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This chapter is from the book

Purchasing and Supply Management and Return on Investment (ROI)

Every dollar saved in purchasing is equivalent to a dollar of new income. Because purchasing is responsible for spending more than one-half of most companies’ total dollars highlights the importance of purchasing’s contribution to the bottom line. Figure 1-2 shows the relationship between cost-savings and ROI. This model is often called the Dupont model and is used in many situations to show how material cost-savings have a greater influence on the ROI than do sales increases, or how it is easier for companies to generate cost-savings versus increasing market share. With trained and skilled purchasing personnel, these cost-savings are often much less difficult to achieve than significant increases in market share. As indicated earlier, purchasing can influence both the top and bottom line of the organization. These two working in tandem have a significant influence on shareholder happiness.

Figure 1-2

Figure 1-2 Supply management and ROI

Figure 1-2 shows what happens if materials costs are decreased by 5 percent, or $120,000. The numbers in red are after the reduction. Given this scenario, the value of inventory also decreases 5 percent, but this is not following standard account rules and assumes that the value of the inventory is zero when the products are received at the reduced material costs. A cost-savings, in this situation, of $120,000 increases ROI by more than 3 percent. This is a valuable presentation to show the strategic opportunity that supply management has in improving stakeholder value.

Purchasing’s Role in Business

Purchasing is one of the basic functions common to all types of business enterprises. Business involves coordinating and integrating the six functions listed here,22 which all fall under the basic plan, source, make, deliver supply chain model made popular in the late 1990s.23

  1. Creation—The idea or design function
  2. Finance—The capital acquisition, financial planning, and control function
  3. Personnel—The human resources and labor relations function
  4. Supply—The acquisition of required materials, services, and equipment
  5. Conversion—The transformation of materials into economic goods and services
  6. Distribution—The marketing and selling of goods and services produced

A number of organizational units are responsible for executing the six functions. For example, research and design are typically engineering functions and most likely involved in the creation aspect. There are finance and accounting departments that typically manage the flow of financial resources into and out of the firm. The purchasing department is responsible for supply—however, other functions are involved as well, such as marketing in the purchase of advertising services.

Supply management has many interfaces with the different organizational units responsible for executing the primary business functions. Figure 1-3 represents many of the internal interfaces of the supply management function and just some of the many activities when the functions are required to interface. These internal organizations represent many of purchasing’s customers. Purchasing has a wide intra- and inter-organizational footprint.

Figure 1-3

Figure 1-3 Purchasing’s intra-organizational relationships and activities24

Many other areas of involvement exist within the organization that are not included in Figure 1-3, and, of course, many additional activities where the functions in Figure 1-3 interact. Many of these activities are discussed throughout this text. Some of the other interactions are briefly discussed here.

Purchasing and Engineering

The product costs associated with quality, material, fabrication, and production are linked to the design specifications. Specifications can be written in a manner that reduces or enlarges the number of firms willing to supply specific items. There can be conflict between engineering and purchasing simply because engineering tries to design the “ideal” product or services without regard for cost or availability of resources.

Often, differing performance metrics between purchasing and engineering generate the conflict, and many times this conflict is not easily resolved. However, involvement of purchasing in initial design conversations with engineering may facilitate better discussion and ultimately results. Another service that purchasing can provide engineering is helping to use “like components” so that there is no need to develop a new component that is already purchased for a different product line. Purchasing can help in reducing SKU proliferation, a problem common in many organizations.

One example of the relationship between engineering and purchasing is the case of a global electronics manufacturer. The specifications for pallet dimensions were supplied to the suppliers, but the suppliers were not following the specification and instead were shipping on multiple-sized pallets in varying conditions. The purchaser held the suppliers accountable for the appropriate pallet dimension and quality, and considered each one sent incorrectly as a defect. After standardization, damage from shipping decreased significantly, and the volume shipped per truckload increased significantly. This particular project led to a number of other improvements in packaging, waste reduction, improved container and trucking capacity utilization, and much more.

A company in the beauty products industry was delivering products to hundreds of countries around the world, many with different language and labeling requirements. In one instance, the company purchased a common jar for one of its products but then had the supplier label and ship each separately. This generated issues with SKU proliferation, and the company saw increasing inventories. The customers in China had different preferences than those in India and products would fall out of favor in one region before another. The purchasers worked with the engineers and the suppliers, and decided to “postpone” the labeling of the bottles. The volume of standard-size bottles increased significantly, the price of the bottles decreased, and the labels were added only when customer (and regional) specific demand was known.

Purchasing and Manufacturing

The timing and quantity of the receipt of purchases often strain the relationship between manufacturing and purchasing. Also, poor planning of requirements at the strategic level causes a bullwhip effect (discussed in the marketing interface). Purchasing needs sufficient time to qualify suppliers, develop competition, and negotiate and ultimately reduce opportunity for special production or premium transportation.

Trouble in this interface often arises because of poor forecasting and therefore poor production planning. Integrating demand and supply sides of the business in sales and operations planning has a tendency to improve the relationship and the outcomes. Also, coordinating in the early design stages for new products can help alleviate this conflict. New product development meetings are generally cross-functional and engage many members of the organization.

There are cases of standardization of materials, standardization of components, and simply reviewing material specifications prior to a purchase that have saved significant money over time. Also, in some cases it makes sense to pay more for an alternative material, as long as it is feasible to do so, and it may save in manufacturing costs in the long run.

Purchasing has to assist in achieving faster time to market and reduced time for changeovers and tool and line setup work by working with suppliers to improve capabilities and increase response time. Manufacturing has the goal of achieving faster time to market, decreasing operational costs and unnecessary setup times and waste. It is also often responsible for inventory costs and have a vested interest in keeping them at optimal levels. Shutting down a production line is extremely costly. There are reports of parts being helicoptered to an automobile manufacturing facility because the cost of a plant shut down was more than $1,000,000 per day. (That is what was invoiced to the supplier.) There are many stories of purchasers “flying” components to customers to avoid the penalties associated with shutting down a facility. Purchasers have had to find emergency sources of supply, often paying much higher costs to avoid a plant shutdown.

Purchasing and Marketing

Many marketing departments spend significant amounts of money on advertising and promotion. This is what typically generates sales. The problem is that sales and marketing activities are often not linked to supply and production activities. Customers often do not communicate promotions and therefore create even more supply chain problems.

Hau Lee, a professor at Stanford, coined the term bullwhip effect.25 The bullwhip effect occurs as even small increases in demand prompt the “whip” to get ever larger as it progresses down the supply chain. The bullwhip is shown in Figure 1-4.

Figure 1-4

Figure 1-4 A visualization of the bullwhip effect

There are four major causes of the bullwhip effect, and much of the cause is generated in the downstream in the supply chain.26 Upstream members tend to overcompensate because of historical issues with demand planning and forecasting.

  • Demand forecast updating—The problem here is that as each entity in the supply chain updates the forecast, it also includes safety stock, tends to buffer the orders of others, and tries to replenish its own stock. An automobile company was having serious trouble with forecasting, and the relationship among sales, marketing, operations, purchasing, and its supply base was strained. Not one entity in the chain believed in the accuracy of other entities’ “guesses.” The result was that at each stage, the person responsible increased the forecast (or the plan) sometimes by as much as 10 percent. If one person said he needed 100, the next person in line would add another 10 to that order and so on. This process trickled down through the bill of materials and ultimately all inventories increased: finished goods, work-in-process, and raw materials. Suppliers increasingly had to expedite materials, and the entire supply chain was operating inefficiently.
  • Order batching—Companies often place orders in batches. Sometimes, it is to reduce the administration of the orders, other times trying to out-guess the schedules of the manufacturers. In this situation, suppliers face erratic ordering with frequent increases and also frequent expediting because customers often don’t want to wait for a batch run. This process was common in the furniture industry in which changeovers in manufacturing were expensive to manage. The products were manufactured in batches and the orders were often allocated to customers based on a set of criteria. Customers knew that if they over-ordered, they would likely receive more of the batch being manufactured.
  • Price fluctuation—Special promotions and price discounts result in customers buying in larger quantities and stocking up. When prices increase, they stop buying, and the consumption patterns are destroyed. Retailers offer many pricing discounts and promotions to generate market demand. These promotions create demand that in effect will shortly vanish because customers will “stock up” while prices are low. An interesting story is about a family that bought peanut butter in bulk. When there was a promotion, and lower prices, the family would buy an entire case of the peanut butter. At one point, there was a salmonella scare in some of the brands of peanut butter. The “case” that was purchased was from the batches that were produced incorrectly. All the peanut butter was recalled and returned. All this fluctuation in demand patterns wreaks havoc on the supply chain. In addition, the forecasters will likely continue to use these demand patterns to forecast future demand and the problems continue to escalate.
  • Rationing and shortage gaming—When supply is low, manufacturers may ration their products. Customers, in an effort to get “the most,” will game the system by over-ordering. Generally, those customers with the most power will try to “hold” the product availability until their demands are known by placing unrealistic orders far in advance. When their demand is known, the orders are changed to reflect more realistic demand patterns. However, supplies were already ordered, labor was already scheduled, and capacity was already fixed on one product when it should have been on another.

All these bullwhip issues still occur today with potentially larger impacts on an extended supply chain. This is more than 15 years after the issues were identified. Prompt and frequent communication throughout the supply chain but especially from sales and marketing to manufacturing and purchasing about changes in sales forecast and expected changes in demand is necessary. Information sharing is one key to minimizing the bullwhip effect on the supply chain.

Another area in which purchasing and marketing are just beginning to interface is in applying the purchasing process to the marketing and advertising spend. Purchasers do not interfere on the design of these services but instead ensure contract compliance and are often involved directly in negotiations.

Purchasing and Finance

Finance is usually purchasing’s best friend and biggest supporter. The reason for this is that purchasing tries to develop ways to save money; it works with the supply base to ensure that the contracts are followed; and it helps to minimize overbilling and underbilling. There are many reasons that purchasers are involved with finance.

Poor financial planning and execution are the major causes of business failure.27 Purchasing is responsible for managing a lot of the financial resources available within a firm. There is a delicate balance between economic conditions and an organization’s financial resources. In some cases, it makes sense to allocate the organization’s finances to forward purchases to avoid a higher price. However, this is a decision that must be made carefully. There are many instances in which purchasers decided that forward buying made the most sense, but then prices fell and the purchaser was “stuck” with high-priced inventory.

Finance also has to be willing to pay suppliers in a timely manner. Delayed payment of invoices has serious implications on the buyer-supplier relationship and may also impact future pricing. Delaying payment to suppliers is a way to improve cash reserves; however, suppliers demand timely payments to obtain their own resources.

In later chapters, financial analysis both internally and externally on some key supply chain metrics help to formulate strategy and mitigate risk. For example, looking at a supplier’s cash-to-cash flow can tell you whether they are effectively managing both payments and receipts. Managing a supplier’s change in revenue compared with a change in costs can tell you how efficiently a supplier uses its resources. The same is true within your own organization. Keeping an eye on days payable and receivable outstanding can help minimize surprises.

As presented earlier, supply management has a major impact on ROI. Being efficient and effective in purchasing can significantly reduce the funds required to operate the firm. The timing and quantities of purchasing expenditures can significantly impact a firm’s financial ratios.

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