PURCHASING

MANAGEMENT

“If you are only measuring your procurement department
“
on what has been saved, you’re missing out on half of
what suppliers can do. They’re not just cost centers
anymore; they are partners. Suppliers can bring new
technology, innovation and process improvement
suggestions that can reduce time to market or improve the
value you deliver to customers. These are opportunities
that can drive incremental revenue in some direct or
indirect way.”

Jonathan Hughes, Vantage Partners

Sourcing Decisions:
The Make-or-Buy Decision
 While the term outsourcing originally referred to buying materials or
components that were previously made in-house
 It is now also commonly used to refer to buying materials or
components from suppliers instead of making them in-house
 The trend has been moving toward outsourcing combined with the
creation of supply chain relationships, although traditionally firms
preferred the make option by means of backward or forward vertical
integration
 Backward Vertical Integration refers to acquiring upstream suppliers,
whereas Forward Vertical Integration refers to acquiring downstream
customers
Reasons for Buying or Outsourcing

Cost advantage
 Cost is an important reason for buying or outsourcing, especially for supplies and
components that are non-vital to the organization’s operations and competitive
advantage
 This is usually true for standardized or generic supplies and materials for which
suppliers may have the advantage of economies of scale because they supply the
same item to multiple users

Insufficient capacity
 A firm may be running at or near capacity, making it unable to produce the
components in-house
 This can happen when demand grows faster than anticipated or when expansion
strategies fail to meet demand. The firm buys parts or components to free up
capacity in the short term to focus on vital operations
Reasons for Buying or Outsourcing

Lack of expertise
 The firm may not have the necessary technology and expertise to
manufacture the item
 Maintaining long-term technological and economical viability for
noncore activities may be affecting the firm’s ability to focus on
core competencies
Quality
 Purchased components may be superior in quality because
suppliers have better technologies, processes, skilled labor and
the advantage of economies of scale
Reasons for Making
Protect proprietary technology
 A major reason for the make option is to protect proprietary
technology. A firm may have developed equipment, product or
processes that need to be protected for the sake of competitive
advantage
No competent supplier
 If suppliers do not have the technology or capability to produce a
component, the firm may have no choice but to make an item in-
house
Reasons for Making
Better quality control
 If the firm is capable, the make option allows for the most direct
control over the design, manufacturing process, labor and other
inputs to ensure that high-quality components are built

Use existing idle capacity

 A short-term solution for a firm with excess idle capacity is to use
the excess capacity to make some of its components
 This strategy is valuable or firms that produce seasonal products
Reasons for Making

Control of lead-time, transportation and warehousing cost

 The make option provides better control of lead-time and logistical costs
since management controls all phases of the design, manufacturing and
delivery processes

Lower cost
 If technology, capacity and managerial and labor skills are available, the
make option may be more economical if large quantities of the component
are needed on a continuing basis
Make-or-Buy Break-Even Analysis
Break-even analysis is a handy tool for computing the cost-effectiveness
of sourcing decisions when cost is the most important criterion.
Several assumptions underlie the analysis:
1. All costs involved can be classified under either fixed or variable
cost,
2. Fixed cost remains the same within the range of analysis,
3. A linear variable cost relationship exists
4. Fixed cost of the make option is higher because of initial capital
investment in equipment
5. Variable cost of the buy option is higher because of supplier profits.
Make-or-Buy Break-Even Analysis
Make-or-Buy Break-Even Analysis
Make-or-Buy Break-Even Analysis

A Las Vegas, Nevada, manufacturer has the option to make or buy one of its
component parts. The annual requirement is 20,000 units. A supplier is able
to supply the parts for $10 per piece. The firm estimates that it costs $600
to prepare the contract with the supplier. To make the parts in-house, the
firm must invest $50,000 in capital equipment and estimates that the parts
cost $8 per piece.
a. Assuming that cost is the only criterion, use break-even analysis to
determine whether the firm should make or buy the item. What is the
break-even quantity and what is the total cost at the break-even point?
b. Calculate the total costs for both options at 20,000 units. What is the cost
savings for choosing the cheaper option?
Roles of Supply Base

 The supply base or supplier base refers to the list of suppliers that a
firm uses to acquire its materials, services, supplies and equipment

 Firms engaging in supply chain management emphasize long-term

strategic supplier alliances by reducing the variety of purchased items
and consolidating volume into one or fewer suppliers, resulting in a
smaller supply base
 For example, both Xerox and Chrysler reduced their supply bases by
about 90 percent in the 1980s
Roles of Supply Base
Besides supplying the obvious purchased items, key or preferred suppliers also
supply:
1. product and process technology and expertise to support the
buyer’s operations, particularly in new product design and value
analysis;
2. information on the latest trends in materials, processes or designs;
3. information on the supply market, such as shortages, price increases
or political situations that may threaten supplies of vital materials;
4. capacity for meeting unexpected demand;
5. cost efficiency due to economies of scale, since the supplier is likely
to produce the same item for multiple buyers.
Supplier Selection

According to Kenichi Ohmae, founder and managing director of Ohmae &

Associates,

“Companies are just beginning to learn what nations

have always known: in a complex, uncertain world filled
with dangerous opponents, it is best not to go it alone.”
Supplier Selection
 The process of selecting a group of competent suppliers for important
materials, which can potentially impact the firm’s competitive advantage,
is a complex one and should be based on multiple criteria
1.Process and product technologies
 Suppliers should have competent process technologies to produce
superior products at a reasonable cost to enhance the buyer’s
competitive edge
2.Willingness to share technologies and information
 Suppliers can assist in new product design and development through
early supplier involvement (ESI) to ensure cost-effective design choices,
develop alternative conceptual solutions, select the best components
and technologies and help in design assessment
Supplier Selection
3.Quality
 Quality levels of the purchased item should be a very important
factor in supplier selection. Product quality should be high and
consistent since it can directly affect the quality of the finished
goods
4.Total cost of ownership or total cost of acquisition
 Includes the unit price of the material, payment terms, cash
discount, ordering cost, carrying cost, logistical costs,
maintenance costs and other more qualitative costs that may not
be easy to assess
 Emphasis on Unit cost is not the only criteria in supplier
evaluation
Supplier Selection

5.Reliability
 Besides reliable quality level, reliability refers to other supplier
characteristics. For example, is the supplier financially stable? Otherwise, it
may not be able to invest in research and development or stay in business
6.Order system and cycle time
 Easiness in ordering with less process time, Placing orders with a supplier
should be easy, quick and effective. Delivery lead time should be short, so
that small lot sizes can be ordered on a frequent basis to reduce inventory
holding costs.
7.Capacity
 The supplier has the capacity to fill orders to meet requirements and the
ability to fill large orders if needed
Supplier Selection

8.Communication capability:
 Suppliers should also possess a communication capability that facilitates
communication between the parties.
9. Location:
 Geographical location is another important factor in supplier selection, as
it impacts delivery lead-time, transportation and logistical costs. Some
firms require their suppliers to be located within a certain distance from
their facilities.
10. Service:
 Suppliers must be able to back up their products by providing good
services when needed. For example, when product information or
warranty service is needed, suppliers must respond on a timely basis
How Many Suppliers to Use

 The issue of how many suppliers to use for each purchased item is a
complex one
 Single sourcing can be a very risky proposition. However, there may
be reasons for single supplier
 To establish a good relationship
 Less quality variability
 Lower cost
Sole sourcing and single sourcing have been used interchangeably,
sole sourcing typically refers to the situation when the supplier is the
only available source, whereas single sourcing refers to the deliberate
practice of concentrating purchases of an item with one source from a
pool of many potential suppliers.
Single Versus Multiple Sourcing
• Prior commitment , successful past experience
• The supplier may be exclusive owner of certain
essential patents
• A given supplier may be outstanding in
performance
• The order may be small and not worthwhile to
divide it
• Bulk discount or impact of transportation
• Future nexus will increase with order size
• Set up cost with multiple suppliers is high
• Emphasis on strong collaborator
• Tradition to use multi-sourcing
• Getting multi-suppliers, help in pressuring on
others with regard to cost
• Assurance of supply is increased in case of any
issue
• Dependency is decreased
• Other suppliers may be a tool as a back-up
• Strategic reasons to deal with multiple suppliers
• Government regulation may force to use multiple
suppliers
• Capacity of one supplier is exhausted
• Volatility in supply markets may be high with
single supplier
Purchasing Organization

 Centralized purchasing is where a single purchasing

department, usually located at the firm’s corporate office, makes
all the purchasing decisions, including order quantity, pricing
policy, contracting, negotiations and supplier selection and
evaluation

 Decentralized purchasing is where individual, local

purchasing departments, such as at the plant level, make their
own purchasing decision
Advantages of Centralization
 Concentrated volume: An obvious benefit is the concentration of
purchase volume to create quantity discounts, less-costly volume shipments
and other more favorable purchase terms. This is often referred to as
leveraging purchase volume.
 Avoid duplication: Centralized purchasing eliminates the duplication of job
functions. A corporate buyer can research and issue a large purchase order to
cover the same material requested by all units, thus eliminating duplication
of activities. This also results in fewer buyers, reducing labor costs.
 Specialization: Centralization allows buyers to specialize in a particular
group of items instead of being responsible for all purchased materials and
services. It allows buyers to spend more time and resources to research
materials for which they are responsible, thus becoming specialized buyers.
Advantages of Centralization

 Lower transportation costs: Centralization allows larger

shipments to be made to take advantage of truckload shipments,
and yet smaller shipments still can be arranged for delivery
directly from suppliers to the points of use.
 No competition within units: A situation may be created in which
units are competing among themselves, especially when scarce
materials are purchased from the same supplier. Centralization
minimizes this problem.
 Common supply base: A common supply base is used, thus
making it easier to manage and to negotiate contracts.
Advantages of Decentralization

 Closer knowledge of requirements: A buyer at the individual unit is

more likely to know its exact needs better than a central buyer at
the home office.
 Local sourcing: If the firm desires to support local businesses, it is
more likely that a local buyer will know more about local suppliers.
The proximity of local suppliers allows materials to be shipped
more frequently in small lot sizes, and is conducive to the creation
of closer supplier relationships.
 Less bureaucracy: Decentralization allows quicker response, due to
less bureaucracy and closer contact between the user and the
buyer.
Hybrid Purchasing Organization

 The hybrid purchasing organization allows the firm to

exploit the advantages of both the centralized and
decentralized systems.
Green Purchasing
Is not a new sourcing concept, there is a push to expand green purchasing
requirements in the public sector.
Public procurement advocates the purchase of
 more energy efficient products,
 bio-based products,
 recycled content products,
 non-ozone-depleting substances,
 green power and other environmentally friendly products.
The term green power refers to electricity products that include large
proportions of electricity generated from renewable and environmentally
preferable energy resources, such as wind and solar energy
The Total Cost of Ownership
 When making the outsourcing decision or comparing suppliers,
many firms make the fundamental mistake of focusing only on the
quoted price, ignoring the fact that many factors affect the total
cost of using a supplier
 The price charged by the supplier is only one of many factors that
affect the supply chain surplus
The Total Cost of Ownership (TCO)
 TCO includes all supply chain costs of sourcing a good or service from a particular
supplier and can be considered in three “buckets”—

 acquisition costs
 ownership costs
 post-ownership costs

Acquisition Costs
 Acquisition costs include all costs associated with the purchase of
material from a supplier until it reaches the buyer and is ready for
use

 These costs include the supplier price, supplier terms affecting

financing costs, taxes and duties, delivery costs, and incoming quality
costs

 Acquisition costs should also include the overhead of managing the

relationship and planning the purchases
Ownership costs
 Ownership costs include all costs associated with the purchased part
from when it arrives from the supplier to when the finished product is
sold to the customer
 These costs include inventory costs, warehousing costs, manufacturing
or conversion costs, production quality costs, and production cycle time
costs
Post-ownership costs

 Post-ownership costs include all costs incurred by the firm after the
finished product has reached the end customer
 These costs include warranty costs, environmental costs, product
liability costs, and reputational costs
Reference

Supply Chain Management : A Balanced

Approach. Joel D wisner
(Chapter 2, 3 &4)