18 Purchasing Basics

Purchasing Basics

Course Introduction

Slide 01: Overview

Welcome to the Supply Chain Academy session: Purchasing. My name is Henry Alex Hutchins, and you can see from the string of letters after my name that I am certified by three professional associations. I hold a CFPIM and a CIRM from APICS (American Production and Inventory Control Society), and the CPM and APP from ISM (Institute for Supply Management). I also hold a CM — that is Certified Professional Manager — from the NMA — that is the National Management Association.

When I graduated from Auburn University in Alabama, I went to work for Lockheed in Marietta, Georgia. After Lockheed, I worked for North American, Rockwell, Aero Commander, Hyper Aircraft, and United Technologies. I spent 15 years at the Kennedy Space Center working for the company that assembles the solid rocket boosters for the space shuttle. I left the Space Center in 1996 to teach full-time.

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Purchasing's Fiduciary Responsibility

The first thing I want to say is that purchasing people are different. Most manufacturing people giggle when I say that but let me illustrate what I mean with an example. Let’s say that you, in manufacturing, and I are playing golf with Paula from purchasing and Sam your supplier. As you tee-up the ball, you say to Sam, the supplier, “That load of widgets you delivered last week? That was the best we have ever seen. You should bring us another load this week.” And later that week, Sam backs his pickup truck to the door and off-loads widgets, and then gives Paula an invoice for $495.

Is the company obligated to pay the bill? The answer is no. But do you know why the company does not have to pay? Is it because there is no purchase order? No, the purchase order number is not required. Is it because there is no written document? No, a verbal contract is legal and enforceable. Is it because you, in manufacturing, are not authorized to order anything? Yes, those of us in manufacturing can talk all we wish without obligating the company. Paula, on the other hand, the one in purchasing, has to be very careful about what she says. Because if Paula had been the one on the golf course that told Sam to bring in the widgets, then the company would be obligated to pay the bill. When purchasing speaks, the company speaks. The purchasing agent has a fiduciary relationship with the company that none of the rest of us has.



Introduction

In many companies today, 50 percent of the sales dollar (or euro) is the cost of raw materials on a part. As companies improve their manufacturing process, that percentage climbs even higher. It is not unusual for two-thirds to three-fourths of the cost of goods sold to be purchased items. This means that purchasing is playing an increasingly important role in the profit margin of the company.

As an example, consider a company with a 10 percent profit margin. If purchasing can save $100 through lowering the cost, better quality, and a more efficient operation, sales would have to have an increase of $1000 in sales just to match the same $100 profit. Efficient means doing things right. Effective indicates that we are doing the right thing. If the purchasing function is not effective and efficient, the company will not be either. Purchasing, of course, is involved with more than just production. Purchasing is responsible for procuring everything that the entire company needs to operate.

While we and the rest of the company are not authorized to place purchase orders, we do have an obligation to work directly with purchasing. We need to understand the purchasing function if we are going to work with them as a team and benefit our enterprise — our company.



Concepts of Purchasing

Slide 04: Objectives of Purchasing

Let’s take a look at the objectives of purchasing and the function that purchasing performs. The next two objectives are relatively new. A generation ago, we told purchasing to keep vendors at arm’s length to get the lowest price. Today, we are teaching purchasing to develop close relationships with suppliers, so that we can ensure the best service by suppliers — including asking for special treatment if we need a part expedited — and to develop and maintain good supplier relations. We are talking about here our most important suppliers — those who are going to partner with us in the supply chain.



Functions of Purchasing

The functions that purchasing performs are to determine what is needed, when, and where. In the old days, before automated systems, the buyer would simply wait in his office until a valid requisition wound its way through the approval system and landed on his desk. Today, most of the requirements for parts will come from the system. The purchasing professional had better be able to use the system to get the information needed. Another function is to select the supplier. This is still the sole responsibility of purchasing. If others in the company have knowledge of the capability of certain suppliers, they should make that information available to purchasing so that supplier can be evaluated. The next one is negotiation of terms and conditions. As the fiduciary agent of the company, the purchasing professional is the only one legally authorized to negotiate and obligate the company. And then finally, to administer the agreement. This has become very important with supply chain. Rather than a one-time order, we are setting up long-term partnerships or relationships, and these agreements will be managed by purchasing.



Agenda

This session is not intended to make you a purchasing agent but to provide enough information for you to work with a purchasing professional as a team member. We will cover the essential concepts of purchasing — what is actually involved. We will examine the selection process — evaluation of suppliers. We will outline the process of managing the purchase order, and then we will briefly list the new types of relationships that companies are forming with their supply chain partners.



Purchasing Cycle

The purchasing cycle starts before the purchase order. It starts with the requirement. The purchasing professional should be looking at a cross-center horizon to analyze the needs of the company. Selection of the supplier should start long before the immediate need. If parts can be obtained from a partner, supplier selection is easy. If a required part is a common commodity, then there are many suppliers from which to choose. But if the requirement is unique, the purchasing professional may have a lot of research to do. Determining the right price used to be easy — just get three competitive bids and select one. With a long-term partnership, the price is not always set. So the purchasing professional has to find other ways to determine if the price is fair.

To issue the authorization means to release the purchase order or other authorizing transactions when not using a purchase order. The purchasing professional is the only one in the company who is authorized to make this transaction. Monitoring the order is normally done on an exception basis. If everything goes according to plan, then the purchasing professional may not have anything else to do. But if there is a problem, it is a purchasing problem. Purchasing people do not receive or inspect the goods, and they do not store the goods. But the people who are doing these activities are doing them on behalf of purchasing. If there are no problems, purchasing only needs to know that the order was received. If there is a problem, however, purchasing will have to get involved. For example, if the goods are rejected, purchasing is the point of contact that lets the supplier know that there is a problem, and then to find out what the supplier wants to do to remedy the situation. And finally, if there is a problem with payment for the order, the purchasing professional is the one who must get involved and resolve these issues.



Vendor versus Supplier

There are some definitions that I refer to as critical terminology. If you use these terms in your daily work, you have a working definition already. If not, you will need to learn these terms because you will need to know them for the exam. Consider this as an example of critical terminology. Vendor and supplier are used interchangeably. But we tend to use the term vendor only when we refer to a one-time purchase order, while the term supplier is used when we intend to do business with a company over a period of time.



Sourcing Approaches

Sourcing refers to supplier selection, and here are some terms you need to be familiar with. Multiple sources means just that — that there is more than one source of the material or component part that we are required. The purchasing professional has a choice of which supplier to use. Lone source means that there is one, and only one, supplier for the product or service that is needed. This could be because there is only one company capable of making the product, or that one company would have a patent on the product or process, and purchasing has to deal with that one supplier if the company is going to have that part.

Single source refers to the situation where there are multiple sources, but the company has decided to deal with only one source. This could be done to obtain a price break or to ensure a constant supply of the item. And as companies move into the supply chain concept, this type of sourcing is going to become more common.



Forms of Agreement

The contract must follow the law of the country or countries where the agreement is to be put in force. The examples given here are in the United States. When I taught classes in other countries, the attendees often asked me how business was conducted in the United States. They needed this information so they could do their job correctly. Before we get into written contracts, let’s take a minute to talk about the verbal contract. In our example in the beginning of the session when you played golf with Paula, Sam, and me, I told you that the verbal contract was a valid contract, and this is a matter of state law and that supersedes your company’s policy. The Uniform Commercial Code (or U.C.C.) is a standard that individual states use so that a company can conduct business across state lines. The U.C.C. allows for a verbal agreement up to $500 and that is enforceable in a court of law. The U.C.C. changed a couple of years ago, and individual states have now validated that change, to up that amount to $5,000. Now the United States and Canada are the two notable exceptions that require a written contract if it is above those amounts. Most countries of the world will allow verbal contracts for any amount.

The purchase order is the common way to procure goods and services that a company is going to need. The P.O. has been replaced with a contract in many supply chains, but there is always going to be a place for the P.O. in a company’s future. To get goods and services from a vendor only one time, a P.O. is the best document to use. Now remember, all P.O.s are contracts but not all contracts are P.O.s.

A blanket purchase order is a special P.O. that allows the supplier to deliver the goods or services multiple times over the year without traditional documents.





The blanket P.O. sets limits on the time and the quantity of the delivery and allows the supplier to ship a product on a regular basis or allows people in production to send a signal to the supplier that it is time to deliver more. How long can a blanket P.O. last? The answer is no longer than a year. A law in the United States requires that the terms of a purchase order be completed within one year. If an agreement needs to be made that goes beyond one year, the blanket P.O. is not the right document. A contract is what is needed instead.

A contract is a legal document between two parties. To be legally binding, it must consist of an offer. That offer must be accepted, and some consideration must be present. You have to pay for the item. The participating parties must be competent, and the contract has to be for a legal purpose.

Contents of Agreements

To avoid problems, we would like to have the following information included in the P.O. The name of the item; the description — so we can identify it when it arrives; the price of the item and the extended price for multiple quantities; the quality specifications for the item — so we can determine that it meets those standards. It is also necessary for the supplier to ship us the right product, the quantity, and the allowed variation from the quantity. For example, we make an order for 1,000 units plus or minus 5 percent. This means any number between 950 and 1,050 would be acceptable, and we can close the P.O. Delivery refers to when and where the items are to arrive at our location. And finally, terms includes such things as payment options, and special instructions, and that type of thing. If it is unusual, it certainly needs to be included in the P.O.





Slide 12: Quiz

Quiz

Supplier Selection & Evaluation

Slide 13: Factors to Consider in Supplier Selection

With the last generation, the purchasing agent, they just get competitor bids and choose the lowest price. Today, we are telling the purchasing professional to analyze all the data before selecting the best supplier. Price is no longer the most important factor but must be considered along with other factors. Quality is now part of the price evaluation. If a supplier offers a lower price but has lower quality, would that really result in a lower cost for the company? What about increased inspection costs, or waiting for additional materials to arrive to replace the defective materials?

Delivery and lead-time have become increasingly important in the supply chain relationship. Our common objective with our supplier and our customer is to move the correct number of units to the right place at the right time. Service may be an intangible, but must be considered when making a selection. Does the supplier offer service before the sale to assist us in determining our needs? Will they offer post-sale service if there is a problem? As we move toward the supply chain partnership, service becomes more important.

And after the selection has been made, the supplier’s performance must be monitored and evaluated. It is a purchasing responsibility to review and analyze the data and to determine if the supplier is performing as expected.



Price and Cost

When we use the term price, we also mean the quoted price in the vendor’s catalog. If we buy the item with the lowest price, have we done the best thing for the company? Not necessarily. We have found that price may be as little as 25 percent of the total cost of acquisition.



Price and Cost - Total Cost of Acquisition

The total cost of acquisition is the price — that is, the vendor’s catalog published price — plus the cost of transportation, plus the cost of receipt and inspection — the total cost of having the item in our facility so we can use it. In this example, Supplier A has a catalog price of $25 which is $2 more than the price of Supplier B. Historically, the quality for Supplier A has been 98 percent, while supplier B has been only 85 percent. We add a surcharge to the price to account for the cost of handling rejected material and holding safety stock. So we have changed the base price by the cost of quality. In this case, the adjusting cost for Supplier A would be $25.50 and the cost for Supplier B would be $26.45. So an order of 1,000 units from Supplier A has a higher price, but it would result in a lower cost. The cost savings would be $950.



Price and Cost - Total Cost of Ownership

Purchasing professionals are now moving beyond the total cost of acquisition and on to the total cost of ownership. This includes the cost of acquisition plus the additional cost of storage, distribution, the cost of scrape and by-product, the cost of disposal at the end of the useful life of the product.





Slide 17: Quiz

Quiz

Delivery Lead-Time

As part of the purchase agreement, the delivery date is established. For most companies, this is still one day. That is, if the shipment shows up first thing in the morning or late in the afternoon, it is still considered to be on time. Some companies will even allow a day or two, on either side of the delivery date, and still consider it on time. To ensure that the material that is required is available when it is needed, we have to know the purchasing lead-time. Initially, there is going to be administrative time involved to research and verify the requirements even before we release the purchase order.

Of course, we have to allow for transportation. Once the shipment is on our dock, we are going to have to incorporate time to receive and inspect the material, and then move it to the user location. On the supplier side, we must allow time for production. In addition, the supplier will need time to prepare the material for shipment. For example, they have the internal paperwork, they have to take it, they have to pack it, and they have to load it for shipment. In the supply chain environment, delivery time becomes increasingly important. We depend on the parts arriving on time every time.



Supplier Selection Factors

If purchasing is no longer choosing the lowest-priced vendor, then what are the criteria for supplier selection? First, technical ability — can the supplier deliver what we need? Sometimes, the supplier will give us samples so we can test it to determine their technical capability. Next comes manufacturing ability. If they can make one, can they produce the quantity we need month after month? Purchasing may have to have help from manufacturing people to make this determination. Are they reliable? Do they have a track record? Did this business start in somebody’s garage last weekend?

Location is a factor. All other things being equal, closer is better. Transportation is normally less expensive. And if there is a problem, they are easier to go pay a visit. We want to make certain that they are financially stable. A supplier in financial difficulty will tend to have a poor quality and greater chance of missing delivery. Remember, we want to establish a long-term partnership, so we want them to be there next year.

And finally, management attitude. We told the last generation of buyers that they should maintain an arm’s-length relationship with vendors, and they were telling the purchasing professional that they are responsible to establish and maintain a close working relationship. Now, it is actually important to be able to get along with the management of the supplier company. Now, which one of these factors is most important? Well, that is going to depend on your company, your industry, or sometimes the project that you are working on.



Monitoring Supplier Performance

It has been said, ‘What you measure is what you get.’ If quality, delivery, and service are important to us, then we should be capturing the data in real-time, and measuring each supplier against the standard. Purchasing will need to let the supplier know that we are tracking them, and how they measure up. There was a supplier that shipped more than 99 percent on time to one of its major customers, but the orders were almost never complete. Out of 100 line items, two or three would be short. And these items would be sent the next day, or on the next truck, or with the next shipment.

After a year, the customer came to this supplier and told them that they were going to drop them as a supplier. The supplier was horrified because they had such a good track record of shipping on time. The customer responded that they were not interested in on-time shipment because the goods always sat in their warehouse a week or two before they were used. What they were interested in is complete orders, because if the order was short on only one line item, it would be kicked out of their system and had to be handled manually. The customer told the supplier that they were just costing too much money to deal with. If the supplier had known what the customer was actually tracking, they could have held the order a day or two and delivered every one 100 percent complete.



Order Management

Slide 21: Purchase Order Management

Let’s go back to the beginning and see what the purchasing professional is doing throughout this process — how the purchasing professional manages the purchase order itself.



Pre-order Processing

Starting with the pre-order process, if a company uses a computer system, most of the requirements are generated by the system. The system plans requirements across the plan horizon, and the purchasing professional also has to plan in advance to ensure that the suppliers are available to meet those requirements. Not all requirements will be system generated. Purchasing is responsible for procuring everything the company needs, not just manufacturing. The purchasing professional must be familiar with the business plan and the production plan as well.

If the company plans to increase production, purchasing will have to go out and procure additional equipment for manufacturing. When a purchase requisition is received by the purchasing agent, he must determine that the person who made the requisition is authorized to do so. The purchasing agent must determine what is needed, what level of quality is acceptable, what quantity is required, and even what unit of measure is appropriate. After all this, he has to quantify all this information and get it to the supplier so that the supplier can understand what is needed. With complete specifications, the purchasing agent has to determine the appropriate supplier for the order. If the requirement can be met by one of the existing suppliers, then the agent just contacts one of those suppliers and asks, ‘Do you want the business?’ But if there are no suppliers that are identified, then the purchasing professional may have to go out and request quotes. This is not a purchase order, but an invitation for suppliers to bid on the work. From the list of potential suppliers that respond to the quote, the purchasing agent can select one, and release the purchase order.



Placing Orders

The purchase order is the legal offer to purchase the good or service. The P.O. can be paper or electronic. Once released, the supplier can acknowledge the order in several ways. The supplier can respond in kind, that is, to sign the order and return it by mail. He can respond electronically, by phone, by fax, by e-mail, or he can simply ship the product. If a change in the order is needed before the goods are received, the purchasing agent can notify the supplier and request that the change be made. The supplier then has the option to agree to the change or refuse to agree to the change and perform to the original agreement.

Suppliers will often go along with the request to change because they want our business in the future — not just one time. But remember, they do not have to accept the change.



Tracking Orders

We have already discussed the fact that most purchased orders are tracked on an exception basis. Since the computer system is tracking orders by date, if the order is received on time, there are no exception reports. This is a case of no news is good news. If there is a problem — the order was not received on time or the quantity was not correct, the quality was bad or any other anomaly — then the purchasing professional must be notified. For example, if the due date of the P.O. has past, the system will let the purchasing agent know. The agent will then contact the supplier to find out why the parts are not there and when they will be there, and what we can do to prevent this from ever happening again. Another example would be problems with quality. If 20 percent of the parts do not meet the requirements, the purchasing agent must contact the supplier and let them know. The supplier will let the agent know if they are shipping additional goods to replace the ones that are defective and what to do with the bad parts. And then it is up to the purchasing agent to see to it that the supplier’s directions are carried out.



Receiving Goods or Services

As previously stated, the receiving and inspection process is not done by purchasing, but it is done for purchasing. If the goods or services are not acceptable, the terms of the P.O. have not been met, the purchasing professional needs to know so they can resolve the issue. Receipt and inspection criteria should be included as part of the P.O. When the shipment arrives, the visual check may be performed to determine that there is no obvious damage. It may be necessary to count the units or the packages to determine the correct amount. After this brief process, the goods can be received, and then inspection may be done within a reasonable time. But that reasonable time should also be stated in the P.O. If we wait too long to perform an inspection, the supplier may determine that the goods were damaged in our place of business and they were good when they arrived. So we would be responsible for the damage. After inspecting the parts, they have to be moved to stock or to the production location.

And this also should be part of the receiving and inspection process and that information may be part of the purchase order data. With supply chain management, we are asking the supplier to perform the inspection process, so the goods do not have to be inspected at our facility. When they arrive, they can be sent directly to production. But the fact that the parts were received must still be entered into the system so that the purchase orders can be closed.



Approving Payment

The traditional way to authorize payment is to hold the purchase order and the receiving documents and accounts payable until the invoice arrives that comes from the supplier. Then we have a three-way match — that is, if what was ordered, what was received, and what was invoiced is all the same, then we will pay the bill. This has always required a lot of paperwork with a lot of time, requiring a lot of research if the data did not match. As companies are moving to payment upon receipt or payment upon use, we are using the system to approve payment. One company that I know of qualifies suppliers to receive their P.O. through e-mail — and there is a bar code, part of the e-mail package. The supplier prints off that bar code and places it on the incoming package. When the shipment arrives at the customer, the bar code is scanned, and the receiving technician will see on his terminal what the parts are, the fact that they do not have to be inspected, how many go to stock, how many go to production.

Oh, by the way, when the bar code is scanned, the funds are transferred from the customer’s bank to the supplier’s bank. Automating these functions saves time and effort for both companies. It reduces the number of transactions that must be processed, and cuts down on the possibility of making a mistake.





Slide 27: Quiz

Quiz

Innovative Relationships

Slide 28: Innovative Relationships

Supply chain management requires a different relationship with our suppliers. Purchasing will lead the way to establishing and maintaining these new affiliations. Let’s look at some of the new opportunities, like consignment, vendor-managed inventory (or VMI), and partners.



Consignment

Consignment refers to holding the supplier’s product until it is used or sold, and delaying payment until that time. The approach allows us to divide carrying costs with our suppliers. Since we have the material on-site, we are paying for storage, handling, warehouse floor space, and that type of thing. But the supplier is paying for the cost of capital, paying interest on the money they borrowed to make the product in the first place. Consignment requires more careful record-keeping and a greater degree of trust between the two companies.



Vendor-Managed Inventory (VMI)

VMI — that is vendor-managed inventory — takes the consignment a step further. The classic example of VMI is the potato chip vendor who visits the grocery store every morning, counts the number of bags on the rack, and then adds more bags to refill the racks for today’s customers. Once again, there has to be trust between the company and the supplier. If there were more bags taken from the shelf then were sold, who suffers the loss? If the process is not managed well, the store can run out of potato chips and have unhappy customers. Both companies have to see that this arrangement is a win-win opportunity.

Let’s take a step beyond the classic example. The real savings available with VMI come from sharing information to make decisions. One example that I have found is a company that schedules work based on orders from its own warehouse. The warehouse ships products to the customer’s distribution center (or DC) in response to a purchase order. The DC sends products to its retail stores based on weekly orders that retail store sells to the end user. Working together under VMI, the retail store captures its sales data and sends it directly to the factory.

The factory uses that data to schedule production. The warehouse is skipped entirely, and the product goes directly to the customer’s DC at the same rate that it is moving from the DC to the retail stores. The result is less inventory at the DC due to shorter lead-time, and less inventory at the factory warehouse. Win-win situation — this is the real power of VMI. But notice that it requires a great deal of trust, and the data has to be very carefully managed.



Partnering

In order to achieve vendor-managed inventory as I just described, companies may have to establish partner relationship. And by partner, I do not mean a legal partnership. We are not trying to merge the two companies. As a matter of fact, some companies use a different term, like alliance, to avoid that kind of confusion. When we use the term partner in our session here, you will understand we are still talking about two separate companies. Reaching this point requires a high degree of trust between the two companies. They will have to exchange information that could be damaging if misused.

An example of this type of partner or arrangement can be found in the automotive industry. A manufacturer will set a schedule for final assembly only three days in advance — that’s the model, the color, the options, and so forth. This schedule is sent to the supplier of seats for the car. They do not build seats in the whole finished goods. They build on demand, and ship them to the final assembly plant in the correct sequence to match the cars coming down the line.

The investment and form of this partnership is very great, both in terms of time and in cost, but the rewards are equally great. In addition to aligning our schedules and our databases, we also have to get our people in our two companies to work together. And quite often, the people part is the most difficult part to put in place.



Summary

Slide 32: Course Summary - Why is Purchasing Important

To summarize what we have said. Purchasing plays a greater role in companies moving into supply chain management. Most of the cost of the product or service provided comes from the purchased item. For the company to operate efficiently and effectively, the function of purchasing must be accomplished correctly.



Course Summary - Purchasing Objectives and Functions

The objectives of purchasing are to obtain goods and services of the quality and quantity required, to obtain goods and services at the right price, to ensure the best service by suppliers, to develop and maintain good supplier relations. The functions of purchasing are to determine what is needed, when and where, select a supplier, negotiate the terms and conditions, then administer the agreement.



Course Summary - The Future of Purchasing

The purchasing function is evolving — requiring more analysis to determine the lowest total cost for the company, not just the lowest price. Purchasing will play a greater role in developing and maintaining supplier relationships, which are key to supply chain management.



18 Purchasing Basics

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