CHAPTER THREE PURCHASING

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3.1 Meaning of Purchasing

• Purchasing function comprises the essential activities associated with the

acquisition of material used in the operation of an organization.
• Because all organization requires supplies of materials, purchasing
functions is common in almost all organizations.

Functions of purchasing

• Generally: Purchasing is the activity of buying things that a company

needs, such as material, parts and equipment's.
• Specifically: Purchasing is the activity of acquiring materials with
• Right Quality, Quantity, Price, Source and Time.

There are two basic types of purchasing in business

• Purchasing for sale is performed primarily by merchants.

• Purchasing for consumption or conversion performed primarily by
manufacturing firms.

3.2 Objectives of purchasing

• More specific operational level

• General managerial level
General managerial level
• From their prospective, relates to the five rights the managements
expects the purchasing department to achieve:
• The right quality
• The right quantity
• From the right supplier
• At the right time
• At the right price
3.2.2 Functional level
• To support company operations with an interrupted flow of materials
• To procure material wisely
• To keep inventory investment and inventory losses at a practical
minimum.
• To develop effective and reliable source of supply.
• To develop good relationship with supplier community and good
continuing relationship with active suppliers.
• To achieve maximum integration with other departments of the firm.
• To hand the purchasing functions proactively: in a professional, cost
effective manner.

3.3 Purchasing Policies

• Purchasing polices are aids for purchasing decisions. Purchasing Policies
Decentralized and Centralized
 Centralized Purchasing
• Centralization exists when the entire purchasing function is
made the responsibility of a single person i.e purchasing
personnel.
• This person is held accountable for performance of purchasing
activities.
• This type purchasing is suitable for • Industries having single
plant or
• Number of plants nearby locations, which are manufacturing
similar products at various plants.

Advantage

1. Quantity discount
2. Simplifies purchasing procedures
3. Simplifies the payment of invoices

Disadvantage

4. Slow decision making

5. May not satisfy departments interest
6. Does not spread risk
  Decentralized purchase
 Decentralization of purchasing occurs when personnel from other
functional areas-operation marketing, finance, HRM, e.t.c decide
unilaterally on sources of supply or negotiate with suppliers
directly for major purchases.
 This type purchasing is suitable for
 Industries having plants at different location and manufacture
variety of product.

Advantage

 Improved efficiency
 Faster procurement
 Diversity of risk

Disadvantage

 Losing control
 Difficulty of obtaining discounts

3.4 Purchasing Procedures Purchasing procedure/purchasing

cycle/purchasing process comprises the following basic steps.

1. Recognize, define and describe the need (purchase requisition)

2. Verification of purchase requisition
3. Request for Quotation (Bids, price quotation)
4. Evaluation and selection of suppliers
5. Issuance of purchase order
6. Follow up and expediting
7. Receipt, and inspection of materials
8. Checking of invoices and bill payment
9. Completion of the records and files
10. Evaluation of the purchase process
1. Recognize, define and describe the need (purchase requisition)
 The need for purchase typically originates in one of a firm's operating
department or in its inventory control section.
 The purchasing department is usually notified of the need by one of
the three basic methods;
a) Standard Purchase Requisition (SPR)
b) Material Requirements Planning (MRP)
c) Bill Of Materials (BOM)
a) Standard Purchase Requisition (SPR)
 It is an internal document numbers serially for requests originating
in the operating departments.
 SPR is used for materials that have to be ordered from suppliers.
 This Requisition form includes;
 Material name/code identification
 The amount needed
 Desired delivery date

Sample Standard Purchase Requisition Date___________________

S.No________________ Date by which material is required_______
Department___________ Item No Description Qty. ____________
_______________ Inventor Authorized by

b) Material requirement Plan (MRP)

 MRP is a technique for determining the quantity and timing for the
requisition of dependent demanded items.
c) Bill of Materials (BOM)
 It is a complete list of all items incorporated in to a finished product
with specifications and quantity required of each item of materials.

2. Verification of Purchase Requisition

 It involves the purchasing department responsibility for
• Checking the document for accuracy and completeness
• Determining that the need has adequately defined
 • Ensuring that the appropriate method of description has been
used.
3. Request for Quotation (Bids, price quotation)
 A request for quotation is a process of initiating potential suppliers
that are willing to compete to supply the required material.
 The request depends on the type of materials because some materials
need "Request for quotation" and others not.

Competitive bidding is dictated by five criteria.

 The Birr value of the specific purchase must be large enough to justify
expense to both buyer and seller.
 The market must consist of an adequate number of sellers.
 The sellers that make up the market must be technically qualified and
willing to compete.
 The specification/description is clear to both the buyer and seller
 The time available must be sufficient for using competitive bidding

Competitive bidding should not be used:

 When it is impossible to estimate costs with a high degree of certainty.

 When price are not the only importance variable. Example, quality,
schedule and service also variables of equal importance
 Repetitive and routine purchase
 Items of low value
 Single/few suppliers

Invitation for Bids (IFB) or Request for Proposal (RFP) or Request for
Quotation (REQ) includes:

 Purchase description /specification

 Delivery schedule (timing and mode)
 Special terms/conditions
 Eligibility of suppliers
 Bid security (Bid bond and Performance bond)
 Any amendments
 Address for further information
 Purchasing company
  Term of payment
 Last date of submitting bids
 Time, date and place of opening the bid

4. Evaluation and Selection of suppliers

 There are two primary supplier sources:
 Internal
 External
 The internal source: - is the company itself.
 The external sources: - are the outside suppliers and the market place.

Thus, when evaluating and selecting a supplier, a buyer should try to find a
supplier who would meet the needs of the quality, quantity and delivery time
(purchase description and specification) at lower cost

5. Issuance of purchase order (PO)

Once a supplier has been selected, the purchasing department prepares and
issues a serially numbered purchase orders.
 Purchase order (PO) is the instrument by which goods are procured
to fill a requirement.
 Once accepted, it has the legal force of a binding contract.

The essential information in every purchase order includes.

 Name and address of purchasing company

 Identifying order number
 Date, number and address of the vendor
 General instructions
 Delivery date required
 Shipping instructions
 Descriptions of materials ordered and the quantity
 Price and discounts
 Terms and conditions
 Signature
6. Follow-up and Expediting
 Follow up: The objective of follow up is to see that the right quality
and quantity of materials is received at the right place and time.
This means ensuring that
o Quotations are received on time
o Replies are received on time from suppliers.
o The supplier(s) acknowledge the order and accept the
delivery schedule given.
o Materials are received according to the delivery schedule
 Expediting: It is speeding up or accelerating the receipt of the item
before the agreed upon time.
7. Receipt and Inspection of Orders
This procedure involves the following activities:

 Unpacking and checking the materials

 Completing the receiving report and distribute to each departments.
 Receive incoming goods
 Sizing the delivery notice presented by the carrier
 Identify and record all incoming materials
 Report their receipt to the purchasing department
 Make prompt desperation of the goods to the appropriate department
Inspection:
 Whenever it is necessary to take technical inspection, we may make
sample/all inspection. This depends on the nature of material and/or
the description of those materials.
8. Checking of invoices and Bill payment
 A simultaneous check and review of purchase order the receiving
report and the invoices.
 By checking the receipt report against the purchase order the purchaser
determines whether the quantity and type of ordered is received.
 Comparing the invoice with the purchase order and receiving report
the firm verifier that the supplier's bill is correctly priced and that if
covers the proper quantity of acceptable material.
9. Completion of the records and files (Closing the order)
 Closing the order simply entails a consolidation of all documents and
correspondence relevant to the order.
 The completed order is filled in the close order file. In most forms, a
completed order consists of:
• The purchase requisition (PR)
• Copy of the purchase order (PO)
• Acknowledgment
• Receiving report
• Inspection report
• Any notes and any notes/correspondence inventorying to the
order
• The completed order file thus, constitutes records of all activities
encompassing the total purchasing cycle.
10. Evaluation of the purchase process
 This stage refers to the evaluation of the purchase process against the
objective and requirement of the overall organizational system.

3.5. Supplier Evaluation & Selection

I. Survey Stage
 All possible sources are explored to obtain information about
available suppliers and searching for all likely suppliers. Potential
sources to a buyer in establishing a list of potential suppliers include;
a. Supplier information file - Trade journals
b. Trade exhibits - Company personnel
c. Other purchasing depts. - Personal contacts
II. Inquiry (analysis) Stage
 Inquiry stage involves prequalification of potential sources which
narrows the filed sources from possible sources to acceptable sources.
 Factors to be considered:
• Location
• Services, which include arrangement of transport, insurance,
after sale service- installation, maintenance, repair warranty,
 discounts, convenient packaging, on time delivery, purchase
reforms.
III. Selection and Negotiation
 Leads to the issuance of Purchase order and both subjective
(qualitative) approach and quantitative approach can be used.
IV. Experience Stage
 This stage involves follow up to ensure that the supplier(s) meet the
terms and conditions of the contract and rating and evaluating supplier
performance.

3.6 Supplier evaluation criteria

 A supplier or vendor rating system is a continuous management
process, designed to measure, evaluate and improve supplier
performance, enabling companies to make informed future sourcing
decisions.
 The buyer evaluate the suppliers based on four rights
• the right quality
• the right quantity
• At the right time
• At the right price
 Quality: the buyer compares the delivery to the agreed requirements
(specifications).
 Quantity: the buyer compares the delivery to the agreed amounts.
 Delivery Reliability: the date, a delivery is made should be checked
against the agreed date.
 Price: the buyer compares actual prices against the agreed price.

After evaluating the supplier based on the above criteria, supplier that fulfills
all requirements will be selected.
3.5. Make or Buy Decisions
 An organization may be in need of different raw materials, parts,
components or products which are processed and/or assembled into a
finished product.
 In sourcing a part or product, it either purchases from an outside
source or the firm may seek to undertake production.
 Accordingly any firm has the following three basic alternatives.
o Buy the parts or products completely from an outside source
o Make all the parts or products within the firm
o Buy some materials or products and make the remaining.

Factors influencing make-or-buy decisions

 Two factors stand out above all other when considering the make or
buy decisions; Cost and availability of production capacity.
 There are also certain factors on which make or buy decisions can be
based.
 Quantity, quality, availability and flexibility of supply, control of
trade secret and patents, research and development, and alternative
sources of supply are the important factors.

Considerations which favor making

 When the cost to make is substantially lower or less than the cost to
buy
 When the suppliers are unable to meet specification in terms of quality
and performance
 When the company has idle capacity like idle space, skilled human
resource, equipment
 Need to exert direct control over production and/or quality • Design
secrecy required or trade secrets,
 When the experience is well suited to make
Consideration which favor buying
 When the cost to buy is substantially lower or less than the cost to
make
 Suppliers research and specialized know-how
 Small volume requirements
 Limited production facilities
 Desire to maintain a multiple-source policy
 When other companies hold trade secrets or patents on a required
material so that it is not possible to make it

Examples for Make-or Buy decision

Example 1:

 ABC Automobile factory produces luxury automobile. It has an

opportunity to produce tires which are currently purchased at 80 Birr
each. Annual demand for the product depends largely on economic
conditions and this has been estimated at 37,500.
 If the company produces the tire itself, it must renovate an existing
work area and purchase machines which will result in annual fixed
costs of Birr 80,000. Variable costs for labor, materials and overhead
are estimated as Birr 60 per tire.

Required:
 Should the company make or buy the cases?
 At what volume of production is it more profitable to produce in-
house rather than purchase from an outside supplier?

Solution:
 Total cost of buying TCB = Price x Demand = Birr 80 x37, 500 = Birr
3,000,000
 Total cost of making, TCM = TVC (D) + TFC = variable cost/unit*
D+ TFC = 60 x 37,500 + 80,000 = Birr 2,330,000

 - 2,330,000 = Birr 670,000
Breakeven Point

 The breakeven point is the volume of production where the total costs
to make equal the total cost to buy
 Total Cost of Make = Total Cost of Buy VC + TFC = TCB 60 +
80,000 = 80 20 = 80,000 Q = 4000 tires
 For volume below 4000 tires

Example
 Toyota Automobile factory produce different automobiles.
 The tires are currently purchased at Birr 42 each. The company is
considering producing in house.
 The labor, materials and overhead costs are estimated as Birr 28 per
tire and fixed costs would be Birr 58,800. Demand is estimated as
shown:

Required

 Should the company produce the tires?

 How much is saved by the company?
 At what volume of production it becomes profitable to produce them
rather than buy from a supplier?

Demand D Probability P(D) 20000.05 30000.10 40000.30 50000.40 60000.15

 Demand,
• D =2000 x 0.05 + 3000 x 0.10 + 4000 x 0.3 +5000 x 0.4 + 6000 x 0.15
= 4500 tires
 Cost to buy: Birr 420 x 4500 = Birr 189,000
 Cost to make: TVC + TFC

= 28 x 4500 + 58,800 = Birr 184,800

 Decision: to make
• Saved amount: 189,000 - 184,800 = Birr 4,200
• TCM = TCB
• 28 + 58,800 = 42
• 42 - 28 = 58,800
• 14 = 58,800

= 4,200 tires