Ethical and Sustainable Sourcing

BEER GAME QUESTIONS AND EXERCISES

Chapter 4 Ethical and Sustainable Sourcing

3 5

Chapter 2

P U R C H A S I N G M A N A G E M E N T

The primary function of the Purchasing Department is to assist our university with the identification, selection and acquisition of required materials and services. Purchasing strives to accomplish this as economically as possible, within acceptable standards of quality and service, while utilizing professional ethics and best business practices throughout the process.1

Total cost of ownership can be determined for a wide variety of corporate initiatives, but when it comes to sustainability—and, especially, social responsibility—hard numbers aren’t always clear.2

Learning Objectives

After completing this chapter, you should be able to

• Understand the role of supply management and its strategic impact on an organization’s competitive advantage.

• Have a basic knowledge of the traditional purchasing process, e-procurement, public procurement and green purchasing.

• Understand and know how to handle small value purchase orders.

• Understand sourcing decisions and the factors impacting supplier selection.

• Understand the pros and cons of single sourcing versus multiple sourcing.

• Understand centralized, decentralized and hybrid purchasing organizations.

• Describe the opportunities and challenges of global sourcing and understand how globalization impacts supply management.

• Understand and compute total cost of ownership.

Chapter Outline

Introduction

A Brief History of Purchasing Terms

The Role of Supply Management in an Organization The Purchasing Process

Sourcing Decisions: The Make-or-Buy Decision Roles of Supply Base

Supplier Selection How Many Suppliers to Use Purchasing Organization

International Purchasing/Global Sourcing Procurement for Government/Nonprofit Agencies Summary

Supply Chain Management in Action

The Key to an Effective Purchasing System: Is It Technology or Supplier Relationship Management?3

Las Vegas based Harrah’s Entertainment Inc., founded in 1937, is one of the world’s largest pro- viders of branded casino entertainment. The company has expanded rapidly through the development of new properties, expansions and acquisitions. On January 28, 2008, Harrah’s was acquired by private-equity firms TPG Capital and Apollo Global Management. Harrah’s operates 52 casinos in six countries and had a net revenue in excess of $9 billion in 2009. Harrah’s owns the famous World Series of Poker and eight properties in Las Vegas—Bally’s, Caesars Palace, Flamingo, Harrah’s, Paris, Rio, Bill’s and Imperial Palace.

Harrah’s operates multiple restaurants in each property. Since foods and beverages account for at least 25 percent of the costs of restaurant sales, it is imperative that Harrah’s has a well- designed supply management system that maintains tight control of the purchasing process and yet provides maximum service to the chefs and other users of the system. Moreover, the system must ensure that suppliers are treated fairly and professionally. Supply management effectiveness impacts not only the operating costs of a restaurant, but more importantly its quality, customer service and ability to introduce new menus quickly.

The Las Vegas division of Harrah’s uses a centralized-decentralized or hybrid purchasing structure that stresses contemporary management philosophy to enable buyers to purchase foods, beverages and operating supplies efficiently and effectively. Contrary to the traditional adversar- ial approach that forces suppliers to bid on each purchase or contract to achieve lowest purchase cost, Harrah’s purchasing system stresses long-term, mutually beneficial buyer–supplier relationships, trust and single sourcing to achieve lowest total acquisition cost.

Harrah’s uses a centralized structure to negotiate blanket orders at the national and regional level, whereas a decentralized structure is used to release orders by buyers at each property.

The regional purchasing office selects the best supplier, and negotiates a blanket order for each item based on quality, reliability, delivery and total costs of acquisition. Estimated usage, price and delivery terms along with the corresponding tolerance for each performance measure are negotiated for each blanket order. The blanket orders are then made available to the buyers at each property, called property buyers, via a computer database. Property buyers purchase goods by issuing order releases against the appropriate blanket orders without the need to re- negotiate prices and delivery terms. Once an order is released, suppliers must deliver the products according to specified terms.

Harrah’s uses a single source for most of its products to achieve purchase volume concentration, low cost and high quality service. However, competing suppliers’terms are listed side-by-side to the single source so that the single source’s performance can be monitored and benchmarked against current market conditions. Besides, this information allows the company to locate an alternate source quickly if problems arise with its single source.

The hybrid purchasing system has many benefits, including cost and time savings by eliminating duplicate bidding by each property for the same product. Moreover, the system allows the regional purchasing office to fully utilize its contracted suppliers, national contracts, regional contracts and other programs. Most notably, the regional office preserves the four fundamental purchasing rights toselect the supplier,use whichever pricing method is appropriate,question the specificationsandmonitor contacts with potential suppliers.

Introduction

In the context of supply chain management (SCM), Thepurchasing profession can be defined as the act of obtaining merchandise; capital equipment; raw materials; services;

or maintenance, repair and operating (MRO) supplies in exchange for money or its equivalent. The purchasing profession can be broadly classified into two categories:

merchants and industrial buyers. The first category, merchants, includes the wholesalers and retailers, who primarily purchase for resale purposes. Generally, merchants purchase their merchandise in volume to take advantage of quantity discounts and other incentives such as transportation economy and storage efficiency. They create value by consolidating merchandise, breaking bulk and providing the essential logistical services. The second category is the industrial buyers, whose primary task is to purchase raw materials for conversion purposes. Industrial buyers also purchase services; capital equipment; and maintenance, repair and operating supplies. The typical industrial buyers are the manufacturers, although some service firms such as restaurants, landscape gardeners and florists also purchase raw materials for conversion purposes.

An effective and efficient purchasing system is crucial to the success of a business.

Indeed, the Annual Survey of Manufactures4 shows that the total cost of materials exceeded value added through manufacturing in the U.S. Thus, it is not surprising that purchasing concepts and theories that evolved over the last two decades focused on industrial buyers’ purchases of raw materials and how purchasing can be exploited to improve competitive success.

The primary focus of this chapter is the industrial buyer. The chapter describes the role of purchasing in an organization, the processes of a traditional purchasing system and the common documents used, how an electronic purchasing system works, various strategies for handling small order problems, the advantages and disadvantages of centralized versus decentralized purchasing systems, purchasing for nonprofits and government agencies, sourcing issues including supplier selection and other important topics affecting the role of purchasing and supply management in supply chain management.

A Brief History of Purchasing Terms

Purchasing is a key business function that is responsible for acquisition of the required materials, services and equipment. However, acquisition of services is widely called contracting. The increased strategic role of purchasing in today’s business setting has brought a need for higher levels of skill and responsibility on the part of the purchasing professionals. Consequently, the term supply management is increasingly being used in place of purchasing to describe the expanded set of responsibilities of the purchasing professionals. The traditional purchasing function of receiving requisitions and issuing purchase orders is no longer adequate, but a holistic and comprehensive acquisition strategy is required to meet the organization’s strategic objectives.

The Institute of Supply Management (ISM) defines supply management as the“identification, acquisition, access, positioning and management of resources an organization needs or potentially needs in the attainment of its strategic objectives.”5Key activities of supply management have expanded beyond the basic purchasing function to include negotiations, logistics, contract development and administration, inventory control and management, supplier management and other activities. However, purchasing remains

Chapter 2 Purchasing Management 39

the core activity of supply management. Although procurement is frequently used in place of purchasing, procurement typically includes the added activities of specifications development, expediting, supplier quality control and some logistics activities; hence it is widely used by government agencies due to the type of purchases and frequent service contracting they made with government suppliers. However, it is difficult to clearly dis- tinguish where purchasing activities end and the supply management function begins.

Moreover, many organizations are still using these terms interchangeably. In many parts of this book, we have retained the traditional term“purchasing”in place of“supply management”to emphasize the term’s original meaning.

The Role of Supply Management in an Organization

Traditionally, purchasing was regarded as being a service to production and corporate executives paid limited attention to issues concerned with purchasing. However, as global competition intensified in the 1980s, executives realized the impact of large quan- tities of purchased material and work-in-process inventories on manufacturing cost, quality, new product development and delivery lead time. Savvy managers adopted new supply chain management concepts that emphasized purchasing as a key strategic business process rather than a narrow specialized supporting function to overall business strategy.

The Annual Survey of Manufactures (Table 2.1), conducted by the U.S. Census Bureau, shows that manufacturers spent more than 50 percent of each sales dollar (shown as “value of shipments”) on raw materials (shown as “cost of materials”) from 1977 to 2006. Purchases of raw materials actually exceeded value added through manufacturing (shown as “manufacture”), which accounted for less than 50 percent of sales. Purchases as a percent of sales dollars for merchants are expected to be much higher since merchandise is primarily bought for resale purposes. Unfortunately, aggre- gate statistics for merchants are not readily available.

However, individual information can easily be obtained from the annual reports of publicly traded companies, either directly or from the U.S. Securities and Exchange Commission (SEC). For example, Wal-Mart Stores, Inc., reported that its cost of sales was more than 75 percent of its net sales for the three most recent fiscal years ended January 31, 2008, 2009 and 2010. This ratio shows the potential impact of purchasing on a company’s profits. Therefore, it is obvious that many successful businesses are treat- ing purchasing as a key strategic process.

The primary goals of purchasing are to ensure uninterrupted flows of raw materials at the lowest total cost, to improve quality of the finished goods produced and to maximize customer satisfaction. Purchasing can contribute to these objectives by actively seeking better materials and reliable suppliers, working closely with and exploiting the expertise of strategic suppliers to improve the quality of raw materials, and involving suppliers and purchasing personnel in product design and development efforts. Purchasing is the crucial link between the sources of supply and the organization itself, with support coming from overlapping activities to enhance manufacturability for both the customer and the supplier. The involvement of purchasing and strategic suppliers in concurrent engineer- ing activities is essential for selecting components and raw materials that ensure that req- uisite quality is designed into the product and to aid in collapsing design-to-production cycle time.

Table 2.1 Cost of Materials as a Percentage of the Value of Shipments

VALUE OF SHIPMENTS COST OF MATERIALS MANUFACTURE CAPITAL EXPENDITURES

YEAR $ MILLIONS $ MILLIONS % $ MILLIONS % $ MILLIONS %

2006 $5,015,553 $2,752,904 54.9% $2,285,929 45.6% $135,801 2.7%

2005 $4,742,077 $2,557,601 53.9% $2,210,349 46.6% $128,292 2.7%

2004 $4,308,971 $2,283,144 53.0% $2,041,434 47.4% $113,793 2.6%

2003 $4,015,387 $2,095,279 52.2% $1,923,415 47.9% $112,176 2.8%

2002 $3,914,719 $2,022,158 51.7% $1,889,291 48.3% $123,067 3.1%

2001 $3,967,698 $2,105,338 53.1% $1,850,709 46.6% $142,985 3.6%

2000 $4,208,582 $2,245,839 53.4% $1,973,622 46.9% $154,479 3.7%

1999 $4,031,885 $2,084,316 51.7% $1,954,498 48.5% $150,325 3.7%

1998 $3,899,810 $2,018,055 51.7% $1,891,266 48.5% $152,708 3.9%

1997 $3,834,701 $2,015,425 52.6% $1,825,688 47.6% $151,510 4.0%

1996 $3,715,428 $1,975,362 53.2% $1,749,662 47.1% $146,468 3.9%

1995 $3,594,360 $1,897,571 52.8% $1,711,442 47.6% $134,318 3.7%

1994 $3,348,019 $1,752,735 52.4% $1,605,980 48.0% $118,665 3.5%

1993 $3,127,620 $1,647,493 52.7% $1,483,054 47.4% $108,629 3.5%

1992 $3,004,723 $1,571,774 52.3% $1,424,700 47.4% $110,644 3.7%

1991 $2,878,165 $1,531,221 53.2% $1,341,386 46.6% $103,153 3.6%

1990 $2,912,227 $1,574,617 54.1% $1,348,970 46.3% $106,463 3.7%

1989 $2,840,376 $1,532,330 53.9% $1,325,434 46.7% $101,894 3.6%

1988 $2,695,432 $1,444,501 53.6% $1,269,313 47.1% $84,706 3.1%

1987 $2,475,939 $1,319,845 53.3% $1,165,741 47.1% $85,662 3.5%

1986 $2,260,315 $1,217,609 53.9% $1,035,437 45.8% $80,795 3.6%

1985 $2,280,184 $1,276,010 56.0% $1,000,142 43.9% $91,245 4.0%

1984 $2,253,429 $1,288,414 57.2% $983,228 43.6% $80,660 3.6%

1983 $2,045,853 $1,170,238 57.2% $882,015 43.1% $67,480 3.3%

1982 $1,960,206 $1,130,143 57.7% $824,118 42.0% $77,046 3.9%

1981 $2,017,543 $1,193,970 59.2% $837,507 41.5% $83,767 4.2%

1980 $1,852,668 $1,093,568 59.0% $773,831 41.8% $74,625 4.0%

1979 $1,727,215 $999,158 57.8% $747,481 43.3% $65,797 3.8%

1978 $1,522,937 $877,425 57.6% $657,412 43.2% $58,346 3.8%

1977 $1,358,526 $782,418 57.6% $585,166 43.1% $51,907 3.8%

Source:“2006 Annual Survey of Manufactures,”Annual Survey of Manufactures, U.S. Census Bureau, November 18, 2008.

Chapter 2 Purchasing Management 41

The Financial Significance of Supply Management

Undoubtedly, purchasing has become more global and gained strategic corporate focus over the last two decades. The increasing use of outsourcing noncore activities has further elevated the role of purchasing in a firm. In addition to affecting the compet- itiveness of a firm, purchasing also directly affects profitability. Next, we discuss the financial significance of purchasing on a firm.

Profit-Leverage Effect

Purchase spend is the money a firm spends on goods and services. Theprofit-leverage effect of purchasing measures the impact of a change in purchase spend on a firm’s profit before taxes, assuming gross sales and other expenses remain unchanged. The measure is commonly used to demonstrate that a dollar decrease in purchase spend directly increases profits before taxes by the same amount. However, it is important to remember that a decrease in purchase spend must be achieved through better purchasing strategy that enables the firm to acquire materials of similar or better quality and yield at a lower total acquisition cost. The profit-leverage effect example in Table 2.2 shows that if a firm manages to lower its purchase spend on materials by $20,000, profits before taxes increase by $20,000 because purchase spend on materials is a part of the cost of goods sold. Indeed, the reduction in purchase spend has an identical impact on gross profits. Table 2.2 shows that gross profits also increased by $20,000 from $500,000 to

$520,000. The direct effect of purchasing on a firm’s profitability is a key reason that drives business executives to continually refine the sourcing function. Boosting sales and cutting costs are not the only ways to increase profits. An often overlooked but very efficient means to improve profits is through smarter purchasing.

Return on Assets Effect

Return on assets (ROA) is a financial ratio of a firm’s net income in relation to its total assets. The ratio is also referred to asreturn on investment (ROI). In the context of accounting, total assets consist of current and fixed assets. Current assets include cash, accounts receiv- able and inventory, whereas fixed assets include equipment, buildings and real estate. ROA indicates how efficiently management is using its total assets to generate profits. A high ROA suggests that the management is capable of generating large profits with little investment.

Assuming the firm in Table 2.2 has total assets of $500,000, its ROA is ten percent ($50,000 ÷ $500,000). If the firm reduces its purchase spend on materials by $20,000 through a more effective purchasing strategy, its ROA increases to fourteen percent ($70,000 ÷ $500,000). The $20,000 reduction in purchase spend on materials is also likely to result in a lower raw material inventory (and thus lower total assets).

Table 2.2 Profit-Leverage Effect

SIMPLIFIED PROFIT &

LOSS STATEMENT

REDUCE MATERIAL COSTS BY $20,000

Gross Sales/Net Revenue $1,000,000 $1,000,000

−Cost of Goods Sold (Materials + Manufacturing Cost) −$500,000 −$480,000

Gross Profits $500,000 $520,000

−General & Administrative Expenses (45%) −$450,000 −$450,000

Profits Before Taxes $50,000 $70,000

However, its effect on ROA is difficult to quantify because the portion of a firm’s raw material inventory to its total assets, and the ratio of materials cost to its total cost of goods sold, vary widely depending on the firm and industry.

Inventory Turnover Effect

Inventory turnover shows how many times a firm’s inventory is utilized and replaced over an accounting period, such as a year. There are numerous ways to compute the inventory turnover ratio, but a widely used formula is the ratio of the cost of goods sold over average inventory at cost. In general, low inventory turnover indicates poor sales, overstocking and/or obsolescence. Through a more effective sourcing strategy, purchasing can help to reduce inventory investment, and thus improve the firm’s inventory turnover.

The Purchasing Process

The traditional purchasing process is a manual, paper-based system. However, with the advent of information technology, personal computers, local area networks and the Internet, many companies are moving toward a more automated, electronic-based system. The goal of a proper purchasing system is to ensure the efficient transmission of information from the users to the purchasing personnel and, ultimately, to the suppliers.

Once the information is transmitted to the appropriate suppliers, the system must also ensure the efficient flows of the purchased materials from the suppliers to the users and the flow of invoices from the suppliers to the accounting department. Finally, the system must have adequate operational orinternal controlto prevent abuse of purchasing funds.

For example, purchase orders (POs) should be pre-numbered and issued in duplicate and buyers should not be authorized to pay invoices. Pre-numbered purchase orders make it easier to trace any missing or unaccounted-for purchase orders. A duplicate purchase order should be issued to the accounting department for internal control purposes and to inform the department of a future payment or commitment of resources.

The Manual Purchasing System

Figure 2.1 shows a simplified traditional manual purchasing system. While some manual systems may look slightly different than what is shown in Figure 2.1, it captures the essential elements of a good purchasing system that is easy to use and yet exerts adequate internal control of the process. The manual purchasing system is slow and prone to errors due to duplications of data entries during various stages of the purchasing process. For example, similar information on the material requisition, such as the product description, is reproduced on the purchase order.

The Material Requisition

The purchasing process starts when the material user initiates a request for a material by issuing a material requisition (MR) in duplicates. A purchase requisition, instead of a material requisition, is used in some firms. The product, quantity and delivery due date are clearly described on the material requisition. The number of duplicates issued depends on the internal accounting control system of the organization. Generally, the issuer retains a copy and the warehouse receives the original plus a duplicate. The duplicate accompanies the material as it moves from the warehouse to the user. This copy also provides the essential information for the accounting department to charge the appropriate user or department for the material.

While most requisitions are transmitted through the generic material requisition, a traveling requisitionis used for materials and standard parts that are requested on a recurring

Chapter 2 Purchasing Management 43

basis. Instead of describing the product on the generic material requisition, the product description and other pertinent information, such as delivery lead time and lot size, are pre- printed on the traveling requisition. When a resupply is needed, the user simply enters the quantity and date needed and submits it to the warehouse. Once the resupply information is recorded, the traveling requisition is returned to the user for future requests.

Planned order releasesfrom the material requirements planning (MRP) system or a bill of materials (BOM) can also be used to release requisitions or to place orders directly with the suppliers. This approach is suitable for firms that use the same components to make standard goods over a relatively long period of time.

If the requested material is available in the warehouse, the material is issued to the user without going through the purchasing department. Otherwise, the requisition is assigned to a buyer who is responsible for the material. If there is a better substitute for the material, purchasing recommends and works with the user to explore whether it is a viable substitute. However, purchasing personnel should not change the specifications of the materials or parts without the user’s knowledge and agreement. While it is the right and responsibility of purchasing personnel to select the appropriate supplier, the user in many cases may suggest a list of potential suppliers when requesting new material.

A sample material requisition is shown in Figure 2.2.

Figure 2.1 Traditional Manual Purchasing System

Ye s

PO 3

MR 2

MR 2 PO 4

PO 3 PO 2

MR 3 MR 2 No

MR 2

PO 2 DO 2

Ye s

PO 3

MR 2 PO 3

PO 3

MR 2 MR 2

Storage/Warehouse Purchasing

PO 4 PO 3 PO 2

PO 4 PO 4 PO 3 PO 3 PO 2 PO 2

MR 3 MR 2

MR 3 MR 3 MR 2 MR 2 No

MR 2 MR 2 MR 2 Issue PO

PO 2 PO 2 PO 2 DO 2

PO 2 DO 2 DO 2 PO 2 PO 2 DO 2

DO 2

Suppliers Users/Requisition Accounting

Materials Requisition

MR 1

Materials Requisition

MR 1

Materials Requisition

MR 1 MR2

Purchase Order

PO 1

Purchase Order

PO 1 PO 2

DO 3 DO 2

Delivery Order DO 1

Delivery Order DO 1 Ship

Materials

INV 2

Invoice INV 1

PO File

Materials Available?

START

Issue

Materials Materials

Accounts Payable

Invoice INV 1 Accounting Information for charging the

appropriate department

MR File MR File

Introduction to Supply Chain Management