Supply Chain Management Chapter 2

Principles of Supply Chain Management (5e)
Chapter 2
PURCHASING
MANAGEMENT
Prepared by Cynthia Wisner, MBA
© 2019 Cengage Learning. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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CHAPTER OUTLINE
• Introduction
• A Brief History of Purchasing Terms
• The Role of Supply Management in an Organization
• The Purchasing Process
• Sourcing Decisions – The Make or Buy Decision
• Roles of Supply Base
• Supplier Selection
• How Many Suppliers to Use
• Purchasing Organization
• Global Sourcing
• Procurement for Government and Nonprofit Agencies
otherwise on a password-protected website or school-approved learning management system for classroom use. 2
A Brief History of Purchasing Terms

Merchants – Wholesalers and retailers who
purchase for resale
Industrial Buyers – Purchase raw materials for
conversion, services, capital equipment, & MRO
supplies
Purchasing - key business function for acquiring
materials, services, & equipment
Contracting - term often used for the acquisition of
services
A Brief History of Purchasing Terms

(Continued)
Supply Management - a newer term to describe

the expanded set of responsibilities of
purchasing professionals
• Institute of Supply Management defined
supply management as the “Identification,
acquisition, access, positioning, and
management of resources an organization
needs or potentially needs in the attainment
of its strategic objectives.”
The Role of Supply Management in an

Organization
The primary goals of purchasing are:
• Ensure uninterrupted flows of raw materials at the lowest total cost,
• Improve quality of the finished goods produced, and
• Maximize customer satisfaction.
Purchasing contributes to these objectives by:

• Actively seeking better materials and reliable suppliers,
• Working closely with and exploiting the expertise of strategic
suppliers to improve quality and materials
• Involving suppliers and purchasing personnel in new product
design and development efforts.
The Role of Supply Management in an Organization

(Continued)
The Financial Significance of Supply Management

Profit-Leverage Effect
A decrease in purchase spend directly increases profits before
taxes (assuming no decrease in quality or other expenditures)
Return on Assets (ROA) Effect
Indicates how efficiently management is using its total assets to
generate profits. A high ROA suggests that management is capable
of generating large profits with relatively small investments.
Inventory Turnover Effect
Increased inventory turnovers indicate optimal utilization of space
and inventory levels, increased sales, avoidance of inventory
obsolesce
The Role of Supply Management in an Organization

(Continued)
The Financial Significance of Supply Management

Profit-Leverage Effect
Simplified Reduce
Profit & Material
Loss Costs by
Statement $20,000
Gross Sales/Net Revenue $1,000,000 $1,000,000
−Cost of Goods Sold (Materials + Manufacturing $500,000 $480,000
Cost)
Gross Profits $500,000 $520,000
−General & Administrative Expenses (45% of $450,000 $450,000
Gross Sales)
Profits Before Taxes $50,000 $70,000
The Purchasing Process – Manual Purchasing (older system)

Step 1- Material Requisition/Purchase Requisition –
Stating product, quantity, and delivery date. May originate as a planned order
release from the MRP system. Traveling requisition used for recurring orders.
Step 2- The Request for Quotation (RFQ) –
Buyer identifies suppliers & issues a request for quotation (RFQ) for routine
items or a Request for Proposal (RFP) for highly technical products. Supplier
Development is used to develop supplier capabilities.
Step 3- The Purchase Order (PO) –
Is the buyer’s offer & becomes a binding contract when accepted by supplier.
When initiated by the supplier on their own terms, the document is a sales
order. The Uniform Commercial Code (UCC) governs transactions in the
U.S., except Louisiana.
The Purchasing Process – Manual Purchasing

Suppliers Purchasing Storage/Warehouse Users/Requisition Accounting
START
Materials Materials
Requisition Materials Requisition
No
MR 1 Available? MR 1
MR 2 MR 2
MR 3
Yes
Issue PO
Materials
Requisition
Purchase Purchase MR 1
Order Order MR 2
PO 1 PO 1 Accounting
PO 2 PO 2
PO 3 MR 2 Information
MR File Issue for charging the
PO 4
Materials
Materials + appropriate
department
DO 3
DO 2
Delivery PO File
Order PO 3
DO 1 MR File
DO 2
MR 2
Ship
Materials
MR 2
DO 2 + Accounts Payable
PO 2
Materials Materials +
PO 2
Delivery
Order Delivery
DO 1 Order
DO 1
INV 2
Invoice
INV 1 Invoice
INV 1

(Continued)

(Continued)
The Purchasing Process –

e-Procurement
Step 1- Material user enters a purchase request
- Relevant information such as quantity and date needed.
Step 2- Purchase requisition approved and transmitted
electronically to buyer
- At purchasing department (hardcopy or electronically).
Step 3- Buyer reviews requisition, assigns qualified
suppliers to bid (if over $50,000)
- Product description, closing date, & conditions are given.
Step 4- Buyer reviews closed bids & selects a supplier

e-Procurement

e-Procurement (Continued)
Advantages of the e-Procurement System

• Time savings
• Cost savings
• Accuracy
• Real time use
• Mobility
• Trackability
• Management benefits
• Supplier benefits
Small Value Purchase Orders

Processing costs for small value purchases are
minimized through:
• Procurement Credit Card/Corporate Purchasing Card
(P-card)
• Blanket or Open-End Purchase Orders
• Blank Check Purchase Orders
• Stockless Buying or System Contracting
• Petty Cash
• Standardization & Simplification of Materials & Components
• Accumulating Small Orders to Create a Large Order
• Using a Fixed Order Interval
Sourcing Decisions – The Make or Buy Decision

Outsourcing –
Buying materials and components from suppliers
instead of making them in-house. The trend has
moved toward outsourcing.
Backward vertical integration –
Acquiring sources of supply
Forward vertical integration –
Acquiring customers
The Make or Buy decision is a strategic decision

(Continued)
Reasons for Buying or Outsourcing

• Cost advantage – Especially for components that are
non-vital to the organization’s operations, suppliers may have
economies of scale
• Insufficient capacity – A firm may be at or near
capacity and subcontracting from a supplier may make
better sense
• Lack of expertise – Firm may not have the necessary
technology and expertise
• Quality – Suppliers have better technology, process,
skilled labor, and the advantage of economy of scale

(Continued)
Reasons for Making

• Protect proprietary technology
• No competent supplier
• Better quality control
• Use existing idle capacity
• Control of lead-time, transportation, and
warehousing costs
• Lower cost

(Continued)
The Make-or-Buy Break-Even Analysis

Costs Make Buy
Fixed $25,000 $500
Variable $5 $7
Annual Requirements 15,000
Find break-even point Q by setting total cost of both options equal and solving for Q:
Total Cost to Make = Total Cost to Buy
25,000 + 5Q = 500 + 7Q
7Q − 5Q = 25,000 − 500
2Q = 24,500
Q = 12,250 units = Break-even point

(Continued)
Total Cost for both options at the Break-even Point

Costs Make Buy TCBE = 25,000 + 5×12,250 = $86,250
Fixed $25,000 $500
Variable $5 $7 Total Cost for the Make Option at 15,000 units;
Annual Requirements 15,000 TCMake = 25,000 + 5×15,000 = $100,000
Total Cost for the Buy Option at 15,000 units;

TCBuy = 500 + 7×15,000 = $105,500 dollars
Cost Difference =TCBuy −TCMake

= 105,500 − 100,000
= $5,500

(Continued)
Roles of Supply Base

Supply Base - list of suppliers a firm uses to acquire its materials,
services, supplies, and equipment
• Emphasis on long-term strategic supplier alliances,
consolidating volume into one or a few suppliers, resulting in
a smaller supply base
Preferred suppliers provide:
• Product and process technology & expertise to support
buyer’s operations
• Information on latest trends in materials, processes, designs,
and the supply market
• Capacity for meeting unexpected demand
• Cost savings due to economies of scale
Supplier Selection
The process of selecting suppliers, is complex and should be
based on multiple criteria:
• Product and process • Order system & cycle time

technologies • Cost
• Willingness to share ▪ Total cost of
technologies & ownership or
information acquisition
▪ Early supplier • Capacity
involvement (ESI) • Communication capability
• Quality • Location
• Reliability • Service
Supplier Selection
Total cost of ownership concept: Example
Order size = 1000 units

Late delivery will cause 50% lost sales &
50% back orders
Supplier Selection (Continued)

Total cost of ownership concept
Description Supplier 1 Supplier 2
1. Total Engine Cost 12,000 units x $500 $6,000,000.00 12,000 units x $498 $5,976,000.00
2. Cash Discount
n/30 $6,000,000 x 10% x 30/365 $49,315.07 $5,976,000 x 10% x 30/365 $49,117.81
1/10 N/A $5,976,000(10% x10/365+1%) $76,132.60
2/10 $6,000,000(10% x10/365+2%) $136,438.36 N/A
Largest discount ($136,438.36) ($76,132.60)
3. Tooling Cost $22,000.00 $20,000.00
4. Transportation Cost
125miles x 12,000units x 22lbs x 100miles x 12,000units x
(22,000 lb LTL) $19,800.00 $15,840.00
$1.20/2000 22lbs x $1.20/2000
5. Ordering Cost 12,000 / 1,000 x $125 $1,500.00 12,000 / 1,000 x $125 $1,500.00
6. Carying Cost 1,000 / 2 x $500 x 20% $50,000.00 1,000 / 2 x $498 x 20% $49,800.00
7. Quality Cost $6,000,000 x 2% $120,000.00 $5,976,000 x 3% $179,280.00
8. Delivery Rating
Backorder (50%) 12,000 x 1% x 50% x $15 $900.00 12,000 x 2% x 50% x $15 $1,800.00
12,000 x 2% x 50% x $4,500 x
Lost Sales (50%) 12,000 x 1% x 50% x $4,500 x 18% $48,600.00 $97,200.00
18%
TOTAL COST $6,126,361.64 $ 6,265,287.40
How Many Suppliers to Use

Single sourcing - a risky proposition. Current trends
favor a few sources.
Reasons Favoring a Reasons Favoring Two or
Single Supplier More Suppliers
▪ To establish a good ▪ Need capacity
relationship
▪ Spread risk of supply
▪ Less quality variability interruption
▪ Lower cost ▪ Create competition
▪ Transportation economies ▪ Information
▪ Proprietary product or process
purchases ▪ Dealing with special kinds
of business
▪ Volume too small to split
Purchasing Organization
Purchasing Organization is dependent on many
factors, such as market conditions & types of
materials required
• Centralized Purchasing – Single purchasing
department located at the firm’s corporate
office makes all the purchasing decisions
• Decentralized Purchasing - individual, local

purchasing departments, such as plant level,
make their own purchasing decisions
Purchasing Organization (Continued)
Advantages - Advantages -
Centralization Decentralization
• Concentrated volumes • Better knowledge
• Avoids duplication of requirements
• Specialization • Local sourcing
• Lower transportation • Less bureaucracy
costs
• No competition between
units
• Common supply base
Purchasing Organization (Continued)
A hybrid purchasing organization

▪ Decentralized-centralized (large multiunit org)-
decentralized corporate and centralized at
business unit
▪ Centralized-decentralized (large organization
w/centralized control) centralized large national
contracts at corporate level and decentralizing
buying at the business unit level
Global Sourcing
Import Broker or Sales Agent – Sales agent who
performs transactions for a fee (They do not take title
to the goods)
Import Merchant – Buys and takes title to the goods
and resells them to a buyer
Tariff – An official list showing the duties, taxes, or
customs imposed by the host country on imports or
exports
Non-tariff barriers – import quotas, licensing
agreements, embargoes, laws and other regulations
imposed on imports and exports
Global Sourcing (continued)
Reasons for Global Sourcing –

Opportunity to improve quality, cost, and delivery
performance
Potential Challenges –
Requires additional skills and knowledge to deal
with international suppliers, logistics,
communication, political environment, and other
issues
Global Sourcing (Continued)
Issues for Global Purchasers

• United Nations’ Contracts for the International
Sale of Goods (CISG)
• Terms of acceptance cannot be modified
• Incoterms (commonly used term referring to the
International Commercial Terms - uniform rules
that simplify international transactions of goods with
respect to shipping costs, risks, and responsibilities
of buyer, seller and shipper
Countertrade – goods and/or services of domestic

firms are exchanged for goods and/or services of
equal value or in combination with currency from
foreign firms
Countertrade can include:
• Barter - complete exchange of goods or services of
equal value without the exchange of currency
• Offset - exchange agreement for industrial goods or
services as a condition of military-related export
Countertrade can include:

• Direct Offset - involves coproduction, or a joint
venture and exchange of related goods or services
• Indirect Offset - involves exchange of goods or
services unrelated to the initial purchase.
• Counterpurchase - the original exporter agrees to sell
goods or services to a foreign importer and
simultaneously agrees to buy specific goods or
services from the foreign importer
Procurement in Government &

Non-Profit Agencies
Public Procurement or Public Purchasing – purchasing & supply
function for government & non-profit sector.
Public Procurement is characterized by:

▪ Competitive bidding - contract is usually awarded to lowest priced
responsive & responsible bidder
• Sealed Bids are used to satisfy the Invitation for Bid (IFB) and are
opened in public display
▪ Bid Bonds - incentive to fulfill contract
▪ Bid or Surety Bonds – guarantee that successful bidder will accept contract
▪ Performance Bonds - guarantee that work will be on time and meet
specifications
▪ Payment Bonds - protection against 3rd party liens not fulfilled by bidder
Procurement for Government &

Non-Profit Agencies (Continued)
Rules that often govern Government & Non-Profit

Procurement:
Federal Acquisition Streamlining Act (1994) – Removed
restrictions on bids less than $100,000. Micro-purchases
(less than $3,000) can be made without bidding
Buy American Act (1933) – US government purchases and
3rd party purchases using federal funds must buy if the US
good is not more than a certain differential above the
foreign good
Green Purchasing – Variety of federal, state, and local
initiatives to include environmental and human health
considerations when making purchases
End of Chapter 2

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Principles of Supply Chain Management (5e)

Prepared by Cynthia Wisner, MBA

A Brief History of Purchasing Terms

A Brief History of Purchasing Terms

Supply Management - a newer term to describe

The Role of Supply Management in an

Purchasing contributes to these objectives by:

The Role of Supply Management in an Organization

The Financial Significance of Supply Management

The Role of Supply Management in an Organization

The Financial Significance of Supply Management

The Purchasing Process – Manual Purchasing (older system)

The Purchasing Process – Manual Purchasing

The Purchasing Process – Manual Purchasing

The Purchasing Process – Manual Purchasing

The Purchasing Process –

The Purchasing Process –

The Purchasing Process –

Advantages of the e-Procurement System

Small Value Purchase Orders

Sourcing Decisions – The Make or Buy Decision

Sourcing Decisions – The Make or Buy Decision

Reasons for Buying or Outsourcing

Sourcing Decisions – The Make or Buy Decision

Reasons for Making

Sourcing Decisions – The Make or Buy Decision

The Make-or-Buy Break-Even Analysis

Total Cost to Make = Total Cost to Buy

Sourcing Decisions – The Make or Buy Decision

The Make-or-Buy Break-Even Analysis

Total Cost for both options at the Break-even Point

Total Cost for the Buy Option at 15,000 units;

Cost Difference =TCBuy −TCMake

Sourcing Decisions – The Make or Buy Decision

The Make-or-Buy Break-Even Analysis

Roles of Supply Base

• Product and process • Order system & cycle time

Order size = 1000 units

Supplier Selection (Continued)

3. Tooling Cost $22,000.00 $20,000.00

7. Quality Cost $6,000,000 x 2% $120,000.00 $5,976,000 x 3% $179,280.00

TOTAL COST $6,126,361.64 $ 6,265,287.40

How Many Suppliers to Use

• Decentralized Purchasing - individual, local

Purchasing Organization (Continued)

Purchasing Organization (Continued)

A hybrid purchasing organization

Global Sourcing (continued)

Reasons for Global Sourcing –

Global Sourcing (Continued)

Issues for Global Purchasers

Global Sourcing (Continued)

Countertrade – goods and/or services of domestic

Global Sourcing (Continued)

Countertrade can include:

Procurement in Government &

Public Procurement is characterized by:

Procurement for Government &

Rules that often govern Government & Non-Profit

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