Chapter 1

Purchasing and Supply Management

©McGraw-Hill Education. All rights reserved.

 Key Question Addressed in
Chapter 1
Every organization needs suppliers. No organization can exist without suppliers. Therefore, the
organization’s approach to suppliers, its acquisition processes and policies, and its relationships with
suppliers will impact not only the performance of the suppliers, but also the organization’s own
performance. No organization can be successful without the support of its supplier base, operationally
and strategically, short- and long-term.

• What can supply and suppliers do to help the

organization
– increase revenues?
and/or
– decrease costs?
Effective purchasing and supply management contributes significantly to organizational success.
This text explores the nature of this contribution and the management requirements for
effective and efficient performance. The acquisition of materials, services, and equipment—of
the right qualities, in the right quantities, at the right prices, at the right time, with the right
quality, and on a continuing basis—long has occupied the attention of managers in both the
public and private sectors.
©McGraw-Hill Education. All rights reserved. 2
 Corporate Supply Changes
• Impact of environmental, security and financial regulations
on competitive advantage
• Increased outsourcing places great reliance on suppliers to
respond to end-customer needs
• Greater dependence on suppliers for design and build
responsibilities for subassemblies and subsystems
• Increased global competition
• Development of new product technologies
• Evolving information systems
• Trend to single sourcing with fewer key suppliers and
strategic supplier relationships
©McGraw-Hill Education. All rights reserved. 3
 Corporate Supply Opportunities
• Identify opportunities to increase revenue
• Implement supply initiatives to improve
customer satisfaction
• Reduce total costs of ownership
• Improve supply process efficiency and
effectiveness
• Maximize value from suppliers
• Make product/service innovations with key
suppliers
©McGraw-Hill Education. All rights reserved. 4
 The Evolution of the Supply
Function
• Late 1800s:
– The Handling of Railway Supplies – Their Purchase and
Disposition, published 1887
• 1900-1950s:
– reliable access to supply of raw materials, supplies and
services
• 1970s:
– senior management attention on the supply function:
• international shortage of basic raw materials
• price inflation

©McGraw-Hill Education. All rights reserved. 5

 The Evolution of the Supply
Function
• 1990s:
– challenges of global supply chains
– increased reliance on suppliers because of outsourcing

• early 21st century technological developments:

– supply chain integration
– lower transaction costs
– faster response times
– New challenges--sustainability, globalization, supply chain security and risk
management

©McGraw-Hill Education. All rights reserved. 6

 The Evolution of the Supply
Function
early early
1900s 21st century
● Clerical and tactical ● Strategic orientation
● Focus on policies and ● Global supply chains
procedures ● Executive level leadership
● Key challenges: ● Key challenges:
availability of supply and Sustainability, security,
cost management globalization, risk
management

©McGraw-Hill Education. All rights reserved. 7

 The Evolution of the Supply
Function
Pre 1939 1940-49 1950-69 1970-89 1990-1999

Managerial Purchasing Integration into

Clerical Supply assurance
emphasis strategy corporate strategy

2000-2010 2010-Future

Sustainability, security,
Integrated supply networks
globalization, risk
and information technology
management

©McGraw-Hill Education. All rights reserved. 8

 Purchasing, Procurement and
Supply Management*
“The integration of related functions to provide effective
and efficient materials and services to the organization.”
Includes:
• Operational and strategic responsibilities
• The standard steps in the acquisition process
• In some organizations: receiving, inspection,
warehousing, inventory control, materials handling,
packaging, scheduling, in/outbound transportation, and
disposal

*Terms are used interchangeably in this text.

©McGraw-Hill Education. All rights reserved. 9

 Steps in the Procurement Process

(1) recognition of need

(2) translation of that need into a commercially
equivalent description
(3) search for potential suppliers
(4) selection of a suitable source(s)
(5) agreement on order or contract details
(6) delivery of products and/or services
(7) payment of suppliers

©McGraw-Hill Education. All rights reserved. 10

 Logistics Management
“Logistics management is
that part of supply chain management
that plans, implements, and controls the
efficient, effective forward and reverse flow and storage
of goods, services, and related information
between the point of origin and
the point of consumption
in order to meet customers’ requirements.”
This definition includes inbound, outbound, internal, and external movements. Logistics is not
confined to manufacturing organizations. It is relevant to service organizations and to both private-
and public-sector firms.
The attraction of the logistics concept is that it looks at the material flow process as a complete
system, from initial need for materials to delivery of finished product or service to the customer. It
attempts to provide the communication, coordination, and control needed to avoid the potential
conflicts between the physical distribution and the materials management functions.

©McGraw-Hill Education. All rights reserved. 11

 Major Logistics Activities
• customer service ● parts and service support
• demand forecasting/planning ● plant and warehouse site
• inventory management selection
• logistics communications ● return goods handling
• material handling ● reverse logistics
• order processing ● traffic and transportation
• packaging ● warehouse storage

©McGraw-Hill Education. All rights reserved. 12

 Supply Chain Management
Supply influences a number of logistics-related activities, such as how much to buy and
inbound transportation. With an increased emphasis on controlling materials flows, the
supply function must be concerned with decisions beyond supplier selection and price.

“The design and management of seamless, value-added processes across

organizational boundaries to meet the real needs of the end customer.

The development and integration of people and technological

resources are critical to successful supply chain integration.”

The term value chain has been used to trace a product or service through its various moves
and transformations, identifying the costs added at each successive stage.
Some academics and practitioners believe the term chain does not properly convey what
really happens in a supply or value chain, and they prefer to use the term supply network or
supply web.
The use of the concepts of purchasing, procurement, supply, and supply chain management
will vary from organization to organization. It will depend on (1) their stage of
development and/or sophistication, (2) the industry in which they operate, and (3) their
competitive position.
©McGraw-Hill Education. All rights reserved. 13
 Characteristics of an
Integrated Strategic Procurement and
Sourcing Function
Executive Leadership Strategic Positioning
• Executive committee support for ● External/internal customer focus
integration across company and ● Matrix management
strategic business unit corporate ● High-level positioning - second,
plans third or fourth levels
Functional Leadership Integration
● Company-wide customer-focused ● Cross-functional, cross-location
leadership teaming
● Establishes integrated visions and ● Part of the technology,
works at results and processes manufacturing and strategic
● Drives supply base/supplier business unit (SBU) planning
management strategies company- process
wide
©McGraw-Hill Education. All rights reserved. 14
 Characteristics of an
Integrated Strategic Procurement and
Sourcing Function
Supplier Management
Supply Base Strategy
•
● Focused on supplier development
Quality driven
• Design standardization
● Joint performance improvement efforts
• Concurrent engineering ● Value focused
• Supply base optimization ● Total cost improvement
• Commercial strategy emerging ● Supplier benchmarking

Measurement Systems
● Customer orientation ● Global databases
● Total value/cost focused ● Historical performance data
● Benchmarking with best in class ● Strategic
● ERP, Internet, EFT, CAD, CAM

©McGraw-Hill Education. All rights reserved. 15

 THE SIZE OF THE ORGANIZATION’S SPEND
AND FINANCIAL SIGNIFICANCE
The amount of money organizations spend with suppliers is staggering. Dollars spent with suppliers as
a percentage of total revenue are a good indicator of supply’s financial impact. Obviously, the
percentage of revenue that is paid out to suppliers varies from industry to industry and organization to
organization, and increased outsourcing over the last decade has increased the percentage of spend
significantly. In almost all manufacturing organizations , the supply area represents by far the largest
single category of spend, ranging from 50 to 80 percent of revenue. Wages, by comparison, typically
amount to about 10 to 20 percent. In comparison, the total dollars spent on outside suppliers typically
ranges from 25 to 35 percent of revenues.
The fi nancial impact of the corporate spend is often illustrated by the profit-leverage effect and the
return-on-assets effect.
Profit-Leverage Effect
The profit-leverage effect of supply savings is measured by the increase in profit obtained by a decrease
in purchase spend.

• Before Spend Decrease • After 10% Spend Decrease

Revenue $100M $100M
Less Purchases -60M -54M (60 x 0.9)
Less Other Costs -32M -32M
Profit 8M 14M (8 x 1.75)
 Return-on-Assets Factors
Financial experts are increasingly interested in return on assets (ROA) as a measure of
corporate performance. Figure 1–1 shows the standard ROA model.
Assuming that inventory accounts for 30 percent of total assets. If purchase costs were reduced
by 10 percent, that would cause an extra benefit of a 10 percent reduction in the inventory
asset base. The numbers in the boxes show the initial figures used in arriving at the 10 percent
ROA performance.

©McGraw-Hill Education. All rights reserved. 17

 Reduction in Inventory Investment

Companies are pushing for reductions in inventory investment, not only by

lowering purchase price but also by getting suppliers to take over inventory
responsibility and ownership, thereby removing asset dollars in the ROA
calculations, but also taking on the risk of obsolescence and inventory carrying
and disposal costs.

Thus, it is a prime responsibility of supply to manage the supply process with the
lowest reasonable levels of inventory attainable. Inventory turnover and level are
two major measures of supply chain performance.

Evidently, the financial impact of supply is on the balance sheet and the income
statement , the two key indicators of corporate financial health used by managers,
analysts, financial institutions, and investors. While the financial impact of the
supply spend is obviously significant, it is by no means the only impact of supply
on an organization’s ability to compete and be successful.

©McGraw-Hill Education. All rights reserved. 18

 Purchasing’s Operational and Strategic
Contributions
1. Supply Contribution

Operational Strategic
Trouble Prevention Opportunity Maximization
The operational side of supply concerns
itself with the transactional, day-to-day The strategic side of supply is
operations traditionally associated with future oriented and searches for
purchasing. The operational side can be opportunities to provide
streamlined and organized in ways competitive advantage.
designed to routinize and automate
many of the transactions, thus freeing up
time for the supply manager to focus on
the strategic contribution.

Whereas on the operational side the focus is on executing current tasks as designed, the
strategic side focuses on new and better solutions to organizational and supply challenges.
©McGraw-Hill Education. All rights reserved. 19
 Purchasing’s Operational and Strategic Contributions
2. Supply Contribution

Direct Indirect
Bottom-Line Impact Enhancing Performance
of Others
The appeal of the direct contribution of supply The supply function also contributes indirectly
is that both inventory reduction and purchasing by enhancing the performance of other
savings are measurable and tangible evidence of departments or individuals in the organization.
supply contribution. This perspective puts supply on the
management team of the organization. Indirect
contributions come from supply’s role as an
information source; its effect on efficiency,
competitive position, risk, and company image;
the management training provided by
assignments in the supply area; and its role in
developing management strategy and social
policy.
The benefits of the indirect contribution may outweigh the direct contribution, but
measuring the indirect benefits is difficult since it involves many “soft” or intangible
contributions that are difficult©McGraw-Hill
to quantify.Education. All rights reserved. 20
 Purchasing’s Operational and Strategic Contributions
3. Supply Contribution

Negative Neutral Positive

Operationally deficient Operationally acceptable Operationally acceptable

Strategically deficient Strategically deficient Strategically acceptable
Directly deficient Directly acceptable Directly acceptable
Indirectly deficient Indirectly deficient Indirectly acceptable

4. Supply Contribution
 Information Source
The contacts of the supply function in the marketplace provide a useful source of
information for various functions within the organization. Primary examples include
information about prices, availability of goods, new sources of supply, new products, and
new technology, all of interest to many other parts of the organization. New marketing
techniques and distribution systems used by suppliers may be of interest to the marketing
group. News about major investments, mergers, acquisition candidates, international
political and economic developments, pending bankruptcies, major promotions and
appointments, and current and potential customers may be relevant to marketing,
finance, research, and top management. Supply’s unique position vis-à-vis the
marketplace should provide a comprehensive listening post.
©McGraw-Hill Education. All rights reserved. 21
 Effect on Efficiency
The efficiency with which supply processes are performed will show up in other operating
results. If supply selects a supplier who fails to deliver raw materials or parts that measure up
to the agreed-on quality standards, this may result in a higher scrap rate or costly rework,
requiring excessive direct labor expenditures. If the supplier does not meet the agreed-on
delivery schedule, this may require a costly rescheduling of production, decreasing overall
production efficiency, or, in the worst case, a shutdown of the production line—and fixed
costs continue even though there is no output.
 Effect on Competitive Position/Customer Satisfaction
A firm cannot be competitive unless it can deliver end products or services to its customers
when they are wanted, of the quality desired, and at a price the customer feels is fair. If
supply doesn’t do its job, the firm will not have the required materials or services when
needed, of desired quality, and at a price that will keep end-product costs competitive and
under control.
The ability of the supply organization to secure requirements of better quality, faster at a
better price than competitors, will not only improve the organization’s competitive position,
but also improve customer satisfaction. The same can be said for greater flexibility to adjust
to customers’ changing needs. Thus, a demonstrably better-performing supply organization
is a major asset on any corporate team.
 Effect on Organizational Risk
The supply function clearly impacts the risk level for the organization in terms of operational,
financial, and reputation risk. Supply disruptions in terms of energy, service, or direct or
indirect requirements can impact the ability of the organization to operate as planned and as
expected by its customers, creating operational risks.

©McGraw-Hill Education. All rights reserved. 22

 Effect on Image
The actions of supply personnel influence directly the public relations and image of a company.
If actual and potential suppliers are not treated in a businesslike manner, they will form a poor
opinion of the entire organization and will communicate this to other fi rms. This poor image
will adversely affect the purchaser’s ability to get new business and to find new and better
suppliers.
 Training Ground
The supply area also is an excellent training ground for new managers. The needs of the
organization may be quickly grasped. Exposure to the pressure of decision making under
uncertainty with potentially serious consequences allows for evaluation of the individual’s
ability and willingness to make sound decisions and assume responsibility. Contacts with
many people at various levels and a variety of functions may assist the individual in learning
about how the organization works.
 Management Strategy
Supply also can be used as a tool of management strategy and social policy. As part of an
overall organization strategy, the supply function can contribute a great deal. Assurance of
supply of vital materials or services in a time of general shortages can be a major competitive
advantage. Similarly, access to a better-quality or a lower-priced product or service may
represent a substantial gain. These strategic positions in the marketplace may be gained
through active exploration of international and domestic markets, technology, innovative
management systems, and the imaginative use of corporate resources. Vertical integration
and its companion decisions of make or buy (insource or outsource) are ever present
considerations in the management of supply. The potential contribution of supply to strategy
is obvious. Achievement depends on both top executive awareness of this potential and the
ability to marshal corporate resources to this end.
©McGraw-Hill Education. All rights reserved. 23
 Differences between
Manufacturing and Services
Organizations
Manufacturing Service Provider
• The largest portion of needs is ●The largest portion of needs is
generated by customer needs. generated by capital, services
• The largest portion of spend and other requirements
with suppliers will be on direct enabling employees to provide
requirements which comprise the service.
products sold to customers. ●In retailing the largest spend is
focused on re-sale
requirements.

©McGraw-Hill Education. All rights reserved. 24

 The Opportunities for Contribution of

• Profit-leveragethe Supply Function

effect
• Return-on-assets effect/Reduction in inventory
investment
• Information source
• Effect on efficiency
• Effect on competitive position and customer satisfaction
• Effect on organizational risk
• Effect on image
• Training ground
• Management strategy and social policy
©McGraw-Hill Education. All rights reserved. 25
Differentiations for Supply in
Public Organizations

©McGraw-Hill Education. All rights reserved. 26

Differentiations for Supply in
Private Organizations

©McGraw-Hill Education. All rights reserved. 27

 Challenges Facing Supply
• Supply chain management
While the giant firms in automotive, electronics, and retailing can force the various
members of the supply chain to do their bidding, smaller companies do not have that
luxury. Thus, each organization has to determine for itself how far it can extend its
sphere of influence within the supply chain and how to respond to supply chain
initiatives by others. Clearly, opportunities to reduce inventories, shorten lead times
and distances, plan operations better, remove uncertainties, and squeeze waste out of
the supply chain are still abundant.
• Measurement
There is significant interest in better measurement of supply not only to provide senior
management with better information regarding supply’s contribution, but also to be
able to assess the benefits of various supply experiments.
• Risk management
Supply chains have become increasingly global and, therefore, face risks of supply
interruptions, financial and exchange rate fluctuations, lead time variability, and
security and protection of intellectual property rights, to name only a few. The trend
to single sourcing has also created the increased risks for supply disruptions. Supply
managers need to continually assess risks in the supply chain and balance risk/ reward
opportunities when making supply decisions.
©McGraw-Hill Education. All rights reserved. 28
• Sustainability
Responsibility for reverse logistics and disposal has traditionally fallen under the supply
organization umbrella . These activities include the effective and
efficient capture and disposition of downstream products from customers. More recently,
however, pressures from government and consumer groups are motivating organizations to reduce
the impact of their supply chains on the natural environment.
• Purchase of non-traditional goods/services
supply can grow in the percentage of the organization’s total spend for which it is meaningfully
involved. Thus, categories of spend traditionally not involving purchasing, such as real estate,
insurance, energy, benefit programs, part-time help, relocation services, consulting, marketing
spend with advertising and media agencies, travel and facilities management, IT, and
telecommunications and logistics, have become part of procurement’s responsibility in more
progressive corporations.
• Contribution to corporate strategy
Supply can grow by its involvement in corporate activities from which it might have been
previously excluded. While involvement in make-or-buy decisions, economic forecasts,
countertrade, in- and outsourcing, and supplier conferences might be expected, other activities
such as strategic planning, mergers and acquisitions, visionary task forces, and initial project
planning might be good examples of broader corporate strategic integration.
• Recognition by senior management
How happy are other corporate team members to have supply on their team? Do they see supply’s
role as critical to the team’s success? Thus, to gain not only senior management recognition but
also the proper appreciation of peer managers in other functions is a continuing challenge for both
supply professionals and academics.
©McGraw-Hill Education. All rights reserved. 29