Chapter 2 - Purchasing Management - FTU - 2019

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
• Supply Chain Management Defined
• The Importance of Supply Chain Management
• The Origins of Supply Chain Management in the U.S.
• The Foundations of Supply Chain Management
• Current Trends in Supply Chain Management
CHAPTER 2
LEARNING OBJECTIVES
You should be able to:
• Describe the role of purchasing and its strategic impact
on an organization’s competitive advantage.
• Describe the traditional purchasing process, e-
procurement, public procurement, and green purchasing.
• Recognize and know how to handle small value
purchase orders.
• Analyze and evaluate sourcing decisions and the factors
impacting supplier selection, including outsourcing,
make-or-buy, and break-even analysis.
otherwise on a password-protected website or school-approved learning management system for classroom use. 3
LEARNING OBJECTIVES (Continued)
You should be able to:

• Analyze and compute total cost of ownership.
• Analyze the pros and cons of single sourcing versus
multiple sourcing.
• Describe the key characteristics of centralized,
decentralized, and hybrid purchasing organizations.
• Describe the opportunities and challenges of global
sourcing.
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
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.”
• Key activities of supply management have expanded beyond the

basic purchasing function to include: negotiations, logistics, contract
development& administration, inventory control & management,
supplier management, and other activities
• - Purchasing remains the core activity of supply management
• Procurement: includes the added activities of specification
development, value analysis, expediting, contract administration,
supplier quality control, and some logistics activities
• => widely used by government agencies due to the types of
purchase and frequent service contracting they made with
government suppliers.
The Role of Supply Management in an

Organization
Purchasing is a key strategic business process rather than a
narrow specialized supporting function
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:
- Purchase spend is the money a firm spends on goods
and services
- The profit- leverage effect of purchasing measures the
impact of a change in purchase spend on a firm’s profit
before taxes
=> A decrease in purchase spend directly increases profits before
taxes (assuming no decrease in quality or other expenditures)
Return on Assets (ROA) Effect: is a financial ratio of a firm’s net

income in relation with total asset
Total asset: current (cash, account receivable, inventory) and fixed
assets (equipment, buildings, real estate)
ROA = Net income/Total assets
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: shows how many times a firm’s

inventory is utilized and replaced over an accounting period
Increased inventory turnovers indicate optimal utilization of space and inventory
levels, increased sales, avoidance of inventory obsolesce
Inventory turnover ratio = cost of goods sold/average inventory
Monthly Inventory turnover ratio = cost of goods sold for the month/ (beginning
inventory + ending inventory)/2
Annual Inventory turnover ratio = cost of goods sold for the year/average monthly
inventory
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.
- Traveling requisition:
- used for materials and standard parts that are requested on a recurring basis
- Product description and other pertinent information (delivery lead time, lot size) are preprinted
- When the resupply is needed, the user enters quantity and date needed & submits to the warehouse
- => traveling requisition is returned to the user for future request
The Purchasing Process – Manual Purchasing

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.

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: e-procurement is more efficient when i) selecting and maintaining a list of
potential suppliers ii) processing requests for quotation and purchase orders, iii) making
repeat purchase
• Cost savings: buyers can handle more purchases, and the manual task of matching bids to
purchase requisitions is reduced; other cost savings include lower price of goods and services
(more suppliers can be contacted), reduce inventory cost (ability to purchase on a more
frequent basis); use of lower admin costs, elimination of the need for preprinted purchase
requisition forms, and faster order fulfillment
• Accuracy: the system eliminates double- key inputs- once by the material user and then once
by the buyers. The system also enhances the accuracy of communications between buyers
and suppliers. More up-to-date information on suppliers, with goods and serviced available
online, allow user to assess their options before preparing a purchase requisition
• Real time use: buyer have real time access to the purchase requisition once it is prepared.
Once the purchase requisition is processed, the buyer can post the bid instantly, instead of
waiting to contact all the suppliers individually to alert them of the bid, the system enables
buyers to initiate bids and suppliers to respond in real time on a 24/7 basis
• 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 technologies: supplier should have competent process
technologies to produce superior products at reasonable cost to enhance the
buyer’s competitive edge
• Willingness to share technologies & information: suitable with current trend
 Early supplier involvement (ESI): supplier can assist new product
design and development through ESI to ensure cost- effective
design choices, develop alternative conceptual solutions, select
the best components and technologies…
• Quality: high and consistent- directly affect to quality of finished goods
• Reliability: quality level, financially stable, reliable delivery lead time …=>avoid
interupted production due to shortage of material
Supplier Selection
• Order system & cycle time: how easy is a ordering system? What is normal
order cycle time? How about delivery lead time? => small lot sizes can be
ordered on frequent basis to reduce inventory holding costs
• Cost
 Total cost of ownership or acquisition: unit cost of item, payment
terms, cash discount, ordering cost, carrying cost, logistics cost,
maintenance cost, and other qualitative cost…
• Capacity: to fill order? Fill large orders?
• Communication capability
• Location: geographical location => impact delivery lead time, transportation,
logistic cost
• Service: supplier must be able to back up their products by providing good
services when needed
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 decentralized
items specific to business unit
Global Sourcing
Import Broker – 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 - successful bidder will accept contract
 Performance Bonds - 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

LEARNING OBJECTIVES (Continued)

You should be able to:

A Brief History of Purchasing Terms

A Brief History of Purchasing Terms

Supply Management - a newer term to describe

• Key activities of supply management have expanded beyond the

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

Return on Assets (ROA) Effect: is a financial ratio of a firm’s net

Inventory Turnover Effect: shows how many times a firm’s

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 – 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

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