control, traffic, receiving, incoming
inspection, and salvage operations.

Purchasing
• The term used in industry and management to denote the
function of and the responsibility for procuring materials,
supplies, and services.

• An individual whose functions may include supplier selection,

negotiation, order placement, supplier follow-up, measurement and
Buyer control of supplier performance, value analysis, and evaluation of new
materials and processes. In some companies, the supplier scheduler
handles the functions of order placement and supplier follow-up.

• Any good or service produced for sale, barter, or

Product internal use.
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► In practice, there may be some overlap in the use of these terms and even in the job titles. Purchasing seems to
be the term of choice among industrial businesses, while procurement seems to be more generally associated
with government agencies.
► A buyer is an individual who performs a purchasing or procurement function. We will use the term product to
indicate both goods and services. Services have become an increasing share of the purchasing responsibility in
recent years. Another reputable source reports, “Terms such as purchasing, procurement, materiel, materials
management, logistics, supply management, and supply chain management, are used almost interchangeably.
No agreement exists on the definition of each of these terms, and managers in public and private institutions
may have identical responsibilities but substantially different titles” (Leenders et al. 2002).
► The Institute of Supply Management (ISM) Career Center lists dozens of job openings with different job titles,
showing variations on assistant buyer, buyer, purchasing agent, director of purchasing, director of procurement,
and sourcing specialist (ISM 2014). Other jobs within the purchasing function may include expediter, buyer–
planner, or value analyst, depending on the scope and scale of a particular purchasing department.
► In keeping with what appears to be a general practice in the business community, we will use purchasing as the
most widely used term and interchangeable with procurement (Gundlach et al. 2006). We will consider a buyer
as someone who performs at least a part of the purchasing function. There may be other jobs within the
purchasing function, such as expediter or value analyst, depending on the scope and scale of a particular
5 purchasing department.
 PROCUREMENT DISCUSSION
President

VP

HR and
Operations Finance
Admin

Production Accounting Admin

Warehouse Audit Maintenance

Logistics Purchasing Recruitment

Training
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 Question #1
What normally are the items
requested by respective
departments ?
Raw materials, tools, equipment, office supplies,
consumable items, uniforms, repair of equipment, etc.

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 Question #2

What will the respective

departments do if they want to
replenish stocks or supplies?

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 MATERIAL REQUEST FORM

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 Question #3

What would the buyer

(purchasing staff) do after
receiving the MRF?

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 Question #4

If you are the buyer, where will

you procure the items requested
thru MRF?

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 Question #5

What will be your considerations in

choosing a supplier?

What do you think are the necessary

documents for the transaction?
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 PURCHASE ORDER

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 Question #6

How well the supplier deliver the

items covered by P.O.?

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 DELIVERY RECEIPT / SALES INVOICE

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 Types of Purchasing
Traditional
• RFQ based on lowest cost assuming that delivery and quality are met
• The traditional purchasing function was concerned primarily with the buying process in which
they placed the orders and followed up to assure delivery of those orders.

Contemporary
• Requires the buying organization to become partners with its
suppliers
• In the broadest sense, the relationship is designed to work for the long-term well-being of all
supply chain participants.

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 Supplier Evaluation
Traditional Contemporary

 Cost  Supplier evaluation

 Supplier selection for
 Quality long-term relationships
 Delivery  Contract structuring and
 Technical negotiation
 Supplier relationship
 Financial management (SRM)
 Supply chain coordination
and collaboration
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 Critical Success Factors of Purchasing
►Functionality ►Reduce Variances in
Delivery
►Availability
►Increase Supplier
►Cost Dependability
►Quality ►Reduce the Bullwhip Effect
►Match Inflow with ►Become an Intercompany
Outflow ►Find Sustainable Suppliers

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 Critical Success Factors of Purchasing
► Functionality -The first CSF for purchasing was to obtain goods or services that satisfied
the needs of the users. While purchasing managers had some flexibility in selecting the
supplier, the expectation was that the product purchased would work as expected. In
specifying more technical purchases, user departments often specified the model number
and what the vendor wanted, and were not willing to accept substitutes. In this case, the
buyer became a routine order placer.
► Availability - Purchasing has always had the primary responsibility to make goods or
services available when needed by the production line, by the retail store when having a
sale, or for a surgeon about to perform an open-heart surgery. The presence of the
expediter job in many companies still attests to the importance of availability. Late
deliveries were bad; early deliveries were generally acceptable, perhaps even considered a
positive indication of supplier performance. However, in recent years, neither early nor late
deliveries, or over amounts or under amounts, are acceptable.
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► Cost - Close behind availability was the requirement to buy goods and services at the lowest
possible cost. The use of purchase price variances (difference between the actual purchase price
and planned, or standard, price) has been a bedrock measure of purchasing performance from
the beginning. Often, the best way to obtain reduced unit prices was to buy larger volumes.
While this helps the buyer’s purchase price variance, it often resulted in excess inventory or the
wrong mix of inventory, or sometimes both.
► Quality - Obtaining a good quality of purchased goods and services has always been an implicit
responsibility of purchasing. Some companies used quality as a measure of purchasing
performance; however, many did not. Production managers may have grumbled about
inspecting many incoming parts to screen out the defective products, but if the price was right,
the purchasing department usually did not receive much criticism. Functionality, availability, cost,
and quality were all important and remain so today. The better the purchasing department, the
better they were able to satisfy these basic requirements. However, purchasing was not often
considered a key member of the top management organization. As the transition to
contemporary purchasing evolved, a number of CSFs have been added.
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 ►Match Inflow with Outflow- One of the best ways to obtain low purchase
prices was to buy in large quantities or to make early buys—buy out of
season to help suppliers balance their production. Buying in large quantities
resulted in excess inventories that were subject to holding costs, damage,
obsolescence, and a premature commitment of funds. One of the authors
remembers an overzealous restaurant manager who purchased ice tea bags
at a discount, quite a few cases, to say the least. There were cases of ice tea
bags in almost every storage area of the facility. The problem though was
that ice tea bags cannot last for a long period of time. Several years of tea
bags were eventually discarded due to old age!

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 ►Reduce Variances in Delivery - In their attempt to more closely match the
arrival of goods with the production department’s needs, purchasing
departments found, in addition to having to moderate their large volume
buys, they had to assess the effectiveness of the delivery practices of their
suppliers. Some suppliers consistently made on-time deliveries; however,
many were inconsistent—sometimes early, but more often late. Some
suppliers shipped complete orders; some shipped multiple partial orders. It
became necessary for purchasing departments to monitor the performance
of their suppliers and encourage them to be more consistent in their
performance. If they did not improve, suppliers faced the prospect of
reduced business, or even elimination as a supplier

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 ►Increase Supplier Dependability - The attention to supplier delivery performance
opened the opportunity and need to evaluate suppliers on other tangible criteria as
well, such as lead times and quality of merchandise, and even to explore such intangible
services such as the supplier’s help in suggesting ways to improve the buyer–seller
relationship. Some suppliers could provide input about new product developments or
market conditions that were of value to the buying organization. As buyers learned more
about their suppliers, it was a natural development to group the suppliers into
categories representing their value to the buying organization. This closer look also
made it easier for purchasing departments to reduce the number of suppliers they
needed and enabled them to place increased business with their more dependable
suppliers.

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► Reduce the Bullwhip Effect - As purchasing departments learned more about their
suppliers and how to match the flow of incoming goods to outgoing goods, they
demonstrated their increased knowledge to other parts of the business, and even to
other members of their supply chains. One of the more troublesome problems for
supply chains was the bullwhip effect. The bullwhip effect is an extreme change in the
supply position upstream in a supply chain, generated by a small change in demand
downstream in the supply chain. The impact is that inventory can quickly move from
being backordered to being excess. This problem is caused by the ripple effect nature of
communicating orders up the chain with the inherent transportation delays of moving
product down the chain. The bullwhip effect can be markedly improved by synchronizing
the supply chain. If purchasing departments could reduce the variances with suppliers,
then each stage of the supply chain could work together to reduce variances and
thereby reduce the bullwhip effect.

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 ►Become an Intercompany Facilitator- As customers demanded more from
fewer suppliers, it became necessary for other functions in an organization
to have access to their counterparts in supplier organizations— engineers
with engineers, marketers with marketers, accountants with accountants,
and the like. Someone had to initiate and help sustain these relationships;
this facilitating function was a natural function for most purchasing groups.
They generally had the most information about suppliers and could expand
their information base to include information desired by other functions in
the buying organization.

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 ►Find Sustainable Suppliers - The reputation of a firm is closely linked to the
social, environmental, and ethical profiles of an organization’s spending
(Reeve and Steinhausen 2007). Purchasing departments must add finding
responsible suppliers to their list of operating objectives.

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 Question #7

Given the nationwide operations,

how will you organize the
purchasing department?

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 Question #8

For a single location

organization, what is much
better, centralized or
decentralized purchasing set-up?
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 Centralized Purchasing
► Business Dictionary defines centralized procurement as a purchasing system in which
all the departments of a company with a wide geographical distribution can make
purchases through a common purchasing organization.
► In simple words, centralized procurement is a purchase of all required goods and
services by a single department for all the branches of the entire company. Generally,
a purchasing manager heads the department.
► Centralized procurement is beneficial in finding the best deals with local vendors for
the corresponding location of the company department. It not only aids in avoiding
duplicity of orders, but also promotes advantages arising from the high-volume bulk
discounts, lower transportation and inventory management costs. Centralized
purchasing is an indispensable solution for those who feel difficulties in managing
long-running transitions and mending fences.

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 Centralized Purchasing
ADVANTAGES DISADVANTAGES
►Overhead expense  Complex management of the company in case
organization becomes too large;
reduction
 Difficulties with timely replacement of
►Better relationships defective materials;
within the organization  High probability of delays – often requisitions
for goods have to be sent from distant areas;
►Advanced control
 Difficulties with purchasing materials from
►Team cohesion local suppliers in case of an emergency;

►Saved money  Centralized purchasing is not suitable, if

branches are located at different geographical
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locations
 Decentralized Purchasing
ADVANTAGES
►Benefit of time: Better relationships within the
organization
►Fosters better coordination
►Fosters correlation between input and output
►Benefit of choice
►Effective Control

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 PURCHASING COST
 Are we paying more than what the product or the
service is really worth?
 Are we being charged the same as another buyer
would be charged?
 How does the current price compare to a price paid
in the past for the same or similar goods or services?
 Is the quoted price a discounted price or a list price?
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Is there room for price haggling?
 TRADITIONAL COSTING

Traditional costing primarily focuses on

what is spent in a given fiscal period
instead of where and why costs incur.

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 TRADITIONAL COSTING
Cost Features
 Costs accrued from the unit being produced.
Direct cost  Most direct costs are variable.
 A reduction in the supplier’s direct cost is generally worth more to the buyer than a major
reduction in the supplier’s profit.
Examples: Direct material, direct labor, and purchasing cost
 Costs incurred in the operation of a production plant or process, but which normally cannot
Indirect cost be related directly to any given unit of production.
Examples: Rent, property taxes, equipment depreciation, data processing, utility, wages and
salaries, and maintenance cost
 Costs that tend to remain the same regardless of the number of units produced.
Fixed Cost  Costs decrease as a cost per unit when output levels are increased.
 Incurrence of costs is a function of top-level management, not lower-level supervisors.
Example: Land purchase and long-term leasing cost

 Costs that are expected to fluctuate in direct proportion to changes in the level of operational
Variable Cost activities such as sales and production levels.
Examples: Labor cost, hourly wage, and material cost
 Costs that tend to change in proportion to changes in the level of operational activities, but
Semi-variable not in direct proportion; partially variable and partially fixed

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cost Examples: Heat, power, light, fuel, and salaries
 Total Cost of Ownership
►The total cost of ownership (TCO) is a management accounting
philosophy that includes all supply chain–related costs
expected to be incurred throughout the entire life of product.
 Acquisition costs—Costs associated with the purchase of a
product or service
 Ownership costs—Costs associated with the ongoing use of a
purchased product or service
 Post-ownership costs—Costs associated with the disposal and
quality assurance of a product or service
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 Total Cost of Ownership Components
Cost Features
Acquisition  Purchase price
 Planning costs (e.g., order preparation)
costs  Administrative costs (e.g., budgeting, bid specifications)
 Taxes/tariffs/customs duties
 Financing costs (e.g., interest)

Ownership  Downtime costs

 Inspection costs
costs  Maintenance costs
 Inventory carrying costs
 Conversion costs
 Non-value-added costs
 Depreciation

Post-ownership  Disposal costs

 Clean-up costs
costs  Environmental compliance costs
 Repair/replacement costs
 Product liability costs
 Reverse logistics costs (e.g., product recall, recycling costs)
 Cost of lost customer goodwill (e.g., lost sales)
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 ACTIVITY-BASED COSTING

Generally refers to a cost accounting system

that aims to identify money losers or winners
by linking cost drivers directly to products or
services that require activities consuming
resources.

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 ACTIVITY-BASED COSTING PREMISE

 Cost objects consume activities.

 Activities consume resources.
 The consumption of resources drives costs.
 The understanding of cost drivers is critical
for managing overhead expenses and
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minimizing cost errors
 TRADITIONAL VS ACTIVITY-BASED COSTING
Category Traditional Costing Activity-based Costing
Principle Allocate costs. Trace costs.
Approach Aggregation for categorization. Disaggregation for details.
Objective Report costs. Manage costs
Focus “What is spent?” “How the resource is utilized.”
“How much was spent?”
Basis Volume driven. Transaction driven.
Per unit cost Same (no reflection of economies Varies.
of scale, learning curve, or
complexity).
Feature Can distort the overhead cost Enhance the visibility of overhead
information by neglecting cost- expenses.
varying activities.
Philosophy Satisfying. Optimizing.
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 Comparison of traditional costing to activity-based costing

General ledger view of warehousing costs Activity-based view of warehousing costs

Storage and handling P40.1 Dry storage P25.0

General and administration 30.9 Refrigerated storage 8.1
Trucking and delivery 14.5 Receiving 20.0
Freight consolidation 2.4 Shipping 18.8
Value-added services 3.3 Billing 3.2
Total P91.2 Delivery 6.0
Packaging/stenciling 1.8
Freight consolidation 3.0
Material handling equipment 5.3
Total P91.2

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 LIFE CYCLE COSTING
Life cycle costing (LCC) is a cost management technique that determines the total
discounted costs of owning, operating, maintaining, and disposing of an asset
over its useful life. It uses a present value method to assess the value of an asset
at the time of purchase, because not all the operating costs incur at the same
time.
• pertinent costs of ownership
• the period of time over which these costs are incurred
• the discount rate that is applied to future costs translated into
present-day costs

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 SUPPLIER’S APPRAISAL
Criteria Attributes
Quality  Quality of products
 Warranty
 Past records on the reliability of products
 Quality certification, affidavits
 Willingness to take the corrective actions
 Willingness to accept a responsibility for defects or latent
deficiencies
 Prompt replacements of rejects
Price  Competitive price
 Accurate price quotation
 No hidden costs
 Correct billing/invoicing
Delivery Services  Delivery on schedule
 Delivery per routing instructions
 Delivery without constant follow-ups
 Prompt responses to emergent and rush delivery requests
 Good packaging
 Geographical location
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 SUPPLIER’S APPRAISAL
Criteria Attributes
Production  Adequate facility, equipment, and know-how
capacity and  Adequate housekeeping (e.g., cleanliness, maintenance)
technical capability  Good labor-management relations
 Skilled labor • Technical ability to innovate
 Information technology/communication system structure
 Room for growth/expansion

Financial stability  Credit rating (e.g., Dun and Bradstreet report)

 Cash flow, liquidity, and profitability
 Bank references

Environmental  Environment-friendly initiatives/policies

compliance  ISO 14000 certification

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 Supplier Selection
► Categorical method—In this method, a purchasing manager is required to keep and maintain a past performance
record of all suppliers. The purchasing manager establishes a list of factors (with equal importance) for evaluation
purposes and assigns a grade (plus, minus, and neutral) that measures supplier performance in each of the
established areas.
► Weighted-point method—An application of the weighted-point method requires the assignment of an appropriate
weight to each performance factor. The specific weight is a reflection of the purchasing manager’s judgment about the
relative importance of the specific performance factor.
► Cost-ratio method—The cost-ratio method relates all identifiable purchasing costs to the value of shipments received
from individual suppliers (Zenz, 1994). Each cost ratio is assigned to a specific rating, subject to various performance
criteria (e.g., quality, delivery, service). The lower the ratio of costs to shipments, the higher the rating for the supplier.
► Analytical hierarchy process (AHP) method—AHP is suitable for systematically selecting the most desirable suppliers
with respect to multiple, confliction factors influencing the supplier selection decision.
► Multiple attribute utility theory (MAUT) method—MAUT was initially proposed by Min (1994) for supplier selection
due to its ability to take into account both qualitative (e.g., quality assurance, perceived supply risk, communication
barriers) and quantitative factors (e.g., quoted price) influencing supplier selection in the presence of risk and
uncertainty.

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 Weighted Point Method
Supplier A for Part Number ____________________________________
Factor Weights How measured? Supplier performance Ratings
(Past 12 months)
Quality 40 1% defective, subtract 5% 0.8% defective 40[100-(0.8×5)]/100 = 38.4

Delivery 30 1 day late, subtract 1% Average 2 days late 30[100-(2×1)]/100 = 29.4

Price 20 Lowest price paid/price P46/P50 20[(46/50)×100)]/100 = 18.4
charged
Service 10 Good = 100%; Fair = 70%; Fair = 70% 10(70)/100 = 7.0

Poor = 40%

Total 100 93.2

Supplier B for Part Number ____________________________________
Factor Weights How measured? Supplier performance Ratings
(Past 12 months)
Quality 40 1% defective, subtract 5% 1.5% defective 40[100-(1.5×5)]/100 = 37

Delivery 30 1 day late, subtract 1% Average 3 days late 30[100-(3×1)]/100 = 29.1

Price 20 Lowest price paid/price P46/P47 20[(46/47)×100)]/100 = 19.6
charged
Service 10 Good = 100%; Fair = 70%; Poor = 40% 10(40)/100 = 4.0

Poor = 40%

Total 100 89.7

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 Thank you for listening
and sharing.

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