Mastering Purchasing Fundamentals

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TABLE OF CONTENTS

Lesson Page

Lesson 1 - Determining A Need 1 Lesson 2 - Communicating & Reviewing The Need 12 Lesson 3 - Finding Potential Suppliers 21 Lesson 4 - Conducting Bidding And/Or Negotiation 28 Lesson 5 - Selecting A Supplier 40 Lesson 6 - Formalizing The Commitment 55 Lesson 7 - Following Up & Closing Out The Transaction 73 Lesson 8 - Big Picture Issues 82

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Lesson 1 – Determining A Need Welcome to the world of purchasing. You have selected an exciting career. There are many challenges in the purchasing function and this course will introduce you to those challenges and show you how to succeed in purchasing. Before we get started, it’s important to discuss terminology. One thing that you may have noticed about the purchasing field is that there are many words describing the same thing. The function and profession alone are referred to as purchasing, procurement, and supply management, just to name a few. These terms are essentially interchangeable. One term that is often used to describe purchasing but technically has a much broader meaning is “supply chain management.” Though many different and conflicting definitions of supply chain management abound, in our definition, purchasing is a component of supply chain management. Purchasing deals primarily with managing all aspects related to the inputs to an organization (i.e., purchased goods, materials, and services), while supply chain management deals with inputs, conversion, and outputs. A supply chain consists of three types of entities: customers, a producer, and the producer's suppliers. The extended supply chain includes customers’ customers and suppliers’ suppliers. Supply chain management oversees and optimizes the processes of acquiring inputs from suppliers (purchasing), converting those inputs into a finished product (production), and delivering those products – or outputs - to customers (fulfillment). This class focuses mainly on giving you deep knowledge in the basics of the purchasing component of supply chain management. This class has two distinct portions: a tactical portion and a big picture portion. The tactical portion will take you step-by-step through the nine steps of a purchasing process. The second portion will give you a "big picture" perspective of purchasing. This second portion will focus more on the management of purchasing rather than on making your way through a single transaction. We’ll begin with the tactical portion. It can be a long time between the time that it is realized that something needs to be purchased to the time that there is no further need to engage with the supplier of that something. There are many steps along the way. It is always helpful to break down a big process into "bite size" pieces. That is what we have done with the purchasing process. We introduce to you the nine steps of the purchasing process:

1. Determining a need 2. Communicating the need 3. Reviewing the need 4. Finding potential suppliers 5. Conducting bidding and/or negotiation 6. Selecting a supplier 7. Formalizing the commitment 8. Following up

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9. Closing out the transaction We will now discuss each step in detail so that you can gain expertise for each step along the way. This will enable you to prepare for what’s ahead. STEP 1: DETERMINING A NEED Why does your organization buy the things it buys? You buy to fulfill a need. This need can arise from a variety of situations:

Your organization uses materials to manufacture a product and does not have enough materials in stock to produce the anticipated quantities of product. An example of such a material would be sheet metal for a manufacturing company.

Your organization uses products that enable workers to perform their jobs. An example of such a product would be a computer for a bank.

Your organization does not have the internal expertise to perform part of a service that it provides to its customers. An example of such a service would be trash pickup for a local municipality.

Your organization cannot perform a task as efficiently or cost effectively as a service provider. An example of such a task would be the delivery of a piece of mail.

There are plenty of possibilities for how a need can arise, but all have one thing in common – buying a product or service helps your organization do what it does. Top managers in organizations know that products and services must be purchased to enable the organization to function properly. Therefore, they allocate money towards these purchases in the form of annual budgets. A purchase should not be made unless the expenditure is first authorized in the requester’s budget. There are a few different types of budgets related to the purchase of products and services:

1. Direct materials budget – A direct materials budget is comprised of funds earmarked for materials that are used in the production process. A direct materials budget is usually based on a forecast of sales that indicates the volume of products that must be produced during a given year. In a mature manufacturing environment, the direct materials budget will be similar from year to year.

2. Capital budget – A capital budget is comprised of funds intended for the purchase of

major equipment and construction services. Because these expenditures are large and only brought about by major changes within the organization, the capital budget may vary tremendously from year to year.

3. Operating budget – These days, it seems that most anything that is not directly used

in production or a capital purchase is considered a Maintenance, Repair, and

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Operating (MRO) supply or service. The operating budget, sometimes called an MRO budget, is generally a "catch all" for these types of supplies and services. But don’t let that fool you into thinking that it is insignificant. In many organizations, the MRO budget is the largest chunk of money in the organization.

In addition to budgets as sources of funding for purchases, some organizations, such as universities, are awarded grants and contracts from government agencies. These grants and contracts often contain strict rules for how funds are to be used. Organizations place a varying degree of controls on their budgets. Some require that departments adhere strictly to the budget, while others have more of a tolerance for variation. Here are some ways that organizations control their budgets:

They make budget data (e.g., amount spent vs. amount left) easily accessible and available in real time

They clearly define the requisitioning and purchasing authority of employees

They clearly define the requisitioning, purchasing, receiving, and payment processes

They review and audit purchasing practices and procedures

They separate the requisitioning, purchasing, receipt, and payment functions to reduce the chance of fraud

They require that purchases be assigned to certain accounting codes for tracking purposes

So now that you know why your organization buys, we will look at when your organization buys. First, you need to understand two terms: lead time and safety stock. Lead time is the amount of time between the time you place your order and the time that the product or material you ordered arrives at your facility. Safety stock is a quantity of goods that organizations keep in inventory to avoid running out of those goods if a shipment was late, usage increased, or both. This means that they don’t schedule their deliveries on the day that the last of their stock is being used, they want to always have at least a fixed quantity of inventory. We said that manufacturers buy materials based on when they are needed for production. If a manufacturer plans on building 1,000 automobiles in a month, it will need 1,000 steering wheel assemblies to be available during that month. Let’s assume that the automobile manufacturer has 1,500 steering wheel assemblies in stock as of July 1. Let’s say that the

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manufacturer plans on building 30 cars per day from July through September. The lead time for a steering wheel assembly is 30 days. Finally, let’s assume that, due to freight charges, it is most economical to have an entire order of steering wheel assemblies delivered at once rather than in partial shipments. When should we order the steering wheel assemblies? Well, if we build 30 cars per day starting on July 1, we will exhaust our in-stock supply of 1,500 steering wheel assemblies in 50 days. That would mean that we would use our last assembly on August 19. Therefore, we need delivery of the new steering wheel assemblies no later than August 19. If the lead time is 30 days, this means that we would need to order the assemblies no later than July 20. And if our safety stock was a quantity of 60, our deadline for ordering would be two days earlier. Here is an exercise to illustrate the concept of order timing. Simply type in a Quantity In Stock, Quantity Used Daily, Safety Stock Quantity, and Lead Time In Days, then click on the Calculate Reordering Instructions to see when you should place your stock replenishment order.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

Quantity In Stock

Quantity Used Daily

Safety Stock Quantity

Lead Time In Days

Reordering Instructions Reorder

If you would like to have a spreadsheet to perform this type of calculation, you can download one from http://www.NextLevelPurchasing.com/classes/fundamentals/lesson1/reorder.xls. If you’re still not sure how the math for reordering works, I’ll give you a little bonus information. The goal is to never have to dig into your safety stock. Theoretically, you should reach your safety stock level at the moment your shipment arrives. Here's an example. Let's say that lead time is 1 day. Your usage is 2 per day. Your safety stock is 4. Your quantity on hand is 10. And let's pretend that today is Monday. If you didn't place an order, here's how your inventory would be depleted. Monday - 10 Tuesday - 8 Wednesday - 6 Thursday - 4

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Friday - 2 Saturday - 0 Because your safety stock is 4, you want to be sure your order gets delivered on or before Thursday - again, you should never plan on depleting your safety stock. If you need goods on Thursday and your lead time is 1 day, you should order no later than Wednesday. Got it now? Good! There are a variety of other factors that may come into play when deciding when to buy. These include:

To secure availability of the product or service provider

In reaction to your organization’s non-forecasted sales

To acquire the remaining stock of a supplier who has produced its last run of a soon-to-be-obsolete product

Ideally, the purchasing department will be given enough time to make the purchase. If insufficient time is available, the purchasing department will be less able to develop adequate competition or engage in thorough negotiations – activities that can result in a lower cost for the organization. When a need is determined, it should be described in writing. A written description of a need is called a specification. Specifications are important because they serve to communicate the requirements for the purchase to both the purchasing department and the supplier. Well-written specifications produce two important benefits:

When multiple suppliers quote from the same set of specifications, the results provide an equitable, or "apples-to-apples," comparison. This enables the purchasing department to select the best supplier.

When specifications are clear, there is a maximum probability that the product or service will perfectly meet the needs of the organization and will not be fraught with quality defects.

Specifications often include acceptance criteria. Acceptance criteria indicate the conditions that the product or service must meet in order to be accepted and paid for. Acceptance criteria may be the measurements of a product, a level of performance of a piece of equipment, or a result of a service. There are many different types of specifications, often called “specs.” They include:

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Performance specs – Performance specs define the result to be achieved by the product or service. For example, a performance spec for a piece of machinery may require that the machinery drill at least 80 holes per minute into 3/16" thick sheets of aluminum. Generally, performance specs allow the supplier complete discretion for determining how to meet the requirement. The risk for conforming performance of the end product is also borne by the supplier. Design specs – Design specs provide a complete description of the look of the product and indicate how the product is to be made, including the materials to be used. Design specs usually do not address performance characteristic guarantees. Design specs maximize the buyer’s control of the end result. However, because the supplier is not allowed to deviate from the design specs, the risk for conforming performance of the end product is borne by the buyer. Functional specs – A functional spec can be thought of as a description of things that a piece of equipment or software should do in various situations from a user’s perspective. Functional specs may also outline a problem to be solved. Progress is measured by determining whether the equipment or software performs the tasks as described in the functional spec or whether the problem has been solved or not. When the equipment or software performs exactly as indicated on the functional spec, an evaluator or team of evaluators often signs off indicating the compliance of the equipment or software with the functional spec. Blueprints/drawings – Blueprints and drawings provide a visual guide for how a product is to be made, including descriptions of the various parts that comprise the product. Trade name or brand specs – Often times, a requisitioner will describe a needed product by its brand name. Many times, this level of specificity is not beneficial. Brand name specs limit the options that a purchaser has. The fewer options, or less competition, available to a purchaser usually results in overpriced products or services. For example, if you had to buy Kleenex brand facial tissues only, you may not be able to take advantage of savings that would be available if you could buy other brands or even generic facial tissues. One strategy to ensure the quality associated with a brand name while also increasing competition is to include several acceptable brand names in the specification (e.g., Kleenex or Puffs). Physical/Chemical specs – Physical/Chemical specs described the scientific attributes of the materials to be purchased So how does the specification development process work? Specifications are usually initiated internally within the organization. They can be developed formally, with technical experts using a proceduralized method, or informally, where the requisitioner simply documents his requirements. Occasionally, when an organization does not possess the internal expertise necessary to draft an adequate specification, it will seek the input of other individuals or groups. These individuals and groups include:

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Suppliers: Suppliers work with various customers’ requirements and know better than anyone what is feasible, reasonable, and understandable. As such, purchasing organizations often tap this expertise in the specification development process. This should be done carefully, however. You need to be sure that (a) you don’t share one supplier’s proprietary information with another supplier, (b) you don’t make a supplier do an excessive amount of work with no compensation, (c) you have a trusted relationship with the supplier if you are not seeking the input of another supplier, and (d) the input of one supplier doesn’t make any future competitive bidding unfair or less than fully competitive.

Consultants: Consultants who have successfully specified a product in the past are a good resource for purchasing organizations that have never specified the product and have not learned what the pitfalls are.

Other Organizations: Organizations who have successfully specified a product before may be willing to assist an organization who is specifying a product for the first time.

Professional Purchasing Organizations: Some purchasing organizations have been compiling specifications to share among their members.

There are a variety of pitfalls associated with specifications. Here are just a few: Absence of standards – Instead of designing a new product to make use of parts used in other products, a specification writer will require the use of non-identical parts. Failing to make use of standard parts eliminates the purchaser’s ability to consolidate volume, thereby lowering prices. In addition, more inventory must be held, which represents additional cost to the organization. For example, a specification for a new component may require the use of hex head screws rather than round head screws, which are used in other existing components. If the round head screws would not degrade quality, they could be used and the cost would be reduced. Over-specification – Specifications can be stricter than they need to be. This often results in less competition and higher costs. For example, a landscaping company may specify the radius of the cord of their "weed whackers" to be 15.5". Black & Decker may make a 15" model and McCollough may make a 16" model, but only one manufacturer makes a 15.5" model and – guess what – it’s the most expensive. If the landscaping company relaxed its specification to require a cord radius of between 15 and 16 inches, they would have more options and, ultimately, a lower cost. Under-specification – The flip-side of over-specification is under-specification. It is where the specification writer was not specific enough. Under-specification is characterized by the omission of key details and/or overly loose limits on key parameters. Under-specification typically results in continual quality problems. Items may meet specifications but do not work in the desired application.

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Slanted/Slanting specs – Slanting specs are specifications that exclude otherwise acceptable products or suppliers. Because slanting specs reduce competition, the purchasing organization will probably pay higher prices. Out-Of-Date/Obsolete specs – Specs that worked in the past may not necessarily work in the present or future. A variety of things can change, from the availability of new materials, to government regulations, to the end product in which a component is installed. Therefore, re-used specifications should always be reviewed for current relevance prior to release. Standards differences between countries – A purchaser should be careful when releasing specifications to suppliers in other countries as standards and measurements may differ. For example, an American gallon is not the same as a British gallon. While a description of a service is often referred to as a specification, it also can be called a statement of work. There are some special considerations with statements of work. Statements of work (SOWs) state what is to be done, when it is to be done, and what constitutes an acceptable result. Statements of work may feature details such as inspector evaluations, testing, quality, paperwork, upkeep, and more. Generally speaking, statements of work include:

Project objectives

Background information such as the history of the problem, why it needs to be solved, possible limitations, etc.

Project requirements such as what needs to be done, quality standards, division of responsibilities, etc.

Work breakdown structure – a division of the service into distinct segments

Schedule

Deliverables – specific, tangible, and measurable tasks that must be accomplished

Hold points or milestones – Points in time where the purchaser and supplier can assess the quality and timeliness of the most recently completed segment and the project as a whole. Often times, hold points and milestones are used to give the option to the buyer to terminate the services or withhold payment until the work is performed satisfactorily.

Reporting requirements

Performance evaluation factors and acceptance criteria Poorly written SOWs result in:

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Services that fail to meet quality expectations

Financial and time loss

Unfavorable costs

Disagreements and litigation Well-written SOWs:

Promote proper scheduling, forecasting, and coordination of resources

Lead to proposals that are both comparable and aggressive in terms of good pricing and other attributes

Reduce, if not eliminate, confusion

We hope that you’ve enjoyed your first lesson. As you will at the end of each lesson, you now must take the quiz. Click on the Quiz button below to begin. If you have any questions, please utilize the Ask Charles! feature to send an instant message to your instructor. You will receive a reply by email within 24 hours.

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Lesson 1 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is not a typical way that a need is determined? a.) an organization does not have enough material on hand to meet its production requirements b.) an employee needs a tool to perform his job c.) a salesman drops off a product and asks to be paid if you like it d.) an outside supplier can perform a portion of a service more cost effectively than your organization has in the past 2. A purchase of all new equipment for a facility will likely come out of which budget? a.) capital budget b.) direct materials budget c.) operating budget d.) all of the above 3. Which of the following is not a technique used to control budget expenditures? a.) making budget data available to employees b.) giving large amounts of petty cash to each department c.) self-auditing d.) using internal account codes 4. The minimum quantity of a certain material that an organization wants to keep on hand is called: a.) reorder point

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b.) economic order quantity c.) inventory level d.) safety stock 5. A written description of a service can be called: a.) a specification or a statement of work b.) a specification but not a statement of work c.) a bill of materials d.) a safety stock

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Lesson 2 – Communicating & Reviewing The Need STEP 2: COMMUNICATING THE NEED The creation of a document called a requisition kicks off the procurement process. Requisitions are often called “reqs” (pronounced like wrecks). Requisitioning is defined as the process that users initiate to convey to the buyer their wants, needs, parameters, etc. There are many different types of requisitions:

1. Standard and electronic reqs – User departments create a requisition to indicate to the purchasing staff what products or services they need, how many of them they need, and when they need them. Technological advances have replaced paper-based requisitions and many organizations use computer systems to prepare and route their requisitions.

2. Bill of materials (BOM) – A BOM lists the materials, components, and subassemblies

required to manufacture a product or perform a service. Buyers can create purchase orders or generate releases against an established contract by using the BOM. The principle behind BOMs is applied to project procurement when technical representatives provide the buyer with a list or lists of the materials, components, subassemblies, and services that are required for the project and the buyer creates orders based on the list(s) as needed.

3. Automatic reqs – Some electronic purchasing systems will create requisitions or even

orders to vendors without human involvement based on the amount of inventory on hand, pre-arranged conditions, etc.

Requisitions must contain certain information to formalize a purchase from both internal and external perspectives. From an internal perspective, requisitions must communicate to purchasing, receiving, and accounting departments who is requesting the purchase, who is authorizing the purchase, which account is being charged, and so forth. From an external perspective, requisitions must communicate to the supplier what is needed, how much, and where to deliver it. Here are some common fields in a requisition:

User’s name

An approver’s signature

Description of the goods and/or services

Unit of measure

Quantity

The date that the goods or services are required

A price estimate

Suggested supplier

The departmental account or budget to which charges should be applied

The location where goods should be shipped or services performed

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Quick note – a unit of measure refers to a quantity grouping in which products are sold. Some products are sold individually (usually noted as “each”), some by the case, some by the pallet, etc. Units of measure usually have abbreviations, such as “ea” for each, “cs” for case, etc. So if you ordered 6 ea. bottles of water, you will get six bottles of water. If there are 10 bottles per case and you order 6 cs. of water, you will get 60 bottles of water. Requisitioning and purchasing systems may have standards for how units of measure are to be abbreviated. In certain electronic transmissions with suppliers, there may be standards as well. Be sure to be familiar with the unit of measure abbreviation standards (if any) that are used by your company and your suppliers.

Below, you will find a sample requisition form. Imagine that you are going to make a request to purchase something for your office, such as a computer. Fill out the requisition accordingly and click on the Next button. You will then have the opportunity to compare your requisition to ours.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

Quantity Description Unit of Measure

Estimated Unit Price

Estimated Extended Price

Date Needed:

Requester’s Name:

Department:

Address:

Approver’s Name:

Approver’s Signature:

Account #:

Suggested Supplier(s)

Compare your completed requisition with ours... Ours...

Quantity Description Unit of Measure

Estimated Unit Price

Estimated Extended Price

2 3.0 GHz computers ea. $3,000 $6,000

Date Needed: 12/31/2004

Requester’s Name: Charles Dominick, SPSM

Department: Purchasing

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Address: P.O. Box 1360, Moon Township, PA 15108

Approver’s Name: Charles' wife

Approver’s Signature:

Account #: 01-111

Suggested Supplier(s) Dateway or Gell

Certain documents are sometimes attached to requisitions such as:

Specifications or a statement of work (when the space on the requisition is not adequate for comprehensively describing the product or service)

No-Bid Justification (when policy requires competitive bidding unless there is a documented, technical reason to award an order to a single supplier)

Internal cost estimates (when the value of a product or service is not known in advance of bidding)

When developing a requisition process, purchasing departments seek to ensure compliance with several aspects of corporate policy:

1. Proper Authority – According to the policies and procedures of many organizations, the purchasing department and its staff are the only “agents” who are authorized to make purchases on behalf of the organization. When someone who is not an agent of the organization commits to a purchase with a vendor without the involvement of an authorized agent, unauthorized purchasing (also known as maverick buying or rogue purchasing) has occurred. Many times, this occurs because of a seller attempting to circumvent the official purchasing process. Unauthorized purchasing can cause these problems:

Loss of control over outgoing payments

Use of unqualified vendors

Absence of proper approvals

Contract “leakage” – the failure to maximize the volume of goods and services purchased under existing contracts

While many of an organization’s employees do not have the proper authority to commit funds to a supplier, the purchasing department does not necessarily have to be the only group permitted to engage with the vendor community. Many organizations allow end users to request "releases" (or shipments of goods at a predetermined price against an existing order), to discuss technical issues with suppliers, and, often, to make small dollar purchases using credit cards.

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2. Approval Limits – Organizations may have written policies delineating the maximum amount of money each purchasing position may spend without a supervisor’s signature. Organizations may also have similar limits for departments requesting items. Such a hierarchy is often called "limits of authority" or "commitment authority." Why are proper approvals needed? Approvals help ensure that control over financial commitments is maintained. Fraudulent transactions can also be identified more easily. Requisitioners have the responsibility to secure proper approvals on reqs and buyers have the responsibility for verifying those approvals before placing purchase orders.

3. Social Responsibility Goals – Some organizations strive to place a certain

percentage of their orders with special classifications of businesses such as those owned locally, by minorities, by women, and so forth. These types of businesses are sometimes referred to as Disadvantaged Business Enterprises, DBE’s, diverse suppliers, or diversity suppliers. Some organizations may be required to purchase from diversity suppliers. For example, the United States of America’s Public Law 95-507 requires government contractors, as well as the government, to increasingly use diverse suppliers.

4. Green Buying – Green buying means that organizations make purchase decisions

that are environmentally conscious. The most progressive of these organizations integrate an environmentally-friendly ideology from the design of a product or process right through the disposal of the product or conclusion of the service. By involving purchasing staff, and even suppliers, on product/process teams early on, users can be encouraged to adhere to green strategies.

STEP 3: REVIEWING THE NEED When requisitions arrive in the purchasing department, they are generally distributed to buyers for further processing. Purchasing departments usually have a predetermined scheme to guide which buyer gets which requisition. Here are some of the most common schemes: Requisition Routed By Category Of Product Or Service - In this scheme, requisitions are routed based on the type of products or services that are being requisitioned. For example, office equipment requisitions are routed to John Smith, construction service requisitions are routed to Sally Jones, and chemical purchases are routed to Charles Ali. This scheme works best when there is a significant amount of technical knowledge required to effectively buy the products and services. Requisition Routed By Supplier - In this scheme, requisitions are routed based on who the supplier is. For example, if the supplier is Office Depot, requisitions are routed to James Hall, if the supplier is General Electric requisitions are routed to Jane Doe, and if the supplier is Thermo Fisher requisitions are routed to Mark Crosby. This scheme works best when your organization works very collaboratively with its suppliers.

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Requisition Routed By Requisitioning Department - In this scheme, requisitions are routed based on who the requisitioning department is. For example, the Accounting department would send its requisitions to Chuck Donovan, the Engineering department would send its requisitions to Evgeni Malkin, and the Marketing department would send its requisitions to Tara Kennedy. This scheme works best when your organization's departments have very unique needs and providing customer service to those departments is a priority. Requisition Routed By Workload Of The Buyers - In this scheme, each requisition is routed to the buyer with the least demanding workload at that point in time. For example, if a requisition arrives and Chrissy Palone is working on 6 requisitions, George Pilarski is working on 6 requisitions, and Jennifer Roberts is working on 5 requisitions, then the requisition would be assigned to Jennifer Roberts because she has the least demanding workload at that time. This scheme works best when the requirements for purchased products and services are so simple that no specialized technical knowledge is required of the buyers - any buyer can purchase any item. Here are the advantages and disadvantages of each scheme:

Requisition gets routed based on the:

Advantages Disadvantages

Category of product or service

Buyers can develop specialized knowledge about a narrow set of products and services.

Both suppliers and internal customers may have multiple points of contact within the purchasing department.

Supplier Buyers can reap the benefits and efficiencies of having a more collaborative, one-on-one relationship with a supplier.

Internal customers may have multiple points of contact within the purchasing department. There may be a need for buyers to gain specific knowledge about more categories.

Requisitioning department Internal customers know exactly who to call when they need purchasing support.

Suppliers may have multiple points of contact within the purchasing department. Buyers may not have the opportunity to develop specialized product or service knowledge because they will have to know about all categories.

Workload of the buyers Workload is distributed Suppliers and internal

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more evenly. customers may have multiple points of contact within the purchasing department. Buyers may not have the opportunity to develop specialized product or service knowledge because they will have to know about all categories.

In cases where an electronic requisitioning system is used, the logic of the requisition assignment scheme is built into the system. Therefore, the requisitions are routed accordingly, without human intervention. When processing requisitions, purchasing departments should have some formal or informal guidelines as to the order in which requisitions are processed. Here are some examples of the order of processing:

1. First come, first served 2. Arranged by date required (e.g., if a product is needed on Thursday, it will be ordered

before a product needed on Friday)

3. Rush/emergency orders first

4. Most important orders first

5. Longest lead time first (lead time is the amount of time between the time the supplier receives an order and the time that the order is delivered to the buyer’s facility. This method would have a product with a 3-week lead time ordered prior to a product with a 2-week lead time)

6. Lowest schedule margin first (schedule margin is the amount of time between the

estimated delivery date based on quoted lead time and the need date.) Because the lowest schedule margin first approach is the most complex, but perhaps the most useful, we’ll discuss it a bit now. The lowest schedule margin first approach prioritizes requisitions by the probability of goods or services being delivered on or before their need date. It takes into consideration the gap between (a) the delivery date based on the lead time and (b) the need date. The shorter the gap (known as schedule margin), the sooner the requisition should be processed. For example, a requisition for an office chair has a need date 21 days from today. The lead time for the chair is 15 days. Therefore, the schedule margin for the chair is 6 days (21-15). A

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requisition for a computer has a need date 31 days from today. The lead time for the computer is 30 days. Therefore, the schedule margin for the computer is 1 day. Using the lowest schedule margin first approach to processing requisitions, the computer should be ordered before the chair. Sometimes, schedule margins are negative. This occurs when the number of days between the need date and the time the requisition is received is less than the number of days of lead time. Using the lowest schedule margin first approach to processing requisitions, the requisition with the lowest number as a schedule margin should be processed first. Here is an example: A requisition with a schedule margin of –21 days should be processed before a requisition with a schedule margin of –3 days, which should be processed before a requisition with a schedule margin of 20 days. It’s time for another exercise. Select an approach to processing requisitions, assign an order to each of the following requisitions, and click on the Evaluate Order button. You will then see the order that we would have processed the requisitions given the approach you selected.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

Approach:

Requisition Number

Time Received In Purchasing

Need Date Lead Time Your Order Our Order

AB11000 10:00 AM 31 days from today

21 days from today

23010CC 10:05 AM 30 days from today

29 days from today

19199ZY 10:10 AM 29 days from today

20 days from today

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Lesson 2 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is not a common type of requisition in modern organizations? a.) standard b.) electronic c.) system-generated d.) traveling 2. Which of the following is the least likely field to be on a requisition? a.) description b.) account number c.) home phone number d.) ship-to address 3. The term that describes how much money an employee can spend is: a.) commitment autonomy b.) commitment authority c.) delegation limit d.) safety stock 4. Which of the following is considered a diversity supplier? a.) a minority-owned business b.) a woman-owned business

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c.) both minority-owned and women-owned businesses d.) none of the above 5. When smooth communication with internal customers is the highest priority, how should an internal customer's requisition be routed? a.) to the buyer that handles a certain supplier b.) to the buyer that handles a certain commodity c.) to the buyer that has the least amount of work d.) to the buyer assigned to the internal customer's department

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Lesson 3 – Finding Potential Suppliers STEP 4: FINDING POTENTIAL SUPPLIERS After receiving a description of the product or service to be acquired, the purchaser must determine the vendors who can supply the product or service. There are many resources that the purchaser can utilize to identify available vendors. These include: Purchasers’ guides/Supplier directories: Web sites such as ThomasNet.com list the contact and other high-level information about suppliers and are usually organized by category. Of note is that ThomasNet.com is a replacement for the Thomas Register, a well-known series of large green books that were kept on hand by many purchasing departments until the final edition was published in 2006. B2B directories: Certain regions feature directories of regional businesses that serve other businesses. Telephone books: Even the good, old-fashioned yellow pages can be a resource for quickly finding local suppliers. Chambers of commerce: Many areas, small and large alike, have a local chamber of commerce whose goal is to promote business in the area. These chambers are usually more than happy to refer you to their member suppliers. Industry/Professional/Trade associations: It seems that almost every trade or profession has an association for individuals who work in the trade or profession. These associations can be contacted for referrals. Trade shows/business expositions: Attending trade shows is a good way for a buyer to not only keep up with the changes in his/her market, but a good way to identify potential suppliers for future business requirements. Trade publications: Articles, and even advertisements, in magazines or journals for a particular industry can introduce you to new suppliers. Peers: Often times, there is no safer way of finding a reliable new supplier than by learning about it from another buyer, be it a buyer in the same organization or a different organization in a different industry. Non-related vendors: Your vendors use vendors, too. If you are looking for a furniture vendor and you know that your raw materials vendor buys a lot of furniture, it doesn’t hurt to ask which furniture vendor they use. Business assistance organizations: There are organizations that exist to help special classifications of businesses. For example, there is a national and many local Minority Business Councils in the United States of America. The US Federal Government also maintains a list of small businesses through its Small Business Administration. These can be

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great resources for identifying suppliers when you want to make an effort to be socially responsible in your purchasing. Supplier collateral: Collecting suppliers’ brochures and meeting with suppliers’ sales representatives is a means of determining whether suppliers have the capabilities to meet your needs. Internet: The Internet allows you to search the world for suppliers. It is perhaps the easiest way to compile a list of new suppliers. Online marketplaces: Online marketplaces are Web sites where buyers can post their requirements, be presented with a list of suppliers who supply the posted product or service, and obtain pricing from the suppliers that they approve. Some online marketplaces even feature the ability to rate suppliers and see how other buyers have rated suppliers in order to reduce the risk of selecting a poor supplier. Internal lists: Most organizations maintain electronic lists of their suppliers. Most buyers fall back on these lists because their organizations have past experience with the suppliers. Some organizations assign various internal classifications to their suppliers. The purposes for such classification include: (a) to communicate the desirability of the supplier, (b) to encourage the use of certain suppliers, and (c) eliminate costly inspection processes when unneeded. Here are a few internal supplier classifications: Approved Suppliers – An approved supplier is simply a supplier from whom the organization’s personnel may buy. The difficulty of becoming an approved supplier depends on the organization. Some organizations require a strict qualification process before the "approved" designation is applied while to others consider a supplier approved if someone had entered their information into their computer system. Preferred Suppliers – As the title suggests, a preferred supplier is one who the purchasing department strongly encourages above all other options. Preferred suppliers are usually selected after a thorough comparison of many suppliers in the market. Relationships with preferred suppliers are usually formalized through a long-term contract. Purchasing policies generally allow the freedom to use suppliers other than the preferred supplier. Single Source Supplier – A single source supplier is one who the buying organization requires the use of despite the fact that more than one supplier is available. A single source supplier is similar to a preferred supplier except that the buying organization strictly mandates that the single source supplier, and no other supplier, is used for a given category of products or services. Single sourcing is usually done to achieve larger discounts. Single source suppliers often require guarantees of exclusivity in contracts in exchange for terms that are favorable to the buyer. Sole Source Supplier – A sole source supplier is the only supplier who is available to provide a product or service.

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Certified Supplier – A supplier becomes certified after a thorough and formal technical audit determines that the supplier’s work is nearly defect free and its quality systems are integrated with the buying organization to the point where inspection of goods at the buyer’s plant is not necessary. Reducing the number of incoming goods inspections through a supplier certification program is often a significant source of cost savings. Barred Suppliers – Suppliers who the organization chooses not to do business with are considered barred suppliers. These suppliers have displayed unacceptably poor performance in the past such as: chronically late deliveries, high costs, a large number of quality problems, or terrible service. Barring suppliers should be a last resort and only executed when corrective action fails. Integrated Supplier – An integrated supplier is one who participates in an exclusive partnering arrangement with the buying organization. The objective of the arrangement is to achieve an optimal balance of the cost and resources utilized in procuring, storing, and distributing MRO supplies. An integrated supplier usually takes responsibility for work previously performed by the buying organization such as entering orders or assuming outsourced duties for a total activity, such as managing a stockroom. There are many decisions to make when deciding which type of suppliers you want to consider. While many purchases are simple enough to restrict the number of supplier-type-decisions for that purchase to one, sometimes you need to go to a series of decisions to come up with the optimal supplier strategy. If you were to make the entire series of the decisions, you are likely to go in order from most general to most specific as we have listed below. Note that you will not use this series of decisions for most small purchases and, as you become more experienced, you’ll make many of these decisions intuitively! Make or buy? Some organizations have the option of making a product or performing a service instead of buying it. There are many factors to consider when deciding whether to make or buy such as the cost of each option, internal capacity, quality requirements, timeframe, etc. Manufacturer or distributor? When buying large quantities, whether at one time or over a long period, it is usually less expensive to buy direct from a manufacturer. Skipping a link in the supply chain will remove costs, specifically the markup that the distributor adds to their cost for the product. Also, working with manufacturers can give you a more direct link to technical expertise. However, if you are a small buyer in the market, the manufacturer may refuse to do business with you. Even if the manufacturer will do business with you, a large distributor who gets a large discount from the manufacturer may be able to offer a lower price to a small buyer than the manufacturer will. In addition, distributors are generally more service oriented than manufacturers and can serve as a single point of contact for the products from several different manufacturers. Multiple source or single source? Using more than one supplier for a purchase reduces risks such as disruption of supply and higher-than-market price increases. However, you dilute your purchasing power when splitting your requirements among two or more suppliers

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and increase the amount of administration required to manage the supply in the applicable category. Both of these factors increase your cost, so there is a price to reduced risk. Currently used supplier or new supplier? If a need is urgent, quality must be perfect, pricing has been recently benchmarked and is fair, and a long-term relationship exists, the use of a current supplier is generally preferred. However, if there is reason to believe that costs can be lowered, quality or service can be improved, or cycle time can be reduced, the feasibility of using a new supplier should be examined. Sometimes, certain events should prompt you to evaluate whether to switch suppliers. These events include:

Changes in the market that have an effect on prices

Changes in the current supplier’s ownership or management that may have a destabilizing effect on its performance

A pending labor stoppage at the current supplier’s facility

The bankruptcy or financially instability of the current supplier

The reduction of the current supplier’s workforce

Orders by other customers that have taxed the current supplier’s capacity

A catastrophe, such as a hurricane, that has adversely affected the current supplier’s operations

Domestic or foreign supplier? Expanding your domestic boundaries to include foreign suppliers provides for more competition and more benefits (e.g., reduced costs, better quality, wider selection, etc.). Buying domestically is often preferred because the buyer and seller share the same legal environment, transportation infrastructure, cultures, currency, and language. In addition, buying internationally involves knowledge of exchange rates, different financial exchange procedures, and duties – the taxes governments levy on goods sold or used across international borders. Despite these disadvantages, cost savings are available through international sourcing. For example, it has been reported that the cost of IT services in the United States is many times more expensive than the same services available from firms in India. National or local supplier? If you can't expand your range of suppliers internationally, expanding your range of suppliers beyond local boundaries to national boundaries will still provide for more competition. Anytime you have more competition, you are assured of more selection, lower prices, and the flexibility that comes with more options. Local sources can be faster, provide less expensive delivery, may offer a more customized approach, and like to protect their local reputation by providing good service. Doing business locally can look good in your community and to political leaders. Large or small supplier? Because of the economies of scale, more resources and greater purchasing power, large suppliers can often offer better prices than small suppliers. However, small suppliers may provide more personalized attention, be more specialized, and offer quicker response time.

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Diversity supplier or non-diversity supplier? Doing business with a diversity supplier may help your organization meet its socioeconomic goals. However, for some purchases, a qualified diversity supplier may not be available.

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Lesson 3 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following resources would be a good choice for finding a new overseas supplier? a.) yellow pages b.) Internet c.) your chamber of commerce d.) internal list 2. The difference between a preferred and a single source supplier is: a.) a preferred supplier is the only supplier available while a single source supplier is a supplier you do business with exclusively despite the availability of other suppliers b.) a preferred supplier is in your purchasing system while a single source supplier is not c.) there is no difference d.) having a preferred supplier does not preclude the organization from doing business with other suppliers, whereas having a single source supplier relationship does 3. The difference between a sole source and a single source supplier is: a.) a sole source supplier is the only supplier available while a single source supplier is a supplier you do business with exclusively despite the availability of other suppliers b.) a sole source supplier is in your purchasing system while a single source supplier is not c.) there is no difference d.) having a sole source supplier does not preclude the organization from doing business with other suppliers, whereas having a single source supplier relationship does

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4. Which of the following is a benefit of doing business with a distributor rather than a manufacturer? a.) ability to combine requirements from several manufacturers into a single order b.) guaranteed lower pricing c.) slower delivery d.) ability to buy in bulk 5. Which of the following may lead you to reconsider doing business with an existing supplier? a.) a good relationship b.) a pending labor stoppage c.) the supplier offered a price decrease d.) the supplier's consistently good quality record

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Lesson 4 – Conducting Bidding And/Or Negotiation STEP 5: CONDUCTING BIDDING AND/OR NEGOTIATION After identifying at least one supplier who may meet your needs, you have three options for the next step:

1. Just buy the product or service from an existing supplier without seeking better terms (e.g., a lower price)

2. Negotiate terms with one or more suppliers

3. Conduct competitive bidding whereby you request quotes or proposals from several

suppliers with the intention of selecting the supplier who submits the most attractive quote or proposal.

Because option #1 requires no thinking, we will focus on comparing the latter two options: negotiation and competitive bidding. Please note that there are many words and phrases used to refer to competitive bidding. These include sourcing, tendering, and other terms. While some words and phrases are used interchangeably around the globe, others are limited to a specific geographic region. For example, the word “tendering” is used extensively in England but is not used at all in that context in the USA. For the purposes of this class, we’ll stay consistent and just refer to the process as competitive bidding. It is very common for purchasing departments to negotiate after receiving quotes or proposals via a competitive bidding process. For the purposes of this class, we’ll consider competitive bidding to include an option for late stage negotiation and we’ll consider negotiation to be negotiation only, without being preceded by competitive bidding. There are several factors to consider when deciding between competitive bidding and negotiation. The following table lists those factors and explains when each option is appropriate.

Factor Bid When… Negotiate When…

Competitiveness of the market

Market features a lot of similar suppliers craving more business

There are few suppliers and they are significantly differentiated on non-price variables

Time sensitivity You have adequate time to prepare a bid package

You do not have adequate time to prepare a bid package

Value of the purchase The potential savings justifies the effort.

The potential savings justifies the effort

Clarity of specifications Specifications are clear and provide for an

Specifications are not clear and can cause

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equitable, "apples-to-apples" comparison of supplier offers.

suppliers to differ significantly in their offerings due to diverse interpretations.

Contract type The price is fixed, making it easy to determine how much you will spend with any bidding supplier

The price is variable (e.g., based on hours).

Clarity of selection procedure

Your criteria for selecting a supplier is clearly defined, objective, and easy to measure.

Your criteria for selecting a supplier is subjective

Ramp-up costs (Ramp-up costs represent the expenditures that a supplier must make in order to perform work or manufacture a product for a customer. For example, if a supplier is going to manufacture a product for a customer that will purchase several thousand units of that product over several years, that supplier may need to buy tooling, hire employees, train its staff, set up its computer systems, and generally take other actions necessary to support the manufacture the new product. All of those costs would be considered ramp up costs.)

If all suppliers have equal investments to make to be able to provide the product or deliver the service

If one supplier has an advantage due to being the only one to have previously made a required investment (e.g., in tooling)

Likelihood of changes to the specifications

If there is no likelihood of changes

If there is a strong likelihood of changes

Note that government and government-related purchasers may not have the luxury of choosing whether or not to use bidding. Many laws require that bidding be done on nearly all purchases.

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Here are two examples of how the negotiation vs. bidding factors would be used. Example #1 A buyer for a large company has to purchase a large quantity of office supplies over the course of a 3-year contract. The contract with the current supplier expires in three months. He has identified five suppliers equally capable of providing the supplies. All of the office supplies are standard catalog items. The lone criterion for supplier selection is the lowest price. Example #2 A company is experiencing severe problems with its computer servers. These problems affect the productivity of nearly every employee and customers are getting frustrated. The company's buyer has been asked to find an information technology firm to diagnose and fix the problem on an as-soon-as-possible basis. The company does not know what tasks are required to fix the problem. The company is located in a rural location, about 100 miles from the nearest city. One reputable information technology firm is located approximately 20 miles away and there is another one in the nearest city. Analysis of Example #1 The following factors describe this situation:

Competitiveness of the market: This market features a lot of similar suppliers craving more business

Time sensitivity: Because the current contract doesn't expire for three months, the buyer has adequate time to prepare a bid package.

Value of the purchase: Because the company is a large one, the spend on office supplies is large and, therefore, represents the potential for a lot of savings that would justify a bidding effort.

Clarity of specifications: Because all items will be standard, catalog-type items, the specifications are clear and can provide for an equitable, apples-to-apples comparison of supplier offers.

Clarity of selection procedure: Because the supplier selection is going to be decided on price alone, the criteria is clearly defined, objective, and easy to measure.

All of these factors indicate that bidding is a more attractive option than negotiating without bidding. Analysis of Example #2

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The following factors describe this situation:

Competitiveness of the market: Because this purchase is for a near immediate on-site service, the proximity of suppliers is important. With only one supplier within 20 miles and only one additional supplier within 100 miles, there are few suppliers available.

Time sensitivity: With the operation of the business negatively impacted by the problem at hand, immediate action is necessary and the buyer does not have adequate time to prepare a bid package.

Clarity of specifications: Because the company does not know what is wrong with its servers, it does not know what types of services are required. Therefore the specifications are not clear and, therefore, the total costs of the services cannot be estimated accurately.

All of these factors indicate that negotiation without bidding is a more attractive option than bidding.

When soliciting quotes or proposals from suppliers, you have to choose the appropriate document as the means of requesting information. There are four primary solicitation documents:

1. Request For Information (RFI) – An RFI is a document that is used to obtain non-price information from suppliers. RFI’s are most commonly used in purchases that are complex or of significant value. Often times RFI’s are used when the purchasing organization needs information to ensure that its specification is feasible or the purchasing organization wishes to narrow down its field of potential bidders to the most qualified candidates. Purchasing departments usually follow an RFI with one of the other three solicitation documents.

2. Request For Quote/Quotation (RFQ) – An RFQ requests that suppliers respond with

only prices, lead time, and terms from suppliers based on fixed specifications. Generally, RFQ’s do not allow for changes to the specification. The lowest price is usually determining factor in awarding an order based on RFQ responses.

3. Request For Proposal (RFP) – Like an RFQ, an RFP requests pricing, delivery, etc.

However, unlike an RFQ, an RFP allows, sometimes requires, supplier input on specifications. RFP’s are often used to find solution to a problem. Orders based on RFP responses are generally awarded based on the best overall value and not necessarily on price alone.

4. Invitation For Bid (IFB) – An IFB is a government version of an RFQ. The

specifications, terms, etc. are all predetermined by the purchasing organization. Price is the only variable. IFB’s are usually advertised publicly and open to any responsible

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bidder. In most government situations, the issuance of an IFB commits the purchasing organization to buy, so government purchasing departments issue an IFB only when well defined specs are available, the value of the order exceeds pre-established thresholds, statute requires such an issuance, and no other method of soliciting pricing is applicable.

Optional: I’ve gotten many requests for examples of solicitation documents. Here are links to a few if you want the option of seeing a few examples. Because these are on external websites, we can’t guarantee that they will be available. But please let us know if the links no longer work. http://www.techsoup.org/binaries/files/RFP_web_sample.pdf http://intra.sd.undp.org/bids/doc/114.pdf www.orafinapps.com/UserFiles/Files/KnowledgeBase/67-934718.doc Occasionally, you may see the acronym RFx. X is a variable, meaning that any letter (such as I, P, or Q) could be substituted for it. Therefore, RFx refers to any type of solicitation document such as an RFI, RFP, and RFQ. After deciding on which type of solicitation document to use, the purchasing professional must decide on the format for bidding. There are several different formats for competitive bidding. These include: Sealed bidding: A sealed bidding situation is where all bids are submitted in a sealed envelope and opened by the purchasing organization at the same time at or after a deadline specified in the solicitation document. Some government organizations open sealed bids publicly. Two-step bidding: No, country dancing is not involved in this bidding format! Two step bidding is used when adequate specifications are not available at the outset of the competitive bidding process. Step #1 for the purchaser is to request technical proposals without pricing. After receiving the technical proposals and identifying the vendors with technical proposals that are acceptable, step #2 for the purchaser is to ask only those vendors to submit additional proposals with prices and other commercial terms. Online bidding: Online bidding, also referred to as eSourcing, allows suppliers to submit their quotes or proposals via the Internet. There are many formats for online bidding, some of which allow the suppliers to see each other’s bids, some of which keep bids private. Internet reverse auctions: Internet Reverse Auctions represent a type of online bidding and have become increasingly popular since the mid-1990’s. Most of us are familiar with a "traditional" auction - where one individual, group, or selling organization has a product or service to sell and a host of buyers compete with each other to buy that product or service.

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The competitive forces at work ensure that the seller gets the highest price in the market for the offered product or service. A reverse auction is where one buying organization has a requirement to buy a product or service and a host of sellers compete for the opportunity to sell that product or service to the buying organization. The competitive forces at work ensure that the buyer gets the lowest price in the market for the required product or service. An Internet Reverse Auction (also called an online reverse auction) is a reverse auction that is conducted live, in real time, over the Internet, thereby permitting sellers in different locations to simultaneously attempt to outbid each other. Internet Reverse Auctions have generated billions of dollars in savings and have become embraced by modern purchasing professionals across many industries. At this point, we’ll make a side note on a legal issue. The Uniform Commercial Code (UCC) is the body of law that governs purchases of goods in the United States. The UCC provides legal definition of a binding contract. One component of a binding contract is the evidence of an offer to buy or an offer to sell. When preparing your solicitation document, make sure that it includes a phrase indicating that the document is not an offer to buy. This will protect you from any claims by bidders who may try to say that they accepted your RFx as an offer to buy. What you want to request is an offer to sell so that you have the option to accept it, reject it, or make a counteroffer. Once you have thoroughly considered your approach to the bidding process, you must prepare a solicitation document. Strive to present complete solicitation content: Your solicitation document should be comprised of at least the following sections:

An overview of the need for the product or service

A description of the evaluation and award process

Response instructions, including a deadline

A specification

Your quantity requirements

The delivery location and schedule

Terms of both the solicitation and the order Now it’s time for an exercise. You will play the role of buyer for the ABC Company. You are to prepare a request for quotation for a product. Answer the questions below. When you click the Next button, your answers will be used in a request for quotation, which will be displayed on the next page.

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NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

What product do you want to buy?

How many of them do you want to buy?

What will you use the product for? What criteria will you use to select a supplier (e.g., lowest price, best quality, etc.)?

What technical requirements will the product have?

On what date are quotations due? On what date will you notify the successful bidder?

On what date will the product(s) be delivered?

Check the terms that you would like to include in your request for quotation.

You want the right to cancel orders without payment at any time You want a five-year warranty to apply to the product(s) You will pay the successful bidder within 30 days of delivery of the product(s) You want to stress that the solicitation is not an offer You want to stress that you have the right to accept or reject responses to the solicitation

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Request For Quotation ABC Company is seeking to buy ___ new ___ to replace its existing ___, which was/were originally purchased in 1977. The new ___ will be used to ___. ABC Company will select its supplier of the new ___ by choosing the response to this solicitation that offers the ___. ABC Company will notify the successful bidder on ___. To be considered for this award, complete the attached response form and mail it to ABC Company, P.O. Box 1360, Moon Township, PA 15108. Only responses received by ___ will be considered. The technical requirements for the new ___ are as follows. The new ___ ___. The new ___ must be delivered to ABC Company's Moon Township facility on ___. The following terms apply to this solicitation and any subsequent purchase: ABC Company has the right to cancel any orders without payment at any time. A five-year warranty will apply to the goods purchased. ABC Company will pay the successful bidder within 30 days of receiving the goods. This solicitation is a request for quotation and is not an offer to purchase goods nor should it be construed to be an offer to purchase goods. ABC Company reserves the right to accept or reject any or all offers made in response to this solicitation. If the results are not perfect, click the back button on your browser, change the selected answers, and click on the Next button. If you like the results, click on the Next button below. Next Level Purchasing has developed the "10-Phase Approach To World-Class Sourcing." The entire approach is comprehensively covered in our class "Savings Strategy Development." Phase VI offers key tips in finalizing the format of your solicitation documents. One of the guidelines in Phase VI is to standardize the structure of supplier responses. We’ll address standardized response structures now. When preparing your documents, visualize a link between the information you request and the manner in which you will evaluate that information. First, determine specifically how you will analyze and compare proposals: will you use a spreadsheet, will you create a checklist, etc.? Then, craft your solicitation document so that all bidders submit their proposals in a format that makes it easy for you to use your analysis and comparison tools. Consider this scenario:

You have waited weeks for your suppliers to respond to your request for proposal. Today, the deadline arrives and so do your suppliers’ proposals in the mail. Just as you begin opening the first package, your boss walks by your office and asks "Are you done looking at those proposals yet?" while stressing the urgency of bringing the project to completion. As the boss walks away, you

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begin feeling pressured as you open each proposal. Each is in a 4" thick binder filled with literature explaining how the suppliers have been in business since 1907 and other irrelevant stuff. You search and search for minutes on end, desperately trying to find the price in each binder. When you do, you find all kind of footnotes and small print explaining why the price you see is not the price you will pay and a more detailed explanation is on page 1047. Some bidders omit information, others seem to not understand it and offer responses that don’t seem to make sense. You frantically try to summarize all of the proposals in an Excel spreadsheet when, 6 hours after his last visit, the boss stops by and asks "Are you done looking at those proposals yet?"

A little dramatic? Perhaps. Unrealistic? Not at all. Collecting and combining proposal information can be very time consuming and labor intensive. That’s why you should include a standard response format in which all bidders will submit their proposals. This way, you can simply take the bidders’ responses, all of which look the same, get the information you need, and summarize it as necessary. This approach easily flushes out anomalies and exceptions, directing you instantly to the bidders who can unconditionally meet your requirements. The solicitation process is one that must be handled very carefully to make the best decision for your organization and to have no negative after-effects. Here are three tips for preparing a successful competitive bidding process:

1. Ensure uniformity: Make sure that specifications are clear and can be interpreted

identically by all suppliers. Also, be diligent in providing the exact same information (including responses to questions and updates) to all bidders. You want to have all suppliers on the same level playing field and want to be able to compare them easily.

2. Be fair and ethical: Do not disclose information about one bidder to another bidder

unless required by law. Treat all bidders equally. Prepare to award the order to the low bidder unless you specify other selection criteria in your solicitation.

3. Optimize the response timeframe: Give the bidders enough time to do a quality job

of compiling the information you are requesting. For non-off-the-shelf type purchases, two to three weeks is usually the minimal amount of time you should allow. Avoid requiring responses to be submitted around a holiday. Bidder staff may be on vacation, mail delivery will be slower, your office hours may vary from standard office hours, etc. All of these factors may contribute to responses that miss the deadline.

It is not uncommon to gather all bidders together to address questions about your solicitation. This is called a pre-bid conference. Pre-bid conferences are scheduled after the mailing of the solicitation document and before the deadline for the submittal of proposals or quotes. Pre-bid conferences are used for purchases that are more complex, more critical, and/or of a high dollar value. Pre-bid conferences enable all suppliers to get identical information about the bidding process and the contemplated purchase. The pre-bid conference is hosted by purchasing and attended by technical personnel and end users who can address specifics about the desired product or service and its use. Some common topics include:

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Requirements for an acceptable response to the solicitation document

Specifications and technical requirements

Terms and conditions

Schedules

Procedures

Selection criteria The competitive bidding process is not without its challenges. Here are some challenges you may face and how you should handle them.

1. A supplier requests an extension. If you feel that a supplier deserves an extension for a valid reason and your organization would not be unduly harmed by granting that extension, you should offer that same extension to all suppliers.

2. A piece of information in the solicitation document must be changed. You should

notify all suppliers in writing at the same time that you are making a change and that their responses must be based on the change.

3. A supplier submits a late bid. If your policy or solicitation document states that no

bids submitted after the deadline will be considered, then do not open the response. Send it back immediately.

4. A bid contains errors, omissions, or other anomalies. How you handle errors,

omissions, and anomalies depends on the problems as well as what is stated in your organization’s policy and/or solicitation document. If your policy or solicitation document states that such irregularities will result in disqualification of the supplier, then you must disqualify the supplier. In cases where the problems with the bid would disadvantage the supplier, you should give the supplier the opportunity to withdraw its bid. If you give the supplier the opportunity to correct the irregularities, be sure that doing so does not give that supplier an advantage over others.

5. A supplier wants to know how their bid compares with other bids. Unless you are

in a situation where the law requires you to disclose all bids, never give a supplier information about their competitors’ bids. They may try to trick you and say something like "Are we off by 10%, 20%?" But never give a supplier any information that would allow that supplier to estimate the prices of their known competitors. This violates the ethics of protecting confidential information. Plus, it can give an advantage to one supplier over another if you begin negotiating with multiple suppliers. Ethics require you to never give one supplier an advantage that you are not giving to all suppliers.

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Lesson 4 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. If specifications are not clear,: a.) competitive bidding is sure to be successful b.) you should buy without bidding or negotiation c.) you should cancel the procurement d.) competitive bidding will have a high probability of failure 2. A solicitation document that normally allows the supplier to submit technical specifications is called an: a.) RFQ b.) RFP c.) RFD d.) None of the above 3. A supplier will not know how competitive his bid is in a(n): a.) sealed bid with private opening situation b.) sealed bid with public opening situation c.) Internet Reverse Auction d.) all of the above 4. Which of the following is not a typical component of a solicitation document? a.) specification b.) disk containing reverse auction software

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c.) due date for responses d.) delivery location and schedule 5. Which of the following may be considered a breach of ethics? a.) having a pre-bid conference b.) refusing extensions to all suppliers c.) returning unopened any late bids d.) sharing the pricing of one supplier with other suppliers

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Lesson 5 – Selecting A Supplier STEP 6: SELECTING A SUPPLIER As supplier bids arrive in your office, record their responses by the received date and file those responses with the solicitation document and all back up materials. On the date when all bids have been received or on the due date, prepare a spreadsheet with a summary of the important information from each bid. An eSourcing system would automate these processes for you. Even if you have utilized a standardized response form in your solicitation document, you need to look for anything that may represent a deviation from your requirements. Some questions to ask when reviewing each bid include: Has the supplier adhered to the requirements and specifications? If not, the supplier may not be selling what you want to purchase and may result in an inequitable, or "apples-to-oranges," comparison with other bids. Is there any mention of substitutions? If so, the supplier may be quoting a lesser quality product or service. This could result in an "apples-to-oranges" comparison with other bids and could result in major problems for your organization. Did the supplier take exception to any terms and conditions? If so, a long legal negotiation may precede the ordering process. You may not have time to engage in such an extended negotiation. When you begin seriously evaluating the bids from your suppliers, you will need to use the information available to you to select the best supplier. A good supplier selection is characterized by:

Minimized costs (both paid to the supplier and incurred as a result of doing business)

Adequate or better quality

On-time deliveries

Responsive service

A poor supplier selection is characterized by:

Higher than expected costs (both paid to the supplier and incurred as a result of doing business)

Poor quality

Late deliveries

Unresponsive service So, as you can see, there are consequences to be suffered if you do not make a good supplier selection decision. To make a good supplier selection decision, you need to look at two things: (1) the financial aspect of doing business with a supplier and (2) the operational

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aspect of doing business with a supplier. Many poor decisions are made when buyers fail to assess the operational aspect of doing business with a supplier. We’ll talk about both aspects now, beginning with the financial aspect. When we refer to the financial aspect of doing business with a supplier, we are talking about both the money you pay to the supplier as well as expenses you incur by purchasing and utilizing the product or service. There are three primary ways to analyze the financial aspect of doing business with a supplier:

Price Analysis

Cost Analysis

Total Cost of Ownership Analysis

To goal of performing any of these types of analysis is to determine which supplier offers you the best deal among all offers that you receive. Price analysis is the comparison of a supplier’s price with a benchmark price. Price analysis is the most common way of analyzing a supplier’s price because it is quick and easy to do. The benchmark price usually takes one of four forms:

1. Other competing bids. Using competing bids gives you a real-time view of the market for the product or service. When the specifications are clear, there is not much differentiation between the quality or delivery of the products or services being compared, and each supplier has an equal opportunity to perform well, using competing bids can be an effective way of performing price analysis.

2. Published prices. For many industry standard goods, suppliers publish catalogs or

post their prices on their Web sites. You can often use these prices to determine the size and fairness of your discount.

3. Previously paid prices. Knowing what you’ve paid in the past can help you determine

if a price is fair. Did the price rise? If so, did it rise by an unreasonable margin? Are you getting the same discount as you have in the past? These are all questions that can help you determine if the quoted price is fair.

4. Should cost models. A should cost model is a calculation that a purchasing

organization performs to estimate a price before a quote is received. It is essentially like preparing a quote. You determine the costs of material and labor then add on percentages of those amounts to cover overhead and profit. Overhead is money that is used to cover costs that do not go directly into the cost of a product or service. It includes things like supervisory salaries, benefits, rent, utilities, etc. Profit is what is left after all costs have been covered. It is the income that the company makes. Overhead and profit rates will differ based on the product or service and the industry. Industry information is available on the Internet and from subscription services such as the one found at www.hoovers.com. Here’s an example of a should cost model for the installation of an electrical outlet:

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Price Component Amount

Material (wire, breaker, outlet) $50.00

Labor (2 hours, technician paid $18/hr) $36.00

Overhead (100% of labor and materials) $86.00

Profit (15% of material, labor, and overhead) $25.80

Final Price $197.80

Cost analysis is a more complex process than price analysis. Yet, it is very helpful when comparing prices. A cost analysis does what a should cost model does – it breaks down a price into components of cost. The difference is that the supplier does the breaking down. To get a cost breakdown from a supplier, you will have to specifically request it. Not many suppliers will provide one voluntarily. In fact, you may occasionally run into a supplier that refuses to provide one, even upon a buyer’s insistence. Cost analysis helps you understand a supplier’s price better. This understanding will help you make a more informed supplier selection. A cost analysis will alert you to potential issues in a way that simple price analysis will not. For example, let’s say you received these three bids from suppliers of the electrical outlet:

Supplier Price

Supplier A $180.00

Supplier B $200.00

Supplier C $202.00

Which supplier would you pick? Many buyers would pick Supplier A based on a price analysis showing that they offered the lowest price. But what if you requested a cost breakdown? Take a look at this cost analysis:

Cost Component Supplier A Supplier B Supplier C

Materials $21.00 $50.00 $51.00

Labor $45.00 $40.00 $36.00

Overhead $80.00 $80.00 $87.00

Profit $34.00 $30.00 $28.00

Total $180.00 $200.00 $202.00

Your eyes should be drawn to the significant difference between Supplier A’s materials cost and that of the other suppliers. Sometimes, differences in cost components are justified – a supplier may be more efficient, have more purchasing power, or allocate a lower percentage to overhead and profit. Other times, differences in cost components serve as "red flags."

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They alert the keen purchaser to situations where a supplier may not have understood the requirements or may be trying to cut corners. In this example, the buyer may have found that Suppliers B & C included the outlet, wire, and breaker in their material quote, but Supplier A failed to include the breaker. Supplier A may have later found that it needed to install the breaker, so it would later charge the consumer. This over-and-above charge may end up resulting in the buyer paying more to Supplier A than it would have paid to Suppliers B or C. Cost analysis gives you a tool to avoid becoming a victim to the unpleasant surprises of over-and-above charges. Total cost of ownership analysis is the most comprehensive way of analyzing the financial aspect of doing business with a supplier. Unlike price analysis and cost analysis, total cost of ownership analysis looks at not only the money you will spend with a supplier, but also the costs that you will incur as a result of buying and utilizing the product or service over the life of that product or service. For capital equipment, total cost of ownership analysis is sometimes referred to as life cycle costing. Here are some non-price cost components that total cost of ownership analysis examines:

Costs to maintain the product/service – can be internal costs, amounts paid to the supplier, or amounts paid to a third party.

Transportation – can include freight, customs, and labor used to unload goods

Storage – includes all costs associated with housing equipment or carrying inventory including a prorated portion of facility rental charges, opportunity cost of not investing money tied up in inventory, insurance, etc.

Inspection – includes the labor costs associated with inspecting goods delivered by a supplier

Quality – includes all costs incurred when defects arise. For example, when an aircraft component fails, a mechanic will have to remove and replace the component. During that time, the plane’s next flight will be canceled and passengers will have to be routed onto another airline. Airline personnel will have to work to adjust the schedule so that planes are in the right places at the right times. All of these activities can cost the airline tens of thousands of dollars for a single component failure.

Rework – includes the purchasing organization’s labor that is used to correct defective work by the supplier.

Training costs – includes costs associated with training the buying organization’s personnel on the goods purchased. Training costs may be charged by the supplier and/or incurred by the buying organization. For example, if a buying organization buys a software package and requires all of its employees to spend three hours in training, the costs of having those employees in training (e.g., their wages) must be included in calculating total cost of ownership.

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Repair parts costs – includes the costs associated with buying spare parts to ensure uninterrupted operation of equipment.

Energy use – Different equipment and services use different amounts of energy such as electric, natural gas, and water. The costs of buying and consuming these resources are factored into a total cost of ownership analysis.

Direct labor – When personnel are going to be using a product and/or their productivity affected by the use of that product, the cost of their involvement or productivity must be factored in to your total cost of ownership calculation.

Installation costs – includes costs paid for the physical installation of equipment as well as costs associated with preparing a location for the installation of equipment

Taxes and duties

Disposal costs – If you have to hire a third party to remove heavy equipment, dispose of hazardous materials, or otherwise rid your facility of a product, these costs should be included in your analysis.

The total cost of ownership should be adjusted downward when certain conditions exist. These things can reduce the calculated value of the total cost of ownership and partially offset the cost components:

Early payment discounts

Payments made in a future year

Income from recycling

Salvage value of the equipment Let me just share a little bit more detail about some of these points. First, let’s talk about payments made in a future year. In their total cost of ownership calculations involving payments over a number of years, advanced purchasing professionals will consider the “time value of money” – a principle that indicates that, due to inflation and the ability to earn interest on cash investments, an expenditure of a monetary amount in the future is less costly than if that same amount was spent today. These purchasing professionals will use a net present value formula to determine a current monetary value that is deemed to be equivalent to the payment of a larger amount in the future. Again, this is a more advanced concept that is beyond the scope of this course. But if you’re curious about this concept, you can check http://www.investopedia.com/articles/03/082703.asp or http://en.wikipedia.org/wiki/Time_value_of_money for more information. (These are third party links outside of our control, so please let us know if they cease to exist or change content)

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Now, let’s talk about asset disposal. When you do not have use for equipment any longer, you may be able to somehow get money (or income) in return for it. This can come in the form of: 1. Recycling, which sells the equipment to someone who can convert its materials into materials that can be used to manufacture something new. 2. Salvage, which sells the equipment to someone who can use it as a "previously owned" piece of equipment or strip it of its parts to resell the parts. OK, time for another exercise. In this exercise you will answer some questions that will allow you to compute a total cost of ownership for a piece of equipment provided by Supplier A that will be used by your organization in its Moon Township, Pennsylvania facility for two years. When entering numbers, please do not use dollar signs, commas, decimal points, or any other punctuation. After clicking on the Next button, you will see the total cost of ownership for Supplier A’s equipment as well as Supplier B’s equipment.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

What is the price of the equipment? $

From what city will the supplier be shipping the equipment?

How much will it cost to ship the equipment to your facility? $

How many employees will need to be trained on the equipment?

What is the average hourly wage of these employees? $

How many days of training will be required?

Will the training be at the supplier’s facility or your facility?

How much will the supplier charge for training? $

What is the cost of energy to be used by the equipment over a two-year period? $

How much could you sell the equipment for at the end of two years? $

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Here is a Total Cost of Ownership (TCO) analysis comparing the TCO for Supplier A based on the information that you just entered and the TCO for Supplier B.

Supplier A Supplier B

Important points Will ship the equipment from Washington, D.C. Requires 2 days of training for 2 employees at buyer's facility.

Will ship the equipment from Pittsburgh, Pennsylvania. Requires 2 days of training for 2 employees at buyer’s facility.

Price $110000 $100,000

Freight $2500 $500

Cost of Employees Time In Training (number of days x average hourly wage x 8 hours per day x number of employees)

$800 $800

Cost of Airfare for Training ($1,000 per employee if training at the supplier’s facility)

$0 $0

Cost of Hotel Accommodations for Training (if training at supplier’s facility for more than one day, $200 per additional day per employee)

$0 $0

Cost of Meals While Training (if training at supplier’s facility for more than one day, $65 per additional day per employee)

$0 $0

Energy Costs $1500 $2,400

Salvage Value ($20000 ) ($10,000)

Total Cost of Ownership $94800 $93700

So which supplier would you select? Is the supplier with the lowest total cost of ownership the supplier with the lowest price? It is considered best practice to select the supplier with the lowest total cost of ownership even if that supplier offered a higher price.

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Now, despite the comprehensive nature of total cost of ownership analysis, not every organization has adopted it. There are a few common reasons why:

1. Lack of skill. Total cost of ownership analysis requires an analytical mind. Not all organizations have this type of analytical thinker in their employ. As a result, they often defer to price analysis where just about any somewhat educated person can pick the lowest price out of two or more bids. In addition to being difficult to compile, a total cost of ownership analysis is difficult to communicate. Because the organization will not be writing a check for the total cost of ownership, it may be difficult to convince an executive that all of these costs will actually be incurred by the organization.

2. Access to data. It is not necessarily easy to obtain all cost information. A new buyer

in a large organization may not know who to ask to get cost information on, say, its cost of electricity or the wage rates of its shop-floor workers.

3. Resistance to change. Humans naturally are resistant to change, especially in the

context of an organizational culture. Not accepting the lowest bid based on a total cost of ownership analysis may be such a deviation from business as usual, that a decision-making team will not be willing to consider it.

There is no universal, strict “rule of thumb” indicating which type of analysis to use. Often times, the situation will dictate which analysis method to use. However, here are some general guidelines to consider if you are unsure of which analysis method to use: Use TCO analysis when there are substantial non-product costs associated with the product. Even an automobile, which consumes increasingly costly fuel, can be subject to TCO analysis. Use cost analysis when the product or service is somewhat or completely customized but doesn't have substantial non-product costs associated with it. And use price analysis when the product or service is a common one and involves no customization on the part of the supplier. Now we’re going to turn our attention to assessing the operational aspect of doing business with a supplier. This is such an important part of the supplier selection process, but it is also one that is often forgotten. When it is forgotten, only luck will save you from problems. Keep in mind that obtaining the lowest price in the world will be meaningless if your supplier doesn’t do what you need it to do. You need to make sure that you select a supplier that is capable of fulfilling your requirements. You need to gather evidence that your supplier has met the needs of others, can meet your specific needs, and will be around for the duration of your transaction. There are five ways to gather this type of evidence.

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1. Do A Reference Check: Ask your supplier to provide the names, phone numbers, and email addresses of representatives in their customers’ purchasing departments. Call these folks. And don’t just shoot the breeze. Have a poignant discussion of the relevant issues. What problems have the customers experienced with the supplier? How has the supplier handled those problems? Is their volume similar to yours? Do the customers have any concern that your capacity will affect the supplier’s ability to perform for them? Develop your questions around the risk that you could anticipate in a worst-case situation. 2. Conduct A Site Visit: Visiting a supplier’s facility is another way of determining whether a supplier is qualified or not. Unfortunately, there is a lack of clarity in the purchasing profession as to how to conduct a meaningful site visit. We often visit a supplier’s facility, stroll through the factory looking at machines of which we have no understanding, have lunch, talk about sports, and leave feeling warm and fuzzy. Obviously, the foregoing process does not necessarily result in a determination whether a supplier is capable of meeting your requirements. Here are a few things to address when conducting a site visit.

If the purchase is technical in nature and high-dollar in value, utilize a cross-functional team to conduct a site visit. Examples of cross-functional team members include a purchasing agent, a quality assurance representative, an operations supervisor, and an engineer. If there is someone you can identify as an end-user, invite that person to participate in the site visit as well. With the "shop-floor" experience of the cross-functional team members, you can get a feel for the quality of the supplier’s operations by looking for (a) documented procedures, (b) a quality-oriented record keeping system, (c) evidence of compliance with regulations or certifications, (d) desirable housekeeping practices, (e) efficient flow of materials and processes in general, (f) high employee morale, (g) quality-oriented charts, and (h) documentation of equipment maintenance history.

Ask to see the supplier’s backlog of orders. Is there a significant number of parts in various stages of assembly that are waiting to be worked on? Try to find the dates that these parts were started, when they will be worked on next, and when they will be finished. Is the amount of days from start to finish longer than the lead time that the supplier quoted to you? Try to determine how much of a delay your orders will add to the backlog.

Ask the supplier to show you the capacity available for your orders. You should see idle tooling or machinery on which your orders will be worked. If no machine is idle, ask the machine operators what they will be working on next. Try to find out if the machine operators are crushed with work or if your work will fit nicely into their current workload.

Ask to see the supplier’s finished goods inventory. See if the supplier has stock on hand of your highest volume and most critical items. The supplier may not have these items on hand perhaps because you are one of the few customers that orders those particular items. If this is the situation, be aware that the supplier may not have a

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strong relationship with its vendors of those types of items and there is no guarantee that the relationship will develop perfectly over night.

In summary, if your site visit finds a small backlog, idle tooling or machinery, and adequate stocking of your most critical and highest volume items, then the supplier may be able to meet your requirements. 3. Obtain Samples: If the potential new supplier provides a product, require that the new supplier submit a sample of the product for your evaluation. If the supplier provides a service, ask to see the result of their services. Treat your supplier evaluation like a court case – put the burden of proof on the supplier for establishing its degree of qualification. Make the supplier provide compelling evidence that it can meet your requirements. 4. Conduct A Pilot Program: One way of finding out whether a supplier can perform for you is to simply have them perform for you. You can negotiate an agreement with a supplier where you can buy their product or service for a short period of time (e.g., 30 to 60 days) for the purpose of evaluating whether or not you want to sign a long-term agreement with them. In such an agreement, there is no obligation for the parties to work together after the pilot program. A pilot program allows both the buyer and the seller to determine if each one can do what they claim to be able to do. This scenario works great for items that are used by many organizations (e.g., office supplies) and services that do not require the supplier to make customer-specific purchases (e.g., janitorial services). Where customized products or services are being purchased, you should reasonably expect to pay for fees. For example, if you are purchasing software that requires some customization, you can expect to pay for the costs associated with customization even though the software provider may allow you to use the software for free during the pilot period. If you are subcontracting the manufacture of a customized part, you can expect to pay for the tooling. If you do pay these up-front costs, you could try to negotiate a credit for those costs if you elect to sign a long-term agreement. 5. Analyze Financial Statements: Doing business with a supplier in poor financial health can be disastrous. The supplier may lay off portions of its work force, resulting in the degradation of its performance for you. The supplier could even go belly up, ceasing operations and not being there when you need it. The good news is that layoffs and bankruptcies are usually not surprises. By analyzing a supplier’s financial statements, you can determine the health of the company. You can get financial statements for publicly-held companies very easily from the Internet. You’ll have to request the financial statements from privately-held companies, however. And don’t be surprised if you meet resistance. The financial statements of privately-held companies contain information about the owner’s earnings – information that they may not even share with their friends and family. However, if the procurement places significant risk upon your organization, you should insist on getting some type of financial statement. You should be prepared to sign and abide by the terms of a confidentiality agreement because of the sensitivity of the data. Financial statement analysis is an in-depth topic – one that could be the subject of its own course. It is covered more extensively in our class "14 Purchasing Best Practices." While we

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won’t cover everything you’ll ever need to know about financial statement analysis in this course, we’ll get you familiar with the process. To simplify matters, there are two signs that a company will be around for the duration of your relationship: profitability and cash sustenance. The first thing to do – which is also the easiest thing to do – is to check whether the supplier is profitable or not. Get a copy of the supplier’s annual report and look at the supplier’s income statement (also called a statement of operations, profit and loss statement, and P&L). Find a line called something like "net income (loss)". If the number is in parentheses, it is negative. Any negative number means that the supplier has lost money for the period covered by the income statement. Beware of any business that is losing money. The second thing to do is to check if the supplier has enough cash to fund its continuing operations. To make this determination, you must look at the supplier’s cash flow statement. Find a line called "Net increase (decrease) in cash and cash equivalents" – we’ll call this the Change In Cash Line. If the number is in parentheses, it is negative. Any negative number on the Change In Cash Line means that the supplier’s cash reserves are dwindling. Dwindling cash reserves mean a lower likelihood that the supplier will be able to pay its bills. When a company cannot pay its bills, it files for bankruptcy. Now, find the line called "Cash and cash equivalents at end of period" – we’ll call this the Remaining Cash Line. The Remaining Cash Line will tell you how much cash the company has left in its coffers. Knowing how much cash is being "burnt" and how much cash is left will enable you to estimate the number of months a company has left to survive if the rate of cash burn remains the same and no external financing is obtained. For example, if a company has burnt $20 million in the past year and has $5 million remaining, you could estimate that the company will only survive for another 3 months if the rate of cash burn ($20 million per year or $5 million per quarter) remains the same and no infusion of cash is achieved. It is recommended that you look not only at the last annual report, but also at the last several quarterly reports. When a company is burning through cash, it usually makes adjustments to reduce the cash burn rate from quarter to quarter. For example, the company that burned through $20 million in cash in the year may have burnt $12 million in the first quarter, $5 million in the second quarter, $2 million in the third quarter, and $1 million in the fourth quarter. As such, the $5 million remaining may last 5 quarters or more if the burn rate is reduced through reduced costs and/or increased revenue. You can also compare suppliers’ profitability and burn rates. Suppliers with higher profits and positive cash flow are more attractive than suppliers with lower profits or losses and negative cash flow. Many financial professionals use ratios to compare the health of different suppliers. Two ratios that we’ll introduce are the Return On Total Assets and Operating Margin. For both of these ratios, the higher the number, the healthier the supplier. Here are the formulas to calculate these two ratios: Return On Total Assets (ROA) = Net income / total assets. Operating Margin = Operating Income / Sales

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Just because a company is healthy financially doesn’t mean that you don’t face the risk of the supplier failing to have the resources to meet your needs. If the supplier’s workforce is unionized, a strike could threaten to disrupt the supplier’s performance for you. So ask your suppliers if they have a unionized workforce. If they do, learn when the contract expires. If the contract expires during the time that you will need the supplier to perform, learn about the supplier’s labor history and its contingency plans. Did the union strike before? How long was the last strike? Did production continue during the last strike? Has the supplier built up inventory to mitigate the effects of a strike? What is the supplier’s back up plan in the event of a strike? Before doing business with a unionized supplier, you need to be convinced that any labor issues will not affect your organization. It’s always helpful to have a checklist when you have to look at multiple factors affecting a decision. Feel free to adopt the following "Ideal Supplier Checklist" to help you with your decisions. This can be used to disqualify suppliers who do not receive at least a certain number of checks.

After thorough analysis, the supplier offers a competitive and attractive price The supplier has past performance that demonstrates a capability of meeting current

requirements

The supplier has been in business long enough to have the expertise necessary to provide the product or service

The supplier has all necessary certifications or licenses

Providing the product or service is the supplier’s main business

The supplier has little or no backlog that could adversely affect its delivery or

performance schedule

The supplier’s references indicated that the supplier would be able to fulfill our needs

The supplier has the appropriate administrative capabilities to handle the processing of our orders

The supplier has the capacity to handle our additional work

The supplier’s purchasing department has a system for measuring and improving

supplier performance

There is no threat of a strike disrupting the supplier’s performance during the applicable timeframe

The supplier is both profitable and has positive cash flow

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The supplier’s capabilities to provide other products and/or services allow for the expansion of the number of products or services we purchase from them

A final consideration for selecting a supplier is to get internal buy-in. An internal customer who doesn’t agree with the supplier selection will lose his confidence in the purchasing department, complain, or, in the worst case scenario, facilitate the supplier’s failure to satisfy your needs. Many organizations are using cross-functional-team-based supplier selection processes to ensure internal buy in. Invite your end users to participate in the supplier selection process, educate them in the things that constitute a good supplier selection, collectively develop supplier selection criteria, discuss and debate the merits of the most attractive suppliers, and reach consensus (or at least a majority vote) on the best supplier to select. So, you can see that there is a lot more to consider in selecting a supplier than just low pricing. You obviously want the best deal for your organization, but should not accept an overabundance of risk to get a low price. Select the supplier that will contribute the most to all aspects of your organization’s success.

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Lesson 5 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is not a result of good supplier selection? a.) minimized costs b.) maximized costs c.) on-time delivery d.) flawless quality 2. Comparing a supplier's price with other competitive bids is a form of: a.) price analysis b.) cost analysis c.) total cost of ownership analysis d.) all of the above 3. Breaking a supplier's price down into components such as material, labor, overhead, and profit is called: a.) price analysis b.) total cost of ownership analysis c.) component analysis d.) cost analysis 4. Total cost of ownership analysis: a.) requires skill b.) has been adopted by all organizations

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c.) is not much different than price analysis d.) none of the above 5. Which of the following may persuade you not to do business with a supplier? a.) a lack of references b.) a recent history of financial losses c.) inability to produce a sample that conforms to specifications d.) all of the above

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Lesson 6 – Formalizing The Commitment STEP 7: FORMALIZING THE COMMITMENT Once you have applied your supplier selection criteria and identified the most desirable candidate, you must formalize the commitment. Commitments or agreements to buy and sell goods and services are governed by laws applicable to sales transactions. It is important to be familiar with applicable laws prior to making a commitment. Students from around the world take this class and bodies of law differ in each country. Unfortunately, it is impossible for us to discuss each country’s bodies of laws within this class. However, we will cover some of the domestic laws that apply within the United States because other countries have similar laws. We will also cover laws that apply to many countries when businesses within those countries purchase from suppliers in other countries. These bodies of laws and what they cover are as follows:

The Uniform Commercial Code governs transactions of goods between buyers and sellers in the United States

The common law system of the United States governs the purchase and sale of services between buyers and sellers in the United States

International regulations govern transactions between organizations in different countries.

We will talk about each of these bodies of law. UCC The most widely discussed body of law in the purchasing profession is the Uniform Commercial Code (UCC). The Article 2 of the UCC governs transactions for goods between buyers and sellers in the United States. Though it is a national code, each state has the option to adopt it into state law. The UCC comprehensively covers, among many other things, how a contract is formed and whether or not it is enforceable. One fundamental principle of the UCC states that oral agreements to buy and sell goods are only enforceable if the value of the goods is less than a certain amount. That amount has historically been $500 (US) and all US states with the exception of Louisiana have adopted that threshold. Article 2 of the UCC has recently been revised and the threshold raised to $5,000 but, as of this writing, no US state has adopted the revised Article 2. Therefore, for the purposes of this class, we will refer to the threshold as $500. If the value is $500 or more, the agreement must be documented in writing to be enforceable.

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The UCC also indicates that the following elements must exist in order for an agreement to be enforceable:

Consideration – For a contract to be enforceable, there has to be an exchange of one thing of value for another thing of value. The easiest example to understand is the exchange of money for a product. Each party must be giving up something that has a tangible worth.

Competent parties – For a contract to be enforceable, neither party be may be under the legal age to enter into a contract, suffering from a mental illness, or under the influence of drugs or alcohol.

Legality of purpose – For a contract to be enforceable, the purpose of the contract must be legal. For example, a contract to buy and sell marijuana is not enforceable under the UCC.

Mutual assent – Both parties must express their agreement to be bound by the contract.

We’ll spend a little bit of time on mutual assent… Mutual assent is often secured when an offer is made by one organization or person (the offeror) and another organization or person (the offeree) unconditionally accepts that offer. An offer remains valid until it is revoked, it is rejected, it becomes illegal, it expires, or it is accepted. To some, it is not clear when an offer occurs and when an acceptance occurs. So, you have to put it into context. You need to look at the first commitment-related correspondence that makes an offer to buy or sell. If a supplier gives you a quote, it is an offer to sell. If you submit a purchase order after receiving that quote and the terms on your order do not conflict with the terms of the quote, you have accepted that offer. Easy enough? Well, it can get more confusing. What if you submit an order to the supplier without having received a quote? Is your purchase order still an acceptance? No! Because your order is the first commitment-related correspondence, your order is an offer. So what is the acceptance? If the supplier returns an indication that the offer has been accepted, such as an acknowledgement, a signed copy of your purchase order, or even an email or fax indicating a ship date, the supplier has formally accepted your offer. But check this out. Also, if the supplier takes any action that creates the appearance that the offer has been accepted (such as shipping the goods in response to your order), then the offer is legally deemed accepted. Performance can constitute an agreement. Confused yet? If not, we’ll try again… Now imagine this. You receive a quote for a product from a supplier. You want to buy the product, but you take exception to the "as-is" provision in the quote. You send a purchase

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order to the supplier and, in the purchase order, you indicate that a condition of your purchase is that you receive a 30-day warranty. Your purchase order is not the offer, because the quote was the first commitment-related correspondence that was exchanged. So is your purchase order an acceptance? If you answered "yes," you’re wrong. The fact that your purchase order contained a term that is different than a term in the quote makes it a counteroffer, not an acceptance. So now the supplier has a de facto offer to which to respond. If the supplier accepts the counteroffer, then the legally enforceable agreement contains a 30-day warranty. A counteroffer officially terminates a previous offer and proposes a new and different offer. The offer/counteroffer scenario can be difficult to manage. Quotations can be followed by purchase orders which can be followed by acknowledgements which can be followed by other correspondence and each document may contain different terms. The UCC addresses this situation, which is commonly referred to as "The Battle of the Forms." The UCC groups terms on these forms (purchase orders, acknowledgements, etc.) into three categories: (a) matching terms, (b) conflicting terms, and (c) additional terms. Here are definitions of each of these categories and how the UCC handles them: Matching terms – These are terms are identical in each form. Therefore, they are legally enforceable. Conflicting terms – These are terms that are present in each form and address the same issue but express different requirements or rights. For example, the purchase order may indicate that the purchasing organization may take up to one year to inspect the goods before being obligated to pay for them. The acknowledgement may indicate that the buyer must pay for the goods prior to inspecting them. There is a conflict on an issue. The UCC indicates that conflicting terms will cancel each other out and the terms of the UCC will prevail. In this case, the UCC will give the purchasing organization a "reasonable" amount of time to inspect the goods before paying for them. It is quite likely that one year is not a reasonable amount of time. Depending on the goods, most courts would probably set around a 30-day limit on the timeframe to inspect prior to payment. In some industries where the industry standard timeframe to inspect is different (such as perishables), the timeframe would likely be set to industry standard. Additional terms – These are terms that relate to a concept addressed in one party’s form but not the other’s. When a term appears in only one form, it becomes part of the agreement between the parties. For example, if the buyer’s purchase order didn’t mention warranty and the seller’s acknowledgement stated that there is no warranty for a product, then there is no warranty for the product. Because the seller addressed warranty and the buyer didn’t, the seller’s term governs the warranty associated with the product. Despite all of this, the UCC contains language outlining conditions in which additional terms cannot become part of a contract. Any of these conditions can preclude additional terms from becoming a part of the contract: (a) the offer expressly limits the offer to the original terms of the offer, (b) the incorporation of additional terms materially alters the contract, or (c) the additional terms are objected to within a reasonable time.

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A possible fourth category of terms is the terms that are missing. If neither form contains language on a certain element of a purchase, the terms of the UCC will govern the rights and obligations of the parties relative to that element. Common Law Governing The Purchase and Sale of Services The UCC does not apply to purchases and sales of services. Common law does. We won’t go as deep into common law issues, but here are two important things about how the law affects services purchases:

1. The way that common law deals with documents that do not contain matching terms differs from the way that the UCC deals with such documents. Service contracts are subject to the Mirror Image Rule. The Mirror Image Rule states that separate documents that are used to finalize an agreement on the purchase and sale of services must match for a contract to exist. If they don’t match, the terms of the last document prevails.

2. Oral contracts for services are not valid if the service cannot be fully performed within

one year of the supposed oral agreement.

International Regulations Governing Transactions Between Organizations in Different Countries International purchasing is a complex topic. When organizations from two countries do business, which country’s laws apply? The answer depends on a lot of factors. We won’t go into detail on the nuances of law related to international business, but we will introduce you to one body of law that affects global transactions. In the last two decades, the United Nations introduced a treaty called the United Nations Convention on Contracts for the International Sale of Goods (CISG). This treaty is designed to standardize the rules governing international sales and purchases. For the CISG to apply to a specific situation, the countries of both buyer and seller must have ratified the treaty. There are several dozen nations who have ratified it so far. Now that we know which law applies to our purchase, we can formalize the commitment to the supplier. Formalizing a commitment to buy can come in a variety of forms, including:

Issuing a purchase order to the supplier

Providing a credit card number to the supplier

Signing a contract with the supplier

Providing a letter of intent to the supplier Here’s a little bit of background on these commitment instruments… 1. Purchase Orders

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Affectionately called PO’s, purchase orders are generally one-page documents that describe the product or service being bought. Purchase orders should contain the following key pieces of information: Buyer’s name and contact information Supplier name Purchase order number Description of the product or service Quantity Price Due date Delivery location Billing instructions Terms and conditions (usually on the back side) Account to be charged Payment terms Shipping terms Most of these items are self-explanatory. However, we will cover descriptions, payment terms and shipping terms in more detail. Descriptions A common question is: "What is better to use on a purchase order: an item number or a free text description?" Well, first let me say that these two pieces of information do not need to be mutually exclusive. The purpose of an item number, purchase order description, or specification is simple: to communicate to the supplier what you have ordered in a manner that makes it unlikely (ideally, impossible) for a supplier to misinterpret what it is that you want to buy. The amount of information required on a purchase order differs depending on what you're buying. When an item number removes the probability of getting something that is different than what you wanted, then that is all you need. But for less common or less tangible purchases (especially services), you will need more descriptive text - maybe even a 40-page specification. So, the only correct answer is "it depends." Payment Terms Payment terms dictate when you will pay the supplier. You can pay a supplier in advance or upon delivery. However, in most corporate environments, buyers usually pay after a product has been delivered or a service has been performed. This is called buying on credit. When

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you buy on credit, the supplier sends to the buying organization an invoice requesting payment. An invoice is simply a bill, like the bills you get at home. It is very common for suppliers to require payment within 30 days of the delivery of a product or performance of a service. When suppliers require payment within 30 days, the common name for such a payment term is "net 30." If the payment were required in 15 days, this would be considered a "net 15" payment term. Sometimes, suppliers will require payment within a certain timeframe, but want to give the buying organization incentive to pay early. So they will offer a discount for early payment. Payment terms start to look strange when these types of arrangements are in effect. For example, "2/10, net 30" means that a buying organization can reduce the amount of the invoice by 2% if it pays within 10 days. If it does not pay within 10 days, then the full amount of the invoice is due within 30 days. The scheme for this type of payment term is as follows: The first number is the percentage to be deducted from the invoiced amount if paying early. The second number is the number of days the buying organization has to qualify for the right to deduct the percentage. The number after the word "net" is the number of days the buying organization has to pay the invoice before being considered late. Shipping Terms Shipping terms indicate whether the buyer or seller is responsible for paying for the freight charges associated with shipping a product. Shipping terms also indicate which of the two parties is responsible for the loss or damage to a shipment while in transit. The party responsible for loss or damage to a shipment is said to bear the "risk of loss." Like payment terms, shipping terms have their own odd nomenclature. And shipping terms used for domestic transactions within the USA are different than the shipping terms used in most other major countries as well as for transactions between a US-based buying organization and a non-US-based selling organization. For domestic transportation in the United States, the letters F.O.B. are used in shipping terms. Technically, F.O.B. means "free on board." Practically, F.O.B. determines at which point the risk of loss of the goods transfers to the buyer from the seller. F.O.B. is usually followed by a name of the place where the risk of loss transfers from the seller or the buyer. The name of the place will be either "origin" or "destination" or a variation on one of these. Origin, also called seller’s plant, shipping point, or something similar, means the supplier’s dock. Therefore, when the shipping terms for a purchase are F.O.B. Origin, the risk of loss transfers from the seller to the buyer as soon as the goods are loaded onto a truck from the seller’s dock. Any damage to or loss of the goods while in possession of the carrier is the responsibility of the buying organization. The buyer would be responsible for filing a claim with the carrier.

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Destination means the buyer’s dock. Therefore, when the shipping terms for a purchase are F.O.B. Destination, the risk of loss transfers from the seller to the buyer as soon as the goods are loaded from the truck onto the buyer’s dock. Any damage to or loss of the goods while in possession of the carrier is the responsibility of the selling organization. The seller would be responsible for filing a claim with the carrier. While F.O.B. Origin and F.O.B. Destination address who bears the risk of loss of goods during transit, they do not indicate which party is to bear the cost of shipping, which is an entirely separate issue. Therefore, these terms need to be completed with one of the following most commonly used terms:

Term Meaning Example

Freight prepaid and allowed

The supplier pays for the freight and does not require reimbursement by the buyer

F.O.B. Destination, freight prepaid and allowed

Freight prepaid collect The supplier pays for the freight and invoices the buyer for reimbursement

F.O.B. Origin, freight prepaid collect

When you have special requirements, such as a carrier to use or an accelerated method of delivery (e.g., next day air), you should specify those requirements on the purchase order. (NOTE: Part of the following material was written by Dick Locke, who is the co-instructor for our online classes “Basics of Smart International Procurement” and “Executing A Global Sourcing Strategy.”) For transactions involving a shipment outside of the USA, Incoterms are used as the shipping terms. Incoterms are internationally recognized terms of sale. They define the responsibilities of both buyer and seller for shipping, paying duties, and clearing customs. They also define where risk of loss transfers between buyer and seller. The International Chamber of Commerce writes and publishes them. They guard their copyright very carefully, so you cannot find the exact wording on the Internet. The book is called Incoterms 2010. ( http://tinyurl.com/275vxsg) It’s revised every 10 years. Incoterms 2010 will be effective on January 1, 2011. Be aware that Incoterms do not discuss title transfer. They only discuss transfer of risk of loss. Consider adding “Title to the goods will transfer at the time and place indicated by the Incoterm on the purchase order" to your purchase agreement. You can also separate title transfer from risk of loss transfer and define the two separately. That might open the door to delayed recognition of inventory until the goods arrive but permit the advantages of picking an Incoterm that enables you to control freight and customs. Here are the 11 Incoterms. We will discuss some of them in more detail.

EXW: Ex Works

FCA: Free Carrier

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FAS: Free Alongside Ship

FOB: Free on Board

CFR: Cost and Freight

CIF: Cost, Insurance and Freight

CPT: Carriage Paid To

CIP: Carriage and Insurance Paid to

DAP: Delivered at Place

DAT: Delivered at Terminal

DDP: Delivered Duty Paid

Note the style: Three capital letters with no periods between them. That’s different than the normal terms used in the United States. The three letter abbreviations have to have a place name after them. There are rules as to what the place name can be for some terms. Sometimes the place name must be in the supplier’s country, and sometimes it must be in the buyer’s country. Four terms (FAS, FOB, CFR, and CIF) may only be used with sea or inland waterway freight. If you surf the International Chamber of Commerce’s Web site, you’ll notice that they use the word “carrier” quite a bit. They are referring to the shipping company that transports the goods from the seller’s country to the buyer’s country. They also refer to “carriage.” Carriage is the transportation of goods from the seller’s country to the buyer’s country. Some recommended Incoterms include EXW, FCA, DDP. Here’s an explanation why… Ex-works (EXW) Under Ex-works, the buyer picks up the goods at the supplier’s shipping dock and the buyer is responsible for all freight costs and duties through the whole shipment. Risk of loss transfers at the supplier’s shipping dock. The place name must be the supplier’s location. Free Carrier (FCA) In Incoterms 2000, the ICC claims they just “clarified” the terms Ex-works and Free Carrier. I recommend Free Carrier for most situations. The place name can be anywhere in the supplier’s country, and on either side of export customs. The most important difference between Free Carrier and Ex-works is that under Free Carrier, the supplier is responsible for any costs or problems clearing export customs. This is true even if the place name is before customs. Some countries (China is one) are now collecting “export duties” on some scarce raw materials, and you don’t want a surprise requirement for you to pay those duties. Another difference is that under Ex-works, the buyer has the responsibility to load the goods into the shipping container or truck at the supplier’s shipping dock. Under Free Carrier, if the place name is the supplier’s shipping dock, the supplier is responsible for loading the goods

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into a freight container or truck. If the place name is somewhere else, the seller can deliver the goods to that place in its own truck and the buyer is responsible for transferring them to its own container or truck. With Free Carrier at the suppliers shipping dock, the buyer and seller are each responsible for customs in their respective countries, and the buyer is responsible for shipping costs. This term is usually recommended to buyers unless you are sure that the seller can ship goods cheaper than you can. Delivered Duty Paid (DDP) The place name is in the buyer's country and not before customs clearance. The seller is responsible for the costs of the entire freight movement, up to the named location. The seller also has risk of loss up to the named location. This term can be problematic because the buying organization loses control of customs and a foreign supplier isn’t always the best contact for working through your country’s customs problems. However, it has potential applications for hazardous cargo. If you use DDP, the supplier is more likely to bear the risks of accidents. Some Incoterms to avoid include FOB (for non-US shipments) and the “C” Incoterms. Here’s why… Free on Board (FOB) – For non-US shipments We only mention this one because it looks similar to the United States’ domestic term f.o.b. Under FOB, risk of loss transfers when goods go over the rail of a ship in the named port of export. The term can only be used for uncontainerized ocean freight and the place name can only be a seaport of export. If you are buying from a supplier in North America, they may quote terms such as “f.o.b.” thinking they are using a standard U.S. term. Be sure to clarify this issue with the supplier. Incoterms are not well known in North America. Incoterms starting with “C” (CIF, CPT, CFR and CIP) Under the “C” Incoterms, the place name must be in the buyer’s country. However risk of loss transfers when the first carrier gets possession of the goods, way back in the supplier’s country. That is a surprise to a lot of people, but it is true. Consider that if the risk of loss belonged to the seller there is no reason for the buyer to pay extra for insurance. Many sellers automatically quote CIF. Usually they also arrange the shipping and pay for an insurance policy payable to the buyer. That insurance policy only has to meet some minimum

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standards. If anything goes wrong, it’s legally the buyer’s responsibility to solve the problem, although some suppliers in long-term relationships will help. Grouping Incoterms In some of their publications, the International Chamber of Commerce groups the Incoterms by their first letters: Group E (for EXW), Group F (for FCA, FAS, and FOB), Group C (for CFR, CIF, CPT, and CIP), and Group D (for DAP, DAT, and DDP). Between these groups, there are differences in risks as well as transportation obligations and transportation costs. For Group E, the buyer assumes the most risk, costs, and transportation obligations because the buyer assumes all responsibility once picking up the items from the seller in the seller’s country. For Group F, the buyer has less risk and cost because the seller assumes the risk and cost for the transportation between the seller’s facility and the carrier. For Group C, the buyer’s risks are similar to those risks in Group F but the difference is that the seller is responsible for the costs of the carrier when using Group C Incoterms. Finally, for Group D, the buyer has the least risk in transportation because the seller bears the risk while the carrier is en route to the destination country. However, Group D can expose buyers to the risk of assuming high costs because the seller is responsible for accepting transportation costs which, one way or another, will be reflected in the amount the buyer pays to the seller. 2. Credit Cards Credit cards used for organizational purchases are called "procurement cards," "purchasing cards," or "P-cards." P-cards have become popular because (a) it is easy for someone without specialized knowledge of the purchasing system to make a purchase, (b) it is a quicker and less costly way of making a purchase compared to submitting a requisition to be processed by a purchasing department, (c) because the buying organization makes one monthly payment for all P-card transactions, it makes the payment process more efficient and less costly, and (d) it relays a sense of empowerment to employees. While purchasing professionals sometimes use P-cards, they are most commonly used by end users for low-value, indirect material purchases. The use of P-cards is usually restricted by certain value maximums (e.g., no more than $1,000 per order, $10,000 per month, etc.) and other restrictions (e.g., only to be used on certain types of items, with certain suppliers, etc.). Because the cost of processing an order with individual attention by the purchasing and accounts payable departments can be in the hundreds of dollars, P-cards offer a way of reducing the transaction costs of a single transaction to $25 or less. As such, they have become very popular among executives. While the threat of losing work has upset many purchasers, ambitious purchasers embrace the P-card trend because it frees them up to work on more strategic work such as negotiating, supplier collaboration, and other forms of saving money and improving performance as opposed to processing mundane transactions.

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If, as a purchaser, you use P-card yourself, you may commonly place orders via telephone. Buyers and suppliers often speak to each other in part numbers. Miscommunicate or mishear a part number and there can be big, unnecessary problems. A tool that is helpful for communicating part numbers is the phonetic alphabet. This is a standard way of communicating that helps ensure that "T's" aren't mistaken for "P's" and "H's" aren't mistaken for "8's." The phonetic alphabet can also save time so you're not thinking "'P' as in, uh, well, um, 'Phish'" or something else. You can just rattle off the part number “PIT123” by saying "Papa India Tango 123." Here it is… Alpha Bravo Charlie Delta Echo Foxtrot Golf Hotel India Juliet Kilo Lima Mike November Oscar Papa Quebec Romeo Sierra Tango Uniform Victor Whiskey Xray Yankee Zulu 3. Contracts While an agreement to buy and sell is technically considered a "contract," for the purposes of this class, we’ll define a contract as a several page document, signed by both parties, which outlines the terms of an agreement to buy and sell.

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Contracts are used for more complex purchases. Purchasers use contracts instead of purchase orders or P-cards when there is a need to specifically address several different aspects of an agreement such as warranties, liability, obligations of the parties, rights of the parties, remedies for failure to perform, and so on. Also, because the buyer-friendly UCC does not apply to purchases of services, many prudent purchasers use contracts when buying services to obtain maximum protection of their interests. One of the possible complexities that drives purchasers to use contracts is the pricing arrangement. Sometimes a price is not as clear-cut as a price on a restaurant’s menu or in a supplier’s catalog. Here are a few different pricing models that are addressed in contracts: Firm Fixed Price - Firm fixed pricing is the most commonly used type of pricing structure. A firm fixed price will, throughout the life of the agreement, never deviate from the one agreed upon at the outset of the agreement. This type of pricing structure is most favorable to the buying organization. Because the supplier is required to hold its price over a given period of time, the financial risk is borne by the supplier. The supplier could lose money if it is not truly diligent at controlling costs. The supplier also gets rewarded if it is more efficient than estimated. Here are examples of how firm fixed pricing affects supplier profit margins:

Supplier’s Estimate

If Supplier Fails At Controlling Costs

If Supplier Excels At Controlling Costs

Price $10,000 $10,000 $10,000

Costs $8,000 $9,800 $7,000

Profit (Price – Costs)

$2,000 $200 $3,000

Profit Margin (Profit / Price)

20% 2% 30%

So you can see that, as a buyer, you pay the same amount regardless of the supplier’s cost. Your price is not dependent upon the supplier being cost-conscious. Adjustable Price – In contracts of a longer duration (two or more years) or for goods with volatile pricing (e.g., oil products), a buyer and seller may agree to begin with a certain price and to change that price later in the contract based on predetermined criteria. Price adjustment provisions (also called escalation and de-escalation clauses) protect the parties from risks associated with inflation or deflation. Price adjustment provisions allow for fluctuations (i.e., increases or decreases) in price due to changes in costs associated with material and/or labor. Buyers and sellers usually agree that pricing will change based upon fluctuations of an objective measurement of price changes such as the Producer’s Price Index – an index published by the U.S. Federal Government’s Bureau of Labor Statistics. Cost-Based Price – In some situations, it is not possible or practical to determine a price in advance. These situations involve the creation of a unique product or the provision of a unique service where the supplier has no history of the costs involved. Therefore, the amount that the buying organization will ultimately pay will depend on the supplier’s actual costs. The

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final price can be broken down into labor, materials, and a markup, hence the common title "Time & Materials." The labor portion of a cost-based price arrangement is a labor rate (e.g., $65 per hour) multiplied by the actual hours worked. The materials portion consists of the actual costs paid by the supplier for materials used in performing the contract. The markup accounts for overhead and profit and is usually calculated by multiplying a fixed percentage by the sum of charges for labor and materials. The next exercise will allow you to play the role of the manager of an auto repair shop who needs to charge a client for work performed on his car.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY Fill in the fields in the blue cells below with whole numbers (no decimals or punctuation) and click on the Calculate Final Price button to determine the final price for this cost-based price service. Experiment a couple of times to see the effects of changes on your final price.

Cost Component Value

Labor Rate $ per hour

# Hours

Total Labor Cost $

Materials Cost $

Total Labor And Materials Cost $

Markup Percentage %

Markup Amount $

Final Price $

This "cost plus percentage" approach to pricing puts the purchaser in a most undesirable position. There is no incentive for the supplier to control costs to keep your price down. In fact, there is an incentive for the supplier to let costs get out of control so that they make more profit at your expense. The financial risk is borne by the purchaser. When dealing with cost-based price arrangements, there are alternatives to basing the markup on a percentage. Here are three such alternatives:

A. Cost Plus Fixed Fee – The markup is set at a fixed dollar value rather than a fixed percentage. This prevents suppliers from raising their profit margins by failing to control costs.

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B. Cost Plus Incentive – The value of the markup is based on whether the supplier meets certain scheduling or cost targets. For example, the contract could state that the supplier will receive a $500 fee, but if the supplier satisfactorily completes work a week early, the supplier will receive a $750 fee.

C. Capped Cost Plus – The supplier’s markup is based on a percentage of costs, but

cannot exceed a specified maximum. Sometimes, the cap is placed on the entire price, not just the markup. This is also called Not-To-Exceed Pricing and is often expressed in abbreviated terms such as "Price NTE $5,000."

In addition to more complex pricing, contracts are often characterized by the allocation of liability. In other words, who is responsible for things that can go wrong and how are the financial consequences to be handled. Here are some common liability concepts addressed in contracts:

Limitation of liability – When a party limits its liability, it establishes the maximum amount that it can be responsible for paying to the other party due to its failure under the contractual terms.

Liquidated damages – Liquidated damages are predetermined amounts of money that one party will pay to the other party if the first party fails to meet its obligations under a contract. For example, a supplier may agree to pay the buying organization $100 for each day that it is late delivering a product. While a liquidated damages provision is commonly referred to as a penalty in informal situations, the term "penalty" should never be used in a contract due to its illegality in certain situations.

Insurance – Where a supplier may be financially liable for large amounts of money, particularly in cases where individuals may be injured or killed during the course of the supplier’s work, it is necessary to require the supplier to maintain adequate insurance coverage. The specific types of insurance and the amount of coverage should be specified in the contract.

Indemnification – An indemnification provision exists to protect the purchaser from loss or damage due to the supplier’s actions or omissions.

Before we move on from contracts, we make the following two recommendations:

I. Whenever possible, use a contract that your organization prepared, not one that a supplier prepared.

II. Always seek legal counsel review and approval of contracts before signing them. 4. Letters of Intent Sometimes you will need to get a project started right away. Every second is precious. In these cases, waiting for a contract to be negotiated, reviewed, and signed may cause an unacceptable delay even though an extensive contract is needed. When these situations arise, some purchasers use a document called a "letter of intent" to make a commitment to

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the supplier. This commitment allows the supplier to begin performing right away so as to support the purchaser’s aggressive schedule. Letters of intent are used to confirm certain agreements and contain the key, basic terms of the agreement. They serve as an interim contract while a more extensive agreement is being negotiated and documented. Letters of intent are generally not recommended to purchasers. Because you make a commitment before negotiations are complete, you lose negotiating leverage and may find it difficult to agree on terms that favor you rather than the supplier. After formalizing your commitment with a supplier, it is a good business practice to formally notify the unsuccessful bidders that you have made a selection. This should be done through a letter that is mailed or emailed to your suppliers. This letter should explain that you’ve made a selection, offer a "thank you" to your suppliers for bidding, and should not contain any specifics about why the successful supplier was chosen or why any supplier was rejected. Sometimes, a supplier will request specific information on why they were not selected. The process of offering this type of feedback to a supplier is called a debriefing. Be honest in a debriefing but, as mentioned earlier, never share information that would enable a supplier to learn or figure out another supplier’s pricing. Be prepared to diffuse hostility during a debriefing and don’t let yourself become emotional. In government purchasing, a supplier who feels that they should have been selected as the successful bidder but was not can file a protest. A protest enables an unsuccessful bidder to present a case to a review board or committee so that the award can be reconsidered.

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Post-Commitment Releases When a relationship with a supplier is characterized by ongoing deliveries of products or services, there are often easier ways to place orders than by purchase order, P-card, contract, or letter of intent. When a buying organization wants to set up a price, lead time, and other basic characteristics of a supplier relationship, but wants to order those items on an "as needed" basis only, the buying organization will arrange a "blanket order" or "systems contract" with the supplier. A blanket order or systems contract is essentially a commitment over a period of time (usually a year or more) to buy certain products or services from a supplier at a predetermined price, but the quantity and the delivery schedule will be determined at the time that the product is needed, not in advance. When the need for the product or service arises, the buying organization will make a "release" against the blanket order or systems contract. The release can take the form of a phone call, purchase order, or special release form. The supplier will then deliver the product or service and bill the buying organization for the applicable amount. Sometimes, a blanket order will specify a fixed or minimum quantity to be ordered over the applicable time period. In production environments, releases can even be made automatically by the purchaser’s Material Requirements Planning (MRP) system. The MRP system will look at inventory levels and will reorder materials so that an adequate supply of inventory is maintained.

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Lesson 6 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is a false statement? a.) the UCC governs transactions of goods in the United States b.) common law governs transactions of services in the United States c.) the UCC governs transactions of services in the United States d.) CISG governs some, but not all, transactions of goods between different countries 2. Which of the following is a UCC requirement for forming an enforceable contract? a.) one party must be under duress b.) the purpose of the contract must be legal c.) there must be either offer or acceptance d.) all of the above 3. Under the UCC, a purchase order is: a.) an offer b.) an acceptance of an offer c.) the documentation of a contract d.) it depends

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4. Two important things that should be communicated to the supplier on a purchase order are: a.) payment terms and shipping terms b.) payment terms and internal account code c.) shipping terms and accounting code d.) shipping terms and warehouse bin number 5. Who is responsible for risk of loss of a shipment during transit when the shipping terms are F.O.B. Origin? a.) the party who pays for shipping b.) the seller c.) the Department of Transportation d.) the buying organization

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Lesson 7 – Following Up & Closing Out The Transaction STEP 8: FOLLOWING UP While getting to and past supplier selection is certainly an accomplishment, it is not the end of the purchasing process. Until all of your supply requirements are satisfied, you must manage the transaction with the supplier. In some cases, this requires regular follow up communication with the supplier. When a contract governs the supplier relationship, this follow up activity is called contract administration. The objectives of follow up and contract administration are to:

Ensure that the vendor is performing and/or progressing in accordance with the parameters set forth in the agreement

Ensure that the buying organization adheres to its agreed upon obligations

Rectify any problems that come to pass

Ensure that all documentation and records are maintained

Negotiate any changes to the agreement such as determining who should incur any unforeseen costs

At the very outset of the supplier relationship, these things should be clear:

Criteria for determining acceptable supplier performance

Dates on which products are to be delivered or services are to be performed

Obligations of both parties

The dates on which payment is expected

What happens if delivery dates are not met

The methods by which changes are authorized, processed, and documented How closely you keep in contact with suppliers depends on the criticality of the purchase. For highly critical purchases, you will want as much contact as possible. Usually, managing your suppliers involves regularly scheduled conference calls and provision of progress reports. However, some instances may require you to visit the supplier’s facility or the job site to assess your supplier’s progress. In terms of progress, you always want to compare where your supplier is against where your supplier said it would be at that point in time. Project management software, such as Microsoft Project, is very helpful in monitoring supplier progress. Even for less critical orders, it is wise to touch base with the supplier to assess the progress of the order. Business situations may require you to request early delivery, or even to delay delivery. When follow up is done to accelerate the delivery date of an order, it is called expediting. Expediting can represent a significant component in the overall cost of the purchasing process. Therefore, buying organizations should seek to decrease the demand for expediting activities by choosing quick, responsive, and reliable vendors. Emphasizing high-quality

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internal forecasting and planning is another way that an organization can reduce its demand for expediting activities. Here are some reasons that you may use follow up and expediting techniques:

To ensure immediate processing of rush orders. Because expediting is an expensive, non-value added process, you should diagnose the cause for the rush order so that you can determine a way to avoid it in the future. Many rush orders are caused by poor planning. If you see a trend in poor planning, try to solve the problem at its root cause.

To obtain delivery of late orders. When a supplier has not met its lead time requirements, you need to stay on top of the supplier so that they are reminded that your requirement is important. Usually, late deliveries are symptomatic of problems and affect many of a supplier’s customers. You are essentially competing with these other customers for a limited supply of the supplier’s resources. By being silent, you are giving those more vocal customers (the "squeaky wheels" if you will) a higher priority in the eyes of the supplier. If you do regular business with the supplier, after your immediate need is filled, work with the supplier to identify and remove the cause of the delay so that future deliveries may be on time.

To obtain delivery of backordered goods. The unfulfilled and late balance of an order that has been partially filled is called a back order. Obtaining delivery of backordered goods should be done in a manner similar to obtaining delivery of late orders.

To monitor progress of long-lead time open orders. If an order has a long lead time, there is a greater risk associated with not following up. Imagine ordering an item with a six-month lead time in January and calling the supplier about it for the first time in June only to find that the supplier never received the order. Now, to get the item, you’ll have to wait another six months. Big problem? Indeed. Always check status of long lead time orders to make sure that you have the time to remedy any unforeseen problems.

To obtain additional delivery information. When following up on a specific order, review with the supplier all of the other open orders your organization has with that supplier. This review may identify other orders that, although not yet past due, are behind schedule.

To avoid early deliveries. A supplier can cause problems for your organization if it delivers certain types of goods prior to their due dates. These types of goods include goods that require large amounts of space or that have limited shelf life. Follow up can help avoid the problems associated with early delivery of these types of goods.

Different organizations handle the expediting process differently. Some organizations have a special expediting staff while buyers in other organizations expedite the same orders that

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they create. Still, in other organizations, the expediting function is decentralized to the end user. Here are the groups most commonly involved in expediting and an explanation of the advantages and disadvantages associated with each structure:

Expediting Handled By:

Background Advantages Disadvantages

Buyers The same people who place orders follow up on them. Used in most small organizations and some large organizations.

Buyers gain a firsthand awareness of poorly performing suppliers and can avoid selecting them in the future

Tactical function of expediting is handled by more highly paid individuals who could be focusing on more strategic tasks

Expediters A specialized staff does nothing but expedite. Used in some large organizations only.

The pay scale for those doing the expediting is more in line with the value of the job.

The people making supplier selections are separated from knowing how well the supplier performs on a day-to-day basis.

End Users The end user expedites. Used for indirect materials and services in mainly large organizations.

There is a quicker process for communicating lateness to the supplier.

End users are not usually trained in professional purchasing etiquette.

Occasionally when expediting, the supplier will indicate that the order has been shipped and/or delivered. If delivery has not been recorded by the buying organization, you can ask the supplier for a proof of delivery. A proof of delivery is a written or electronic record that shows the date, time, and location of delivery and, in some cases, the name of the person who accepted the delivery. The well-known small package carriers offer this service as well as a service that can trace a package in transit. Many transportation companies’ Web sites offer you the capability of tracking your packages yourself. Changing Orders In between the time that an order is placed and the goods are delivered or the services are performed, a change to your order may be required. Changing an order may involve issuing an official “change order” or simply making the change to an existing purchase order. A typical way of visually differentiating change orders from purchase orders is adding a suffix to the purchase order number. For example, the original purchase order may be numbered 123456, the first change order would be numbered 123456-C1, the second change order would be numbered 123456-C2, etc.

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Actually, there are no standard rules for a change order vs. amended P.O. across companies. A lot of it depends on your company's own systems and procedures as well on any contractual requirements your company may have agreed to with its vendors. If I had to make a recommendation on some guidelines where there are no system/procedure/contract constraints, I'd say that numeric changes, such as to price or quantity, can be done by changing the P.O. as long as you have clear communication of the change with the supplier and a record in your system of the change and the reason for it. Most times, these changes are easily communicated verbally and are often just made so that there are no hang-ups when the supplier's shipment or invoice arrives. Any major change to the items ordered or the scope of work can be done on a change order. In my opinion, change orders generally imply that something major has changed. Many purchase order systems track the revisions of the order, which can be helpful if there are a lot of changes after the original order placement and you find yourself trying to later do an autopsy on a messed up situation. Handling Supplier Failures Sometimes, despite all of your expediting and follow up efforts, suppliers will fail to perform. Your contract and the law (including the UCC) may offer remedies for supplier’s failure. It is important to know what remedy or remedies you have available in the event that your supplier fails to perform. These may include:

1. Cover damages. When you are entitled to cover damages, you may cancel your order with the original supplier, purchase the product or service from another supplier, and charge the original supplier for the difference between its price and the price paid to the new supplier. The price paid to the new supplier must be reasonable, however. In this next exercise, you will compute cover damages. Simply fill in the New Supplier’s Price field and click on the Compute Cover Damages button.

NOTE: THIS EXERCISE AVAILABLE ONLINE ONLY

Price of the Failed Supplier $

Price of the New Supplier $

Cover Damages $

2. Liquidated damages. Liquidated damages refers to an amount agreed upon by the

parties in the contract. This amount becomes payable to one party when the other party fails to meet specific obligations.

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3. Termination. Where permissible, you may cancel the contract and all obligations of both parties.

STEP 9: CLOSING OUT THE TRANSACTION Hopefully you have done a good job of selecting a supplier and you did not have to resort to any remedy for a supplier’s failure to perform. At this point, you can focus on the less labor intensive job of closing out the transaction. Closing out the transaction consists of three elements: (1) receiving the goods or accepting the services, (2) paying for the goods or services, and (3) ensuring the satisfactory life cycle of the product or service. We’ll discuss each of these concepts. Receiving the Goods or Accepting the Services When goods or delivered or a service is completed, it is necessary to do a number of checks to make sure that the goods or services are acceptable. When goods are delivered, receiving personnel often enter a transaction into the organization’s purchasing system to acknowledge that the goods are acceptable. A receipt is essentially the first of usually two authorizations required to pay a supplier. Here are some things that a receiver may check before considering the goods to be "received:"

Does the purchase order number on the packing slip match a purchase order number in the purchasing system?

Does the supplier’s name on the packing slip match the name of the supplier in the purchasing system for that particular order?

Is the ship-to location specified in the order the location to which the package was delivered?

Is there a match between the items described on the packing slip and purchase order and do those descriptions match what is actually in the package?

Is there a match between the quantity specified on the packing slip and the actual quantity of items in the box and does that quantity match the quantity on the purchase order?

Is there visible damage to the shipping container or the items?

Do the items pass all necessary inspections and tests, if any? If the receiver answered "no" to any of the preceding questions, there is a receiving discrepancy. According to most organizations’ policies, shipments for which there are receiving discrepancies are to be set aside until the buyer and the supplier resolve the discrepancy.

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Paying for the Goods or Services Most buying organizations have an accounts payable department – a group responsible for paying the bills. After shipping goods or performing services, suppliers will send to the accounts payable department an invoice requesting payment. Just like the receiving function, the accounts payable representative must perform some auditing to ensure that the invoice meets certain criteria for approval. An invoice approval is the second of usually two authorizations required to pay a supplier. Here are some things that an accounts payable representative may check before considering the invoice to be "approved:"

Does the purchase order number on the invoice match a purchase order number in the purchasing system?

Does the supplier’s name on the invoice match the name of the supplier in the purchasing system for that particular order?

Is there a match between the items described on the invoice and purchase order?

Is there a match between the quantity specified on the invoice and the quantity on the purchase order?

Has a receipt been posted against the order?

Is there a match between the price on the invoice and the price on the order? If the accounts payable representative answered "no" to any of the preceding questions, there is an invoice discrepancy. According to most organization’s policies, invoices for which there are invoice discrepancies are to be set aside and not paid until the buyer and the supplier resolve the discrepancy and the buyer authorizes payment. Because all of the work that today’s purchasing professionals do, the act of resolving invoice discrepancies is often regarded as a low priority. However, when it comes to resolving invoice discrepancies, procrastinating is not always a smart idea for a few reasons:

Failure to pay invoices can damage supplier relationships

Failure to pay invoices can result in being put on “credit hold,” where the supplier refuses to ship new orders (which may be important to your organization) until overdue payments are made

Failure to pay invoices can result in the supplier placing a lien against your organization’s property.

Ensuring That No Liens Exist I’ll provide a little more detail on that last bullet point. When a supplier performs work on a vehicle or real property (e.g., buildings, facilities, land, etc.) and the customer does not pay, the supplier has the right to file through a magistrate’s office a “lien.”

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A lien is a legal process intended to ensure payment. When money is borrowed from a bank to purchase a vehicle or real property, the lender becomes a holder of a lien on that vehicle or property. There is a special type of lien called a “mechanic’s lien” that can be filed when a contractor does not receive payment for services it performed on a vehicle or real property. A lien is reflected on the title of the property and such property cannot be resold until the lien is lifted. Some liens may also enable the lender or supplier to seize the property on which it holds a lien. Therefore, a lien is something to be avoided. If a lien is held and your organization makes payment of the amount due, the lien should be removed. The removal of a lien is often done through the use of a lien release. A lien release assures your organization that no other parties have a stake in the vehicle or real property in question. A lien release is often a simple form which can be obtained online or through an attorney. It serves to document that your organization’s financial obligations have been satisfied. Exchanging Funds When invoices are authorized to be paid, a check is usually automatically printed and mailed on a schedule that takes into account the payment terms of the supplier. More sophisticated organizations use Electronic Funds Transfer to send money directly and electronically from their bank account to the supplier’s bank account. Ensuring the Satisfactory Life Cycle of the Product or Service Even after orders have been placed, delivered, received, paid for, and used, there may be some involvement of purchasing. Every now and then, a product or service will fail during its warranty period. Upon such failure, it is the buyer’s responsibility to work with the supplier to remedy the failure. The options for remedy will be dictated by the agreement with the supplier, if there is an agreement, or by supplier policy or law. The three most common remedies are: (1) repair, (2) replacement, and (3) refund. For critical items that your organization depends upon to operate, you should include which remedy you want and how quick you want it in your contract. Once all three of these elements have been completed, you have successfully closed out the transaction and made it all the way through the purchasing process! Alright, we have made it through all the steps of being "in the trenches." Next, we’ll look at the big picture of purchasing through the eyes of a manager or executive.

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Lesson 7 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is an objective of contract administration? a.) to make sure that the supplier complies with the agreement b.) to ensure that the purchasing organization fulfills its obligations c.) to resolve any problems that arise d.) all of the above 2. Which of the following should be known at the outset of a contract? a.) whether the supplier plans on a new marketing campaign b.) the home phone number of the supplier's president c.) the delivery dates d.) all of the above 3. Purchasers expedite to: a.) pass time b.) speed up delivery of orders c.) keep in contact with suppliers d.) all of the above

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4. What is one benefit of having a buyer expedite her own orders? a.) she'll get first hand awareness of poor performing suppliers b.) it makes the best use of the company's money c.) there is no lag time from the time the end user recognizes the need for expediting d.) none of the above 5. What is the difference between liquidated damages and cover damages? a.) the amount of cover damages is known in advance of a failure b.) the amount of liquidated damages is not known in advance of a failure c.) the amount of liquidated damages is known in advance of a failure d.) liquidated damages do not involve money

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Lesson 8 - Big Picture Issues As we looked at each step of the nine-step purchasing process, the goal of each step was to get to the next step. We progressed from step to step until the product was delivered or the service was performed and met our expectations for the desired time period. Well, from an executive perspective, purchasing is more than just getting products delivered or services performed. Purchasing is a key element in the financial success of an organization. In the eyes of a CEO, the purchasing department has three roles:

1. Manages spending 2. Supports operations 3. Manages risk

We’ll talk about each of these three roles. Role #1 - Managing Spending In terms of managing spending, purchasing can impact profitability dramatically. By minimizing total costs through negotiation, competitive bidding, value analysis, standardization, and other programs, purchasing can deliver real value to the bottom line. Consider the following example… A manufacturer has the following annual sales, expenses, and pre-tax profit. All numbers are in millions.

Sales $100

Cost of Goods Sold $60

Labor $20

Overhead $10

Pre-Tax Profit $10 (10% of annual sales)

This organization’s pre-tax profit margin is 10%. This means that for every dollar the organization has in sales, it makes a dime in profit. If purchasing was able to focus on saving money, they might be able to reduce the cost of goods sold by 10%. So, what does that do to pre-tax profit? Let’s see.

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Sales $100

Cost of Goods Sold $54

Labor $20

Overhead $10

Profit $16 (16% of annual sales)

By reducing the cost of goods sold by 10% to $54 million from $60 million, the organization was able to increase its profit by 60% to $16 million from $10 million. Reducing the cost of goods sold by 10% might be a reasonable goal for a purchasing department. Now, to really demonstrate how impressive this is, consider how much of an increase in sales is required to produce the same increase in pre-tax profit (60%). Before we addressed cost reductions, we said that the organization’s pre-tax profit margin was 10%. So to achieve $16 million in pre-tax profit, we’d need to produce $160 million in sales – a 60% increase in sales! So a 10% reduction in costs produces the same result as a 60% increase in sales. Which do you think is easier? Of course! A 10% reduction in cost. This shows the leverage that purchasing has on an organization’s success. While managing spending is probably the most prominent of purchasing’s roles, it is certainly not the only critical one. Role #2 - Supporting Operations In the nine-step purchasing process, you saw how everything progressed towards getting goods or services delivered and having them remain effective for their expected life. In the big picture, purchasing is relied upon to consistently provide a steady stream of goods and services so that the organization can operate efficiently. To realize the impact of this role, consider what would happen if you failed to get products delivered or services performed on time or to an acceptable level of quality. Your production line may shut down. Without an operating production line, your organization could fail to meet its commitments to its customers. Consistent failure to meet customer needs will result in customers taking their business elsewhere. Enough business that goes elsewhere means that your organization will cease to exist. Is purchasing important in keeping the organization alive? You bet! Role #3 - Managing Risk We talked a little bit about risk when we were covering contracts. There is a lot of risk involved in the purchase of goods or services. Think of an automobile manufacturer buying poor quality components. Imagine the safety problems that would exist. This is just one of

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many examples of risks that must be addressed in purchasing. Executive management counts on purchasing to identify potential risks and to minimize them through good supplier selection, tight contracts, and proper management of suppliers. Excellence in these three roles can catapult an organization into success. Think about why your organization’s customers choose to do business with your organization rather than your competitors. The answer usually includes one or more of these reasons:

Lower cost

Faster delivery

Higher quality

Better service Whatever reason drives customers to your organization rather than elsewhere is called your organization’s competitive advantage. Purchasing can be the key driver of competitive advantage. Purchasing can keep costs low through negotiation and other cost improvement techniques. Purchasing can help your organization deliver faster by selecting suppliers that deliver faster. Purchasing can help your organization deliver high quality goods and services by purchasing high quality materials, goods, and subcontracted services. Excellent purchasing performance can be the foundation for a successful organization. So seeing that purchasing plays such a prominent role in the success of an organization, leaders set goals for purchasing and measure purchasing performance. Purchasing performance is usually measured in metrics – statistics used to compare performance. Here are some example measurements of purchasing performance:

Dollars saved through negotiation, bidding, or other techniques (the higher the better)

Percent of on-time deliveries (the higher the better)

Percent of quality defects (the lower the better)

Supplier response time (the lower the better) So you can see that management is interested in the overall performance of purchasing, not just how well one transaction went. So in order to meet management demands, purchasing departments put programs together to achieve their goals. Here are two examples of such programs: Spend Consolidation. By buying from fewer, rather than more, suppliers, purchasing departments can achieve large volume discounts. So, purchasing departments often put together strategies for consolidating their spending and reducing costs. Instead of doing bidding for a single purchase, purchasing departments will bid years’ worth of requirements at one time with the intent in entering a long-term, exclusive contractual relationship with a supplier. This type of activity, often called strategic sourcing, is a big driver of cost savings. Supplier Performance Evaluation Programs. Purchasing departments often look not only at whether or not a supplier delivered a single order on time, but also how well all suppliers

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have performed over a long period of time. They formally evaluate their suppliers’ performance with the intent of improving all suppliers’ performance year after year. This type of process also helps purchasing departments weed out the bad suppliers from the good, so that purchasing may make future supplier selections that will be more beneficial to the organization. So where is purchasing going in the future? Well, because more and more executives are realizing the positive impact that purchasing has, you can expect that the demands upon purchasing professionals will grow. Purchasing will be responsible for improving profits year after year. Purchasing will be expected to obtain flawless quality and perfect delivery from its suppliers so that the organization can provide the same to its customers. To save money, organizations will continue to divest non-core functions and purchasing will be responsible for selecting outsourced suppliers to provide better service at a lower cost. With all of the accounting scandals of the early 21st century, purchasing will be expected to operate with the highest level of integrity. Purchasing will be counted on to embrace technology as eProcurement and eSourcing software offerings have proven to reduce costs and make purchasing processes more efficient. And with newer technology always being introduced, more savings and efficiencies can be anticipated. To meet all of these strategic expectations, purchasing will be less and less involved in the transaction processing aspect of acquiring goods and services. Purchasing professionals will spend their time on strategic, bottom-line oriented tasks. Ordering will move to end users, with purchasing setting up standardized products and services for them to choose from pre-selected suppliers who have proven to be the best choice for the organization. It is an exciting time to be beginning a purchasing career. We hope that this class has accelerated your introduction to this new world. If there is any way that Next Level Purchasing, Inc. can assist you with your purchasing career, please don’t hesitate to contact us. This is the last lesson of the class, so now it’s time to take the final quiz. Good luck!

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Lesson 8 Quiz

NOTE: TAKE THIS QUIZ ONLINE FOR IMMEDIATE FEEDBACK

1. Which of the following is not one of the main roles modern CEO's see purchasing playing? a.) managing spending b.) cutting PO's c.) supporting operations d.) managing risk 2. A company's financial performance is improved when purchasing can: a.) impact profitability b.) cut PO's well c.) maintain costs d.) schedule negotiations 3. Purchasing can support operations when: a.) it selects suppliers who can reliably provide a steady stream of goods b.) it procures materials whose quality does not force production line shutdowns c.) it focuses on meeting the needs of the organization's customers d.) all of the above

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4. Which of the following is not a true statement? a.) poor quality purchased products can result in liability issues for an organization b.) tight contracts can reduce risks c.) ignoring issues related to the quality of purchased products does not increase an organization's risk d.) none of the above 5. What are the four cornerstones of competitive advantage? a.) lower cost, higher quality, faster delivery, better profit margins b.) lower cost, higher quality, faster delivery, better service c.) higher cost, higher quality, faster delivery, better profit margins d.) lower cost, higher quality, faster delivery, adequate technology