Purchasing Law and Legal Definition
Purchasing is the act of buying the goods and services that a company needs to operate and/or manufacture products. Given that the purchasing department of an average company spends an estimated 50 to 70 percent of every revenue dollar on items ranging from raw materials to services, there has been greater focus on purchasing in recent years as firms look at ways to lower their operating costs. Purchasing is now seen as more of a strategic function that can be used to control bottom-line costs. Companies are also seeking to improve purchasing processes as a means of improving customer satisfaction.
THE TRADITIONAL PURCHASING PROCESS
The traditional purchasing process involved several steps—requisition, soliciting bids, purchase order, shipping advice, invoice, and payment—that have come to be increasingly regarded as unacceptably slow, expensive, and labor intensive. Each transaction generated its own paper trail, and the same process had to be followed whether the item being purchased was a box of paper clips or a new bulldozer.
In this traditional model, purchasing was seen as essentially a clerical function. It was focused on getting the right quantity and quality of goods to the right place at the right time at a decent cost. The typical buyer was a shrewd negotiator whose primary responsibility was to obtain the best possible price from suppliers and ensure that minimum quality standards were met. Instead of using one supplier, the purchaser would usually take a divide-and-conquer approach to purchasing—buying small amounts from many suppliers and playing one against the other to gain price concessions. Purchasing simply was not considered to be a high-profile or career fast-track position—when surveys were taken of organizational stature, purchasing routinely rated in the lowest quartile.
That attitude has changed in recent years, in part because of highly publicized cases wherein companies have achieved stunning bottom-line gains through revamped purchasing processes. In addition, increased competition on both the domestic and global levels has led many companies to recognize that purchasing can actually have important strategic functions. As a result, new strategies are being used in purchasing departments at companies of all sizes.
Analysts observe that in this new purchasing environment, a guideline known as the total cost of ownership (TCO) has come to be a paramount concern in purchasing decisions. Instead of buying the good or service that has the lowest price, the buyer instead weighs a series of additional factors when determining what the true cost of the good or service is to his or her company. TCO calls for closer attention to what else should be counted in addition to price. Categories include freight, warranty requirements, financing costs, tooling requirements, storage/inventory costs, disposal costs, and the like—but netting out scrap values.
To lower TCO, companies are taking a number of steps to improve purchasing.
Strategic sourcing is one of the key methods that purchasing departments are using to lower costs and improve quality. Strategic sourcing involves analyzing what products the company buys in the highest volume, reviewing the marketplace for those products, understanding the economics and usage of the supplier of those products, developing a procurement strategy, and establishing working relationships with the suppliers that are much more integrated than such relationships were in the past. During this process, the team conducting the analysis should ask these questions:
- Why do we buy this product or service?
- What do we use it for?
- What market conditions do suppliers operate under?
- What profit margin do suppliers seek to obtain?
- What is the total price of purchasing from a particular vendor (in other words, the cost of the item plus the costs associated with quality problems)?
- Where is the good or service produced?
- What does the production process look like?
The products that are purchased in the highest volume will be the best candidates for cost reductions. That is because once those products are identified, the company can then justify the time and expense needed to closely study the industry that supplies that product. It can look at the ways key suppliers operate, study their business practices to see where the most money is added to the final cost of the product, and then work with the supplier to redesign processes and lower production costs. This maximizes the contribution that suppliers make to the process.
By knowing the market and knowing how much it costs for a supplier to do business, the purchasing department can set "target prices" on goods. If the supplier protests that the price is far too low, the purchasing company can offer to visit the supplier's site and study the matter. Such visits can occasionally spot problems in the supplier's operation that can help the vendor shave costs and thus lower price. Such "supplier alliances" can result in improved buyer/seller communication, improved planning, reductions in lead time, concurrent engineering, decreased paperwork, and better customer service.
The alliances also can sometimes register significant improvements in product quality. Buyers can build clearly-defined quality targets into their target prices. It will then work with the supplier to improve the manufacturing process until that quality target is met. Such a process can yield enormous benefits for buyers, including reduced inventory levels, faster time to market, significant cost savings, and reduced development costs.
Not all suppliers can meet the high standards demanded in this purchasing environment. Some studies indicate that companies that adapt strategic sourcing have lowered the number of suppliers they use by an average of nearly 40 percent. What characteristics make a good supplier, then? If the supplier is willing to partner, then analysts have identified several traits that good suppliers share:
- Commitment to continuous improvement
- Encourages employee involvement
- Financially stable
- Able to provide technical assistance
Analysts indicate that suppliers receive some benefits in the emerging purchasing dynamic as well. Reduced paperwork, lower overhead, faster payment, long-term agreements that lead to more accurate business forecasts, access to new designs, and input into future materials and product needs have all been cited as gains. Other observers, meanwhile, point out that some buyer-supplier relationships have become so close that suppliers have opened offices on the site of the buyer, an arrangement that can conceivably result in even greater improvements in productivity and savings. Of course, companies are not going to form such "partnerships" with all of their suppliers. Some form of the traditional purchasing process involving bidding and standard purchase orders and invoices will continue to exist at almost every company, and especially at smaller companies that do not have the financial weight to make large demands on their suppliers.
In addition to strategic sourcing, there are other methods companies can use to improve purchasing. One is creating cross-functional teams that involve purchasing personnel in every stage of the product design process. In the past, purchasers were not involved at all in the design process. They were simply instructed to purchase the necessary materials once a new product had been created. Now, purchasers (and suppliers) are increasingly included from the start of the new product process to ensure that the products needed to create product are readily available and are not prone to quality problems. Suppliers tend to be experts in their field, so they bring a large knowledge base to the design process that would otherwise be missing. This can help prevent poor designs or manufacturing mistakes.
These teams have broken down barriers and helped abolish the old manufacturing method that was known as the "over the wall" method of productions—each business unit would work on a project until its portion of the job was completed. It would then "throw the product over the wall" to the next functional team that was waiting to perform its part of the manufacturing process. The new cross-functional teams often include personnel from purchasing, manufacturing, engineering, and sales and marketing.
Purchasing teaches other members of the team how to deal directly with suppliers, cutting the purchasing personnel out of the loop. This is important in that it eliminates much of the time-consuming work that buyers had to deal with (soliciting bids, creating purchase orders, etc.) and frees them to concentrate on the part of their job where their expertise most pays off: finding suppliers and negotiating prices and quality standards.
Just-in-time (JIT) manufacturing became one of the biggest trends in all facets of industry in the 1990s. JIT companies maintain only enough inventory to manufacture the products they need in the very near future. Parts are ordered on a near-continuous basis and often go directly from the loading dock to the assembly line. The benefits of this system include reduced inventory, improved quality, reduced lead time, reduced scrap and rework, and reduced equipment downtime. However, when a company shifts to JIT manufacturing, it must also shift to JIT purchasing.
JIT purchasing requires a nearly 180-degree change in purchasing philosophy. Traditional purchasing meant building a supplier list over time by constantly adding new suppliers, spreading purchases around, and maintaining higher inventory levels in case demand for a product soared or quality from a supplier dipped suddenly. JIT purchasing demands that buyers narrow their supplier list to a chosen few who can deliver high-quality products on-demand and in a timely fashion.
The JIT purchasers pays a fairly high cost in homework and vendor relations to achieve the "just-in-time" optimum. In addition to meeting specifications, suppliers must have the ability to make frequent, on-time deliveries and to provide very large volume commitments or single sourcing arrangements. Quality may be the toughest of these standards for suppliers to meet; the JIT purchaser should deal only with companies that utilize statistical analysis to verify the quality of their output. Failure to do so should eliminate the supplier from even being asked to submit a bid.
For frequent, on-time deliveries, it often helps if the supplier is located in the same geographic region as the buyer. That way, it is easier for the supplier to react to a sudden, unexpected demand for its product, and it costs far less to make the frequent deliveries that are needed. Those lower costs can in part be passed on to the buyer.
In single sourcing arrangements, it is not uncommon for the buyer to exert some influence over the supplier's business processes. The buyer has made such a significant commitment to the supplier, and is such a large portion of the supplier's total business, that it has the right to expect some say in the supplier's business practices. For some suppliers, this is an uncomfortable arrangement.
As transaction costs soar (some companies report spending as much as $300 per transaction in clerical and other costs), companies are looking to buy smarter and cut costs any way possible. One popular method is recent years is to supply selected employees with purchasing or corporate procurement cards.
The cards are similar to credit cards; in fact the big three credit card companies—VISA, MasterCard, and American Express—are among the leaders in purchasing cards. In most cases, the cards are used to purchase small business items. A master bill is sent straight to the purchasing department. These cards are true credit cards, however. In some cases, they work only between a buyer and suppliers identified in advance, eliminating the bank that is involved with credit cards. Additionally, the cards can be coded to include a variety of important transaction information that reduces the amount of paperwork needed to track the sale, including sales tax data, customer code (such as job number or cost center), taxpayer identification number, and more. This coding allows companies to receive valuable information about each transaction and greatly streamlines the purchasing process.
The cards are beneficial to suppliers as well. The most important advantage is that the vendor receives payment much more quickly than in the past—sometimes in as short a period as two or three days. Additionally, the supplier saves money by not having to issue and mail an invoice, and the supplier knows the credit worthiness of the customer before the transaction is even processed.
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Hillstrom, Northern Lights
updated by Magee, ECDI