Sourcing Decisions and
the Purchasing Process
Introduction
• Why purchasing is critical
• The sourcing decision
• Sourcing strategies
• The purchasing process
• Multi criteria decision models in
sourcing and purchasing
• Trends in purchasing management
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 2
Focus
Sourcing decisions and purchasing activities serve to
link a company with its upstream supply chain partners
• Sourcing decisions –
High level, often strategic decisions regarding which
products or services will be provided internally and which
will be provided by external supply-chain partners
• Purchasing –
The activities associated with identifying needs, locating
and selecting suppliers, negotiating terms, and following up
to ensure supplier performance
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 3
Why Purchasing
is Critical – I
The Changing Global Competitive
Landscape
• To compete globally, you need to
purchase globally
• Global purchasing efforts are
supported by advances in
information systems
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 4
Why Purchasing
is Critical – II
Financial Impact
• For the average manufacturer,
52.5% of the value of shipments
comes from materials
• Purchasing represents a major
opportunity to increase profitability
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 5
Why Purchasing is Critical
Financial Impact - I
Lowe’s Company
Earnings and Expenses
Sales
COGS
Pretax earnings
$26,491
$18,465
$2,359
Every dollar saved
in purchasing
lowers inventory
Selected Balance Sheet Items
Merchandise inventory
Every dollar saved in
purchasing
increases pretax
profit by one dollar
(assets) by one dollar
$3,968
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 6
Why Purchasing is Critical
Financial Impact - II
3% purchasing reduction in COGS
Earnings and Expenses
Sales
COGS
Pretax earnings
Current
$26,491
$18,465
$2,359
With 3% saving
$26,491
$17,911
$2,913
ROA increases
from 14.6% to
18.2%
Selected Balance Sheet Items
Merchandise inventory
$3,968
Pretax earnings
increase by
$554 (23.4%)
$3,849
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 7
Why Purchasing
is Critical – III
Performance Impact
• Quality
• Delivery
• Ability to exploit new technologies
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 8
Why Purchasing is Critical
Performance Impact - I
Sourcing dialysis machine valves
Cost per
valve
% good
Delivery
lead time
Supplier A
$10
Supplier B
$2
99.8%
95%
Overnight
delivery
1 day to
3 weeks
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 9
Why Purchasing is Critical
Performance Impact - II
Effect of defective dialysis machine
valves
•
•
•
•
Interruption in patient treatment
Rescheduling difficulties
Reduction in the effective capacity for dialysis
Possible medical emergencies
Estimated cost of a failed valve = $1,000
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 10
Why Purchasing is Critical
Performance Impact - III
Sourcing dialysis machine valves
(Total Costs)
Supplier A
Valve costs
Failure
costs
Backup
inventory
Total costs
Supplier B
50 x $10 = $500
50 x $2 = $100
0.2% x 50 valves x
$1,000 = $100
5% x 50 valves x
$1,000 = $2,500
1 valve x $10 = $10
3 valves x $2 = $6
$610
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
$2,606
Chapter 10, Slide 11
The Sourcing Decision
Sourcing decisions are high-level, often
strategic decisions that address:
Which will use resources within the firm
Which will be provided by supply chain partners
• Insourcing –
The use of resources within the firm
to provide products or services
• Outsourcing –
Make or Buy
Decision
The use of supply chain partners
to provide products or services
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 12
Advantages and
Disadvantages of Insourcing
Advantages
Disadvantages
• High degree of control
• Ability to oversee the
entire program
• Economies of scale
and/or scope
• Required strategic
flexibility
• Required high
investment
• Loss of access to
superior products and
services offered by
potential suppliers
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 13
Advantages and
Disadvantages of Outsourcing
Advantages
Disadvantages
•
•
•
•
• Possibility of choosing
a bad supplier
• Loss of control over the
process and core
technologies
• Communication and
coordination challenges
• “Hollowing out” of the
corporation
High strategic flexibility
Low investment risk
Improved cash flow
Access to state-of-theart products and
services
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 14
Factors Affecting the Decision
to Insource or Outsource
Factor
Favors
Insourcing
Favors
Outsourcing
Environmental uncertainty
low
high
Competition in the supplier market
low
high
Ability to monitor supplier performance
low
high
Relationship of product/service to
buying firm’s core competencies
high
low
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 15
Total Cost Analysis
A process by which a firm seeks to
identify and quantify all of the major costs
associated with various sourcing options
• Direct costs –
Costs that are tied directly to the level of
operations or supply chain activities
• Indirect costs –
Costs that are not tied directly to the level of
operations or supply chain activity
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 16
Insourcing and
Outsourcing Costs
Insourcing
Direct
costs
Indirect
costs
Outsourcing
•Direct material
•Direct labor
•Freight costs
•Variable overhead
•Price (from invoice)
•Freight costs
•Supervision
•Administrative support
•Supplies
•Maintenance costs
•Equipment depreciation
•Utilities
•Building lease
•Fixed overhead
•Purchasing
•Receiving
•Quality control
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 17
Sourcing Strategies
• Single sourcing –
The buying firm depends on a single company for all or nearly all
of an item or service
• Multiple sourcing –
The buying firm shares its business across multiple suppliers
• Cross sourcing –
Using a single supplier for a certain part or service and another
supplier with the same capabilities for a similar part
• Dual sourcing –
Using two suppliers for the same purchased product or service
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 18
The Purchasing Process
Needs identification
Description
No
Is there a preferred supplier?
Supplier identification
and evaluation
Yes
Supplier selection
Purchase order preparation
Follow up and expediting
Order
cycle
Receipt and inspection
Invoice clearance & payments
Records maintenance
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 19
The Purchasing Process
Needs Identification
Needs identification
• Purchase requisition –
An internal document completed by a user
that informs purchasing of a specific need
• Reorder point system –
A method used to initiate the purchase of
routine items. Typically, each item has a
predetermined order point and order
quantity
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 20
The Purchasing Process
Description
Description
The communication of a user’s needs
to potential suppliers in the most
efficient and accurate way possible
• Description by market grade/industry standard
• Description by brand
• Description by specification
• Description by performance characteristics
• Description by prototypes or samples
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 21
The Purchasing Process
Supplier Identification and Evaluation - I
Supplier identification
and evaluation
The amount of effort increases as:
• The complexity of the product
or service increases
• The amount of money that is
committed increases
• The length of the proposed
buyer-supplier relationship
increases
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 22
The Purchasing Process
Supplier Identification and Evaluation - II
Supplier identification
and evaluation
Criteria for supplier
assessment:
• Process and design capabilities
• Management capability
• Financial condition and cost
structures
• Planning and control systems
• Environmental regulation
compliance
• Longer-term relationship potential
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 23
The Purchasing Process
Supplier Selection - I
• Preferred supplier
Supplier selection
• Competitive bidding
• Negotiation
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 24
The Purchasing Process
Supplier Selection - II
Preferred supplier
Supplier selection
A supplier that has
demonstrated its performance
capabilities through previous
purchase contracts and
therefore receives preference
during the supplier selection
process
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 25
The Purchasing Process
Supplier Selection - III
Competitive bidding is most
effective when:
Supplier selection
• The buying firm can provide
qualified suppliers with clear
descriptions of the items or
services
• Volume is high enough to justify
the cost and effort
• The firm does not have a
preferred supplier
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 26
The Purchasing Process
Supplier Selection - IV
Negotiation is most effective
when:
Supplier selection
• The item is new or technically complex
with only vague specifications
• The purchase requires agreement about a
wide range of performance factors
• The supplier must participate in the
development effort
• The supplier cannot determine risks
and costs without input from the buyer
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 27
The Purchasing Process
The Order Cycle
• Purchase order preparation
Purchase order preparation
Follow-up and expediting
Receipt and inspection
Invoice clearing and payment
Records maintenance
74% of firms currently have electronic
data interchange (EDI) with some part of
their supply base
• Follow-up and expediting
• Receipt and inspection
• Invoice clearance and payment
• Records maintenance
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 28
Multi-Criteria Decision
Models in Sourcing and
Purchasing
How do we evaluate alternatives when criteria
include both quantitative measures (such as
costs and on-time delivery performance) and
qualitative factors (such as management
stability and trustworthiness)?
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 29
Weighted-Point Evaluation
System - I
Purpose:
• Evaluating potential suppliers
• Tracking suppliers’ performance over time /
ranking current suppliers
The Process:
• Assign weights to performance dimensions
• Rate the performance of each supplier with
regard to each dimension
• Calculate the total score
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 30
Weighted-Point Evaluation
System - II
Summary Data for Alternative Suppliers
Performance
Dimension
Aardvark
Electronics
Beverly
Hills Inc.
Conan the
Electrician
$4/unit
$5/unit
$2/unit
5% defects
1% defects
10% defects
95% on time
80% on time
60% on time
Price
Quality
Delivery
reliability
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 31
Weighted-Point Evaluation
System - III
Criteria Weights
WPrice
= 0.3
WQuality = 0.4
WDelivery = 0.3
Scoring Scheme
5 = excellent
4 = good
3 = average
2 = fair
reliability
1 = poor
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 32
Weighted-Point Evaluation
System - IV
Performance Values for Alternative Suppliers
Performance
Dimension
Aardvark
Electronics
Beverly
Hills Inc.
Conan the
Electrician
4
3
5
Quality
3
5
1
Delivery
reliability
4
2
1
Price
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 33
Weighted-Point Evaluation
System - V
Total Scores for Alternative Suppliers
Score Aardvark = (4 x 0.3) + (3 x 0.4) + (4 x 0.3) = 3.6
Score Beverly = (3 x 0.3) + (5 x 0.4) + (2 x 0.3) = 3.5
Score Conan = (5 x 0.3) + (1 x 0.4) + (1 x 0.3) = 2.2
Aardvark should improve their quality
Beverly Hills should improve their delivery and price
Conan is out of the running as a potential supplier
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 34
Trends in Purchasing
Management
• Long-term Contracts and Consolidation
• Supply Base Reduction
• Global Purchasing
• Supplier Performance Measurement
• Supplier Technology
• Information Technology
• Professionalism in Purchasing
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 35
Trends in Purchasing
Management - I
Area of
Purchasing
Traditionally
In the Future
Contract
length
Competitive bidding,
reviewed annually or
semiannually
Long-term contracts (> 2 years)
with performance improvement
clauses
Purchase
consolidation
Products and services
purchased by
individual business
units
Purchases consolidated across
business units to leverage
volumes and purchasing
efforts
Number of
suppliers
Suppliers switched
often, with many
suppliers for each
purchased item
Firms more likely to singlesource or dual-source in order
to improve performance and
reduce costs
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 36
Trends in Purchasing
Management - II
Area of
Purchasing
Location of
suppliers
Traditionally
Primarily domestic or
even local
In the Future
Global sourcing to access the
best suppliers in the world
Top
Purchasing seen as a
management’s nuisance or non-value
perception of added activity
purchasing
Purchasing sees as a way to
harness suppliers’
capabilities
Importance of
time
Cycle times a critical orderwinner; suppliers cooperate
in new product development
to reduce development time
Long cycle times
tolerated; little
involvement of
suppliers in new
product development
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 37
Trends in Purchasing
Management - III
Area of
Purchasing
Traditionally
In the Future
Improvement
of suppliers’
capabilities
Suppliers expected to
improve . . . or else!
Buying organizations
improving supplier
performance through supplier
development programs
Supplier
performance
measurement
Random or nonexistent
monitoring of suppliers,
quality, delivery, and
price over time
Detailed, formal performance
measurement systems to
track price, delivery, quality
and other measures
Supplier
performance
standards
Low standards, if any
Increasing levels of
performance expected
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 38
Trends in Purchasing
Management – IV
Area of
Purchasing
Traditionally
In the Future
Reliance on
supplier product
and process
technology
Little to none; suppliers
expected to deliver
exactly what was asked
for and no more
Suppliers active in new
product/process development
Information
systems linking
buyers and
suppliers
Little or none
Increasing use of EDI, B2Bs,
Cad/CAM, and Web to link
supply chain partners
Purchasing
responsibilities
Primarily clerical –
processing purchase
orders
Increased use of technology
for routine activities; more
time spent managing key
supplier relationships
©2006 Pearson Prentice Hall — Introduction to Operations and Supply Chain
Management — Bozarth & Handfield
Chapter 10, Slide 39