UNIT 1
PURCHASING MANAGEMENT
Contents of the Unit
1. Objectives
1.1 Introduction
1.2 Purchasing and Related Concepts
1.3 Purchasing Place in Business
1.4 Objective of Purchasing
1.5 Interdepartmental Relationships
1.6 Summary
1.7 Answers to Check Your Progress
1.8 Model Examination Questions
1.9 References
1.0 Objectives
This chapter will introduce distance learners to basics functions of purchases. At the end of
this unit, students will have knowledge and understanding of:
 purchasing and related concepts like procurement and materials management
 the role of purchasing in business
 the objectives of purchasing
 the relationships between purchasing and other departments
1.1 Introduction
Dear student! Any business transactions, involve buyers and sellers. Thus purchasing is one
of the basic functions of any business organization. Buyers require goods and services to
satisfy their needs and wants. Thus, they seek seller/s that can supply them with what they
need. Purchasing could be simple or complex based on the nature of the company. More
complex company requires expert buying.
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1.2 Definition of Purchasing &The Related Concepts
1.2.1 Purchasing defined
What is purchasing?
A managerial activity that goes beyond the simple act of buying, and which includes the
planning and policy activities covering a wide range of related and complementary activities
is Purchasing. such activities include the research and development required for the proper
selection of materials and sources; the follow-up to ensure proper delivery; the inspection of
incoming shipments to ensure both quantity and quality compliance with order; the
development of proper procedures, methods, and forms to enable the purchasing department
to carry out established polices; the co-ordination of the activities of the purchasing
department with such other external divisions of the concern such as traffic, receiving,
storekeeping, and accounting, so as to facilitate smooth operations; and the development of a
technique of effective communication with top management of the company so that a true
picture of the performance of the purchasing function is presented.
A typical purchasing department performs a number of specific activities. Involved in the
primary responsibilities of a purchasing department are buying, value analysis and
purchasing research. Many purchasing departments, however, also include activities such as
inventory control, stores, receiving, subcontracting, and traffic. Consequently, when one
encounters the term “Purchasing department” the name alone does not reveal precisely what
operations are involved.
1.2.2 Procurement
A term whose genesis can be traced to early government parlance is Procurement. Today it is
widely used by the armed forces to define one of several supply functions involved in
logistics activities. In the broadest sense, the government defines procurement to include the
entire process by which all classes of resources (People, materials, facilities, and services) for
a particular project are obtained.
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The term “Procurement” originated in governmental organizations but it has also been used
by industries for many years. The meaning of procurement in industry parallels its meaning
in government. In both cases, the procurement concept encompasses a wider range of supply
activities than does the purchasing concept. The difference between can be more specifically
stated as Procurement is concerned with the overall gathering of resources, while purchasing
is the specific act of acquiring something by paying money for it. Purchasing is one form of
procurement.
1.2.3 Materials management
Materials management is the branch of logistics that deals with the tangible components of a
supply chain. Specifically, this covers the acquisition of spare parts and replacements, quality
control of purchasing and ordering such parts, and the standards involved in ordering,
shipping, and warehousing said parts. As practiced in business today, can be defined as a
confederacy of traditional materials activities bound by a common idea- the idea of an
integrated management approach to planning, acquisition, conversion, flow, and distribution
of production materials from the raw-material state to the finished – product state.
The specific form of materials organization most appropriate for one firm may not be the best
form for another. A brief discussion of two materials activities will illustrate why the unique
nature of a specific firm’s operating activities influences its form of materials organization so
heavily. Assume that a plant purchases all the parts, components, and subassemblies for the
product it manufactures. In this situations, if production were uniform, the production
planning schedule and the purchasing schedule, allowing for lead time, would be similar or
identical. Consequently, for this firm to achieve optimal material and cost control, production
control should realistically be included in the materials management department. Assume
now that a plant manufactures all the parts, components, and subassemblies that are used in
producing its product. In this situation, there may be very little similarity between the
production planning and purchasing schedules. Therefore, in this firm, a strong case could be
made for locating production control with in the production department.
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In practice, the theoretical extremes discussed above seldom exist. For most firms, the
production planning and purchasing schedules overlap significantly. Unfortunately, this
frequently produces a continuing source of conflict. One of the paramount advantages of
materials management is that it forces co-ordination between purchasing and production
control. Purchasing and production control are both responsible for the on time delivery of
production materials. Division of this authority between two different operating units
inevitably leads to conflict. When materials do not arrive on time, production control is
seldom satisfied to work through the purchasing department. Frequently, production control
personnel proceed to expedite the late materials directly with the supplier. Since the
expediting of purchased materials and negotiation with suppliers are basic purchasing
responsibilities, conflict ensues. Such conflict is much more readily resolved when
production control and purchasing report to a single boss- the materials manager.
As with purchasing and production control, substantial benefits also accrue when inventory
management, value analysis, receiving, stores, and surplus and salvage are placed in a
materials management department
Probably the single greatest benefit a firm receives from having a materials manager is that
this manager thinks as the president and other top vice presidents do-that is, in terms of the
firm as a whole. Managers of individual materials functions, such as purchasing, inventory,
and traffic usually are compelled to think more narrowly in terms of the unique
responsibilities associated with their specific function. Consider a typical situation. In
practice, production and purchasing often develop a tacit agreement on carrying a higher
level of inventories than a good materials manager normally sanction. High inventories
protect production from manufacturing delays and purchasing from production pressures. If
top management complains of high inventories, production and purchasing blame each other
for the condition. One large firm, with sales exceeding $ 1 billion, recently reduced
inventories over 25% after creating a materials management organization and appointing an
experienced top management person as its new vice president for materials.
Check Your Progress
What is materials management?
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1.3 Purchasing Place in Business
What is the role of purchasing in business management? Why is it important? To answer
these questions, the purchasing function will be observed from three points of view: first, as a
function of business, second, as one of the basic elements required to accomplish productive
work; and third, as the department responsible for outside manufacturing.
i) Purchasing as a function of business
One of the basic functions common to all types of business enterprise is purchasing. It is
basic because no business can operate without it. All businesses are administered or managed
by co-coordinating and integrating these six functions:
i.
Creation of idea or business function.
ii.
Finance, the capital acquisition and financial planning and control function.
iii.
The human resources and labor relations function.
iv.
Purchasing, the acquisition of required materials, services and equipments.
v.
The transformation of materials into economic goods and services which could
be termed as Conversion.
vi.
The marketing and selling of goods and services produced, Distribution.
The design engineering department, the finance or controller’s department, the personnel or
human resources department, the purchasing department, the production department, and the
sales or marketing department are the common industrial titles of the organizational units
responsible for performing these six functions. In non-industrial enterprises, the same
functions must be performed, but they may be identified by different names.
These basic functions may be supervised by a single manager or by individual managers for
each function, depending on a company’s size. Regardless of how they are supervised, they
are performed by someone in every business. Some small firms, for example, do not have a
purchasing department; nevertheless, the purchasing function must still be preformed.
Sometimes it is performed by the president; at other times it is performed by an executive
who administers several basic functions, including purchasing.
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By its very nature, purchasing is a basic and integral part of business management. Why is
this fact important? For a business to be successful, all its individual parts must be
successful. It is impossible for any organization to achieve its full potential without a
successful purchasing activity. In the long run, the success of a business enterprise depends
every bit as much on the purchasing executive as it does on the executives who administer
the other functions of the business.
This is not to imply that all purchasing departments are of equal importance to the success of
their companies. They are not; their importance varies widely. The importance of any
individual business function within a specific organization is dependent on a number of
factors. Among these factors are the type of business, its goals, its economic circumstances,
and how the enterprise operates to achieve these goals. In some situations purchasing can
function in a perfunctory manner without jeopardizing a company’s profit. These situations,
however, are exceptions. Similar exceptions can be found in marketing, finance, or any other
function of business. For example, in a firm selling a highly advanced technical product, the
marketing department usually does not have weighty responsibilities. Engineering excellence
does more than efficient marketing techniques to sell the product. On the other hand,
marketing a highly competitive standard product requires selling ability of the highest order.
In such companies, the marketing department has a position of major importance.
ii) Purchased Materials as Resources or Elements of productive work
The basic goal of any industrial activity is the development and manufacture of products that
can be marketed at profit. This goal is accomplished by the appropriate blending of what
management authorities historically have called the five Ms: machines, manpower materials,
money, and management. Materials today are the lifeblood of industry. No industrial
organization can operate without them. Materials of the appropriate quality must be available
at the right time, in the proper quantity, at the needed location, and at an acceptable price.
Failure to fulfill any of these responsibilities concerning materials adds to company costs and
decreases company profit just as surely as do outmoded production methods, inefficient
personnel, and ineffective selling.
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iii) Purchasing as the manager for outside manufacturing
The materials which go into a typical company’s products can originate from either of two
sources. The company’s production department is the first source; this department converts
raw materials into processed parts. The company’s purchasing department is the second
source. This department not only purchases raw materials, which the production department
converts into processed parts, but it also purchases finished parts and components. The parts
made by the production department are combined in assembly with the items bought by the
purchasing department to make the company’s final products.
The percentage of industrial components being purchased externally is constantly increasing
compared with the percentage being manufactured internally.
The trend in manufacturing is toward the development of three distinct types of factories.
The first type does not make finished end products; it is equipped with costly high-volume
specialty machines and produces machined and fabricated parts in large quantities at low unit
cost. These parts are sold to numerous factories of the second and third types. The second
type of factory, like the first type, does not make finished end products; it makes
subassemblies. The required parts for the subassemblies come form factories of the first type,
or from the parts it makes, or from a combination of both. The third type of factory makes
finished end products. As economic circumstances dictate this type of factory assembles the
finished product from a combination of the parts it makes (usually parts that are unique to its
product) and the standard parts or subassemblies it buys from factories of the first and second
types.
In the multiple-type factory system of today, any company generally uses two distinct
sources of supply: inside manufacture and outside manufacture. The production department
is responsible for inside manufacture, including the authority to schedule production in
economical quantities, and to do so far enough in advance to have materials available when
needed.
The purchasing department, on the other hand, has the responsibility and authority to
schedule the delivery of outside production. Purchasing executives have the same managerial
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interests concerning their outside production as production executives have concerning their
internal production. Both must schedule accurately. Production executives are interested in
low unit costs and high quality. Purchasing executives are interested in keeping their
suppliers’ costs down. In addition, they are interested in maintaining scheduled deliveries and
good quality control to assure that production schedules are met and to minimize the costs of
inspection and unacceptable materials.
1.4 Objectives of Purchasing
The objectives of purchasing and materials management can be viewed from three levels: (1)
a very general managerial level, (2) a more specific functional or operational level, and (3) a
detailed level at which precise strategic buying plans are formulated.
The general objectives of purchasing have traditionally been expressed as the five rights
which management expects the department to achieve the acquisition of materials. This also
holds true from a top managerial perspective. These rights include the right:
i.
quality
ii.
quantity
iii.
time
iv.
supplier
v.
price
A sixth factor implied in these items includes the desired services necessary for optimal
supply and utilization of the materials.
Even the casual observer will detect just a bit of the “apple pie and motherhood” syndrome
reflected in these five rights. Idealistically, they are all highly desirable. In practice, the
department can rarely fulfill them all equally, because in a given procurement conflicts
inherently exist between some of the objectives. Usually some trade-offs must be made.
From a practical point of view, materials personnel seek a reasonable balance among them.
From an operating or functional perspective, then, it is necessary to probe more deeply to
develop a set of statements that provide practical and useful targets for decision-making
purposes. In this sense, the eight basic objectives of purchasing and materials management
are identified and discussed briefly below.
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1. To support company operations with an uninterrupted flow of materials and
services.
This is the most fundamental of all purchasing and materials management objectives. In a
logistical sense this is a key reason for the existence of the department. Responsibility for
performance of the function is located in a single operating unit, there by facilitating coordination and control of the supply activities.
2. To buy competitively
Buying competitively involves keeping abreast of the forces of supply and demand that
regulate prices and availability of materials in the market place. At times; it also involves an
understanding of a supplier’s cost structure, coupled with ability to minimize the supplier’s
costs with in reason-then to negotiate price and service arrangements that are fair relative to
the supplier’s costs. A buyer who pays significantly more than his or her competitor does for
a given material or service generally is not buying competitively.
3. to buy wisely
Buying wisely involves a continual search for better values that yield the best combination
of price, quality, and service, relative to the buyer’s needs. This frequently involves
coordination with users in defining the need. It may also involve co-coordinating and
reconciling users’ needs with suppliers’ capabilities to achieve optimal value considering
both issues. A firm that purchases a silver-plated part when a copper plated part could
perform the function just as well usually is not buying wisely.
It is the combination of buying competitively and buying wisely that typically contributes
most to the profitability of the firm.
4. To keep inventory investment and inventory losses at a practical minimum.
Although maintaining a large inventory is one way to achieve objective number one, it is also
costly. Generally, speaking, most firms today pay in indirect costs between 25 and 35 percent
of the average inventory value per year for the convenience of having the inventory
available. Hence, the materials management job is to achieve a reasonable balance between
the level of inventory required to support operation and the cost of carrying the inventory.
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Through proper buying, packaging, and storing, it is also the department’s objective to
minimize losses that occur as a result of deterioration, obsolescence, theft, and so on.
5. To develop reliable and effective sources of supply.
Cooperative suppliers that are willing to work with a buyer to help solve the buying firm are
problems and to minimize its materials-related costs are an invaluable resource. Progressive
buyers today tend increasingly to “buy suppliers”, as opposed simply “buying products”. The
identification, investigation, selection, and in some cases development of competent and
responsive suppliers is a buyer’s paramount responsibility. It is difficult indeed for a firm to
perform optimally if it cannot depend on the planned performance of a reliable contingent of
suppliers.
6. To develop good relationships with the vendor community and good continuing
relationships with suppliers.
Good relationships with suppliers are imperative, and good relationships with potential
suppliers are invaluable. The achievement of the preceding objective on a continuing basis is
virtually impossible if mutually satisfactory continuing relationships are not maintained.
Potential suppliers are much more interested and eager to acquire a firm’s business if the
buying firm is likely to be a “good customer”. And, when a contractual relationship has been
formed with a supplier, the myriad operating problems that inevitably arise throughout the
life of the contract are much more easily and effectively solved when the relationship is
sound and mutually beneficial. Suppliers naturally direct their research, provide advance
information on new products and prices, and in general give better service to such customers.
7. To achieve maximum integration with the other departments of the firm.
It is essential for buyers to understand the major needs of their using departments, so that
these needs can be translated into materials support actions. While these actions vary from
firm to firm, they normally require the purchasing and materials operation to support a using
department in one or more of its major responsibilities. The most common types of support
involve actions such as developing materials standardization programs (in Co-ordination with
on going design programs), forecasting future prices and general business conditions,
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performing economic make-or buy analyses, and serving as a repository of information and
data from suppliers regarding new materials, processes, prices, and materials availability.
8. To administer the purchasing and materials management function in a professional,
cost-effective manner.
Management should expect the preceding seven objectives to be achieved in a professional
manner at a cost that is commensurate with their value to the total organization. This involves
the acquisition and development of highly competent personnel who are motivated to
perform their responsibilities effectively, with the over all goal of helping the firm maintain a
competitive position in its industry. Such personnel also serve as a reservoir of talent from
which future executives of the firm can be drawn.
A part of this composite effort also involves the development of operating policies and
procedures that facilitate accomplishment of departmental objectives at the lowest reasonable
operating costs.
All these objectives apply in principle to all categories of industrial buying activities:
manufacturing concern, governmental units, schools, hospitals, and all other types of buying
units that buy for consumption or conversion. A non profit activity, of course, cannot seek to
“maximize its profit”. It can, however, seek to maximize the benefits the organization
receives from its appropriated or endowed birr. A principle common to all types of
purchasing activities is to obtain the greatest value from each birr the purchasing department
spends.
The third level focuses on detailed objectives that are developed when precise buying plans
are made (usually annually) for each of the major categories of materials the firm uses in its
operations. These objectives are spawned from the functional-level objectives just discussed,
and are applied to fulfill the specific needs associated with each type of purchase. The precise
set of objective for each material typically varies because the usage requirements, the
operating conditions, and the markets in which each material is purchased usually are
different.
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1.5 Interdepartmental Relationships
A purchasing department exists to supply the needs of other departments in the company. To
a considerable extent the attitudes and reactions of these other departments toward the
purchasing department depend on the degree and kind of service that the purchasing
department extends and the nature of the existing interdepartmental relations.
Purchasing is constantly working with the other departments in the company, and thus it is
essential that mutual trust and cooperation prevail in order to foster efficiency. There are
areas where friction may develop between purchasing and other departments because of
misunderstanding over who should do the work. In many companies the materials
management form of organization has been introduced to minimize this friction and to
improve coordination among the materials departments. An organizational manual that
clearly describes the duties and responsibilities of each department help to minimize conflicts
of interest. Such manuals are becoming common place today, especially in larger companies.
The following paragraphs will be devoted to a brief discussion of some of these
interdepartmental relationships.
i) Purchasing and Production
Production and purchasing have the common goal of efficient and profitable operation;
however, their philosophies differ. A production executive quite naturally thinks in terms of
having all he needs of the best materials. This philosophy can easily lead to excessive
inventories of unnecessarily high quality. The purchasing executive may find himself in an
unpopular position when he must contend for a reasonable quantity of the appropriate
quality. To a considerable extent, the relationships between these two departments can be
harmonized through the exchange of information which each department develops in the
normal course of its operations.
Production must keep purchasing informed as far in advance as possible about production
plans and schedules. With such information purchasing is able to plan its procurement
program intelligently so as to minimize emergency and “rush” orders. As changes in
production plans develop, they should be communicated to purchasing so that time is
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available for vender selection, negotiations, and delivery. The production department must be
made to realize the “lead time” that exists between the issuance of a requisition and receipt of
goods. Efficient purchasing procedures can minimize this time but, at best, production must
work closely enough with purchasing in anticipating needs to allow for the minimum “lead
time”.
On the other hand, purchasing has certain responsibilities toward the production department.
The purchasing department must keep production informed of expected arrivals, and must
notify the production department promptly of any unusual delays so that production may be
rescheduled without plant stoppages.
The purchasing department has a valuable tool for the production department in its file of
vendor’s catalogs. These should be supplied on call to the production department. Purchasing
also has the responsibility of informing the production department about any new materials,
machines, or methods that come to the buyers’ attention through visiting salesmen or trade
literature. A buyer sometimes is instructed to secure samples for testing by the production
department. At other times a buyer should secure samples on his own initiative and bring
them to the attention of the production department for testing purposes.
In many companies the purchasing and production departments share joint responsibility for
development of standards and specifications for materials and supplies to be purchased. In
other companies purchasing merely has a voice in the matter, with responsibility in the
production department. The important thing is for the purchasing department to make sure
that wherever possible, standards conform to materials that are readily available in the market
and avoid unnecessary deviations that add to costs.
In the purchase of plant equipment, purchasing and production are but two of many
departments involved in the decision. Each, however, has a role to play in the purchase of
equipment. Production concerns itself with initiating the action and determining the kind of
equipment to be purchased. Purchasing surveys the potential suppliers who will be requested
to bid on the order and has an important voice in deciding who gets the order. The treasures,
the engineering department, some times the sales department, and often the president
participate in the decision.
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ii) Purchasing and Engineering
The engineering department is primarily responsible for the design and specifications of the
products the company makes and the processes the company uses. Engineers in such
departments have definite ideas about the physical and chemical properties required in the
end product and know what materials have the desired properties. However, because there
frequently are several materials possessing suitable properties, it is important for someone to
determine which material can be purchased most advantageously. This is a proper
responsibility of the purchasing department.
A close working arrangement must be developed between the engineering and purchasing
departments. Engineering should not be so exacting that its demands override price and
market considerations, and purchasing must not stress price to the point where it interferes
with sound engineering requirements.
The two departments should complement each other; and close cooperation is essential for
smooth and successful relationships. Good engineering produces a product up to company
specifications, with both technical and market efficiency.
iii) Purchasing and Sales
No company can stay in business for long unless its products can be sold at a profit. The
purchasing department can help the sales department by buying at the lowest possible cost so
that a company’s selling price can be competitive. About 50 percent of a typical sales
department sells has been purchased from others. The sales department can help purchasing
schedule its purchases effectively by apprising the purchasing department of sales quotas and
sales expectations. The sales department can be particularly helpful by giving the purchasing
department as much advance information as possible during negotiations with customers for
special orders and non-stock items. In many companies the practice of reciprocity calls for
the maintenance of close liaison between purchasing and sales in order to properly effectuate
the policy.
iv) Purchasing and Finance
Purchasing relationship with finance is different from its relationships with production,
engineering, and sales. The difference stems from the fact that cost determinations cannot be
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hidden in the purchasing-finance relationship as they often can in the other relationships. The
importance of good financial planning is highlighted by the fact that poor financial planning
is the major cause of business failure. Among the basic data needed by an organization for
proper planning of its working capital and cash-flow positions are accurate sales forecasts
and accurate purchasing schedules. It is just as important for purchasing to inform finance of
changes in its schedule as it is to inform production and sales of these changes.
There are many economic factors that periodically bring favorable and completely
unexpected buying opportunities. A supplier for example, may momentarily have excess
capacity because of the cancellation of a large order. During the period that this condition
exists, the supplier may sell products at prices designed to recover only out-of-pocket costs.
(Include direct costs paid for making a specific product). This may be done because it is in
the long-term interest of the firm not to reduce its labor force. The potential income from
such unexpected buying opportunities must be weighted against the potential income from
other alternative uses of the company’s capital. Acquiring new equipment, adding to plant
facilities, and increasing sales and promotional efforts are some of the alternative uses of
capital that a company must consider. Usually, the alternative offering the greatest income in
the long run should be selected, since no firm has enough capital to satisfy all requirements.
Regardless of the price advantage obtainable, the right time to buy from the stand point of
business conditions is not always the right time to buy from the stand point of the company’s
treasury. If the purchasing department places orders to take advantage of unusually low
prices without consulting the finance department, the company could find itself paying for
these purchases with funds needed for other purposes. On the other hand, if the finance
department does not strive delight to make funds available for such favorable buying
opportunities, the company may have to pay higher prices for the same material. Therefore, it
is routine procedure for all purchase requests to clear through the finance department to
ascertain that there is an uncommitted balance in the proper account equal to the
contemplated purchase.
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v) Purchasing and Stores
If the stores department is independent of the purchasing department, the relationship
between the two is closer and more continuous than those between any other two
departments. On all shelf stock items the stores department initiates the purchase requests on
which the buyer acts. The buyer’s decision concerning a purchase is based on such factors as
rate of use, number of defective parts, and trends in the rate of use. This information is most
easily secured through the records of the stores department. The buyer must keep the stores
department informed on minimum stocks and reorder points so that the stores department can
keep its inventories at proper levels.
Check Your Progress Exercise
1.What are the main differences between purchasing and procurement?
……………………………………………………………………………………………
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2.Discuss materials management concept.
……………………………………………………………………………………………
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3.What are included in materials management?
……………………………………………………………………………………………
…………………………………………………………………………………
4.What are the basic reasons for adopting materials management form of organizations?
……………………………………………………………………………………………
…………………………………………………………………………………
5. Mention and discuss the objectives of purchasing.
……………………………………………………………………………………………
…………………………………………………………………………………
6.What are the problems involved in purchasing-production relationships?
……………………………………………………………………………………………
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7.Identify and discuss the problems involved in the daily operating relationship between
purchasing and design engineering.
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8.Explain how sales and purchasing can help each other by establishing a good
relationship.
……………………………………………………………………………………………
…………………………………………………………………………………
9. Explain “purchasing as the manager for outside manufacturing” as one of the elements
of purchasing function.
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1.6 Summary
Purchasing is closely related to other concepts like procurement and materials management.
In general purchasing can be called that function responsible for the acquisition of required
materials, services and equipment.
Purchasing is one of the integral part of business management. For a business to be
successful all the functional areas must be successful. It is impossible for any organization to
achieve its full potential with out a successful. It is impossible for any organization to
achieve its full potential with out a successful purchasing activity.
The objectives of purchasing can be divided into two as general and specific detail
objectives. The general objectives are related to a top managerial perspective where as the
specific objectives are viewed from an operating or functional perspective.
Purchasing has a close working relationship with other departments like production,
engineering, sales, finance and stores. In order to minimize frictions and misunderstanding
the duties and responsibilities of each department have to be described properly. In addition,
departments have to exchange information which they develop is the normal course of their
operations.
1.7 Answers to Check Your Progress
1. They are different in terms of operation because the term “procurement” is wider concept
that encompasses a wider range of supply activities than does the purchasing concept.
2. Refer section 1.2.3
3. Production control, inventory control, materials handling, traffic control, warehousing, etc.
4. The manager of materials management department can think as president and other vice
top residents do- in terms of the firm as a whole, not think narrowly in terms of the
unique responsibility associated with their specifications.
5. Refer section 1.4
6. Refer section 1.5
7. Refer section 1.5 II
8. Refer section 1.5 III
9. Purchasing department is responsible for materials bought from outside suppliers or
manufacturers.
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1.8 References
1) Purchasing Management: Materials in Motion by J.H. Westing, I.V. Fine and G.J. Zenz
2) Purchasing and Material Management by Donald W. Dobler, Lamar Lee, Jr and David N.
Burt.
3) Public Purchasing and Materials Management by Harry Robert.
4) www.wikipedia\purchasing management.
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UNIT 2
ORGANIZATION FOR PURCHASING
Contents of the Unit
2.0 Aims and Objectives
2.1 Introduction
2.2 Location of the Purchasing Function in an Industrial Organization
2.3 Organization for Purchasing in a Single Plant Company
2.4 Organization for Purchasing in a Multi-Plant Firm
2.5 Factors Affecting Feasibility and Desirability of Centralization
2.6 The Materials Management Concept
2.7 Summary
2.8 Answers to Check Your Progress Exercises
2.9 References
2.0 Aims and Objectives
Students will be introduced to significance of organizational location of purchasing and
importance of materials management in organization in this unit. At the completion of this
unit, students will have knowledge and understanding of:
the importance of organization
how the location of the purchasing function can be determined for an organization
the advantages of bolts centralized and decentralized purchasing systems.
the factors affecting feasibility or desirability of centralization
the concept and practice of materials management.
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2.1 Introduction
Dear students! Organization is needed when people are jointly trying to reach some common
goal. A person alone in a wilderness with the goal of survival does not need organization. For
example, a group of people relaxing on a beach do not need organization because they have
no joint objective. However, if a group of people are put into an inhospitable wilderness from
which they wish to save themselves they will quickly devise an organizational pattern. The
organization may be thought of as the harness that enables each person to apply his
individual effort toward accomplishing the defined goal.
A good organization is essential if the efforts of each individual are to be optimized. In a
poor organization the efforts of some may be largely nullified by the efforts of others
working at cross-purposes. The efforts of some may be less productive than they might be
because their organizational harness may not be properly integrated with that of other parts of
the total organization. The secret of good organization, then, is to provide a comfortable
harness for everyone and to see that the various segments of the total are so well integrated
that everyone is working toward the same goal with maximum effectiveness.
Organization may be thought of in two dimensions. One deals with motivating the
individuals and subgroups of the total organization to get them to contribute optimally. The
other deals with the pattern of formal interrelationships that tie the members of the group
together. These dimensions often find expression in organizational charts. It is this aspect of
the organization of purchasing that we shall emphasize.
The most significant recent changes in purchasing organization involves a movement toward
uniting purchasing with other departments dealing with materials under a single responsible
executive. This practice is usually refereed to as materials management concept.
There is much to be derived from sound organization Responsibilities are clearly assigned to
the personnel in the organization, which assures that all activities will be performed, but with
no duplication of effort. A sound organization also clearly defines authority so that each
individual in the organization knows to whom he reports and who reports to him. This
definition of authority tends to lessen friction between individuals. Another benefit of sound
20
organization is the saving in time for executives. With proper assignment of responsibility
and authority, most routine decisions can be handled by a subordinate, and the executive can
devote his time to broad procedural and policy matters.
Sound organizational structure also permits a chain of promotion to be established. As a
concomitant of sound organization it is usual to find the development of job specification.
These in turn facilitate training of individuals for their own positions and for the positions
immediately above them. The existence of such a chain of promotion and systematic training
for promotion greatly strengthens and improves morale within an organization. Finally, a
sound organization will promote harmony among the component parts of the organization.
There is less possibility of jealousy or jurisdictional rivalry if the organizational
responsibilities are clearly outlined.
It should be recognized that there are distinct limitations to what can be achieved through
organization, and there are certain organizational weaknesses to be avoided in setting up a
business organization. An inherent limitation to any organization is the personnel who staff
it. The best principles of organization are of little value if the personnel who are assigned to
carry out the various responsibilities are incapable of doing so. It frequently happens that
organizational principles must be compromised so as to assign responsibilities to capable
personnel. It is a recognized fact that most company organization charts do not accurately
reflect the lines of authority and responsibility which flow through persons as well as their
positions.
A second factor to consider is the possibility of over organizing. There are many
organizations in which all duties and responsibilities are so minutely defined that excessive
red tape results. Over organization leads to a slowing down of decision making because the
channel to the decision making executive is too long or too devious. A highly refined
organization can be made to run smoothly by retaining policy control at the upper levels,
with authority and responsibility delegated to lower levels subject only to reporting and
review. On the whole, there is greater risk of poor performance through under organizing
than there is through over organizing. In purchasing there are two major organization
problems: (1) the place of the purchasing department in the overall company structure and,
21
(2) the internal organization of the purchasing department. Two basic issues are involved in
the first problem: (a) the desired degree of centralization of the purchasing function within
the company, and (b) the executive (or division) to whom the purchasing officer should be
responsible.
2.2 Location of the Purchasing Function in an Industrial Organization
Organizational structure reflects management’s basic attitudes toward the major activities
involved in its operation and where the different departments in a given organization are
situated. Where should the purchasing function fit in a firm’s organizational structure then?
The two most commonly found alternatives are shown diagrammatically in the following
figures.
PRESIDENT
EXCUTIVE
VICE PRESIDNET
Manager
Manager
Manager
Manager
Manager
Finance and
Human
Manufacturing
Marketing
Purchasing
Accounting
Resources
Figure 2. 1 – Skeleton of organization for a medium sized firm, with purchasing as a
top-level function.
22
PRESIDENT
EXCUTIVE
VICE PRESIDNET
Manager
Manager
Manager
Manager
Manager
Finance and
Human
Engineering
Manufacturing
Marketing
Accounting
Resources
Manager
Purchasing
Figure 2.2 – Skeleton of organization for a medium sized firm, with purchasing as a secondlevel function.
In a given firm, how does one tell whether purchasing is a top-level function that should
report to a general management executive, as do marketing and production, or a sub function
that should report to one of the top functional executives? Answers to these questions can be
determined only by finding the answers to several more basic questions.
How important is the purchasing activity to the total company operation? Will the company
suffer significantly if purchasing does not perform as effectively as it might? How important
is it that purchasing activities be coordinated closely with engineering and finance activities?
Is it essential that materials costs be tightly controlled?
23
Due to the varied nature of different firm’s products and operations, answers to the preceding
questions differ among firms. The importance of purchasing in any specific firm is
determined largely by four factors:
1. Availability of materials
Are the major materials used by the firm readily available in a competitive market? Or are
some key materials bought in volatile markets subject to periodic shortages and price
instability? If the latter condition prevails, creative performance by analytical purchasing
professionals is required; this typically is a top – level group.
2. Absolute birr volume of purchases
If a company spends a large amount of money for materials, the sheer magnitude of the
expenditure means that top-fight purchasing can usually produce significant profit. Small unit
savings add up quickly when thousands of units are purchased.
3. Percent of product cost represented by materials
When a firm’s materials costs are 40 percent or more of its product cost (or its total operating
budget), small reductions in material costs increase profit significantly. Top-level purchasing
usually pays off in such companies.
4. Types of materials purchased
Perhaps even more important than the preceding consideration is the amount of control
purchasing personnel actually have over materials availability, costs, and services. Most large
companies use a wide range of materials, many of whose price and service arrangements
definitely can be influenced by creative purchasing performance. Some firms, on the other
hand, use a fairly small number of standard production and supply materials, from which
even a top flight purchasing department can produce little profit as a result of creative
management, pricing and supplier selection activities.
24
2.3 Organizations for Purchasing in A Single Plant Company
A basic approach to organization
The nature of purchasing activity permits effective use of the fictionalization concept.
Purchasing work divides naturally into five distinct classifications, each of which
encompasses a fairly wide range of activities. In most cases the classifications can be further
divided into more specialized tasks, each of which still involves working with different
problems, different products, and different vendors. This circumstance permits the attainment
of a high degree of specialization, without creating motivational problems for most
purchasing personnel. Moreover, this type of functions permits reasonable flexibility in
expanding the work force to meet operational demands.
The five classifications of work found in a purchasing operation are:
1. Management
Management of the purchasing function involves all the tasks associated with the
management process, with emphasis on the development of policies, procedures, controls,
and the mechanics for coordinating purchasing operations with those of other departments.
On an exception basis, it also involves the management of unique supplier and commodity
problems.
2. Buying
This includes a wide variety of activities, such as working with users to help develop
requirements
and
specifications,
reviewing
requisitions,
analyzing
specifications,
investigating vendors, analyzing vendor capabilities, interviewing sales people, studying
costs and prices, analyzing bids, negotiating, and selecting suppliers.
3. Follow-up and expediting
Order follow-up activity involves various types of supplier liaison work, such as reviewing
the status of orders, writing letters, telephoning and telegraphing suppliers, and occasionally
visiting suppliers’ plants.
25
4. Special research work
A well-developed purchasing operation has an unending number of special projects or studies
requiring specialized knowledge and uninterrupted effort. These projects commonly are
found in the areas of formal value analysis, economic and market studies, special cost
studies, special vendor investigations, and systems studies.
5. Clerical
Every department must write orders and maintain working files, catalog and library
materials, and record for commodities, suppliers, prices, and so on.
The precise manner in which purchasing work is subdivided and grouped depends on the size
of the department, which in turn depends on the size of the company. The size of the
purchasing department typically runs somewhat over 1 percent of the total company
workforce in small firms to substantially less than 1 percent in large firms.
In a small company, say 150 employees, purchasing frequently is a two-person department.
The purchasing manage handles all work in the first four classifications, and a secretary
performs the clerical work. As the size of the department increases, additional personnel are
usually assigned joint buying and follow-up duties. At this point, buyers begin to specialize
on the basis of board classifications of commodities which the buy and each buyer typically
do his or her own follow-up and expediting work. As the department grows, buyers continue
to specialize in increasingly narrows commodity classification. Eventually, the follow-up and
expediting work may be withdrawn from the buyers and assigned to expediters, who may
specialize in somewhat the same manner as buyers. Continued growth finally results in the
addition of one or more staff personnel who specialize in various kinds of special projects.
The typical organization structure
The following figure illustrates a typical structure for the internal organization of a single
plant purchasing department in a medium-sized firm.
26
MANAGER
PURCHASING
BUYING DEPT.
MANAGER
STAFF RESEARCH SECTION
1. Value analysis studies
2. Economic & Commodity studies
3. Systems studies
4. Vendor Studies
BUYING DEPT.
MANAGER
BUYER
MATERIALS
‘A’
SUPERVISOR FOLLOW UP
AND OFFICE
ADMINISTRATION
BUYER
MATERIALS
‘D’
EXPEDITER I
ASSISTANT
BUYER
BUYER
MATERIAL B
BUYER
MATERIALS ‘E’
EXPEDITER II
WORKING
FILES
ASSISTANT
BUYER
EXPEDITER III
ASSITANT
BUYER
ORDER
PREPARA
TION
RECORDS
AND
CATALOGES
BUYER
MATERIALS ‘F’
BUYER
MATEIRALS ‘C’
Figure 2.3 a typical basic structure fore the internal organization of a singleplant purchasing department in a medium-size firm.
i) Manger of purchasing
The chief purchasing executive assumes various titles in different companies, such as
manager of purchasing, director of purchases, or, occasionally, purchasing agent. In a small
department he or she usually performs major buying activities as well as the required
27
management duties. As the department grows, most of the manager’s time is devoted to
management issues, except for the negotiation of a few major contracts.
ii) Buyers
Buyers and their assistants perform the actual buying activity and work directly with
suppliers. Each buyer, and assistant if the job requires one, handles a specific group of
materials. For buying purposes, materials can be grouped in two ways: (1) materials whose
purchase requires similar buying skills and technical knowledge can be grouped together, or
(2) materials that are used in the same finished product or by the same operating department
can be grouped together. The former practice is the more common grouping materials that
have similar buying and technical characteristics permits a buyer to become a technical
specialist. For example, he or she may specialize in buying electronic parts, metal castings, or
abrasive materials. In most firms today this is highly desirable. As materials continue to
become more complex, specialized knowledge of their characteristics, manufacturing
processes and markets is indeed required to purchase them intelligently.
If a buyer’s materials are grouped by similarity of end use, one buyer may buy some or all of
the parts for finished product A, and another buyer may buy the parts for finished product B.
or one buyer may handle the materials used by the lubrication department and another may
handle the components for the assembly department. Generally speaking, when materials are
grouped by end use, the buyer buys a wider range of items and becomes less of a specialist
than would be the case under the preceding method. This arrangement also produces some
duplication of effort because several different buyers invariably buy some of the same types
of materials.
A major advantage of grouping materials by end use, however, is the fact that buyers do not
become immersed in their own technical specialties. They have a tendency to identify to a
greater extent with the product or the department for which they are buying. In these
circumstances, the buyer frequently feels that he or she is an integral part of a specific
production effort. Companies favoring this form of organization believe that the loss of
technical buying specialization is more than compensated for by the added effectiveness of
the purchasing-production team effort that results. The extent to which this is actually true in
28
a specific situation depends on the range and complexity of materials purchased by each
buyer and the effectiveness achieved by the team effort.
iii) Buying supervisors
The size of the buying staff and the complexity of the purchases handled determine the need
for buying supervision. In some departments eight or ten buyers can report directly to the
purchasing manager or to a line assistant. In other cases, each commodity buying group is
handed by a senior buyer who reports to the chief purchasing executive. Possibly the most
common arrangement is depicted in Figure – 3. In this case, buyers are organized into larger
groups on the basis of similar commodity characteristics. An intermediate manager, who
reports to the chief executive, is assigned to each group (some times called a buying
department). These managers are variously titled senior buyers, assistant purchasing agents,
purchasing agents, or buying department managers, consistent with the title of the top
purchasing executive. The duties of these individuals typically encompass both managerial
and actual buying activities.
iv) Expediters
The most common form of organization for the follow up and expediting activity is shown in
Figure – 3. Formation of a separate expediting department permits a high degree of
specialization; additionally, it facilitates an even distribution of the work load and efficient
utilization of expediting personnel.
However, there is a wide difference of opinion concerning the most effective arrangement for
handling the expediting activity. Some firms require each buyer to do his or her own
expediting. Because of the buyer’s status and intimate knowledge of the order, these firms
believe that a buyer can obtain more effective results from suppliers than can someone of
lesser status in the organization. More important, companies using this approach want the
buyer to assume ‘total’ responsibility for each of his or her orders. They feel the buyer can do
this best by personally participating in all phases of the purchase. Additionally, if a buyer is
responsible for all phases of an order and for all vendor contacts, it is easier to measure and
control his or her performance.
29
Since much follow-up and expediting is routine work, however, it often represents an
efficient use of a buyer’s time. Some companies therefore develop a hybrid organization. To
achieve the benefits of specialization, they assign the follow-up and expediting function to a
separate expediter. So that the buyer can retain full control of his or her orders, though, each
expediter is assigned directly to one buyer (for a buying group). Thus, the expediter drops his
or her work as directed by the buyer, and the buyer is held fully responsible/accountable for
his or her orders. In practice, the expediter usually handles all routine follow-up inquires and
all other buyer for assistance with the difficult or delicate expediting problems this form of
organization when fully developed, produces a commodity-type organization structure that
minimize the division of responsibility between buyers and expediters, and tends to produce
a beneficial esprit de corps among buyers, expediter’s and clerical personnel assigned to a
particular commodity group. In addition, this approach helps develop an internal source of
new buyers – its experienced expediters. This form of organization clearly may also be less
flexible and more costly, especially in small firms.
iv) Staff Research Personnel
The number of staff specialists employed depends on the size of the department, the
complexity of its operation, and the types of material it purchases. Theoretically, in making
pre purchase investigations good buyers should perform nearly all the activities such staff
specialists are hired to do. However, most companies now realize that under the pressure of
daily operations, most buyers simply do not have time to conduct all desired investigations in
adequate depth. This is particularly true for complicated purchase that influences future
procurement efficiency. This fact, coupled with an awareness of the benefits specialization
can produce in planning and research, has led many firms to organize such activities
functionally within a special staff group. The specific activities of this group are related to
value analysis and purchasing research.
30
2.4 Organizations for Purchasing in a Multi Plant Firm
A multi plant firm faces one additional organizational question that does not concern most
single-plant companies: To what extent should purchasing activity be centralized at the
corporate level? In practice, virtually every firm answers this question differently. Some
firms centralize the activity almost completely, doing the buying for all plants at a central
head quarters office. Others decentralize the function entirely, giving each plant full authority
to conduct all of its purchasing activities. Still other firms-the majority of them-develop an
organization some where between these two extremes. Each extreme approach offers
significant benefits that are discussed in the following sections.
2.4.1 Advantages of centralization
1. Greater Buying Specialization
Perhaps the greatest benefit of centralization stems from the fact that it permits greater
technical specialization among buyers. This leads to the development of more knowledgeable
and more highly skilled buying personnel.
Centralization enables a firm to do a better technical job of buying, or it permits a job of
buying comparable with that under decentralization to be accomplished with fewer buyers. It
also provides for the capable buying of major capital equipment and construction services
which are required only intermittently by any single plant, but which on a company wide
basis represent a continuing purchasing activity.
In most companies, the importance of specialized buying cannot be overvalued. The
complexity of industrial materials increases constantly. A buyer who does not fully
comprehend the significance of materials major technical and manufacturing characteristics
cannot perform effectively. If buyers fail to perform with technical competence, the
important buying decisions will ultimately be made in the using departments, and buyers will
be relegated to a glorified clerical status.
2. Consolidation of Requirements
Just as single-plant centralization facilitates the consolidation of plant requirements, multi
plant centralization facilitates the consolidation of material requirements at the corporate
31
level. In most situations, such consolidation results in larger purchases from a smaller
number of suppliers, yielding more favorable prices and increased supplier service. Increased
purchase volumes also permit the negotiation of highly profitable long-term contracts for
many production materials.
3. Easier purchasing coordination and control
When all company purchasing activities are consolidated in one office, procedures for
coordinating and controlling individual segments of activity can be affected more quickly
and with less paper work. Consolidation permits more direct administration and control of
such important policies as those affecting supplier selection procedures, supplier relations,
purchasing ethics, budget compliance, and the consistency of general purchasing practice
among the various buying groups. In general, under this type of organization, the chief
purchasing executive finds it easier to control the total efficiency of the corporate purchasing
activity.
4. Effective planning and research work
The existence of a centralized group to handle corporate wide purchasing requirements
provides the concentrated staff know-how to improve purchasing research work. Virtually all
purchasing planning needs – from internal systems design to strategic materials planning-can
be conducted in more depth with greater efficiency for all purchasing operations throughout
the corporation
2.4.2 Advantages of decentralization
1. Easier coordination with operating departments
From an operating standpoint, the greatest advantage of decentralization is that it facilitates
the coordination of purchasing activities with the activities of using departments with in each
plant. When a complete purchasing unit is located at each operating site, purchasing
personnel are close to the users’ operating problems and develop a much better feel for
unique plant needs and their implication in the purchasing area. Buyers can personally
discuss purchasing matters with using supervisors anytime they wish. Value analysts and
technical coordinators can work daily with engineering personnel whenever necessary. Also,
a plant purchasing department can develop a much closer working relationship between
32
suppliers’ technical representatives, buyers, and plant engineers than is possible under a
centralized organization.
In brief, under a decentralized arrangement, purchasing personnel can participate more fully
as members of a specific purchasing – production team.
2. Speed of Operation
A purchasing department located at the plant clearly can respond more quickly to users’
needs. The transmittal of information from plant to head quarters by means of a conventional
paperwork system typically lengthens the purchasing procedure by one or two days. Of
course, telephone, fax equipment, and computer links can be used in many cases, but often
these are not practical as a regular method of communication. If most operating need could
be adequately planned, and plans always functioned according to schedule, the time delay
factor would be a minor problem. In a dynamic business situation, however, unforeseen
events cause enough deviations from schedule so that this is rarely the case.
3. Effective Use of Local Sources
If a firm’s plants are geographically dispersed, it can be difficult for a centralized purchasing
department to locate and develop potentially good suppliers in the locale of each plant. At
times this difficulty deprives a plant of various technical and purchasing benefits resulting
from close working relationships between plant personnel and suppliers. If plants are
separated by great distances, decentralized purchasing departments in many cases may also
be able to reduce material transportation costs by the wise use of local suppliers.
4. Plant Autonomy
A fundamental principle of management holds that the delegation of responsibility must be
accompanied by the delegation of adequate authority to carry out that responsibility. A plant
manger who is given full responsibility for the operation and profit performance of a plant
can properly contend that he or she should have full authority over expenditures for
materials. Decentralization of purchasing gives a plant manager this authority.
Although entirely valid, the preceding idea implies that a plant manger has no control over
materials expenditures if purchasing is centralized. This need not be true. While a plant
manager has no line control over a centralized purchasing department, many firms develop
33
coordinating committees to correct purchasing situations that are unsatisfactory to plant
management. If these are established with in the proper framework, a plant manager, through
such a mechanism, can exercise satisfactory indirect control over the performance of a
centralized purchasing department.
2.5 Factors Affecting Feasibility & Desirability of Centralization
Three factors determined how feasible or desirable centralization of the purchasing function
may be in a given situation: (1) Similarity of the classes of materials used in each of the
plants, (2) Size of each individual plant purchasing department, and (3) Distance separating
the individual plants.
(1) Similarity of Materials Usage
If a firm’s plants use entirely different materials, centralization of purchasing offers only
minimal benefits, the major benefits of increased specialization and requirement
consolidation cannot be achieved. In such cases, potential disadvantages of centralization
usually outweigh the advantages gained from better co-ordination and control.
Most firms, however, generally have a greater similarity of materials usage among plants that
is at first apparent. To make specialization profitable, the various plants do not have use
exactly the same items. The important thing is the similarity of types of materials (or
markets). Specialization of buyers is accomplished on the basis of material (or market)
classifications. Most firms find that their plants do use a number of the same classifications
of materials.
(2) Plant Department Size
As a general rule, centralization is more advantageous when a firm’s individual plant
purchasing departments are not large. If plant purchasing operations are large, a high degree
of buyer specialization may already have been achieved. Similarly, the benefits to be gained
from consolidating requirements of large departments are less significant than those gained
from consolidating the requirements of small plants. This is not to say that consolidation of
large departments does not yield benefits. It usually does. The benefits, however, are not as
significant as in the case of small departments, and they are frequently outweighed by the
offsetting disadvantages.
34
(3) Geographic Dispersion of plants
The closer a firm’s plants are situated geographically, the easier centralization becomes.
Conversely, if much centralized buying is done, the more widely the plants are dispersed, the
more serious the disadvantages of centralization become. Even if a centralized purchasing
office has direct telephone and fax service to the production scheduling offices at each plant
when a plant is 1,000 miles distant, the problems of communication and coordination with
that plant are difficult indeed.
2.6 The Materials Management Concept
To this point, the discussion has dealt mostly with the organization of the purchasing
function. In designing an organization structure for a total plant, management must decide
how to group and coordinate the other activities whose major interest also focuses on the
company’s acquisition and utilization of materials. In addition to purchasing, the departments
that are primarily concerned with materials are inventory (materials) control, receiving,
stores, production scheduling, and traffic. To which functional executives should these
departments report?
Historically, firms have divided responsibility for the various materials activities among two
or three functional departments (i.e. purchasing, production, and marketing). This division of
responsibly makes it difficult to coordinate the interrelated activities of the materials oriented
departments. More important, it makes effective identification and control of total materials
costs extremely difficult, if not impossible. The materials management concept, and its
related form of organization, has evolved in response to these needs.
Materials management provides an integrated systems approach to the coordination of
materials activities and the control of total materials costs. If advocates assigning to a single
operating department all major activities which contribute to the cost of materials. The
objective is to optimize performance of the materials system, as opposed to sub optimizing
the performance of individual operating units that are parts of the materials system. The
organization of materials activities that stems form the materials management concept takes
the general form shown in Figure 2.4.
35
Although the theory is simple and straight forward, its implementation provides some basis
for differences of opinion. Top executives and management consultants do not agree
completely on the exact form the materials management organization should take. In many
cases, these differences in application of the concept are quite legitimate, simply because
each firm is some what unique in terms of its specific orientation, its operating environment,
and its specific problems. Consequently, some companies do not include all the materials
activities in the materials management department. In fact, the title of the department varies
considerably from firm to firm. Some firm’s adopt the philosophy underlying the concept,
but for various reasons assign some or all of the materials activities to a strong existing
department (often the purchasing department), without creating a department bearing the
materials management name.
PRESIDENT
EXECUTIVE
VICE PRESIDENT
Manager
Financne
Manager
Personnel
Manager
Materials
Manager
Marketing
Purchasing
Stores And
Receiving
Manager
Manufacturing
Traffic
Inventory
Control
Production
Control
Figure 2.4 the general structure of an organization employing the materials management
concept
36
Check Your Progress Exercise
1. What is the difference between good organization and poor organization? discuss
………………………………………………………………………………………………
……………………………………………………………………………………
2. Identify and discuss the factors that determine the importance of purchasing in any
specific firm.
………………………………………………………………………………………………
……………………………………………………………………………………
3. State and explain where the purchasing department should be located in a single-plant
manufacturing company.
………………………………………………………………………………………………
……………………………………………………………………………………
4. If you are asked to study a plant’s purchasing department and to recommend an ideal
organization to the manger, discuss what you would do and how you would conduct the
study.
………………………………………………………………………………………………
……………………………………………………………………………………
5. Explain how and by whom expediting function should be conducted in a purchasing
department.
………………………………………………………………………………………………
……………………………………………………………………………………
6. What are the specific advantages and disadvantages of centralized purchasing in a multi
plant company? Explain each of them.
………………………………………………………………………………………………
……………………………………………………………………………………
7. When is it neither feasible nor desirable to centralize the purchasing activity in a multiplant company? Explain.
………………………………………………………………………………………………
……………………………………………………………………………………
8. Is centralized multi plant purchasing likely to expand or decline in the decade ahead?
Explain.
………………………………………………………………………………………………
……………………………………………………………………………………
9. Discuss the shortcomings or limitations and the basic reasons for adopting materials
management form of organization.
………………………………………………………………………………………………
……………………………………………………………………………………
10. How materials management concepts affect a firm’s organization structure?
………………………………………………………………………………………………
……………………………………………………………………………………
37
2.7 Summary
One of the commonly discussed questions that have to be answered is where should
purchasing be located in the organization structure? The answer depends up on the type of
industry, variety and volume of purchase that the firms conduct. The modern approach is to
have an integrated materials department headed by a materials manager with the purchase
manager under him. If there is no separate integrated materials department, it would be ideal
to place the purchase manager directly under the chief executive in the headquarters.
The importance of purchasing in any specific firm is determined largely by four factors.
Namely: availability of materials, absolute birr volume of purchases, percent of product cost
represented by materials and types of materials purchased.
Purchasing work divides into five classifications. These include management, buying,
follow-up and expediting, special research work and clerical.
Location of purchasing or material’s department with in a firm’s organizational hierarchy is
determined very simply by one factor – management’s perception of the importance of the
function. In a majority of manufacturing firms the purchasing/materials functions reports to a
top-management executive, but in a sizable minority it is seen as a second level function.
Some multi-plant firms centralize the purchasing activity almost completely, doing the
buying for all plants at the head quarter office. Others decentralize the function entirely,
giving each plant full authority to conduct all its purchasing activities. Since each extreme
approach does have its own advantages and disadvantages, the majority of multi-plant firms
develop an organization some where between these two extremes.
There are three factors which determine how feasible or desirable centralization of the
purchasing function may be in a given situation. These are (1) similarity of materials usage
(2) plant department size and (3) geographic dispersion of plants.
The materials management concept is a system approach that coordinates and controls the
material management activities, which include purchasing, traffic, stores and receiving,
inventory control and production control.
38
2.8 Answers to Check Your Progress
1. Refer section 2.1
2. Availability of materials, absolute birr value of purchases, percent of product cost
represented by materials and types of materials purchased.
3. It depends up on the purpose that the purchasing department offers to the firm
4. I have to study the various functions carried out by the firm and by the department of
purchasing. Then I consider the complexity of the firm and the department and suggest
the location of the department.
5. By follow-up and expediting section in the purchasing department.
6. Refer section 2.4.1 and 2.4.2
7. Refer section 2.5
8. It will decline because most model companies use in between the two extremes i.e.,
centralization and decentralization.
9. Refer section 2.6
10. Refer section 2.6
39
2.9 References
1) Purchasing Management: Materials in Motion by J.H. Westing, I.V. Fine and G.J.
Zenz
2) Purchasing and Materials Management by Donald W. Dobler Lammar lee, Jr and
David N. Burt.
40
UNIT 3
COST AND PRICING APPROACH
Contents of the Unit
3.0 Aims and Objectives
3.1 Introduction
3.2 Cost Concept
3.2.1
Definitions
3.2.2
Cost Classification
3.3 Marginal Costing and Cost Volume Profit Analysis
3.4 Pricing Approach
3.5 Summary
3.6 Answers to Check Your Progress
3.7 References
3.0 Aims and Objectives
The objective of this unit is to introduce the student with the concept of cost and pricing
approaches. It is aimed at the classifications of costs so that the cost of products and services
may be accurately determined. Therefore, at the completion of this unit, students will have
knowledge and understanding of:
different ways of classifying costs
the marginal costing technique
the relationship between marginal costing and cost volume profit analysis
how to calculate contributions, profit volume ratio, break-even point, and margin of
safety
determine the purchase price of the materials bought from suppliers
different methods of issuing materials from the store.
41
3.1 Introduction
Dear students! The knowledge of costs and prices of various products and services is very
important for purchaser to understand the base purchase cost/price of the product or service.
The scope of the term ‘cost’ is extremely broad and general. It is therefore, not easy to define
or explain this term in a simple statement. It is true that a cost must be understood in its
relationship to the purpose which it is to serve. When the term ‘cost’ is used specifically, it
should be qualified with reference to the object cost by such descriptions as fixed cost, direct
cost, labor cost, selling cost, marginal cost, prime cost, conversion cost etc. All these terms
will be explained in this unit. Cost can also be explained by its ways of classifications. In this
unit we shall also discuss the various ways of classifying costs. Moreover, the unit deals with
the pricing methods for purchased items, the method of pricing for materials issued from the
store and the pricing of finished products.
3.2 Cost Concept
3.2.1 Definitions
It is difficult to define cost in a simple term. There are different ways of defining it. A cost is
the value of money that has been used up to produce something, and hence is not available
for use anymore. In business, the cost may be one of acquisition, in which case the amount of
money expended to acquire it is counted as cost. In this case, money is the input that is gone
in order to acquire the thing. This acquisition cost may be the sum of the cost of production
as incurred by the original producer, and further costs of transaction as incurred by the
acquirer over and above the price paid to the producer. Usually, the price also includes a
mark-up for profit over the cost of production. More specifically, some of the definitions of
costs are the following:
i.
Cost is defined as the amount of resources given up in exchange for some goods
or services. The resources given up expressed in monetary terms
42
ii. It has also be defined as the classifying, recording and allocating of expenditure
for the determination of costs and the relationship of these costs to sales volume
and profitability
iii. Cost is also defined as the amount of expenditure incurred or attributable to a
given thing
iv. Cost is the price paid for some thing. It is obvious that a cost must be understood
in its relationship to the purposes, which it is to serve.
Costs are grouped in different ways to help managers to make decisions. To aid decisions,
managers want the cost of some thing. This something is known as cost object or cost center.
Cost object (center) is defined as any activity for which a separate measurement of cost is
desired. It refers to the section of the business to which costs can be charged. It may be a
location such as department, sales area, or an item of equipment such as a machine, delivery
of equipment, and a person such as a sales man, a machine operator or a group of these. A
cost center (object) is primarily of two types.
a. Personal cost center which consists of a person or a group persons
b. Impersonal or an item of equipment or a group of these.
From functional point of view, cost centers may be of the following two types.
a. Production cost center-those cost centers where actual production work takes place.
Examples are drilling shops, machine shop, welding shop, finishing shop etc.
b. Service cost center – those cost centers, which are ancillary to and render services to
production cost center. Examples are powerhouse, tool room, stores department,
repair shop etc. costs incurred in service cost centers are of indirect type.
3.2.2 Cost Classification
According to their common characteristics, costs are classified into different classes. It is a
systematic placement of similar items together according to their common features. There are
various ways of classifying costs. Each classification serves different purposes.
43
3.2.2.1 Classification according to identifiably with cost unit
Costs are classified into direct and indirect on the basis of their identifiably with cost unit or
jobs or processes.
i. Direct costs. These are those costs, which are incurred for and may be conveniently
identified with a particular cost unit, processes or departments. These costs include direct
material costs and direct labor costs. Direct material costs are acquisition costs of all
materials that are physically identified as a part of manufactured goods. They are costs which
can be identified in the product and can be conveniently measured and directly charged to the
product. These materials directly entered the production and form part of the finished
product.
Example – Timber in furniture making
- Cloth in dress making
- Leathers in shoes making
- Steel in machines etc
Direct labor costs are the wages of all labor that can be identified specifically with the
manufactured goods in an economically feasible way. It is that labor which can be
conveniently identified to a particular job, product or process and convert raw materials into
finished goods.
Example
- Wags of machine operator
- Assembler
- Shoemaker
- Carpenter
- Tailor etc.
ii. Indirect costs. These costs cannot be conveniently identified with a particular cost unit,
process or department. These are general costs and are incurred for the benefit of a number of
cost units or cost centers. These indirect costs are known as factory overhead costs. These are
the aggregate costs of indirect materials indirect labor and other indirect expenses that are
associated with the manufacturing process.
44
Indirect materials are those materials, which cannot be conveniently identified with
individual cost unit. These are minor, small and relatively inexpensive items, which may
become a part of the finished product E.g. Pins, crews, nuts and bolts, thread etc. and those
items which do not physically become a part of the finished products E.g. Coal, lubricating
oil and Greece, soap etc.
Indirect labor is the labor that is not directly engaged in the production operations but only to
assist or help in production operation.
Examples are janitors, plant guards, store room clerks, supervisor, etc
Indirect expenses are all indirect costs other than indirect materials and indirect labor costs.
These costs cannot be directly identified with a particular job, process or work order and are
common to cost units and cost centers. Examples are: rent, depreciation, lighting and power,
advertising, insurance, etc.
This classification is important from the point of view of accurate ascertainment of cost.
Direct costs of a product can be conveniently determined while the indirect costs have to be
arbitrarily allocated to various cost units. For example in ready made garments, the cost of
cloth and wages of tailor are accurately ascertained without any difficulty and are thus direct
costs. But the rent of factory, managerial salaries etc; which are indirect costs, has to be
apportioned to various cost units on some arbitrary basis and cannot be accurately
ascertained.
3.2.2.2 Classification according to functions
This is a traditional way of classifications. A business has to perform a number of functions
like manufacturing, administration, selling, distribution and research. Costs may have to be
ascertained for each of these functions. On these bases costs are classified into the following
categories.
i. Prime and conversion costs
Prime cost consists direct material and direct labor costs. Conversion cost is used to denote
the sum of direct labor and overhead costs in the production of particular product. It is the
total cost of converting a raw material into finished product.
45
ii. Manufacturing cost
Also called production ‘cost or factory cost,’ this is the cost of the sequence of operations
which begins with supplying materials, labor and services and ends with completion of
production. Manufacturing costs include Materials, Labor, and Factory rent, Depreciation,
Power and Lighting, Insurance, Store Keeping, etc.
iii. Administration cost. This is general administrative cost and includes all expenditure
incurred in formulating the policy; directing the organization and controlling the operations
of a company, which is not directly related to production, selling, distribution, research and
development function.
Examples of administrative costs are office expenses, audit fees, legal expenses, office rent,
director’s salaries, postage and communication etc.
iv. Selling and distribution costs
Selling cost is the cost of seeking to create and stimulating demand and of securing orders
selling costs include;
-
advertising
-
salaries and commissions of salesmen
-
travel expense
-
show room expense.
Distribution cost is the cost of sequence of operations which begins with making the packed
product available for dispatch and ends with making the re-conditioned returned empty
package for re-use. Distribution cost includes:
-
packing costs
-
carriage outward
-
warehousing costs
-
upkeep and running costs of delivery equipment.
46
v. Research and development cost
Research cost is the cost of searching new or improved products or methods. It comprises
wages and salaries of research staff, payments to outside research organizations, materials
used in laboratories and research departments etc.
After completion of research, the management may decide to produce a new improved
product to employ a new or improved method. Development cost is the cost of the process
which begins with the implementation of the decision to produce a new product or to employ
a new or improved method and ends with the commencement of formal production of that
product or by that method.
3.2.2.3 Classification according to variability or behavior
Costs sometimes have definite relationship to the volume of production rises or falls. As such
they are described fixed, variable and semi-variable or semi-fixed costs.
i. Fixed costs
These costs remained fixed in total and do not increase or decrease when the volume of
production changes. But the fixed cost per unit increases when volume of production
decreases or fixed cost per unit decreases when the volume of production increases.
Example- If a shoe factory rents a factory building for birr 100,000 per year, the unit of rent
applicable to each pair of shoe will depend on the total number of shoes produced. If 100,000
pair of shoes produced cost per unit will be birr 1 (100,000  100, 0000); if 50,000 pairs of
shoes produced, cost per unit will be birr 2 (100,000  50,000). From this, we realize that the
per unit cost of fixed cost will vary while the total cost remain the same.
Examples of fixed costs are:
-
rent and lease
-
managerial salaries
-
building insurance
-
salaries of permanent staffs.
47
Characteristics of fixed costs include:

they are fixed in total amount within a relevant output range

they increase or decrease in per-unit when quantity of production changes

they allocated to departments on some arbitrary basis.

such costs can be controlled mostly by top-level management.
ii. Variable costs
These costs tend to vary in direct proportion to the volume of output. In other words, when
volume of output increases, total variable cost also increases and when volume of output
decreases, total variable cost also decreases. But the variable cost per unit remains fixed.
Example 1, if a company pays 20% commission on the amount of sales for the door-to-door
sales personnel, the total cost of the commission would be 20% times the total volume of
sales.
2. If a shop owner buys a number of bags at birr 5 each, the total cost of bags would be 5
times the number of bags purchased.
Here we see that per unit costs i.e. 20% and 5 birr are constant but the total cost depends
upon the amount of sales and the number of bags purchased.
Variable costs include:
-
direct materials
-
direct labor
-
power
-
royalties
-
commission of sales people
-
small tools etc
Characteristics of variable costs:

variability of the total amount in direct proportion to the volume of output

fixed amount per unit in the pace of changing volume

easy and reasonably accurate allocation and allocated to departments

such costs can be controlled by functional managers.
48
iii. Semi-variable or semi-fixed costs
These costs are partly fixed and partly variable. A semi-variable cost has often a fixed part
below which it will not fall at any level of output.
Examples are: Telephone expenses, light and power, depreciation, etc.
3.2.2.4 Classification according to product costs and period costs.
Product costs are those costs which are necessary for production and which will not be
incurred if there is no production. These costs consist direct materials, direct labor and some
of the factory overhead costs. They are called inventor able costs because they are included
in the cost of products as work-in-progress, finished goods or cost of sales.
Period costs are those which are not necessary for production and are written off as expenses
in the period in which they are incurred. Such costs are incurred for a time period and are
charged to profit and losses of the period. Example of period costs are rent, salary of
company executives etc. These costs are not inventoried i.e. they are not included in the
volume of finished stocks.
3.2.2.5 Classification according to controllability
Costs can also be classified into controllable and uncontrollable costs:
i. Controllable costs: - These are the costs which may be directly regulated at a
given level of management authority. Variable costs are generally controllable by
department heads. For example cost of raw material may be controlled by
purchasing department.
ii. Uncontrollable costs: - These are those costs which cannot be influenced by the
action of a specified member of an enterprise. Fixed costs are generally
uncontrollable costs.
49
Check Your Progress
1. What is cost?
___________________________________________________________________________
___________________________________________________________________________
__________________________________________
2. Briefly explain the cost center and its classification from the different points of view
___________________________________________________________________________
___________________________________________________________________________
__________________________________________
3. Explain the different ways of classifying costs and the classes of costs accordingly.
___________________________________________________________________________
___________________________________________________________________________
__________________________________________
4. Briefly explain the characteristics of fixed cost and variable costs.
___________________________________________________________________________
_____________________________________________________
3.3 Marginal Costing and Cost-Volume Profit Analysis
3.3.1 Definition
The costs that vary with a decision should only be included in decision analysis. For many
decisions that involve relatively small variations from existing practice and/or are for
relatively limited periods of time, fixed costs are not relevant to the decision. This is because
either fixed costs tend to be impossible to alter in the short term or managers are reluctant to
alter them in the short term.
Marginal costing distinguishes between fixed costs and variable costs as convention ally
classified.
The marginal cost of a product –“is its variable cost”. This is normally taken to be; direct
labor, direct material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as: ‘the accounting system in which variable costs are
charged to cost units and the fixed costs of the period are written-off in full against the
aggregate contribution. Its special value is in decision making’. (Terminology.)
50
The term ‘contribution’ mentioned in the formal definition is the term given to the difference
between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
CONTRIBUTION SALES - MARGINAL COST
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the
total marginal costs of a department or batch or operation. The meaning is usually clear from
the context.
Note: Alternative names for marginal costing are the contribution approach and direct costing
in this lesson, we will study marginal costing as a technique quite distinct from absorption
costing.
3.3.2 Marginal costing techniques
The marginal costing technique advocates that fixed costs are not relevant for the purpose of
planning. It considers only marginal costs for efficient planning of expenses and profit. The
logic is that fixed costs would remain fixed over a short period of time, hence, should be
ignored. Differences between the sales and variable costs are called contribution. A firm
which can maximize contribution can automatically maximize net profit, fixed cost
remaining constant.
51
3.3.3 Characteristics of marginal costing
The main features of marginal costing are as follows:
1.Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and
fixed costs. It is the variable cost on the basis of which production and sales policies
are designed by a firm following the marginal costing technique.
2.Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit cost under absorption costing method.
3.Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various
decisions. Marginal contribution is the difference between sales and marginal cost. It
forms the basis for judging the profitability of different products or departments.
Advantages and Disadvantages of Marginal Costing Technique
Advantages
i.
Marginal costing is simple to understand.
ii.
By not charging fixed overhead to cost of production, the effect of varying charges
per unit is avoided.
iii.
It prevents the illogical carry forward in stock valuation of some proportion of current
years fixed overhead.
iv.
The effects of alternative sales or production policies can be more readily available
and assessed, and decisions taken would yield the maximum return to business.
v.
It eliminates large balances left in overhead control accounts which indicate the
difficulty of ascertaining an accurate overhead recovery rate.
vi.
Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed
overhead, efforts can be concentrated on maintaining a uniform and consistent
marginal cost. It is useful to various levels of management.
52
vii.
It helps in short-term profit planning by breakeven and profitability analysis, both in
terms of quantity and graphs. Comparative profitability and performance between two
or more products and divisions can easily be assessed and brought to the notice of
management for decision making.
Disadvantages
i.
The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
ii.
Normal costing systems also apply overhead under normal operating volume and this
shows that no advantage is gained by marginal costing.
iii.
Under marginal costing, stocks and work in progress are understated. The exclusion
of fixed costs from inventories affect profit and true and fair view of financial affairs
of an organization may not be clearly transparent.
iv.
Volume variance in standard costing also discloses the effect of fluctuating output on
fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories.
v.
Application of fixed overhead depends on estimates and not on the actual and as such
there may be under or over absorption of the same.
vi.
Control affected by means of budgetary control is also accepted by many. In order to
know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less effective
since a major portion of fixed cost is not taken care of under marginal costing.
vii.
In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the
assumptions underlying the theory of marginal costing sometimes becomes
unrealistic. For long term profit planning, absorption costing is the only answer.
53
3.3.4 Marginal cost equation
For the sake of convenience, the elements of costs can be written in the form of equations as
follows.
Sales = Variable cost + Fixed costs  Profit/Loss
Or Sales – Variable costs = Fixed costs  Profit/Loss
Or S – V = F  P/L where ‘S’ stands for sales, V for variable costs, F, for fixed expenses, P
for profit and L for Loss.
Or S – V = C because F + P, is equal to contribution (C) i.e Fixed cost + Profit =
Contribution.
In order to make profit, contribution must be more than the fixed expenses and to avoid any
loss, contribution must be equal to the fixed expenses.
The marginal cost equation of S – V = F  P is very useful to find any of the four factors i.e.,
S, V, F or P if three of these factors are known
Example: Determine the amount of fixed cost from the following
Sales ------------------------------------------------------------------------- $ 240,000
Direct material costs ---------------------------------------------------------- 80,000
Direct labor costs -------------------------------------------------------------- 50,000
Variable overheads ------------------------------------------------------------ 20,000
Profit -----------------------------------------------------------------------------50,000
Solutions
Given S = 240,000
V = 150,000 (80,000 + 50,000 + 20,000)
P = 50,000
Marginal equation = S – V = F + P
240,000 – 150,000 = F + 50,000
90,000 = F + 50,000
F = 90,000 – 50,000
F = 40,000
54
3.3.5 Break-even (cost volume profit) analysis
Break-even analysis is a logical extension of marginal costing. It is based on the same
principles of classifying the operating expenses, into fixed and variable. Now a day it has
become a powerful instrument in the hands of policy makers to maximize profits.
There may be change in the level of production due to many reasons such as competition,
introduction of a new product, increased demand for the products, scarce resources, change
in the selling prices of products etc. In such cases management must study the effect on profit
on account of the changing levels of production. A number of techniques can be used as an
aid to management in this respect. One such technique is the break even analysis.
The term breakeven analysis is interpreted in the narrower as well as broader sense.
In the narrower sense, it is concerned with finding out the break-even point i.e. the level of
activity where the total cost equals total sales. In its broader sense, it means that the system
of analysis which determines the probable profit at any level of production. The break-even
analysis establishes the relationship of costs, volume and profit. The management of profit
seeking organization usually studies the relationships of revenue, cost and net income
(profit). This study is commonly called cost volume profit analysis.
In order to understand mathematical relationship between cost, volume and profit, it is
desirable to understand the following four concepts.
i. Contribution
ii. Profit -volume ration (P/V ratio)
iii. Breakeven point
iv. Margin of safety
3.3.5.1 Contribution
Contribution is the difference between the sales and the marginal cost of sales and it
contributes towards fixed cost and profit.
55
Example selling price per unit $ 15
Variable cost per unit 10
Fixed cost total $ 150,000
Units of production 30,000 units:
Contribution per unit = 15 – 10 = $ 5
Total contribution = 30,000 unit x 5 = $ 150,000 which is sufficient to cover fixed cost and
no profit.
- If out put is 20,000 units, contribution will be 20,000 x 5 = $ 100,000 which is not
sufficient to cover fixed cost of $ 150,000 and the result is the loss of
$ 50,000.
- If output is 40,000 units contribution will be 40,000 x 5 = $ 20,000 sufficient to
cover fixed cost and result in a profit of $ 50,000.
Thus contribution will first go to meet fixed cost and then to earn profit.
Contribution can be represented as:
Contribution = Sales – Variable cost
Or Contribution = Fixed cost + Profit
Or Contribution – Fixed cost = Profit
Or Contribution – Profit = Fixed cost.
In marginal costing, contribution is very important as it helps to find out the profitability of a
product, department or division to have better product mix, for profit planning and to
maximize the profit of the company.
3.3.5.2 Profit volume ration (P/V ratio)
This ration is calculated in the following way
Contribution
C
i.e
Sales
S
P/V ration =
Fixed cos t  profit
FP
i.e
Sales
S
Or =
56
Sales  Variable Cost
S V
i.e
Sales
S
Or =
Change in Pr ofits
Or = Change in Sales
Change in Contributions
Change in Sales
Or =
The ratio can be expressed in percentage form if it is multiplied by 100
Example. If the selling price is $ 15 and the marginal cost $ 10, then
15  10
5
1

x 100  33 %
10
3
P/V ratio = 15
The profit/volume ratio is one of the most important ratios for studying the profitability of
operations of a business and establishes the relationship between contribution and sales. In
the above example for every birr 100 of sales, contribution is 331/3%. A sale of every Birr
100 will bring a profit of 331/3 after fixed costs are covered. Comparison of P/V ratios for
different products can be made to find out which product is more profitable. The higher the
P/V ratio, the more the profit will be, and the lower the P/V ratio, the lesser the profit will be.
Therefore, it should be the goal of every company to increase or improve the P/V ratio.
P/V ratio is important for calculating the following variables.
Fixed Cost
i. Break-even point = P / V ratio
ii. Value of sales to earn
Fixed Cost  Desired Pr ofit
P / V ratio
a desired amount of profit =
Pr ofit
iii. Margin of safety = P / V ratio
iv. Profit = (Sales x P/V ratio) – Fixed Cost
v. Fixed Cost = (Sales x P/V ratio) - Profit
vi. Variable Cost = Sales (1 – P/V ratio).
Example calculate P/V ratio from the following information
57
a. Selling price $ 10 per unit
Variable costs 6 / unit
b. Given the profit and sales of two periods
Period
Sales in birr
Profit in birr
1994
200,000
70,000
1995
220,000
75,000
Solutions
Contribution 10  6
4


x 100  40%
Sales
10
10
a. P/V ratio =
Change in profit
b. P/V ration = Change in Sales
25,000  20,000
5000

x 100
220
,
000

200
,
000
20
,
000
=
= 25%
Check your progress
1. Given – Sales --------------------- $ 900,000
- Variable expense
500,000
- Fixed expense
400,000
Find
a. Contribution Margin
b. Net income
2. Given – Sales ---------------------- $ 800,000
- Contribution margin
- Net income
360,000
70,000
Calculate
a. Variable expense
b. Fixed expense
3. Given – Selling price/unit $ 20
- Variable cost/unit 15
58
- Total contribution $ 100,000
Net income----------------- 11,000
Find
a. Total unit sold
b. Total fixed cost
4. – Variable cost/unit = $ 8
-
Total unit sold = 80,000
-
Total Contribution margin $ 160,000
-
Total fixed Cost $ 110,000
Find
a. Selling price/unit
b. Net income
3.3.5.4 Break-even point
Break-even point is a point of sales expressed in units or money value at which a firm makes
no profit or loss. A business is said to break-even when its total sales are equal to its total
costs. At this point contribution is equal to fixed cost. The break-even point can be calculated
by the following formula.
Total fixed cos t
Selling Pr ice  M arg inal
cos t per unit
Break-even point (in units) = per unit
Or
Total fixed cos t
= Contribution per unit
Fixed cos t
Break-even point (in sales) = PV ratio
Or
Fixed cos ts
X
= Contribution / unit
Or
Fixed cos ts
X Total Sales
Total
Contributi
on
=
59
Sellingpri ce / unit
Example: From the following data calculate
i.
BEP expressed in amount of sales
ii.
Number of units that must be sold to earn a profit of Birr 120,000/year
iii.
The amount of sales to earn a profit of birr 60,000.
Selling price per unit $ 40
Variable cost per unit 25
Fixed cost total $180,000
Solutions
i.
40  25 15

x 100  37.5%
40
P/V ratio = 40
FC
180,000

 $480,000
P
/
V
ratio
0
.
375
BEP (in sales) =
Fixed cos t
Or BEP (in units) = Selling price Unit  Variable cos t Unit
180,000 180,000

 12,000units
40

25
15
=
BEP = (in sales) = 12,000 x 40 = $ 480,000
ii.
Output to earn a profit of 120,000
Fixed cos t  profit
Selling price / unit  M arg inal cos t / unit
180,000  120,000 30,000

 20,000units
40

25
15
=
iii.
Fixed cos t  desired profit
PV ratio
Sales =
180,000  60,000
0.375
=
= $ 640,000
60
3.3.5.5 Margin of safety
Margin of safety may be defined as the different between actual sales and sales at break-even
point. It is the amount by which actual volume of sales exceed the break-even point. Sales or
out put beyond break-even point is known as margin of safety because it gives some profit, at
break-even point only fixed costs are recovered.
Margin of safety may be expressed in absolute money terms or as percentage of sales.
Example If actual sales are Birr 500,000 and break-even sales are Birr 300,000, then margin
of safety is Birr 200,000. (500,000 – 300,000).
200,000
x 100
500
,
000
In terms of percentage 40% i.e.
Margin of safety (M/S) = Actual sales – Break-even point
Pr ofit
Or = P / V ratio
The size of the margin of safety indicates the soundness of a business. When margin of safety
is large, it means the business can still make profits after a serious fall in sales. On the other
hand, if the margin is small, small reduction in sales or production will be a serious matter
and lead to loss. The margin of safety at break-even point is zero because actual sales volume
is equal to the break-even sales.
The management of the company should make great effort to increase the margin of safety so
that more profit may be earned. This margin can be increased by taking the following steps.
a. Increase the volume of sale
b. Increase the selling price
c. Reduce fixed cost
d. Reduce variable cost
e. Substitute the existing product by more profitable products.
61
Check Your Progress
1. Define Marginal Costing
2. Explain the characteristics of Marginal Costing and also its advantages and disadvantages.
3. What is the marginal costing equation?
4. Explain the fowling concepts
i.
Contribution
ii.
Profit-volume ratio (P/V ratio)
iii.
Break-even point
iv.
Margin of safety
5. A company had incurred fixed cost of Birr 450,000 with sales Birr 1,500,000 and earned
profit of birr 300,000 during the first half-year. In the second half year suffered a loss of
$150,000. Find:
i. The profit volume ratio
ii. Break-even point
iii. Margin of safety for the first half year
iv. The expected sales volume for the second half year assuming that selling price and
fixed cost remained unchanged during the second half year.
v. Break even point and margin of safety for the whole year.
6. Assuming that the cost structure and selling prices remain the same in periods I and II, find
out
b. Profit volume ratio
c. Fixed cost in period I
d. Fixed cost in period II
e. Break-even point in sales in period I
f. Profit for period II when sales are of Birr 100,000
g. BFP in sales in period II
h. Sales required to earn a profit of Birr 20,000 in period I
i. BEP for the two periods
j. Margin of safety in period I at a profit of 15,000
62
k. Variable cost in period II.
Period
Sales in birr
Profit in birr
I
120,000
9,000
II
140,000
13,000
7. By saying weather the P/V ratio will increase or decrease or no change, state how the
following independent situations will affect the P/V ratio.
a. An increase in physical sales volume
b. An increase in the fixed cost
c. A decrease in the variable cost per unit
d. A decrease in the contribution margin
e. An increase in selling price per unit
f. A decrease in the fixed cost
g. A 10% increase in both selling price and variable cost per unit.
h. A 10% increase in selling price per unit and 10% decrease in the physical sales
volume.
i. A 50% increase in the variable cost per unit and 50% decrease in fixed cost.
3.4 Pricing Approach
Pricing is the amount of money which is needed to acquire a product or service.
3.4.1 Purchase price
The invoice received from the supplier provides a base figure of a purchase price, but certain
adjustments have to be made in this figure to arrive at the real materials cost. This adjustment
is made through discount and allowance or addition.
Discount and allowances result in a deduction from a base or list price. The deduction may
be in the form of reduced price or some other concession. Discounts can be used as a
technique for reducing prices in order to encourage purchases to buy materials. However,
purchasers should be careful that discounts are not always useful. They have to weight the
advantages and disadvantages of taking discount. Discounts take several forms as explained
below.
63
a. Quantity discount. This is an allowance made by the supplier to the purchaser to
encourage large orders. The discount often varies according to the size of the order i.e the
larger the quantity order, the higher is the discount.
For example,
-
For purchase up to 200 units no discount
-
For purchase between 200 unit – 400 units 2% discount
-
For purchase between 401 unit - 800 units 4% discount
-
For purchase more than 800 unit 10% discount
Quantity discount is allowed by a supplier as a measure of the savings in his cost which
arises from the production and distribution on a large scale. Part of these savings enjoyed by
the supplier is passed on the purchaser in the form of quantity discount. The amount of the
quantity discount is deducted from the purchase price to arrive at the material cost/price.
b. Trade discount. Trade discounts called functional discounts, are deductions, from the list
price offered to buyers in payments for marketing functions that the buyer will performfunctions such as storing, promoting and selling the product.
The idea is to cover the expenses and profit of the dealer who is providing service to help the
original supplier to distribute his goods. This discount is also deducted from the purchase
price to arrive at the material cost price.
Example: A manufacturer may quote a retail price of Birr 400 with trade discount 40% for
retailer and 10% for wholesaler. In this case, the retailer pays to the whole sales Birr 240
(400 less 40% of 400). The whole sealer pays to the manufacturer Birr 216 (240 less 10% of
240). The wholesaler is expected to keep the 10% to cover cost of the whole selling functions
and pass on the 40% discount to retailers.
c. Cash discount. This discount is allowed by the supplier to a purchaser to encourage
prompt payment of invoices. Example 2% discount may be allowed if payment is made
within 30 days and 4% discount if payment is made within 7 days.
64
d. Sales Tax and other Levies. Items like sales tax, custom duty, excise tax etc, should be
added to the purchase price.
e. Transport charges. These include sea, land, air freight, dock charges, insurance etc on
materials purchased. Some times the purchase price quoted by the supplier includes all these
charges, but if the price does not include these charges they should be added to the purchase
price.
f. Cost of containers. The supplier may or may not separately charge for containers. If there
is no such charge, no adjustment is required in the purchase price. However, if containers are
separately charged, all such costs should be included in the purchase price i.e.
i. The costs of containers if these are not returnable.
ii. The difference between the cost of container and the amount refunded when
container is returned.
3.4.2 Material issue pricing
It is obvious that the stock consist of materials purchased in different lots at different times
and at different prices. However, when materials are to be issued to production, what price
should be charged for costing the materials that are issued and what should be the value of
the remaining un issued stock in hand must be known. Whether it should be the original
purchase price or the average price or the current market price on the date of issue or some
other price that should be used for this purpose.
There are many methods of pricing material issues. The most important are the following:
3.4.2.1 First-in first-out (FIFO) method
In this method the assumption is that the first materials purchased are the first materials
consumed. If materials are already on hand, these are issued first and the first purchase issued
next. Thus the FIFO method uses the price of the first batch of materials purchased for all
issues until all materials from this first batch are fully issued. After the first batch is fully
issued, the price of the next batch of materials becomes the next issue price. That means the
unit costs are allocated to the cost of production according to their chronological order of
receipts in store.
65
This method is most suitable in times of falling prices because the issue price of the materials
to the job will be high while the cost of replacement will be low.
The important effects of using FIFO method are
i.
Materials are priced at the actual cost.
ii.
Charge to production for materials cost is at the oldest price of materials in stock.
iii.
Ending inventory is valued at the latest price paid
3.4.2.2 Last-in-first-out (LIFO) method
The issues under this method are priced in the reveres order of purchases, i.e. the price of the
latest available purchase is taken first. It is based on the assumption that the last materials
purchased are the first materials issued. Thus the price of the last batch of materials
purchased is issued for all issues until all units from this batch have been completed and then
after the price of the previous batch received is used. This method is most suitable in times of
rising prices because materials will be issued from the latest purchase at a price which is
closely related the current price levels.
The important points regarding this method are:
i.
materials issues are priced at actual cost.
ii.
charge to production for material cost is at latest price paid.
iii.
the ending balance of stock valuation is at the latest price paid and is out of line
with the current price.
3.4.2.3 The average cost methods
These methods are based on the assumption that when materials purchased in different lost
are stored together (mixed up), their identity is lost so that an issue can not be made from any
particular lot of purchases.
i.
Simple average method
66
Simple average price is calculated by dividing the total of the unit purchase price of different
materials in the stock on the date, of issue by the number of price used in the calculation. It
does not take into account quantities of materials in stock while composing the average price.
For example 400 units purchased at Birr 7/unit
100 units purchased at Birr 9/unit
500 units purchased at Birr 5/unit
7  9  5 21

 $7
3
3
Simple average price =
ii.
Weighted average method
This method gives due weight to the quantities held at each price when calculating the
average price. The weighted average pricing is calculated by dividing the total cost of
material in stock by the total quantity of material in that stock.
Refer the above example.
400 x 7   100 x 9  500 x 5
Weighted average price =
795
2800  900  2500
6200
$
21
21
=
= $295.24
3.4.2.4 Replacement price method
Replacement price is the price at which materials would be replaced i.e. the market price on
the date of issue. This method is used when it is desired to reflect the current prices in costs.
It is most suitable for businesses that buy large quantities of materials well in advance of
requirements to take advantage of cheap prices.
The main advantage of this method is that it is simple to operate as no calculations are
required to be made of the issue prices as it is done in the average, LIFO, and FIFO methods.
Secondly material cost is charged at the current market price.
67
3.4.2.5 Standard price method
Standard price is a pre-determined price which is fixed for a definite period, such as a year,
and takes into account factors like probable trend of prices over that period, market
conditions, discounts etc. Standard prices are fixed for each item of material and where prices
of materials fluctuate heavily; standard prices should be fixed for a short period and revised
when required.
Under this method all receipts are posted in the stores ledger at actual cost and issues are
priced at standard price. The different between actual and standard price is transferred to
material price variance account.
3.4.3 Pricing of finished product
Price is the amount of money charged for a product or service. It is the sum of all the values
that consumers exchange for the benefit of having or using the product or service. Managers
of any business enterprise always face decisions on the pricing and profitability of their
products. All profit making organizations and many non profit organizations must set prices
on their product or services because price is the only element that produces revenue.
3.4.3.1 Factors that affect the setting of prices
The settings of prices of the company products or services are affected by internal factors of
the company and the external environmental factors.
i. Company internal factors are the following

Company objectives. The company objective may be survival. This would happen if
there is stiff (heavy) competition and if there is a changing or shifting of consumer
demand. In this case, to maintain its survival a company may set low price in order to
increase demand for its product or serve. Therefore, price is less important than
survival.

The company objective may be maximization of company profit. In this case, the
company would focus on setting high price which will produce maximum profit, cash
inflow or return on investment.
68

The objective of the company may be market share leadership. In this case it has to
set its price as low as possible. This would happen if the cost of the product is low so
that the company would obtain highest long-run profit.

If the company’s objective is product quality leadership, the company must set its
price as high as possible in order to cover the cost of the product that spent for design,
research and development, promotion, distribution etc.

Cost is another internal factor that affects the pricing decision of the company. Costs
determine the lower (floor) limit that the firm can charge for its product when setting
price the company should cover all its costs for producing, distributing and selling the
product and deliver a fair rate of return for its effort.
ii. External factors that affect pricing

The nature of market and demand. Since costs set the lower limit of price, demand for
the product or service sets the upper limit. If the demand is high for the product, the
company can set high price. Therefore, before setting prices the marketer must
understand the relationship between price and demand for its product.

Pricing may be based on competitor’s decision. Sometimes competitor’s reactions
influence pricing decisions. If competition is very heavy the company might be
forced to reduce its price. A good market information system enables the company to
get information about the price and cost conditions of the competitors.

Other environmental factors such as economic and governmental conditions have
great influence on setting price. The economic factors such as boom or recession,
inflation and interest rate affect pricing decisions because they affect both the cost of
producing a product and consumer perceptions of the products price and value.
Government is also another important external influence on pricing decision. In
addition to this the purchasing power of the population should be considered in
setting pricing decisions.
69
Check Your Progress
1. Explain the difference between quantity discount and trade discount
___________________________________________________________________________
_________________________________________________________________
2. What costs should be added to the invoice to determine the purchase price?
___________________________________________________________________________
_________________________________________________________________
3. List the different methods used to issue materials from the store.
___________________________________________________________________________
_________________________________________________________________
4. Identify the internal and external factors to set the selling price of finished goods?
___________________________________________________________________________
_________________________________________________________________
5. If the materials purchased in different lots are mixed together and their identity is lost,
which method of pricing is used to issue materials from the store? Why?
___________________________________________________________________________
_________________________________________________________________
6. Identify and discuss the three effects of using FIFO method.
___________________________________________________________________________
_________________________________________________________________
70
3.5 Summary
The term ‘cost’ is defined as the amount of resources given up in the exchange for some
goods or services. The resources given up expressed in monetary terms. For decision making
purpose costs are grouped in different basis of cost centers. Cost centers could be personal
cost centers which consist of persons or group of persons or impersonal cost centers which
consist of a location or an item of equipment. From the functional point of view cost centers
are group as production cost center and service cost center.
It is also possible to classify costs according to their common characteristics. Based on some
common features costs are classified according to their identifiably with cost unit such as
direct cost and indirect cost, according to their function such prime and conversion,
administration, selling and distribution and research and development costs, according to
their variability such as fixed, variables, and semi-variables and according to controllability
such as controllable and uncontrollable costs.
Marginal cost is the amount by which aggregate costs are changed if the volume of output is
increased or decreased by one unit. Marginal cost equation is expressed by the following
formula.
Sales = Variable cost + Fixed cost  Profit/Loss
Or Sales – Variable cost = Fixed cost  Profit/Loss
Or S – V = F  P/L
Or S – V = Contribution (C)
To studying the relationship between revenue, cost and profit is known cost volume profit
analysis. To understand these relationships, it is necessary to know the concepts such as
contribution, profit-volume ratio, Break-even point and margin of safety.
Materials purchased in different lots at different times and at different prices are to be
allocated to production using different methods. Firms use various method to issue materials
from the store. Some of the important methods are Fist-In-First-Out (FIFO) method, Last-InFirst-Out (LIFO) method, average method, replacement price method, and standard price
method. In addition to determine the issue price of raw materials organizations must set
prices on finished product because price is the only element that brings revenue.
71
3.6 Answers to Check Your Progress Questions
1. Cost is defined in different ways. Refer No. 3.2.1
2. Cost center is any activity for which a separate measurement of cost is desired.
3. It is grouping of costs according to their common characteristics. Refer No. 3.2.2.
4. Refer No. 3.2.2.3
5. Refer No. 3.3.1
6. Refer No. 3.3.3
7. Sales = variable cost + Fixed cost  Profit/Loss or Sales – Variable cost = Fixed cost
 Profit/Loss
8. i. The difference between sales and variable costs
ii. The ratio of contribution to sales
iii. When total revenue is equal to total cost i.e. the point where there is no profit or
loss
iv. The difference between actual sales and sales at break-even point.
450,000  300,000
750,000

x 100
1500
,
000
1500
,
000
9. I. a. P/V ratio =
= 50%
450,000
 $ 900,000
b. B.E.P = 0.5
c. M/S = 1500,000 – 900,000 = $600,000
450,000  150,000 300,000

0.5
0.5
II. Expected sales =
= $600,000
450,000  450,000
0.5
III. B.E.P for the whole year =
900,000
= 0.5 = $1,800,000
Sales for the whole year 1500,000 + 600,000
= 2,100,000
72
M/S – 2100,000 – 1800,000
4,000
x 100  20%
10. a. P/V ratio = 20,000
b. Fixed cost in period I = (120,000 x 0.2) - 9000
24,000 – 9000 = $15,000
c. Fixed cost in period II = (140,000 x 0.2) – 13,000
28,000 – 13,000 = $15,000
15,000
d. B.E.P in sales for period I = 0.2 = $ 75,000
FC  profit
e. Profit when sales are of = sales = PV ratio
15,000  P
0.2
100,000 =
= 0.2 (100,000) = 15,000 + P
P = $5,000
15,000
f. B.E.P in sales in period II. 0.2 = $75,000
FC  P
g. Sales = PV ratio
15,000  20,000 35,000

0.2
0.2
=
= $175,000
h. BEP for two periods
Fixed cost for two periods 15,000 + 15,000
= 30,000
30,000
B.E.P for two periods = 0.2 = $150,000
Pr ofit
15,000

0.2 = $75,000
i. M/S = PV ratio
73
j. Variable cost = (1 – PV ratio) x sales
(1 – 0.2) x 140,000
0.8 x 140,000 = $112,000
11. a. will not change
f. will not change
b. will not change
g. will not change
c. will increase
h. will increase
e. will increase
i. will decrease
Note: Increase or decrease in physical sales volume will not affect PV ratio. But if per
unit sales or per unit cost will be increased or decreased, it will affect PV ratio. Similarly,
the fixed cost, whether decrease or increase will not affect P/V ratio.
12. Quantity discount encourages large orders whereas trade discount is deduction from list
price.
13. Transportation charges, sales taxes, cost of containers etc.
14. First-In-First-Out (FIFO), Last-In-First-Out (LIFO), Average method, Replacement price
and standard price methods.
15. Refer No. 3.4.3.1
16. The average method because it is impossible exactly to identify the price by which each
item is bought.
17. Refer No. 3.4.2.1
74
3.7 References
1) BAVESH M. PATEL, Cost Accounting for management decision, Allied publishers
Limited, 1997
2) MN ARORA A TEXT BOOK OF, COST ACCOUNTANCY, FOURTH REVISED
EDITION, 1981.
3) S.P JAIN, KL NARANH Cost and Management Accounting, Kalyani Publishers,
1994.
75
UNIT 4
OPERATING PROCEDURE
Contents of the Unit
4.0 Aims and Objectives
4.1 Introduction
4.2 Purchasing Procedure
4.2.1
Recognition, Definition, Description and Transmission of the Need
4.2.2
Supplier Selection and Preparation of the Purchase Order
4.2.3
Acknowledgment and Follow up the Order
4.2.4
Receipt and Inspection
4.2.5
The Invoice Audit and Completion of the Order
4.3 Purchasing Department Records
4.4 Handling Emergency /Rush Orders
4.5 The Small Order Problem
4.6 Summary
4.7 Answers to Check Your Progress Questions
4.0 Aims and Objectives
At the completion of this unit, students will have knowledge and understanding of:
purchasing procedure
the various steps involved in purchasing
the various form used in connection with purchasing
the various records maintained by the purchasing department
4.1 Introduction
Dear students! Planning governs the survival, and progress of any organization in a
competitive and ever-changing environment. Further managers at every level of management
perform the planning function. However we should not induct from this view that planning is
76
an isolated activity required in the beginning only. It is really a continuous and unending
process to keep the organization as a going concern and other functions are also performed
simultaneously. Managerial operations in organizing, staffing, leading and controlling are
designed to support the accomplishment of enterprise objectives. Planning logically preceded
all other managerial functions.
Procedures are plans that establish required methods of handling future activities. They are
guides to action rather than to thinking and they detail the exact manner in which certain
activities must be accomplished. They are chronological sequence of required actions.
Procedures often at across departmental levels for example, in a manufacturing company, the
procedure for handling orders will almost certainly involve the sales department (for the
original order), the finance department (for acknowledgement of receipt of funds and for
customer credit approval), the accounting department (for recording the transaction), the
production department (for the order to produce goods or authority to release them from
stock) and the traffic department (for determination of shipping means and rates).
4.2 Purchasing Procedure
The process of purchasing starts when the material requisitioned is not available at stores.
That is, the requesting department - be it finance, production, marketing, etc. will request for
the supply of materials from stores. If the material requisitioned is available at stores, the
storekeeper issues the material to the requested department. The form used in connection
with issue, requisition, transfer, return, etc. of materials is as illustrated below:-
77
SHEGER PLC.
STORES REQUISITION
Requesting Dept.: ______________________
Purpose:
________________________
SR.
No.
Item
No.
No.____________________
Date:___________________
Unit of
Description
Measures
Quantity
Remark
Prepared by _______________________Chief of Stores _________________ Approved by
______________________Recipient's name _______________
Distribution:White - Accounts
Yellow - Stores recording & control Blue - Stores
Pink - Requesting unit
Green - Pad
SHEGER PLC.
STORES ISSUE VOUCHER
Requesting Department: __________________
No._________________
Classification of Goods____________________
Date: ________________
Consumables ____________________
Spare parts ___________
ST.R.No________________
Fixed Assets __________
SR.
Item
Description
Unit of
No.
No.
(Item issued)
Measure
Quantity
Unit
Total
Price
Price
Reasons
Issued by ___________Approved by ______________ Received by __________
Distribution:White - Accounts
Pink - Requesting or Gate passes
Yellow - Stores recording & control
Blue - Stores Green - pad
A purchasing department buys many different types of materials and services, and the
procedures used in completing a total transaction normally vary among the different types of
purchases. However, the general cycle of activities in purchasing most operating materials
and supplies is fairly standardized. The following steps constitute the typical purchasing
cycle.
78
1. Recognize, define and describe the need
2. Transmit the need
3. Investigate, qualify and select the supplier
4. Prepare and issue the purchase order
5. Follow up the order (including expediting and de-expediting)
6. Receive and inspect the material (except in the case of some JIT systems and
some partnering agreements)
7. Audit the invoice
8. Close the order
4.2 Recognition, Definition and Description and Transmission of the need
The need for a purchase typically originates in one of a firm’s operating departments or in its
inventory control section. The purchasing department is usually notified of the need by one
of the basic methods.
i) Standard purchase requisition or
ii) A material requirements planning (MRP) schedule. If the need is one time purchase,
then an engineering bill of materials is sometimes used.
A) Standard Purchase Requisition
The purchase requisition is an internal document, in contrast with the purchase order, which
is basically an external document. Most companies used a standard, serially numbered
purchase requisition form for requests originating in the operating departments. The user
generally makes a minimum of two copies.
79
SHEGER PLC.
Purchase requisition
Please supply the following materials to the ----------------------Dept
No.___________
Classification of Goods
Date:___________________
Consumable __________ Spare parts ____________
S.R. No. ______________
Fixed assets _________________________________
SR.
Item
No.
No.
Unit of
Description
Measure
Quantity
Received
Unit
Total
Price
Price
Remark
Ordered
Prepared by __________ Checked & Received by_________ Approved by ___________
Distribution:Original - General Accounts
(white)
1st copy - Costs & stock Accounts (Yellow)
Red - Purchasing
Pink - Stores recording and control
Blue - Storekeeper
Green - pad
B) Material Requirements Planning Schedule
When a design engineer completes the design of a part or an assembly, he or she makes a list
of all the materials (and quantity of each) required to manufacture the item. This list is called
an engineering bill of materials. In firms using computerized production and inventory
planning systems such as an MRP system, the engineering bill of materials is first
reconfigured into a structured multilevel bill of materials. This structured bill of materials
for each item being manufactured can then be used in determining specific materials for each
item being manufactured can then be used in determining specific material requirements for a
given production schedule during a specific time period.
80
C) Engineering Bill of Material
In firm’s that do custom manufacturing work, or for various reasons are involved in unique
one-time projects, a similar but less sophisticated approach can be used. When purchase of
the required materials is a one-time affair, the engineering bill of materials, along with the
production department’s need for materials. The buyer then obtains total requirements
simply by manually extending the bill of materials for the production quantity scheduled.
Thus, communications are simplified and the need for purchase requisitions is eliminated.
Bill of Material
No._______________
Date of Issue: ____________________Production / Job Order No.__________
Department Authorized _______________________________
For Department use only
Serial
No.
Code
Description
No.
Material
Quantity Reqn. No.
Quantity
Date
Demanded
Remark
D) Definitions and Description of the need
Regardless of the form of transmission used, material requirements must be defined
effectively and the most appropriate methods of description should be selected for the
situation at hand. The point to be understood here is that clear, complete, appropriate
definition and description is a joint responsibility of the user and the buyer. One of the
reasons why every purchase authorization document should be approved by designated
departmental supervisors is to ensure that qualified individuals initially review it and
subsequently comes to purchasing in correct form.
E) The stock check
Some companies route all requisitions for tools, supplies and production type materials to
inventory control before they are sent to purchasing. If a sizeable percentage of a firm’s
requisitions involve stores-type items, this procedure expedites the supply process and
reduces clerical work in the purchasing department. Supplier’s selection and preparation of
the purchase order.
81
4.2.2 Supplier selection and preparation of the purchase order
The purchase of a new or a high value item, on the other hand, may require a lengthy
investigation of potential suppliers.
If the item to be purchased is complex or highly
technical, the firm may utilize across functional sourcing team, first to qualify potential
suppliers and perhaps eventually to make a team decision about the most desirable supplier.
After qualifying a preliminary group of potential sources, the buyer may employ the
techniques of competitive bidding or negotiation or both when competitive bidding is used
the buyer initiates the procedure by requesting quotation from a reasonable number of firms
with whom the buying group is willing to do business. Although “request for quotation”
forms vary widely among firms, typically they contain the same basic information that will
subsequently be included on the purchase order.
A. Sources of Supply
While purchasing and supply management has the ultimate responsibility for selecting the
“right” source, the process in handled in many ways. Procedurally, the simplest approach is
when the buyer alone conducts the analysis and makes the selection. A second common
approach calls for the use of a cross-functional team consisting of representatives of
purchasing and supply management, design engineering, operations, quality and finance.
The third common approach is the use of a commodity team.
B. Commodity Teams
Many progressive firms use commodity teams to source and manage a group of similar
components.
Commodity teams frequently consist of buyers, materials, engineers and production planners.
Large commodity teams include a commodity manager (normally from purchasing and
supply management) and representatives of materials, design and manufacturing engineering,
quality and finance. Commodity teams are essentially a type of cross-functional team. The
principal difference between them is that commodity teams tend to be fairly permanent,
while cross-functional teams tend to be one-time assignment.
82
C. Evaluating g a potential supplier
After developing a comprehensive list of potential suppliers, the buyer’s next step is to
evaluate each prospective supplier individually. A process of elimination develops a selected
list of potential suppliers with whom the buying company may be willing to do business.
Unless a decision has been made to employ a single source of supply, the supplier list should
be complete enough to bring to bear every type of competition desired, including: Technological and quality competitions, resulting from identifying potential suppliers
who excel in good ideas, engineering planning, design, material quality and
production techniques.
 Price competition, resulting from identifying the lowest cost producers or distributors.
 Service competition, resulting from identifying those suppliers that are especially
anxious to get contracts and that are willing to add “plus” values over and above
functional value (quality) and price.
What kind of company makes the best supplier? It would be difficult to improve on the
definition given by Professor Wilbur England of Harvard University.
A good supplier is one who is at all times honest and fair in his dealing with the customers,
his own employees, and himself. Who has adequate plant facilities, and know-how so as to
be able to provide materials which meet the purchaser’s specifications, in quantities required
and at the time promised, whose financial position is sound whose price are reasonable both
to the buyer and to himself, whose management policies are progressive, who is alert to the
need for continued improvement in both his products and his manufacturing process. And
who realizes that in the last analysis his own interests are best served when he best serves his
customers.
D) Type of Evaluation Needed
The type of evaluation needed required determining supplier capability varies with the
nature, criticality, complexity and dollar value of the purchase to be made. It also varies with
the buyer’s or buying team’s knowledge of the firms being considered for the order. For
many uncomplicated low dollar value purchases, an examination of the information already
available in the department library (such as supplier information file, catalogue and
brochures) is sufficient. To differentiate among those suppliers who understands the
83
complexities of the purchase and those who do not. By eliminating those who do not, the
search for the right supplier is further narrowed.
1. Preliminary surveys
If an examination of existing data indicates that a firm appears to be an attractive
supplier for existing or anticipated requirements, a telephone or mail survey should be
conducted to obtain additional information. Such a survey should provide sufficient
knowledge of the supplier to make a decision to include or exclude the firm from
further consideration. Clearly, this sound precedes any plant visits.
The survey is based on a series of questions, which cover the following areas:
i)
the principal officers and titles
ii)
bank reference
iii)
credit references
iv)
the annual history of sales and profit for the past five years
v)
a referral list of customers
vi)
the number of employees
vii) the space currently occupied
viii) expansion plans (including sources of funds)
ix)
the current production defect rate for similar products
x)
the number of inspection used
xi)
the date when statistical process control was adapted
xii) a list of all equipment and tools, which would be used to manufacture, test,
and inspect the purchase in question.
2. Financial condition
Preliminary investigation of a potential supplier’s financial conditions often can avoid
the expense of further study. A qualified buyer or professional from the finance
department conducts these investigations. A review of financial statements and credit
ratings can reveal whether a supplier is clearly incapable of performing satisfactorily.
Financial stability is essential for suppliers to assure continuity of supply and
reliability of product quality. Imagine the difficulty of getting
i. A financially weak supplier to maintain quality;
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ii. A supplier who does not have sufficient working capital to settle an expensive
claim; or
iii. A financially unsound supplier to work overtime to meet a promised delivery date.
In addition to informing a buyer or the sourcing team about a supplier’s capability to perform
a contract, financial information can be useful in other ways as well. Financially, strong
firms are usually managerially strong. Hence they generally make good suppliers. An
analysis of a firms balance sheet and operating statement is helpful in numerous ways i.e. on
discovering that a firm’s financial conditions has started to deteriorate a buyer should tighter
quality monitoring and consider either searching for a new supplier or reducing the size of
the orders given to the distressed firms.
3. Quality capability
A critical factor to examine is the firm’s quality capability. IF the prospective supplier’s
process capability is less than the buying firm’s incoming quality requirements, the suppliers
typically is not worthy of further investigation. An obvious exception is the case in which no
supplier possesses the required capability.
i. Specifications are most detailed methods of describing requirements. Various
types of design specifications are the detailed descriptions of the materials, parts
and components to be used in making the product. They are verbal and written
descriptions that tell the seller exactly what the buyer wants to purchase.
In a manufacturing firm, when specification is fixed, the final design of a product is also
fixed. Then the products competitiveness and its profit potential are also fixed.
Specification is very important because the cost of materials clearly dictates that their
selection is an important consideration during product design. The costs of many materials
are identified through specifications during the design stage. This is the first and sometime
the only point at which numerous costs can be reduced. It is at the time of the original
designing that the greatest cost saving obtained from both specification and standardization.
Since specifications imports the activities of engineering operations, purchasing and quality,
optimum specification mainly influence the contribution made by all these departments to the
firm’s success. A good specification is to satisfy the procurement consideration of clear,
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concise and unambiguous communication. To meet the needs of all departments, a
specification must satisfy many requirements – Design and marketing requirements for
functional characteristics chemical properties, dimensions appearance etc.
ii) Standardization is the process of establishing agreement on uniform identifications for
definite characteristics of quality, design, performance, quantity service and so on.
Standards reduce varieties and create consistencies. Standards are usually essential in
exchange of parts. The use of standards permits a firm to purchase fewer items in large
quantities and lower price. This reduces purchasing, receiving, inspection and payment
costs.
Stocking fewer items makes controlling inventories easier and less costly.
Consequently, the purchase of standardized materials saves money in four ways
4. Plant visit
By visiting a supplier’s plant or distribution facility, the sourcing team can obtain firsthand
information concerning the adequacy of the firm’s technological capabilities, manufacturing
or distribution capabilities and its management’s technical know-how and orientation.
Depending on the importance of the visit, the company may send representatives from only
purchasing and engineering or it may also include some combination of representation from
finance, operations, quality assurance, marketing and industrial relations.
In planning plant visits only a few outstanding potentials suppliers’ plants should be chosen
for observation due to the time and costs involved. The buying firm wants suppliers whose
management is committed to excellence. To make such a determination properly requires an
overall appraisal.
Among the factors to be addressed are:
i) Attitude and stability of the top and middle management teams
ii)
Research and Development capability
iii)
Appropriateness of equipment
iv) Effective of the production control, quality assurance and cost control systems
v)
Competence of the technical and managerial staffs.
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Other important factors include:
i)
morale of personnel at all levels
ii)
industrial relations
iii)
willingness of the potential supplier to work with the buying firm
iv)
quantity of back orders
v)
effectiveness of purchasing and supply management and materials
management operations
And past performance
i)
past major customers
ii)
general reputation
iii)
letters of reference
The plant visit should be planned carefully to provide the required level of knowledge and
insight into the potential supplier’s operations, capacity and orientation. The efficiency with
which the plant visit is planned and conducted reflects on the buying organization.
The prospective supplier usually is requested to provide additional information on the
company’s history, current customers, sales volume and financial stability. In the quality
area, the buyer and his or her sourcing teammates should attempt to understand.
Once a supplier has been selected, the purchasing department prepares and issues a serially
numbered purchase order.
In most cases the purchase order becomes a legal contract
document. For this reason, the buyer should take great care in preparing and wording the
order. Quality specifications must be described precisely. If engineering drawings or other
related documents are to be considered an integral part of the order they should be
incorporated clearly by reference. Quality requirements, price and delivery and shipping
requirements must be specified accurately. In the event of that statistical process control or
sampling inspection is to be used, conditions of acceptance should be stated or referenced on
the order. Similarly, any other important factor affecting the acceptability of the product
should be stated precisely. In short, the order should include all data required to ensure a
satisfactory contract and it should be worded in a manner, which leaves little room for
misinterpretation by either party.
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Purchase Order
Garad CO.
ADDRESS
To: Sheger Plc.
Address:
Ref: Our Tender NO Sheger/ 100/ 08 Dtd
: Your quotation No. sheger / 100/ 08 Dtd
Dear Sirs/Madame,
We kindly request you to supply the following items as per the following specifications:
SR NO.
Item code
Item description
Unit of
Unit price
measurement
Total
price
Thank you,
Yours faithfully,
Terms and conditions
Summary of information contained in purchase order
i.Buying firms and document identification
i.Shipping instructions
ii.Internal identification
ii.Summary totals
iii.Purchase order identification
iii.Purchase order item number
iv.Supplier identification
iv.Item identification number
v.Specific shipping destination
v.Item description
vi.Internal information
vi.Delivery quantity
vii.Accounting change
vii.Shipping / delivery dates
viii. Payment terms
viii.Unit price and measures
ix.Additional contract inclusions
ix.Extended price x quantity
x.Point of title transfer
x.Buyer identification and date
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Remark
4.2.3 Acknowledgement and follow-up of the order
In most cases, the original copy of the purchase order, which is sent to the supplier,
constitutes a legal “often” to buy. No purchase “Contract” exists, however, until the seller
“Accepts” the buyer’s offer. The seller’s acceptance can take one of the two forms.
i.
performance of the contract or
ii.
formal notification that the offer is accepted.
The purpose of sending the supplier an acknowledgement form along with the purchase order
is two fold. First, it is a form that can be completed conveniently and returned to the buyer,
acknowledging acceptance of the order. At the same time, the supplier can indicate whether
or not it is able to meet the desired delivery date. If a supplier ships the ordered item
immediately from stock, it frequently disregards the acknowledgement form.
Regardless of the specific system used, follow-up communication with the supplier usually
takes one of the two forms. A fax or a telephone call is typically used for most critical
orders. Mailing or faxing a preprinted enquiry to the supplier usually accomplishes routine
follow-up for the less critical orders.
In some firms, the buyer handling the order conducts follow-up procedures. In others, a
separate expediting group conducts follow-up activities. Although relatively few in number,
some firms maintain a force of follow-up personnel in the field such firms typically purchase
a great deal of critical material or major equipment on very tight schedules. To ensure that
all material is available when needed, these firms track critical purchases by having traveling
follow-up representatives personally visits suppliers’ plants. In some situations these field
personnel have the additional responsibility of attempting to speed up (expedite) or even
delay (de-expedite) delivery as the buyer’s timing requirement undergo unexpected changes.
4.2.4 Receipt and inspection
The next step in the traditional purchasing cycle is receipt and inspection of the order. When
a supplier ships material, it includes in the shipping container a packing ship, which itemizes
and describes the contents of the shipment. The receiving clerk uses this packing slip in
conjunction with his or her copy of the purchase order to verify that the correct material has
been received. After a shipment has been inspected for quality and for general condition of
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the material, the receiving clerk issues a receiving report. In some cases, the report is
prepared on separate receiving department forms. However, the trend in most companies
today is to reduce the clerical work by using an online computer based system, coupled with
bar code order identification or by preparing a receiving report form during the same typing
or printing operation that prepares the purchase order.
SHEGER PLC.
INSPECTION NOTE
Supplier Name: ________________________
No.________________________
Invoice No.:
Date: ___________________ P.O. No.
________________________
_____________________________
SR.
No.
Item
No.
Unit of
Description
Quantity
Received
Rejected
Measure
Distribution:Original - General Accounts
1st copy - Costs & stock Accounts
2nd copy - Purchasing
3rd copy - Stores recording and control
4th copy - Storekeeper
5th copy – Pad
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Reasons
SHEGER PLC.
GOODS RECEIVING NOTE
Supplier ______________________________
No.____________________
Classification of Goods
Date: _____________
Consumable __________ Spare parts ____________
P.R. No. __________
Fixed assets _______________________________ P.O. No. __________
Supplier Inv.No_____
SR.
Item
No.
No.
Unit of
Description
Measure
Quantity
Received
Unit
Total
Price
Price
Remark
Ordered
Prepared by ______ Checked & Received by______ Approved by ___________
Distribution:Original - General Accounts
(white)
1st copy - Costs & stock Accounts (Yellow)
Red - Purchasing
Pink - Stores recording and control
Blue - Storekeeper
Green - pad
The necessity and advantages of a goods received note are:i)
It provides a complete record of all materials received.
ii)
It informs the storekeeper or other interested departments of the quality of goods
received.
iii)
It provides a means of checking the supplier's invoices.
4.2.5 The invoice audit and completion of the order
Occasionally, a supplier’s billing department makes an error in preparing an invoice or its
shipping department makes an incorrect or incomplete shipment.
To ensure that the
purchased makes proper payment for the materials actually received, sound accounting
practice dictates that some types of review procedure precede payment to the supplier.
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4.3 Purchasing Department Records
The files of a purchasing department contain an endless flow of operating data. Despite its
huge volume, much of this information can be useless in daily operations unless it is
organized in a manner, which makes it readily accessible. The following basic records are
essential for the effective operation of most purchasing departments.
i. A record of open order
ii. A record of Closed orders
iii. Purchase log
iv. Commodity record
v. Supplier record
vi. Contract record
vii. Special tool record
4.3.1 Record of open orders
All buyers need immediate access to information concerning the status of their outstanding
orders. The record system can be maintained on a computer, in hard copy form, or as a
combination of the two.
4.3.2 Record of closed orders
The closed order file provides a historical record of all completed purchases. It frequently
serves as a useful reference when questions arise concerning past orders and when certain
historical data are needed to guide future decisions.
4.3.3 Purchase log
Every purchasing department should maintain an ongoing record, in numerical sequence, of
all purchase orders issued. The record not be elaborate, but it should contain the purchase
order number, the status of the order, the supplier’s name, a brief description of the material
purchased and the total value of the order. Such a record summarizes the commitments for,
which the purchasing executive is responsible. In the event that the working copy of an order
is lost, basic data concerning the purchase can be found in the log. The log further serves as
a convenient record from which summary administrative data can be extracted concerning
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such matters as the number of small orders, rush orders, and total orders issued. The volume
of purchases from various suppliers the value of outstanding commitments; and so forth.
4.3.4 Commodity records
The file of commodity records constitutes a vast reservoir of materials data that makes
efficient “mass production purchasing” possible. A commodity record card or computer file
should be maintained for each major material and service that is purchased repetitively.
Typically included in the record is a complete description of the material or service, with full
reference to necessary engineering drawings and specification, which might be filled
elsewhere. Also included should be a list of approved suppliers and their price schedules.
Competitive quotations may be included in the file, although it is more common to
summarize bid data in the record, note a cross reference to the original quotation and place
all quotations in a separate file.
4.3.5 Supplier record
To provide quick access to information about suppliers, most companies centralize such
information in a single record file. A separate card or computer record is maintained for each
major supplier. In this record is recorded the address, telephone number and the names of
personnel to contact on a specific matters of inquiry. Selling terms and routing instructions
for shipping purposes also usually are included. Although the practice varies, many firms
additionally summarize in this record the supplier delivery and quality performance, as well
as the annual volume of materials purchased from the supplier.
4.3.6 Contract record
Today most firms are purchasing an increasing number of items on a long-term contractual
basis. In such cases, it is usually convenient to consolidate all contracts in a separate file. In
addition to providing immediate access to all contract documents, the file also apprises all
buying personnel of the materials that are purchased in this manner. If the number of
contracts is large, it is desirable also to list them in summary form to provide a bird’s eye
view of all contract purchases and their expiration dates.
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4.3.7 Special tool record
Many companies have no need for this record. However, such a record is essential to those
firms that purchase many items requiring special tooling for their manufacture. On some
orders the purchaser buys the required dies, figs, fixtures, and patterns. On others the
supplier owns them. By maintaining a record of special tools, the buyer can summarize for
quick reference the special tools owned, the age and location of each and the essential
mounting and operating characteristics of each.
4.4 Handling Emergency/ Rush Orders
Every department executive tries to develop an orderly and systematic pattern of operation
that efficiently utilizes the resources of that department. In a well run purchasing department
systematic analysis and processing of most orders is completed in two to four days after the
purchase request is received.
How should purchasing handle the emergency needs that inevitably arise in any business
operation? Clearly, a special procedure for processing rushes requisition is needed. The key
elements of such a procedure are discussed in the following paragraphs.
Even in the case of emergencies, it is unwise to accept oral requisitions – in person or over
the telephone. Too much chance for erroneous interpretation of the requirement exists. The
requisitioned should state the need in writing and preferably, deliver to the buyer in person.
For purposes of identification, emergency requisitions can be printed on paper of a different
color or they can be identified with a visible emergency sticker. Typically, the buyer should
process these requisitions and telephone emergency orders to the supplier. In no case,
however, should an order be placed without assigning it a purchase order number. For most
purchases, a confirming purchase order subsequently should be mailed to the supplier. In
cases where the emergency is less urgent, the buyer may process such requisitions at
appointed times twice daily (say at 10:30 am and 2:30 pm).
Rush orders always cost more than if they were handled through the normal purchasing
system. Higher prices frequently are paid because rush purchases are not investigated as
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thoroughly as those handled in the normal routine and of a buyer’s scheduled work by the
emergency request invariably produce inefficiency in normal purchasing department activity.
Consequently, steps should be taken to discourage all rush orders that arise because of poor
planning in the using departments. In practice, three approaches have proved successful.
The first involves a concerted effort to coordinate the activities of the using group of
production scheduling and purchasing. Some companies require that realistic order points
for inventory materials be established jointly by production scheduling and purchasing is
required to issue periodic lead time reports to users for all major classes of materials. A
second approach, designed to reduce unjustifiable requests, requires the requisitioned to
obtain approval from a general management executive for all emergency requisitions. A
modification of this approach requires an after-the fact review of all rush orders by top
management. Still another approach assesses the requisitioning department a predetermined
service charge for each emergency requisition processed.
4.5 The Small Order Problem
Small orders are a serious problem in every organization. Examination of a typical
company’s purchase order file reveals that a sizable percentage (sometimes up to 80 percent)
of its purchases involve in an expenditure of less that 250.
In total, however, these purchases constitute a small percentage (seldom more than 10
percent) of the firm’s annual dollar expenditure.
Clearly no manager wants to devote more buying and clerical effort to the expenditure of less
than 10 percent of his or her funds than to the expenditure of the other 90 percent.
The very nature of business requires the purchase of many low-value items. Nevertheless,
small orders are costly to buyer and seller alike.
The various methods used by purchasing manager to deviate the small order problem can be
as illustrated below.
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4.5.1. Centralized store system
A stores system is the first approach typically used to reduce the volume of small-order
purchasing activity. When expenditure shows that the same supply items are ordered in small
quantities time after time, the logical solution is to order these items in larger quantities and
place them in a centralized inventory for withdraws as needed. An analysis of repetitively
used production materials leads to the same action for the multitude of low-value items. If
usage of an item is reasonably stable, an optimum order quantity can be computed using a
basic economic order quantity approach.
4.5.2. Blanket order system
A store system solves the small-order problem only for items that are used repetitively. A
blanket order system helps solve the problem for the thousands of items a firm cannot carry
is inventory, as well as some that it does carry.
Briefly, the general procedure used for this type of purchase is as follows. On the basis of an
analysis of past purchases, the buyer determines which materials should be handled in this
manner. After bidding or negotiation, the buyer selects a supplier for each item, or family of
items, and issues a blanket order to each supplier. The order includes a description of each
item, a unit price for each item when possible, and the other customary contract provisions.
However, no specific order quantities are noted. The blanket order typically indicates only an
estimated usage during the period of coverage (usually one to three years). It also states that
all requirements are to be delivered up on receipt of a release from the buyer or other
authorized person. On receiving a requisition for one of the materials, the buyer merely sends
a brief release form to the supplier. On the release form are noted the blanket order number,
the item number, and the quantity to be delivered. Receiving reports are filed with the
original order, and at the end of the month are checked against the suppliers’ monthly
invoice. At the end of the period, the order may be reviewed or placed with another firm,
depending on the suppliers’ performance record.
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The blanket order system offers six important benefits:
1. it requires many fewer purchase orders and reduces clerical work in purchasing,
accounting and receiving.
2. it releases buyers from routine work, giving them more time to concentrate on major
problems.
3. it permits volume pricing by consolidating and grouping requirements.
4. it can improve the flow of feedback information, because of the grouping of materials
and suppliers.
5. because of some suppliers will stock material for prompt delivery, this system may
reduce the buyer’s lead times and inventory levels.
6. it develops longer-term and improved buyer supplier relationships.
To function effectively in the long run, however, any blankets order systems must provide
adequate internal control. Absence of the control element encourages petty fraud and poor
supplier performance.
4.5.3. Systems contracting
A system contracting is simply an extinction and more sophisticated development of the
blanket order purchasing concept. Some firms call it “stockless” purchasing.
As its name implies, systems contracting involves the development of a corporate wide
agreement, often a one-to five year requirements contract, with a supplier to purchase a large
group or “family” of related materials. The items to be purchased are usually described in
detail is a “catalog” that belongs part of the contract. Estimated usage usually is included, a
long with a fixed price for each item and an agreement by the supplier to carry a stock of
each item adequate to meet the buyer’s needs. Various types of supplies and commonly used
operating items, typically purchased from distributors, are the materials most often covered
by these types of agreement.
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4.5.4. Telephone/fax order systems
Most companies now use a telephone or fax ordering system to reduce the paperwork
associated with small-order purchasing. Under this system, when the purchasing department
receives a requisition, it does not prepare a formal purchase order. Instead, the order is placed
by telephone or fax, and the requisition is used in the receiving procedure.
4.5.5. Petty cash and C.O.D
Most firms today use a petty cash fund for making small one-time purchases. For this
purpose, many firms define “small” as under $ 100. it is often less expensive for an
individual user to buy minor items personally and pay for them from a petty cash fund than it
is to buy them through the conventional purchasing system. Some firms also find it
economical to make small one-time purchase on a C.O.D basis. Material can be ordered by
telephone and paid for an arrival. Payment can be made using petty cash or a departmental
check written on an account set up for such purchases.
4.5.6. Supplier stores/consignment system
It a purchaser buys a large enough volume of certain materials from a single supplier, the
supplier sometimes can afford to start a small “store” at the purchaser’s plant and operate it
on a consignment basis. Users then simply go to the store and sign for their purchases. At the
end of the month the company is billed for its purchases just as if the user had “gone
downtown” to buy the material. This system clearly is not a short-term arrangement. The
purchaser, therefore, must take great care is selecting the supplier and in negotiating the
terms of the agreement.
4.5.7. Supplier delivery system
The supplier delivery system is somewhat similar to a supplier stores system, but it is more
feasible for firms with a smaller volume of purchases. Many suppliers who are not willing to
set up a store at the buyer’s plant are willing to stock numerous miscellaneous materials and
make daily or semiweekly deliveries. The buyer typically reviews and accumulates purchase
requisitions for such materials. The suppliers delivery person them pecks them up on the
specified day, and at the same time delivers the material ordered on the preceding batch of
requisitions.
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Check Your Progress
1. Identify and explain in detail the purchasing procedure
________________________________________________________________________
________________________________________________________________________
2. What is a purchase register? Explain
________________________________________________________________________
________________________________________________________________________
3. Discuss in detail the various records maintained by the purchasing departments
________________________________________________________________________
________________________________________________________________________
4. Discuss at least 4 methods used to curb the problem of small-order problem
________________________________________________________________________
________________________________________________________________________
4.6 Summary
Every business units develops a series of procedures to assist operating personnel in carrying
out the polices and plans of the unit. In total these procedures establish the ground rules for
the daily activities of the department.
The specific procedures employed by each firm should be designed to meet the unique needs
of that firm. Generally speaking properly designed procedures should accomplish four
objectives:
1. accomplish each task satisfactorily with a minimum of time, effort and paperwork
2. effectively communicate and coordinate the efforts of one work group with another.
3. minimizing overlapping efforts and group conflicts by clearly designating
responsibility for each step of the procedure.
4. permit effective management by exception.
It is important too, to consider the external dimension of the procedures issue. The nature of
the procedural interface that is established units a supplier is defined by the form of
relationship that is developed with the firm. This area is undergoing a rapid evolutionary
change as acquisition needs of purchasing firms become more dynamic.
4.7 Answers to Check Your Progress Questions
1.
2.
3.
4.
Refer 4.2
Refer 4.2.2
Refer 4.3
Refer 4.5
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UNIT 5
INVENTORY CONTROL
Contents of the Unit
5.0 Aims and objectives
5.1 Introduction
5.2 Meaning of Inventory
5.3 Motives for Holding Inventory
5.4 Objectives of Inventory
5.5 Types of Inventory
5.6 Inventory Control Techniques
5.7 Summary
5.8 Answers to Check Your Progress Questions
5.0 Aims and Objectives
At the completion of this unit, students will have knowledge and understanding of:
inventory control
the types of inventory items
the inventory control techniques
5.1 Introduction
Dear students! Inventory constitutes the most significant part of current assets of a large
majority of companies. On an average, inventories are approximately 60% of current assets
in any organization. Because of the large size of inventories maintained by a firm, a
considerable amount of money is required to be committed to them.
It is, therefore,
absolutely imperative to manage inventories efficiently and effectively in order to avoid
unnecessary investment. Management of inventory assumes importance due to the fact that
investment in inventory constitutes one of the major investments in current assets.
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5.2 Meaning of Inventory
“Inventory control is the technique of maintaining store-keeping items at the desired level,
whether they be raw materials, goods in process or finished products. “
Inventory means all the materials, parts, supplies, expense tools and in process or finished
products recorded on the books by an organization and kept in its stocks, warehouses or
plants for some period of time. Inventory control keeps track of inventories. It is observed
that “too much”, “too little” or badly balanced inventories are all to be avoided because they
cost too much on many counts.
5.3 Motives for Holding Inventories
Company may hold the inventory with the various motives as stated below.
1. Transaction Motive
The company may be required to hold the inventories in order to facilitate the smooth and
uninterrupted production and sales operation. It may not be possible for the company to
procure raw materials whenever necessary. There may be a time lag between the demand for
the material and its supply. Hence it is needed to hold the raw material inventory. Similarly,
it may not be possible to produce the goods immediately after they are demanded by the
customers. Hence it is needed to hold the finished goods inventory. The need to hold work
in progress may arise due to production cycle.
2. Precautionary Motive
In addition to the requirement to hold the inventories for routine transaction, the company
may like to hold them to guard against the risk of unpredictable changes in demand and
supply forces.
Example: - The supply of raw materials may get delayed due to the factors like strike,
transport, disruption, short supply, lengthy process involved in import of raw materials etc.
Hence the company should maintain sufficient level of inventories to take care of such
situation. Similarly, the demand for finished goods may suddenly increase (especially in
case of seasonal types of products) and if the company is unable to supply them, it may mean
gains of the competitors. Hence the company will like to maintain sufficient stock of
finished goods.
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3. Speculative Motive
The company may like to purchase and stock the inventory in the quantity, which is more
than needed for production and sales purposes. This may be with the intention to get the
advantages in terms of quantity discounts connected with bulk purchasing or anticipated
price rise.
5.4 Objectives / Functions of Inventory Management
Though inventory control may not be treated as an executive function but it is one of the
most important functions in an enterprise. The following are the main objective / function of
inventory control.
1. To carry maximum inventory in order to facilitate efficient and smooth production
and sales operation.
2. To minimize investment in inventory to maximize profitability.
3. To better use of men, material and capital.
4. For production economies.
5. Control of stock volume.
6. Control against theft, pilferage, etc.
Both over investment and under investment in inventories is undesirable as both involve the
consequences.
Over investment involves the consequences like:1. Unnecessary blocking of funds in inventory and hence loss of profit.
2. Excessive storage and insurance cost.
3. Risk of liquidity: - The inventory once purchased and stored are normally difficult to
dispose off at the same value. In other words, the value of inventory reduces with the
increasing holding periods.
The under investment involves the consequences like:
1. If sufficient stock of raw materials and work in process is not available, it may result
into frequent interruption in production.
2. If sufficient stock of finished goods is not available it may not be possible for the
company to serve the customers properly and they may shift to the competitors.
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Thus, the objective of inventory management is to avoid the situation of over investment as
well as under investment. The level of inventory should be maintained at the optimum level.
The Importance of inventory to an organization can be:1. Provides and maintains good customer service.
2. Enable smooth flow of goods through the production process.
3. Provides protection against the uncertainties of demand and supply.
4. Various production operations can be performed economically and independently.
It can allow temporary variation in operating rates.
5. Ensures a reasonable utilization of material, labor and capital etc.
However, Inventory Control Has the Following Limitations
1. Efficient inventory control methods can reduce but cannot eliminate business risk.
2. The objective of better sales through improved service to customer.
Reduction in
inventories to reduce size of investment and reducing cost of production by smoother
production operations are conflicting with each other.
3. The control of inventories is complex because of the many functions it performs. It
should be viewed as shared responsibility.
5.5 Types of Inventories
Inventory is an essential part of an organization.
Every business / manufacturing
organization, however, big or small has to maintain some inventory. Types include:1. Raw material
2. Work-in-progress (Semi-finished goods)
3. Finished goods
4. Maintenance / Repair / Operating supplies (MRO)
1. Raw materials
These represent inputs purchased and stored to be converted into finished goods in future by
making certain manufacturing process on the same.
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2. Work-in-progress (Semi-finished goods)
These represents semi-manufactured products, which need further processing before they can
be treated as finished products.
3. Finished goods
This represents the finished products ready for sale in the market.
4. Maintenance / Repair / Operating supplies
These represent that part of inventory, which does not become a part of final product but are
required for production process. They may be in the form of cotton waste, oil and lubricants,
soaps, brooms, light bulbs, etc.
Normally, they form a very minor part of total inventory and do not involve significant
investment.
5.6 Inventory Control Techniques
Firm’s uses different inventory control techniques to keep track of their inventories. Some of
the techniques used by the firms are as stated below.
5.6.1 Economic order quantity
Economic order quantity, which is fixed in such a way that the total variable cost of
managing the inventory can be minimized such cost basically, consists of two parts.
A) Ordering cost
Ordering cost consists of the costs associated with the administrative effort connected with
preparation of purchase requisition, purchase enquires, comparative statements and handling
of more numbers of bills and receipts.
B) Inventory carrying cost
The cost of carrying or holding the inventory which in turn consists of go down rent,
handling expenses, insurance, opportunity cost of capital blocked i.e. interest etc.
There is a reverse relationship between these two types of costs i.e. if the purchase quantity
increases, ordering cost may get reduced but the carrying cost increases and vice versa. A
balance is to be stuck between these two factors and it is possible at economic order quantity
104
where the total cost of managing the inventory is minimum. This technique is based on
several assumptions.
1. Demand is known, constant and independent.
2. Lead-time that is the time between placement and receipt of the order is known and
constant.
3. Receipts of inventory is instantaneous and complete. In other words, the inventory from
an order arrives in are batch at one time.
4. Quantity discount are not possible.
5. The only variable costs are the cost of setting up or placing an order (ordering cost) and
the cost of holding or storing inventory over time (carrying cost).
6. Stock outs (shortages) can be completely avoided if orders are placed at the right time.
It is possible to fix the economic order quantity with the help of a mathematical formula.
Let: Q be economic order quantity
A be annual requirement of material in units
O be cost of placing an order (which is assumed to remain constant irrespective of size of
order
C be cost of carrying one unit per year
.i be carrying cost expressed as a percentage of unit purchase price.
‘A’ is the annual requirement and ‘Q’ is the size of one order, the total number of orders will
be ‘A/Q’ and the total ordering cost will be: ‘A/Q x Q’.
Similarly, if the size of one order is ‘Q’ and if it is assumed that the inventory is reduced at a
constant rate from order quantity to zero when it is replenished, the average inventory will be
‘Q/2’ and the cost of carrying one unit per year being ‘Ci’, the total carrying cost will be ‘Q/2
x Ci. Thus, Total cost = Ordering cost + carrying cost
= (AQ/Q) + Q/2Ci)
Optimal order quantity is found when ordering cost equals to carrying cost. Thus, economic
order quantity could be mathematically presented as follows:A/QO = Q/2Ci
105
To solve for Q, we just simply cross-multiply and isolate ‘Q’ on the left of the equal sign.
= 2AO = Q2Ci
= Q2 = 2AO
Ci
Q = 2AO
Ci
Where Q = Order quantity
A = Annual demand
O = Ordering cost per order
C = Carrying cost per unit per year
.i = Carrying cost expressed as a percentage of a unit purchase price.
E.g. 1 A manufacturer uses 200 units of components every month and he buys them entirely
from outside supplies. The order placing and receiving cost is Br. 100 and annual carrying
cost is Br. 12. From this set of data, calculate economic order quantity.
Solution:- EOQ =
2xAxO
C
= 2 x (200 x 12) x 100
12
= 200 units.
E.g. 2 from the following data, workout the EOQ of a particular component.
Annual requirement 1600 units
Acquisition cost
$50 per order
Carrying cost
10% of purchase price
Purchase price
$10
Determine the economic order quantity and the total cost in comparison with the EoQ, if the
firm purchase in various lots as follows:i) 800 units
ii) 400 units
Solution: 1. EOQ = 2 x A x O
Ci
iii) 200 units iv) 100 units v) 500 units
= 2 x 1600 x 50
10% of 10
106
= 400 units
vi) 1600
Solution 2.
Order
Quantity
No. of
Orders
A/Q
Ordering
Cost
A/QO
Carrying
Cost
Q/2Ci
Total
Cost
Birr
Savings by
EOQ
Birr
100
200
400
500
800
1600
16
8
4
3.2
2
1
800
400
200
192
120
50
50
100
200
250
400
800
850
500
400
442
520
850
450
100
- Optimal level
42
120
450
It can be observed from the above data that the order size of 400 units proves to be the most
economic one in terms of minimum total cost. If the purchase is made in any other way, the
same may not result into minimum total cost.
5.6. 2 ABC analysis
ABC analysis divides on hand inventory into three classifications on the basis of annual
dollar volume. ABC analysis is an inventory application of what is known as the pare to
principle. The pare to principle states that a ‘vital few and trivial many’. The idea is to
establish inventory policies that focus resources on the few critical inventory parts and not
the many trivial ones. It is not realistic to monitor inexpensive items with the same intensity
as very expensive items.
To determine annual dollar volume for ABC analysis, we measure the annual demand of
each inventory item times the cost per unit.
A – Class items are these on which the annual dollar volume is high. Although such items
may represent only about 15% of the total inventory items, they represent 70 to 80% of the
total dollar usage.
B – Class items are those inventory items of medium annual dollar volume. These items may
represent 30% of inventory items and 15 to 25% of the total value.
C – Class items are those with low annual dollar volume. These items may represent 5% of
the annual dollar volume but about 55% of the total inventory items.
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The importance of the various items may be decided on the basis of the following factors.
1. Amount of investment on inventories
2. Value of material consumption
3. Critical nature of inventory items
An example of ABC analysis can be given as below.
Class
No. of
Item
% of total
No. of items
Value
Consumption
% of Total Value
Consumption
A
B
C
300
1500
3200
6
30
64
560,000
160,000
80,000
70
20
10
5000
100
800,000
100
In order to exercise proper inventory control, A class items are watered very closely and
control is exercised right from initial stages of estimating the requirements, fixing minimum
level / lead time, following proper purchase / storage procedure etc. whereas in case of C
items, only those inventory control measures may be implemented which are comparatively
simple, elaborate and inexpensive in nature. Advantages of ABC Analysis can be as
illustrated below:
1. A close and strict control is facilitated on the most important items which constitute a
major portion of overall inventory valuation or overall material consumption and due to
this the costs associated with inventories may be reduced.
2. The investment in inventory can be regulated in a proper manner and optimum utilization
of the available funds can be assured.
3. A strict control on inventory items in this manner helps in maintaining a high inventory
turnover ratio.
E.g. 1 Make the ABC classification of the following inventory items
Sr.
No.
Item
Stock
Number
Annual
Units
Unit
X Cost
1
2
3
4
5
10286
11526
12760
10867
10500
1000
500
1550
350
1000
$ 90.00
154.00
17.00
42.86
12.50
Sr.
No.
Item
Stock
Number
Annual
Units
Unit
Cost
6
7
8
9
10
12572
14075
01036
01307
10572
600
2000
100
1200
250
14.17
.60
8.50
.42
.60
108
Solution
Item
No.
Item
units
% No. of
Items
Volume
Units x Cost
10286
11526
12760
10867
10500
12572
14075
01036
01037
10572
Total
1000
500
1550
350
1000
600
2000
100
1200
250
8550
12
6
18
4
12
7
23
1
14
1000 x 90.00
500 x 154.00
1550 x 17.00
350 x 42.86
1000 x 12.50
600 x 14.17
2000 x 0.60
100 x 8.50
1200 x 0.42
250 x 0.60
18%
34%
48%
3
100%
Annual Dollar
% of Value
Birr
%
90,000
77,000
26,350
15,001
12,500
8,502
1,200
850
504
150
232,057
38.8
33.2
11.3
6.4
5.4
3.7
.5
.4
.2
.1
100%
Class
72%
A
23%
B
5%
C
5.6. 3 Inventory levels
Fixation of inventory levels facilitates initiating of proper action in respect of the movement
of various materials in time so that the various materials may be controlled in a proper way.
However, the following preposition should be remembered.
1. Only the fixation of inventory levels does not facilitate the inventory control. There has to
be a constant watch on the actual stock level of various kinds of materials so that proper
action can be taken in time.
2. The various levels fixed are not fixed as a permanent basis and are subject to revision
regularly.
The various levels fixed are as below:1. Maximum level
2. Maximum level
3. Recorder Level
4. Danger level
A) Maximum level
It indicates the level above, which the actual stock should not exceed. If it exceeds, it may
involve unnecessary blocking of funds in inventory while fixing this level following factors
are considered.
1. Maximum usage
2. Lead-time
3. Storage facility available, cost of storage and insurance
109
4. Prices for the material
5. Availability of funds
6. Nature of material i.e. if certain type of material is subject to government regulations in
respect of import of goods etc. maximum level may be fixed at a higher level.
Maximum level can be expressed in the following mathematical expression.
1. Maximum Level = Reorder level + EOQ – (Minimum usage x Minimum lead time)
B) Minimum Level
It indicates that level below which the actual stock should not reduce. If it reduces, it may
involve the risk of non-availability of material whenever it is required while fixing this level,
following factors are considered.
a) Lead time
b) Rate of consumption
Minimum level = Reorder level – (Normal usage x Normal lead time)
C) Reorder level
It indicates that level of material stock at which it is necessary to take the steps for
procurement of further loss of material.
This is the level falling in between the two
existences of maximum level and minimum level and is fixed in such a way that the
requirements of production are met properly till the new lot of material is received. Reorder
level = Maximum usage x maximum lead time
D) Danger level
This is the level fixed below minimum level. If the stock reaches this level it indicates the
need to take urgent action in respect of getting the supply. At this stage, the company may
not be able to make the purchase in a systematic manner but may have to make rush
purchases, which may involve higher purchases cost. Danger level = Normal usage x Lead
time for emergency purchases
E) Average Level
This is the level, which has been held at an average during the period. It can be obtained as:
Average Level = Maximum level + Minimum Level
2
110
There may be one more way in which the various inventory levels may be fixed and for this,
determination of safety stock (also called as minimum stock or buffer stock is essential).
Safety stock is that level of stock below which the actual should not be allowed to fall. The
safety stock may be calculated as:Safety
Stock = (maximum usage x minimum lead-time) – (Normal usage x Normal lead-time)
According to this method, the various inventory levels as discussed above may be fixed as
below.
1. Minimum level equals to safety stock
2. Maximum level = Safety stock + EOQ
3. Reorder level = Safety stock + (Normal usage x Normal Lead-time)
4. Average stock level = Safety stock + EOQ/2
Example:- Components X and Y are used as follows
Normal usage – 50 units per week each
Minimum usage – 25 units per week each
Maximum usage – 75 units per week each
Reorder quantity X – 400 units
Y – 600 units
Reorder period
X – 4 to 6 weeks
Y – 2 to 4 weeks
Calculate for each component
a) Reorder level
b) Minimum level
c) Maximum level
d) Average stock level
Solution:a) Reorder level = Maximum usage x maximum lead – time
X = 75 units x 6
Y = 75 x 4
= 450 units
= 300 units
b) Minimum level = Reorder level – (Normal usage x Normal lead-time)
X = 450 – (50 x 4+6/2)
= 200 units
Y = 300 – (50 x 2+4/2)
= 150 units
111
c) Maximum = Reorder level + Reorder quantity–(minimum usage x minimum lead time)
X = 450 + 400 – (25 x 4)
Y = 300 + 600 – (25 x 2)
= 750 units
= 850 units
d) Average stock level = Maximum level + minimum level
2
X = 750 + 200
Y = 850 + 150
2
= 475 units
= 500 units
5.6. 4 Inventory turnover ratio (ITR)
Inventory turnover indicates the ratio of materials consumed to the average inventory held. It
is calculated as below:ITR = Value of material consumed
Average inventory held
Where value of material consumed can be calculated as:= Opening stock + purchases – Closing stock
Average inventory held can be calculated as
= Opening stock + Closing stock
2
Inventory turnover can be indicated in terms of number of days in which average inventory is
consumed. It can be done by dividing 365 days by inventory turnover ratio.
A high inventory turnover ration or low inventory turnover period indicates that maximum
material can be consumed by holding minimum amount of inventory of the same, this
indicating fast moving item. Thus high inventory turnover ratio or lower inventory turnover
period will always be preferred.
Thus, knowledge of inventory turnover ratio or inventory turnover period in case of various
types of material will enable the organization to exercise proper control.
112
Example:Calculate the inventory turnover ratio for the year 1990 from the following information and
determine which of the two materials is fast moving.
Materials in hand 01.01.01
Materials in hand 31.12.01
Purchase during the year
Material A
Birr
Material B
Birr
60,000
20,000
200,000
80,000
60,000
120,000
Solution:Material Consumed = Opening stock + purchases – Closing stock
A = 60,000 + 200,000 – 20,000
B = 80,000 + 120,000 – 60,000
= 240,000
= 140,000
Average Inventory = Opening stock + Closing stock
2
A = 60,000 + 20,000
;
B = 80,000 + 60,000
2
= 40,000
= 70,000
Inventory Turnover = Cost of material consumed
Average inventory held
A = 240,000
B = 140,000
40,000
70,000
= 6 times
= 2 times
Inventory holding period =
365 days
.
Inventory turnover
A = 365
B = 365
2
= 63.83 days
= 182.5 days
 64 days
 183 days
Therefore, material A is fast moving
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5.6.5 Bill of material
In order to ensure proper inventory control, the basic principle to be kept in mind is that
proper material is available for production purposes whenever it is required. This aim can be
achieved by preparing what is normally called as “Bill of Material”.
A bill of material is a list of material required for a job process or production order. It gives
the details of the necessary materials as well as the quantity of each item. As soon as the
order for the job is received, bill of materials is prepared by production department or
production planning department. The form in which bill of material is usually prepared is as
below.
Bill of Material
No._______________
Date of Issue: ______________________ Production / Job Order No._______________
Department Authorized _______________________________
Serial
No.
Description
Code
No.
For Department use only
Material
Quantity
Quantity Reqn. No. Date
Demande
d
Remark
The function of bill of materials is as below:a) Bill of material gives an indication about the order to be executed to all the persons
concerned.
b) Bill of material gives an indication about the materials to be purchased by the purchase
department if the same is not available with the stores.
c) Bill of material may serve as a base for the production department for placing the material
requisition slip.
d) Costing / Accounting department may be able to compute the material cost in respect of a
job or a production order. A bill of material prepared and valued in advance may serve as
a base for quoting the price for the job or production.
114
5.6.6 Perpetual inventory / cycle counting
In order to exercise proper inventory control, perpetual inventory system may be
implemented. It aims basically at two facts.
1. Maintenance of bin cards and stores ledger in order to know about the stock in quantity
and value at any point of time.
2. Continuous verification of physical stock to ensure that the physical balance and the book
balance tallies.
The continuous stock taking may be advantageous from the following angles.
a) Physical balance and book balances can be compared and adjusted without waiting for the
entire stocktaking to be done at the year-end. Further it is not necessary to close down the
factory for annual stocktaking.
b) The figures of stock can be readily available for the purpose of periodic profit and loss
account.
c) Discrepancies can be located and adjusted in time.
d) Fixation of various levels and bin cards enables the action to be taken for the placing the
order for acquisition of material.
e) Stock details are available correctly for getting the insurance of stock.
f) A systematic maintenance of perpetual inventory system enables to locate slow and nonmoving item and to take remedial action for the same.
5.6.7 Fixed period systems
In a fixed period system, however, inventory is ordered at the end of a given period. Then,
and only then, is on hand inventory counted. Only the amount necessary to bring total
inventory up to a pre specified target level is ordered.
The advantage of the fixed period system is that there is no physical count of inventory item
after an item is withdrawn – this occurs only when the time for the next review comes up.
This procedure is also convenient administratively especially if inventory control is only one
of several duties of an employee.
A fixed period system is appropriate when vendors make routine (that is at fixed – time
interval) visit to customers to take fresh orders or when purchasers want to combine orders to
115
save ordering and transportation costs (therefore, they will have the same review period for
similar inventory items).
The disadvantage of this system is that because there is no tally of inventory during the
review period, there is the possibility of a stock out during this time. This scenario is
possible if a large order draws the inventory level down to zero right after an order is placed.
Therefore, a higher level of safety stock (as compared to a fixed – quantity system) needs to
be maintained to provide protection against stock out during both the time between reviews
and lead-time.
5.6.8 Just in time (JIT)
When properly implemented a JIT system results in the following supply chain benefits,
reduced inventory, increased quality, reduced lead time, reduced scrap and rework and
reduced equipment down time. The benefits of JIT protect and enhance the success of firms
that embrace it.
Unfortunately, too frequently a key prerequisite to successful
implementation of such a system is ignored. JIT requires defect free incoming purchased
material.
In addition, to requiring virtually defect free incoming materials, JIT requires a high degree
of integration of the customer’s and production plan and schedules affect the suppliers’
schedules. Experience has demonstrated that dependable singly – source partnership are
virtually essential if the required level of integration is to result.
A firm that is considering the adoption of JIT manufacturing must focus on its suppliers’
abilities and willingness to meet the stringent quality and schedule demand imposed by the
system. The sourcing team must carefully investigate a potential supplier’s capability as a
JIT manufacturer.
Check Your Progress
1. Good luck company estimates its carrying cost at 15% and its ordering cost at Birr 9 per
order. The estimated annual requirement is 38,000 units at a price of Birr 4 per unit.
Determine the EOQ?
___________________________________________________________________________
_____________________________________________________________________
116
2. Two components, A and B are used as follows:
Normal usage 100 units each per week
Minimum usage 50 units each per week
Maximum usage 150 units each per week
Reorder quantity A: 300 units B 500 units
Reorder period A: 4 to 6 weeks, B 2 to 4 weeks
Calculate for each component
a) Records level
b) Minimum level
c) Maximum level
d) Average stock level
3. A firm has seven different items in its inventory. The average number of each of these
items held, along units then unit costs, is listed below. The firm’s wishes to introduce an
ABC inventory system. Suggest a breakdown of the items into A, B and C classification.
Item No.
Average number of
Average costs
Unit’s inventory
per unit
1
20,000
60.80
2
10,000
102.40
3
32,000
11.00
4
28,000
10.28
5
60,000
3.40
6
30,000
3.00
7
20,000
1.30
4. Calculate the inventory turnover ration from the following data furnished. Determine
which item is/are fast moving.
A
Material on hand
B
C
D
50,000
80,000
60,000
70,000
Materials on hand
31/12/2004
30,000
20,000
40,000
30,000
Purchase during
70,000
100,000
90,000
01/01/2004
117
200,000 the year
5.7 Summary
Inventory control is a technique of maintaining a stock keeping item at a desired level, be it
raw material, semi-finished goods, finished goods and maintenance repair and operating
supplies (MRO). The firm may hold inventory at a desired level due to transaction motive,
precautionary motive; and speculative motive. The main objectives of inventory is to
maintain the optimal level of inventory in order to have a smooth running of production
process and sustainable finished product supplying to customers.
The first step in inventory planning/control process is the classification of different types of
inventory to determine the type and degree of control required for each. The ABC system is a
widely used classification techniques for the purpose. Based on this value of investments,
items of inventory are classified as A, B and C.
The second aspect repeats to the determination of size/quantity of inventory, which would be
acquired. I.e., the order quantity. The economic order quantity or economic lot size (EOQ) is
that level of inventory where the total cost of managing inventory will be at its minimum.
Yet another important question relating to inventory planning and control is: when should the
order to procure inventory be place (Reorder point). The reorder point is that inventory level
which is equal to the consumption during the lead time /Procurement true etc.
5.8 Answers to Check Your Progress Questions
1. Refer section 5.6.1
2. Refer section 5.6.3
3. Refer section 5.6.2
4. Refer section 5.6.4
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UNIT 6
PURCHASE DESCRIPTIONS, QUALITY
SPECIFICATIONS AND STANDARDIZATION
Contents of the Unit
6.0 Aims and Objectives
6.1 Introduction
6.2 Definition of Quality
6.3 Total Quality Management (TQM)
6.4 Purchased Description
6.5 Standardization
6.6 Simplification
6.7 Summary
6.8 Answers to Check Your Progress Questions
6.9 References
6.0 Aims and Objectives
The main purpose of this unit is to introduce students with the importance of purchase
descriptions, quality specifications and standardizations.
At the completion of this unit, students will have knowledge and understanding of:
purchase descriptions
quality
total quality management
the different types of specifications
the meaning and definition of standardization
simplification
119
6.1 Introductions
Dear students! The fundamental to any purchasing program is the determination of quality
specification and the cost of achieving those specifications. Quality in everyday life and
business, engineering and manufacturing has a pragmatic interpretation as the non-inferiority,
superiority or usefulness of something. It is viewed as quantifiable or measurable
characteristics or attribute of product’s or service and also termed as the product fitness for
use, and it entails identifying the dimension of product or service that the customer wants.
This unit is concerned with the important aspects of written descriptions of quality and their
impact on good purchasing. Purchase descriptions directly affect the quality and performance
of the item purchased and the price paid. The unit also deals with the discussion of total
quality management, specifications, standardization and simplification.
6.2 Definitions of Quality
Different people interpret quality in different ways and it is not easy to define the concept
‘quality’ in a precise way. Quality is frequently defined as ‘fitness, excellence, free of
defect”. This is the definition most people have in mind when they think of quality.
In industrial and institutional purchasing, quality is related to suitability and cost rather than
to intrinsic excellence. The best quality is that which can be purchased at the lowest cost to
fulfill the need or satisfy the intended function for which the material is being purchased.
Moreover, the functions of design, production and service may find it difficult to use the
definition as a basis for quality measurement.
I. The product based definitions
Quality is viewed as quantifiable or measurable characteristics or attribute. For example,
durability or reliability can be measured and the engineer can design to that bench mark.
Although this approach may have benefits, it has limitations as well. Where quality is based
on individual test or preference the bench mark for measurement may be misleading.
120
II. User based definition
Quality is an individual matter, and products that best satisfy the preference (i.e. perceived
quality) are those with the highest quality. This is the rational approach but it leads to two
problems. A first consumer preference varies and secondly it is difficult to aggregate these
preferences into products with wide appeal.
III. Manufacturing based definition
Quality “Conformance to requirement”. Requirement or specifications established by design
and any deviation implies a reduction in quality. The conformance quality refers to the
degree to which the product or service design specifications are met. Execution of the
activities involved in achieving conformance is of a tactical day-to-day nature. It should be
evident that a product or service can have high design quality but low conformance quality,
and vice versa.
One of the most important responsibilities of a buyer is to ensure that suppliers have the
ability, the motivation and adequate information to produce materials and components of the
specified quality in a cost-effective manner. In fulfilling this responsibility a buyer can, to a
great extent, control the quality and related cost of incoming material.
Generally, speaking four factors determine the long-run quality level of a firm’s purchased
materials.
i. Creation of complete and appropriate specifications for quality requirements.
ii. Selection of suppliers having the technical and production capability to do the desired quality.
iii. Development of a realistic understanding with suppliers of quality requirement and
creation of the motivation to perform accordingly.
iv. Monitoring a supplier’s quality/cost performance and exercise of appropriate control.
Purchasing and supply management is directly responsible for the second and third
factors and it should play a strong cooperative role in the first and fourth factors.
121
6.3 Total Quality Management (TQM)
Total quality management (TQM) is the integration of all functions and processes within an
organization in order to achieve continuous improvement of the quality of goods and
services. It is the process of instilling quality throughout an organization and its business
processes. The system of Total Quality management aims at achieving success and customer
satisfaction through embedding an awareness of quality all the way through a business,
through planning and feedback.
Quality has become the major concern in many organizations, particularly in light of intense
foreign competition, more demanding customers and poorer profit performance owing to
reduced market share and highest cost.
TQM is a philosophy that uniform commitment to quality in all areas of the organization will
promote a culture that meets consumer’s perceptions of quality. It involves coordinating
efforts directed at improving customer satisfaction, increasing employee participation and
empowerment, forming and strengthening supplier partnerships and facilitating an
organizational culture of continuous quality improvement.
TQM is based on a number of ideas. It means thinking about quality in terms of all functions
of the enterprise and is a start-to-finish process that integrates interrelated functions at all
levels. It is a system approach that considers every interaction between the various elements
of the organization. Thus, the over all effectiveness of the system is higher than the sum of
the individual outputs from the sub-system. The subsystem includes all the operational
functions in the life cycle of a product such as design, planning, production, distribution and
field service.
The management subsystem also requires integration, including strategy with a customer
focus, the tools of quality and employee involvement (the linking process that integrates the
whole). A corollary is that any product, process or service can be improved, and a successful
organization is that consciously seeks and exploits opportunities for improvement at all
levels.
122
As a management philosophy TQM relies heavily on the talents of employees to improve
continually the quality of the organization’s goods and services.
TQM as a Foundation
TQM is the foundation for activities which include;
i.
Meeting Customer Requirements
ii.
Reducing Development Cycle Times
iii.
Just In Time/Demand Flow Manufacturing
iv.
Improvement Teams
v.
Reducing Product and Service Costs
vi.
Improving Administrative Systems Training
Ten Steps to Total Quality Management (TQM)
The Ten Steps to TQM are as follows:
i.
pursue new strategic thinking
ii.
know your customers
iii.
set true customer requirements
iv.
concentrate on prevention, not correction
v.
reduce chronic waste
vi.
pursue a continuous improvement strategy
vii.
use structured methodology for process improvement
viii.
reduce variation
ix.
use a balanced approach
x.
apply to all Functions
Principles of TQM
123
The Principles of TQM are as follows:
i. Quality can and must be managed.
ii. Everyone has a customer and is a supplier.
iii. Processes, not people are the problem.
iv. Every employee is responsible for quality.
v. Problems must be prevented, not just fixed.
vi. Quality must be measured.
vii. Quality improvements must be continuous.
viii. The quality standard is defect free.
ix. Goals are based on requirements, not negotiated.
x. Life cycle costs, not front end costs.
xi. Management must be involved and lead.
xii. Plan and organize for quality improvement.
Processes must be Managed and Improved
Processes must be managed and improved! This involves:
i.
defining the process
ii.
measuring process performance (metrics)
iii.
reviewing process performance
iv.
identifying process shortcomings
v.
analyzing process problems
vi.
making a process change
vii.
measuring the effects of the process change
viii.
communicating both ways between supervisor and user
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Check Your Progress Exercises
1. What are the different bases of defining quality?
________________________________________________________________________
________________________________________________________________________
__________________________________________
2. What is the limitation of defining quality on product basis?
________________________________________________________________________
__________________________________________________________________3.
Explain the total quality management (TQM).
________________________________________________________________________
__________________________________________________________________
6.4 Purchase Descriptions
The purchase description forms the heart of the procurement. Whether or not a purchase
order or contract will be performed to the satisfaction of the buying organization frequently is
determined at the time the purchase description is selected or written, specifying the quality
requirements. Purchase descriptions directly affect the quality and performance of the item
purchased and the price paid. Purchase description serves a number of purposes it:
i. communicates to the buyer in the purchasing department what to buy
ii. communicates to prospective suppliers what is required
iii. serves as the heart of the resulting purchase order
iv. establishes the standard against which inspection, tests, and quality checks are
made.
Many firms pay a “fair and reasonable” price for materials; however, they do not always pay
the right price. The right price is paid only when the right material is specified after all
reasonable efforts to improve the purchase descriptions have been exhausted.
Purchase descriptions can be classified into two broad categories
i. Detailed specifications
ii. Other purchase descriptions
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6.4.1 Detailed specifications
Specifications are most detailed method of describing requirements. Various types of
designing specifications are the detailed descriptions of the materials, parts, and components
to be used in making the product. They are verbal and written descriptions that tell the seller
exactly what the buyer wants to purchase. Because they impact the activity of engineering,
operations, purchasing, and quality, optimum specifications vitally influence the contribution
made by all these departments to the firm’s success.
In a manufacturing firm, when specifications are fixed the final design is also fixed when the
final design is fixed; the products competitive stance and its profit potential are also fixed.
6.4.1.1 Importance of specifications
Specifications are very important because the cost of materials clearly dictates that their
selection is an important consideration during product design. The important characteristics
of a product are specified when it is designed, prior to its manufacture. These characteristics
are called the design specification. After the product has been produced, we can observe the
extent to which it conforms to or deviates from the design specifications. The costs of many
materials are identified through specification during the design stage. This is the first and
sometimes the only point at numerous costs can be reduced and controlled.
It is at the time of original design that the greatest cost saving obtained from both
specification and standardization.
Since specifications are important, the activity of engineering, operations, purchasing and
quality optimum specifications mainly influence the contribution made by these entire
department to the firm’s success. A good specification is to satisfy the procurement
consideration of clear, concise, and an unambiguous communication.
Preparing specification for a product involves four major considerations:
i. Design considerations of function
ii. Manufacturing consideration of economical production
iii. Procurement consideration of markets, materials availability, supplier capability
and cost.
iv. Marketing considerations of consumer acceptance
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It is common for these considerations to conflict with one another. But top management must
provide the encouragement and direction that will motivate all departments to cooperate and
seek a company solution, rather than departmental solutions.
When specifications conflict arises, final authority for the decision should rest with the
departments having responsibility for the product’s performance. This is usually the designengineering department. However this is not a justifiable reason for engineering
unnecessarily to subordinate the design considerations of manufacturing, procurement,
quality and marketing. From a company viewpoint, the right specifications are those that
blend the requirements of all departments only. Such specifications can satisfy the goals of
top management i.e. increased sales, decreased costs and the added corporate security which
comes with an increasing strong competitive position.
To develop specifications that properly become product quality characteristics and product
cost, management must coordinate the firm’s technical and business skills. Four approaches
can be used.
i. Early purchasing and supplier involvement
ii. The formal committee approach
iii. The informal approach
iv. The purchasing coordinator approach
I. Early purchasing and suppliers’ involvement
During the early stages of new product development, more and more, progressive firms
involve purchasing and potential suppliers. Such early involvement optimizes the
development of specifications since the technical and commercial issues are addressed at a
point where there is maximum objectivity and flexibility. This can improve product quality
and reliability, while compressing development time and reducing total material cost.
As more and more firms embrace the use of cross functional teams in the development of
new products, early purchasing and supplier involvement becomes an inherent component of
the process that culminates in the development of specifications. Progressive firms find that
this approach is an important element in their quest at realistic costs.
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II. The formal committee approach
This approach recognizes that a good specification is a compromise of basic objectives. A
specifications review committee is established, with representatives from design engineering,
production engineering, purchasing marketing, operations, quality and standards. When a
new product design is proposed, all members of the committee receive copies of all
drawings, bills of material and specifications. No design becomes finding until it is approved
by the committee.
III. The Informal approach
This method emphasizes the concept of a buyer’s responsibility to “challenge” materials
requests. At the same time, top management urges designers to request advice from buyers
and work with them on all items that may involve commercial considerations. Emphasis at
all times is placed on person to person communication and occupation between individual
buyers and designers. Using this approach, a company oriented, cost-conscious attitude is
developed at the lower level through out the organization.
IV. The Purchasing coordinator approach
One or more positions are created in the purchasing department for individuals, frequently
called material engineers, to serve in a liaison capacity with the design department.
Typically, the materials engineers spends most of his or her time in the engineering
department reviewing design work as it comes off the drawing boards.
6.4.1.2 Writing specifications
After the design of a product determined, the next step is to translate the individual part and
materials specifications into written form. The need for clarity and precision of expression is
important in all business communications.
To meet the needs of all departments, specification must satisfy many requirements.
-
Design and marketing requirements for functional characteristics, chemical
properties, dimensions, appearance etc.
-
Manufacturing requirements for workability of materials and product ability
-
Inspection’s requirements to test materials for compliance with the specifications.
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-
Stores requirement to receive, stores, and issue the material economically.
-
Purchasing and supply management’s requirement to procure material without
difficulty and with adequate competition from reliable sources of supply
-
Production controls and purchasing requirement to substitute material when such
action becomes necessary.
-
Total firm’s requirement for suitable quality at the lowest over all cost.
6.4.1.3 Types of specifications
There are different types of specifications among which the main once are described below.
a. Chemical specifications. Explain the nature of material and how it reacts in relation to
another materials and environment.
b. Physical specification. Explain the size and dimension of the materials such as length,
weight, thickness etc.
c. Material specification. Explain from what materials the product is made such as
wood, plastic, steel etc.
d. Method specification. It explains the method used to in making a product i.e. manual,
mechanical etc.
e. Blue prints. These are special types of specifications used for constitution. Blue prints
are usually diagrams and illustrating of building and other construction items.
Check Your Progress Exercise
1. List and describe the major classifications of purchase descriptions.
___________________________________________________________________________
__________________________________________
2. Briefly explain the importance of specifications
___________________________________________________________________________
__________________________________________
3. What are the different types of specifications?
___________________________________________________________________________
__________________________________________
4. What are the purposes of Purchase descriptions? Explain.
___________________________________________________________________________
__________________________________________
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6.4.2 Other purchase description
6.4.2.1 Performance specifications
A performance specification in theory is a perfect method of describing a requirement.
Instead of describing an item in terms of its design characteristics, performance
specifications describe in wards, and quantitatively where possible, what the item is required
to do.
This type of description is used extensively in buying highly technical military products. For
example the product wanted could be a missile capable of being launched from particular
place with a designated speed, range and accuracy.
Potential suppliers are told only the performance that is required. Though performance is
specified in precise detail, suppliers are not told how the product should be manufactured or
what material should be used in its manufacture.
Performance specifications are not limited to such complex items as spacecraft electronic air
craft and automobile companies. It is also possible to use this method to buy such common
materials as electric wire, batteries and radios. A performance specification for wire may
require it to withstand a given temperature, have a designated resistance to abrasion, and
have a given conducting capability.
Industry uses performance specifications extensively to buy expensive complicated machines
and machine tools. Today more production machines are replaced because of technological
obsolescence than because of wear. Therefore, in buying such a machine, a firm should make
every effort to obtain the ultimate in technological advancement. Often this can be done best
by using performance specifications. To reduce and control the expense associated with this
approach to describing requirements, descriptions should be written as explicitly as possible.
There are two primary advantages of describing quality by performance specifications
i. Ease of preparing the specifications
ii. Assurance of obtaining the precise performance desired. For complex type of products
it is the easiest type of specification to write.
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6.4.2.2 Function and fit specifications
Such purchase descriptions are a variation of performance specifications and are used in
early supplier involvement programs. With this approach, the design team describes the
function to be performed and the way the item is to fit into the larger system. For example,
automobile, computers etc, together with several design objectives such as cost, weight,
reliability. As early supplier involvement becomes more common this approach to describing
requirements undoubtedly will increase in popularity.
6.4.2.3 Brand or trade names
When manufacturers develop and market a new product, they must decide whether or not to
brand it. Branding or differentiating a product is generally done to develop a recognized
reputation and gains repeated sales, protect the product against substitutes, maintain price
stability; and simplify sales promotion. The primary reason most manufactures brand their
product is to obtain repeated sales. Consumers develop a preference for brands. Therefore,
branded products can generally be sold at higher prices than unbranded products of similar
quality. A brand represents the manufacturers pledge that the quality of the product will be
consistent from one purchase to the next. A buyer can be certain that a reputable
manufacturer will strive to keep this pledge.
Brand name products are among the simplest to describe on purchase order. Thus, they save
purchasing time and reduce purchasing expense. Inspection expense is also low for branded
products.
6.4.2.4 Samples
Samples have been called the lazy person’s method of describing requirements. When
samples are used, the buyer does not have to look for an equal brand, pick standard
specification, or describe the performance wanted. Samples are neither the cheapest nor the
most satisfactory method of purchase. Usually the money saved in description costs are
substantially exceeded by the money spend on inspection costs. It is difficult to determine by
inspection that the product delivered is the same as the sample.
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Samples generally should be used only if other methods of description are not feasible. Color
and texture, printing and grading are three broad areas in which other method of descriptions
are not feasible.
6.4.2.5 Grading
Grading is a method of determining the quality of commodity. A grade is determined by
comparing a specific commodity with standards preciously agreed on. Grading is generally
limited to natural products such as lumber, wheat, hides, cotton, tobacco, food products and
so on. The value of grades as a description of quality depends on the accuracy with which the
grades can be established and the ease with which they can be recognized during inspection.
In buying graded commodities, industrial buyers often use personal inspection as a part of
their buying technique. Just as individuals select by inspecting the shoes, dresses and shirts
they buy, so industrial buyers select by inspecting some of the commodities they buying in
primary markets. There can be a significant difference between the upper and the lower grade
limits of many commodities. The difference is so great that materials near the lower limit of
the grade may be unacceptable.
6.4.2.6 Combination of methods
Many products cannot adequately be described by a single method of description. In such
case, a combination of two or more methods should be used. For example, in describing the
quality desired for a particular vehicle, performance specifications could be used to describe
numerous over all characteristics of the vehicle, such as its ability to withstand certain
temperatures, to perform certain predetermined maneuvers in space at precise time
sequences, etc. physical specification could be used to describe the vehicles configuration as
well as other instruments it will carry. Commercial standards or brand names might be used
to describe selected pieces of electrical or mechanical hardware used in the vehicle’s support
systems. A chemical specification could be used to describe the vehicles paint. Finally, a
sample could be used to show the color of this paint.
Check Your Progress
1. Explain the various types of purchase descriptions.
___________________________________________________________________________
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6.5 Standardization
Standardization is the process of establishing agreement on uniform identifications for
definite characteristics of quality, design, performance, quantity, service and so on.
Standards reduce Varity and create consistencies. Standards are usually essential in exchange
of parts. The use of standards permits a firm to purchase fewer items in large quantities and
lower price. This reduces purchasing, receiving, inspection and payment costs. Stocking
fewer items makes controlling inventories easier and less costly. Consequently, the purchase
of standard materials saves money in the following ways.
i. Lower price
ii. Lower processing costs
iii. Lower inventory carrying costs
iv. Fewer quality problems
6.5.1 Kinds of industrial standards
In industry there are three basic kinds of material standards.
i. Company standards
ii. Industry or national standards
iii. International standards
If an elevator or user cannot adopt national or international standards for his purpose, the
second choice is to use company standards. Where can one get standard specification?
Specification for items that have been standardized can be obtained from the organization
that have developed them such as international standard organization (ISO), National Bureau
of Standard (such as Quality and Standards Authority of Ethiopia (QSAE)), etc.
6.5.2 International standards
The need for international standards is fundamental. By eliminating technical trade barriers,
international trade standards facilitate increased international trade and prosperity. The ISO
9000 serves the quality standards, now used voluntarily world wide is good illustration.
Establishing the multi national trade agreements, the mechanism used to create international
standard was relatively easy. However, actually getting international standards adopted in
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some cases will be a long difficult task. The economic states associated with the development
of international standards are so high-in terms of increased international trade and prosperity.
Because private organizations national and regional governments and other international
organizations are all involved in the adoption process, political fighting is un escapable.
In general, the concept and advantages of international standards are widely recognized and
accepted. Progress toward their implementation is being made. As in most international
efforts, however, progress is slow.
6.5.3 Commercial standards
Recurring needs for the same materials have led industry and government to develop
commercial standards for these materials. A commercial standard is nothing more than a
complete description of the item standardized. The description includes the quality of
materials and workshops that should be used in manufacturing the item, along with
dimensions, chemical composition, etc. It also includes a method for testing both materials
and workmanship. Commercial standards are a cornerstone of the mass production system.
Therefore, they are important to efficient purchasing and to the standard of any product.
Materials order by standard specifications leave no doubt on the part of either the buyer or
the seller as to what is required. Standard specifications have been prepared for many goods
in commercial trade. National trade associations, standards associations, national engineering
societies, the government and national testing associations all contribute to standard
specifications and standard method of testing. Commercial standards are applicable to raw
materials, fabricated materials, individual parts and component and sub assemblies.
Purchasing by commercial standards is some what similar to purchasing by brand name. In
both methods, the description of what is wanted can be set forth accurately and easily. With
the exception of proprietary products, most widely used items are standard in nature; hence,
they are highly competitive and readily available at reasonable prices. There are many users
of standard products; therefore, manufacturers who make them can safely schedule low-cost
production runs for inventory.
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Inspection is only moderately expensive for materials purchased by commercial standards.
Commercial standard products require periodic checking in addition to sight identification to
assure buyers that they are getting the quality specified.
Commercial standard items should be used whenever possible. They contribute greatly to the
simplification of design, purchasing procedures, inventory management and cost reduction.
Copies of standard specifications can be obtained from a number of government, trade
association, and testing association sources. However the easiest way to get a particular
specification is to ask a manufacturer to provide a copy of the standard specification of
material.
Check your progress
1. How the purchases of standard materials save money? Explain
________________________________________________________________________
__________________________________________________________________
2. What are the different kinds of standards?
________________________________________________________________________
__________________________________________________________________
3. What is commercial standard?
________________________________________________________________________
__________________________________________________________________
6.6 Simplifications
Simplification means reducing the number of standard item a firm uses in its product design
and carries in its inventory.
Some authorities consider simplification an integral part of standardization, rather than a
corollary of it. They visualize the simplification process or taking place primarily at the
design level, rather than at the stocking level, they think in terms of simplifying (or reducing)
the number of related items that is approved as standard in the first places.
The absence of a simplification program affected the cost of goods sold in another way. In
many instances, design engineers were specifying raw materials that were similar but not
identical to materials already in use for other products.
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For example, one company formerly used twenty-seven different kinds of standard
lubricating greases in the maintenance of its machinery. Analysis showed that in some cases
the same greases could be used for several different applications and that totals of only six
kinds of greases were needed. Hence, through simplification the number of standard greases
used was reduced from twenty-seven to six.
Check Your Progress
1. What is Specification?
________________________________________________________________________
________________________________________________________________________
__________________________________________
2. Explain the similarity and difference of simplification and standardization.
________________________________________________________________________
________________________________________________________________________
__________________________________________
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6.7 Summary
We have said that quality is frequently defined as “fitness, excellence, free of defect”,
Quality is defined on various basis. On the basis of product, quality is viewed as quantifiable
or measurable characteristics or attributed. On the basis of its manufacturing, quality is
“conformance” to requirement. On the basis of the user quality is an individual matter, and
products that best satisfy this preference.
Quality is viewed from its total management. In this sense, total quality managements (TQM)
is a philosophy that uniform commitment to quality in all areas of the organization will
promote a culture that meets consumer’s perceptions of quality.
Purchase description is specifying the quality requirement when at the time the purchase
order is written. Purchase description serves the purpose to:
-
communicate to the buyer in the purchasing department what to buy
-
communicate to prospective suppliers what is required
-
serve as the heart of the resulting purchase order
-
establish the standard
Purchase description is classified into two broad categories – detailed specification and other
purchase descriptions.
There are four approaches to develop specifications. These are:
-
early purchasing and supplier involvement
-
the formal committee approach
-
the informal approach and
-
the purchasing coordinator approach
Standardization is the process of establishing agreement on uniform identifications for
definite characteristics of quality, design performance etc.
Simplification is simply reducing the number of standard items a firm uses in its production
design and carries in its inventory.
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6.8 Answers to Check Your Progress Questions
1. Product, user, manufacturing etc.
2. When product quality is based on individual tats, the bases for measurement may be
misleading.
3. Refer No. 6.3
4. Detailed specification and other purchase descriptions.
5. Refer No. 6.4.1.1
6. Refer No. 6.4.1.3
7. It serves to communicate to buyers, suppliers, and serves as standard for inspections,
tests and quality.
8. Performance specification, function and fit specifications, brand or Trade Name,
samples, and grading.
9. By: lower price, lower processing cost, lower inventory carrying cost, and fewer
quality problems.
10. Company standards, industry or national standards, international standards.
11. Refer No. 6.5.3
12. Refer No. 6.6
13. Simplification is reducing the number of standards whereas standard is producing
uniform products.
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6.9 Reference
1) Purchasing Management: Material’s in Motion by J.H. Westing, IR. Fine and G.J Zent.
2) Purchasing and Materials Management by Donald W. Dobler, Lamar Lee, Jr. and David
N. Burt.
3) Production and Operational Management by Everett E. Adams Jr. Ronald J. Ebert.
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