CHAPTER III

PURCHASING
3.1 Meaning of Purchasing
Purchasing function comprises the essential activities associated with the acquisition of
material used in the operation of an organization. Because all organization requires
supplies of materials, purchasing functions is common in almost all organizations.
Generally: Purchasing is the activity of buying things that a company needs, such as
material, parts and equipment.
Specifically: Purchasing is the activity of acquiring materials with right quality, quantity,
price, source and time.
Purchasing can be defined as ensuring right – price, quality, contractual term, time,
source, material, mode of transportation and attitude for all organizations (big or small,
business or non-business, public or private) depend on varying degrees for materials
and sources acquired through a group of activities known as procurement.
There are two basic types of purchasing in business
i. Purchasing for sale is performed primarily by merchants.
ii. Purchasing managers who buy materials for consumption or
conversion performed primarily by manufacturing firms.
3.2 Objectives of purchasing
The standard statement of the overall objectives of purchasing function is obtaining the
right material (meeting quality requirements), in the right quality, for delivery at the
right time and to the right place, from the right source at a right condition.
The objectives of purchasing can be viewed from:
1. a very general managerial level
2. more specific operational level
3.2.1 General managerial level:
From their prospective, relates to the five rights the management expects the
purchasing department to achieve:
 The right quality
 The right quantity
 From the right supplier
 At the right time
 At the right price
3.2.2 Functional level
 To support company operations with an interrupted flow of materials
- this is the most fundamental of all purchasing objectives
- in a logical sense this is a key reason for the existence of the department
 To procure material wisely
- as much as possible with low cost
 To keep inventory investment and inventory losses at a practical minimum.
- Although maintaining a large inventory is one way to achieve objectives, it is
also costly. Hence, the purchasing department job is to achieve a reasonable
balance because the level of inventory required supporting operations and
cost of carrying the inventory.

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 - JIT (Just-in-time) production inventory system helps considerably in
achieving their objective.
- Though proper buying, handling, storing, if is also the department is
responsible to minimize losses that occur.
 To develop effective and reliable source of supply.
- It involves the identification, investigation, selection and development of
competent and responsive suppliers.
- Progressive buyers tend increasingly to “buy suppliers’ as opposed to simply
“buying products” which may lead to develop partnering
arrangements/strategic alliance with the suppliers.
 To develop good relationship with supplier community and good continuing relationship
with active suppliers.
 To achieve maximum integration with other departments of the firm.
- understand material needs of user department
- Support user department in actions like material standardization, forecasting
future prices, performing more or by analysis.
 To hand the purchasing functions proactively: in a professional, cost effective
manner.
3.3 Purchasing Policies
Policies are general statements, understanding, and guidelines in making operating
decisions that channel actions toward achievement of the objectives. Policies are areas
within which a decision is to be made and assure that the decision will be consistent
and contribute to objectives clarity and improve relationship with other functions.
Purchasing polices are aids for purchasing decisions.
There are two approaches of placing purchasing function;
I. Centralized II. Decentralized
I. Centralized Purchasing
Centralization exists when the entire purchasing function is made the responsibility of a
single person i.e purchasing personnel. This person is held accountable for performance
of purchasing activities.
This type purchasing is suitable for
Industries having single plant or
Number of plants nearby locations, which are manufacturing similar products
at various plants.
Advantage
Quantity discount
Simplifies purchasing procedures
simplifies the payment of invoices
Disadvantage
Slow decision making
May not satisfy departments interest
Does not spread risk
II. Decentralized purchase

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Decentralization of purchasing occurs when personnel from other functional areas-
operation marketing, finance, HRM, e.t.c decide unilaterally on sources of supply or
negotiate with suppliers directly for major purchases.

This type purchasing is suitable for

Industries having plants at different location and manufacture variety of
product.
Advantage
Improved efficiency
Faster procurement
Diversity of risk
Disadvantage
 Losing control
 Difficulty of obtaining discounts
3.4 Purchasing Procedures
A procedure outlines in detail the specifications to be taken to accomplish a given task,
within the guideline of any applicable policies. In short, it establishes the way of doing
things.
Purchasing procedure/purchasing cycle/purchasing process comprises the following
basic steps.
1. Recognize, define and describe the need (purchase requisition)
2. Verification of purchase requisition
3. Request for Quotation (Bids, price quotation)
4. Evaluation and selection of suppliers
5. Issuance of purchase order
6. Follow up and expediting
7. Receipt, and inspection of materials
8. Checking of invoices and bill payment
9. Completion of the records and files
10. Evaluation of the purchase process
1. Recognition, Definition and Description of need Purchase Requisition (PR)
The need for purchase typically originates in one of a firm’s operating department or in
its inventory control section.
The purchasing department is usually notified of the need by one of the three basic
methods;
a. Standard Purchase Requisition (SPR)
b. Material Requirements Planning (MRP)
c. Bill of Materials (BOM)
a) Standard Purchase Requisition (SPR)
It is an internal document numbers serially for requests originating in the operating
departments. SPR is used for materials that have to be ordered from suppliers.
This Requisition form includes;
 Material name/code identification
 The amount needed

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  Desired delivery date
SPR formats vary widely because each company designs its format to simplify its own
Communication problem. A typical SPR is given below.

Date___________________ S. No________________
Date by which material is required_______
Department___________

Item Description Qty.

No

____________ _______________
Inventor Authorized by

The user department generally makes a minimum of two copies-one copy is sent to
purchasing, the other is retained in the using department’s file.

b) Material requirement Plan (MRP)

MRP is a technique for determining the quantity and timing for the requisition of
dependent demanded items.
c) Bill of Materials (BOM)
It is a complete list of all items incorporated in to a finished product with specifications
and quantity required of each item of materials.
2. Verification of Purchase Requisition
It involves the purchasing department responsibility for
 Checking the document for accuracy and completeness
 Determining that the need has adequately defined
 Ensuring that the appropriate method of description has been used.
3. Request for Quotation (Bids, price quotation)
A request for quotation is a process of initiating potential suppliers that are willing to
compete to supply the required material. The request depends on the type of materials
because some materials need “Request for quotation” and others not.
 Competitive bidding is dictated by five criteria.
a) The dollar value of the specific purchase must be large enough to
justify expense to both buyer and seller.
b) The market must consist of an adequate number of sellers.
c) The sellers that make up the market must be technically qualified and
willing to compete.
d) The specification/description is clear to both the buyer and seller
e) The time available must be sufficient for using competitive bidding
 Competitive bidding should not be used:
 When it is impossible to estimate costs with a high degree of certainty.

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  When price is not the only importance variable. Example, quality,
schedule and service are also variables of equal importance
 Repetitive and routine purchase
 Items of low value
 Single/few suppliers
 Invitation for Bids (IFB) or Request for Proposal (RFP) or Request for Quotation (REQ)
includes:
 Purchase
 description /specification  Any amendments
 Delivery schedule (timing &  Address for further information
mode)  Purchasing company
 Special terms/conditions  Term of payment
 Eligibility of suppliers  Last date of submitting bids
 Bid security (Bid bond and  Time, date and place of opening
Performance bond) the bid
4. Evaluation and Selection of suppliers
There are two primary supplier sources:
 Internal
 External.
The internal source: - is the company itself.
The external sources: - are the outside suppliers and the market place.
Thus, when evaluating and selecting a supplier, a buyer should try to find a supplier
who would meet the needs of the quality, quantity and delivery time (purchase
description and specification) at lower cost.
5. Issuance of purchase order (PO)
Once a supplier has been selected, the purchasing department prepares and issues a
serially numbered purchase orders. Purchase order (PO) is the instrument by which
goods are procured to fill a requirement. Once accepted, it has the legal force of a
binding contract.
 The essential information in every purchase order includes.
 Name and address of  Shipping instructions
purchasing company  Descriptions of materials
 Identifying order number ordered and the quantity
 Date, number and address of  Price and discounts
the vendor  Terms and conditions (also
 General instructions called boiler plate)
 Delivery date required  Signature
 Most companies prepare PO on multipart forms. These multipart forms provide
enough copies of the order to satisfy both internal and external common needs.
6. Follow-up and Expediting
Follow up: The objective of follow up is to see that the right quality and quantity of
materials is received at the right place and time. This means ensuring that
 Quotations are received on time
 Replies are received on time from suppliers.

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  The supplier(s) acknowledge the order and accept the delivery
schedule given.
 Materials are received according to the delivery schedule
Expediting: It is speeding up or accelerating the receipt of the item before the agreed
upon time.
7. Receipt and Inspection of Orders
 This procedure involves the following activities:
 Unpacking and checking the materials
 Completing the receiving report and distribute to each department.
 Receive incoming goods
 Sizing the delivery notice presented by the carrier
 Identify and record all incoming materials
 Report their receipt to the purchasing department
 Make prompt desperation of the goods to the appropriate department
 Inspection:
Whenever it is necessary to take technical inspection, we may make sample/all
inspection. This depends on the nature of material and/or the description of those
materials.
8. Checking of invoices and Bill payment
A simultaneous check and review of purchase order the receiving report and the
invoices.
 By checking the receipt report against the purchase order, the purchaser
determines whether the quantity and type of ordered is received.
 Comparing the invoice with the purchase order and receiving report the firm
verifies that the supplier’s bill is correctly priced and that it covers the proper
quantity of acceptable material.
Note. Theoretically, the purchasing department job is completed when the material
covered by the purchase order has been received. Thus, invoice auditing can be handled
by accounting personnel.
9. Completion of the records and files (Closing the order)
Closing the order simply entails a consolidation of all documents and correspondence
relevant to the order. The completed order is filled in the close order file. In most forms,
a completed order consists of:
 The purchase requisition (PR)
 Copy of the purchase order (PO)
 Acknowledgment
 Receiving report
 Inspection report
 Any notes and any notes/correspondence inventorying to the order
The completed order file thus, constitutes records of all activities encompassing the total
purchasing cycle.
10. Evaluation of the purchase process
This stage refers to the evaluation of the purchase process against the objective and
requirement of the overall organizational system.

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3. 5. Supplier Evaluation & Selection
A firm has two categories of suppliers; the firm itself and Outside suppliers. There are
four stages in selection process of right supplier;
I. Survey Stage
All possible sources are explored to obtain information about available suppliers and
searching for all likely suppliers. Potential sources to a buyer in establishing a list of
potential suppliers include;
- Supplier information file - Trade journals
- Trade exhibits - Company personnel
- Other purchasing depts. - Personal contacts
II. Inquiry (analysis) Stage
Inquiry stage involves prequalification of potential sources which narrows the filed
sources from possible sources to acceptable sources.
Factors to be considered:
 Location
 Services, which include arrangement of transport, insurance, after sale service-
installation, maintenance, repair warranty, discounts, convenient packaging, on
time delivery, purchase reforms.
III. Selection and Negotiation
Leads to the issuance of Purchase order and both subjective (qualitative) approach and
quantitative approach can be used.
IV. Experience Stage
This stage involves follow up to ensure that the supplier(s) meet the terms and
conditions of the contract and rating and evaluating supplier performance.
3.6 Supplier evaluation criteria
A supplier or vendor rating system is a continuous management process, designed to
measure, evaluate and improve supplier performance, enabling companies to make
informed future sourcing decisions.
The buyer evaluates the suppliers based on four rights
 The right quality
 The right quantity
 At the right time
 At the right price
Quality: the buyer compares the delivery to the agreed requirements
(specifications).
Quantity: the buyer compares the delivery to the agreed amounts.
Delivery Reliability: the date, a delivery is made should be checked against the
agreed date.
Price: the buyer compares actual prices against the agreed price.
After evaluating the supplier based on the above criteria, supplier that fulfills all
requirements will be selected.
3.7 Make or Buy Decisions

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An organization may be in need of different raw materials, parts, components or
products which are processed and/or assembled into a finished product. In sourcing a
part or product, it either purchases from an outside source or the firm may seek to
undertake production. Accordingly, any firm has the following three basic alternatives.
1. Buy the parts or products completely from an outside source
2. Make all the parts or products within the firm
3. Buy some materials or products and make the remaining.
Factors influencing make-or-buy decisions
Two factors stand out above all other when considering the make or buy decisions; Cost
and availability of production capacity. There are also certain factors on which make or
buy decisions can be based. Quantity, quality, availability and flexibility of supply,
control of trade secret and patents, research and development, and alternative sources
of supply are the important factors.
Considerations which favor making
 When the cost to make is substantially lower or less than the cost to buy
 When the suppliers are unable to meet specification in terms of quality and
performance
 When the company has idle capacity like idle space, skilled human resource,
equipment
 Need to exert direct control over production and/or quality
 Design secrecy required or trade secrets,
 When the experience is well suited to make
Consideration which favor buying
 When the cost to buy is substantially lower or less than the cost to make
 Suppliers research and specialized know-how
 Small volume requirements
 Limited production facilities
 Desire to maintain a multiple-source policy
 When other companies hold trade secrets or patents on a required material so
that it is not possible to make it.

Example 1: ABC Automobile factory produces luxury automobile. It has an opportunity

to produce tires which are currently purchased at 80 Birr each. Annual demand for the
product depends largely on economic conditions and this has been estimated at 37,500.
If the company produces the tire itself, it must renovate an existing work area and
purchase machines which will result in annual fixed costs of Birr 80,000. Variable costs
for labor, materials and overhead are estimated as Birr 60 per tire.
Required:
a) Should the company make or buy the cases?
b) At what volume of production is it more profitable to produce in-house
rather than purchase from an outside supplier?
Solution: A.
Total cost of buying TCB = Price x Demand
= Birr 80 x37, 500

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 = Birr 3,000,000
Total cost of making, TCM = TVC (D) + TFC
= variable cost/unit* D+ TFC
= 60 x 37,500 + 80,000
= Birr 2,330,000
Decision  to make (produce)
Amount saved  Birr. 3,000,000 – 2,330,000 = Birr 670,000

B. The breakeven point is the volume of production where the total costs to make equal
the total cost to buy
Total Cost of Make = Total Cost of Buy
VC + TFC = TCB
60x + 80,000 = 80x
20x = 80,000
Q = 4000 tires
 For volume below 4000 tires  Buy
 For volume above 4000 tires  Make

Example
Toyota Automobile factory produces different automobiles. The tires are currently
purchased at Birr 42 each. The company is considering producing in house. The labor,
materials and overhead costs are estimated as Birr 28 per tire and fixed costs would be
Birr 58,800. Demand is estimated as shown:

Demand D Probability
P(D)
2000 0.05
3000 0.10
4000 0.30
5000 0.40
6000 0.15
Required
a) Should the company produce the tires?
b) How much can be saved/lost by the company if it decides to produce?
c) At what volume of production, it becomes profitable to produce them
rather than buy from a supplier?
a) Demand, D = 2000 x 0.05 + 3000 x 0.10 + 4000 x 0.3 +5000 x 0.4 + 6000 x 0.15
= 4500 tires
Cost to buy: Birr 42 x 4500 = Birr 189,000
Cost to make: TVC + TFC
= 28 x 4500 + 58,800 = Birr 184,800
Decision: to make/produce
b) Saved amount: 189,000 – 184,800 = Birr 4,200
c) TCM = TCB

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 28x + 58,800 = 42x
42x – 28x = 58,800
14x = 58,800
= 4,200 tires
 For volume below 4,200 tires  Buy
 For volume above 4,200 tires  Make

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