PURCHASING for BUYERS OF
GOODS
& SERVICES IN INDUSTRY
PURCHASING for BUYERS OF
GOODS
& SERVICES IN INDUSTRY
1.1.1 Introduction
1.1.2 Sources
1.1.3 Source Policy
1.2.1 Introduction
1.2.2 Vendor Rating
1.2.3 Negotiation of the Agreement
1.3.1 Supplier Partnerships - Production Control
1.3.2 Supplier Partnerships - Internal Communications
1.3.3 Supplier Partnerships - Supplier Base Reduction
1.3.4 Supplier Partnerships - Supplier Scheduling
1.3.5 Supplier Partnerships - Technical Communications
2.1 Order Placement
2.1.1 Introduction
2.1.2 Invitation to Tender
Competitive Tendering
Selective Tendering
Negotiated Tendering (PTN)
2.2 The Contract
2.2.1 The Law of Contract
Certainty of terms, estoppel & parol agreements
2.2.2 Contractual Terms
representations and misrepresentation
express terms
implied terms
conditions
warranties
exclusion clauses
2.2.3 The 'Battle of the Forms' (whose contractual terms are to prevail?)
2.2.4 Termination of the Contract
Frustration
Force Majeure
Mistake
Breach of Conditions
2.2.5 Remedies (Damages)
Liquidated Damages
Unliquidated Damages
2.3 The Carriage and Receipt of Goods
2.3.1 The INCOTERMS
EXW (Ex Works)
2.3.2 The Delivery of Goods
2.3.3 The Acceptance of Goods
2.3.4 Passage of Title
2.4 Status of the Goods
Specific goods
Unascertained goods
Bailments
Goods which have been processed
3.1 The Ordering Process
3.1.1 The Trail of Commercial Information
3.1.2 The Purchase Order
3.1.3 Progressing and Expediting
3.2 The Order Quantity to Minimise Cost
3.3 ABC Analysis and Bought-In Parts
3.3.1 How to Perform ABC Analysis
3.3.2 Managing the A, B, and C Class Items
3.3.3 Class D and the Two-Bin System
3.4 Buying Capital Equipment
3.4.1 Purchasing Membership of a Team
3.4.2 Leasing, Hiring and Hire Purchase
Leasing
Financial Lease
Operating Lease
Hire Purchase
Hire or Rent
3.4.3 Managing Stage Payments
4.1 Supply and Demand
4.1.1 Economic Theory
4.1.2 Market Distortions
4.1.3 Price Elasticity
4.2 The Buyer, Costs and Costing
4.2.1 Assigning a Cost to a Product
Accumulating costs & production cost centres
Allocating costs & 'prime costs'
Cost driver
Production Overhead
Prime Cost
4.2.2 Calculating Standard Costs
4.2.3 Budgets and Variances
4.2.4 The Breakeven Point
4.2.5 Alternative Types of Costing (Job, Batch, Contract, Process)
4.3 Prices and Large Contracts
4.3.1 Major Contracts and Fixed Price Agreements
4.3.2 Contract Price Adjustments (CPA)
4.3.3 Discounts
4.3.4 Budget Buying
4.4 The Cost of Technically Novel Items
4.5 Commodity Prices
4.5.1 Private Bargains and 'Physicals'
4.5.2 Commodity Futures
4.6 The Price of Foreign Purchases
4.6.1 Introduction
4.6.2 The Forward Market
4.6.3 Other Foreign Exchange Payment Methods
4.6.4 Exchange Controls Abroad
4.7 Effecting Foreign Payments (Letters of Credit)
4.8 Government Buying (UK)
5.1 The Supplier and SPC
5.2 Raw Material Quality - Inspection v. No Inspection
5.3 Incoming Raw Material Quality - Sampling
LTPD sampling tables
AQL sampling tables
Operating characteristic (OC)
5.4 ISO 9000 2000
6.1 Organisation
6.1.1 Support the Negotiators!
6.1.2 Centralisation v. Decentralisation
6.2 The Split in Purchasing/Technical Responsibilities
The Purchasing Job Remit
6.3 Measures of Buyer Performance
6.4 Ethics
6.5 The Chartered Institute of Purchasing and Supply (CIPS)
6.6 The Chartered Institute of Purchasing and Supply's Ethical Code
1.1.1 Introduction
"Sourcing" is the term used generally to denote the process of finding suppliers of goods and services specifically required by the company. As part of purchasing research, it can also mean finding suppliers of goods and services which may one day be useful and which may therefore point the way to new avenues of product development.
Before the investigation begins, the purchaser must be fully aware of the relative importance of the product in relation to three factors ...
I. Strategic Material Position
'Strategic' - These might be bulk raw materials such as oil, crops, widely used metals (copper, borax ...) and even complex, expensive sub-assemblies such as engines. The sourcing of such purchases is a major task, since the end result is of such vital importance to the company. Price, reliability of supply, continuity of supply and quality are likely to be predominant. 'Mainstream' - Typically, these are materials required for the production of the company's main products. Sourcing policy may take comparatively more account, say, of the logistics of supply than other facets such as price or continuity.
II Quality and Improvement
How important is it that the material being delivered should be, literally, 100% conforming? If the material is to be used in production directly on receipt, this importance may be paramount. In which case sources of supply will be confined either to companies having SPC programmes or to companies willing and competent to start them. If it is relatively cheap and easy to inspect incoming supplies, quality requirements might be relaxed if sources indicated a compensating advantage. In addition to physical quality itself, the supplier with a TQC programme is also expected to show continual improvement in quality and, through the evidence of a "sufficient" R & D budget and an on-going commitment to improved design and capability.
III Delivery Logistics
'Constant Deliveries' - External supplies used constantly in large numbers, indicating that sources should if possible be physically close at hand and capable of reacting quickly to change. 'Batch Deliveries' - Deliveries should be timely, if only to reduce stockholding and enable adherence to the production schedule. Nevertheless, the stock delivered is for several discrete production runs over many days or weeks. Sources need not be close and might even be overseas.
Clearly, not all sourcing merits the same time and attention. The buyer should carefully consider which items are critically important.
1.1.2 Sources
When the criticality of the material or service warrants it, it is important that the buyer should put behind him the temptation to turn to a familiar but unduly limited group of suppliers and, instead, search the whole supply marketplace. Sources of information relating to products are given below. As well, as stated above, it should also be said that a mark of a good buyer is that he should maintain and foster a large circle of personal contacts among suppliers.
(a) Catalogues (including those by merchant distributors)
(b) Trade Journals and Magazines
(c) Trade Directories. An example is the 3-volume directory Kompass, which has a product classification system that enables the purchaser to determine sources from an extensive but not exhaustive list of UK companies. Other directories are Dun & Bradstreet's Key British Enterprises, Kelly's, Ryland's and Buyer's Guide.
(d) Yellow Pages and Industrial Yellow Pages. Yellow pages give the phone numbers of city and district firms by trade classification. The Industrial pages give major industrial groups by UK region.
(e) Sales Representatives
(f) Exhibitions. Attendance at exhibitions by purchasing staff should be a methodical affair with careful filing afterwards of the glossy leaflets and business cards.
(g) Foreign Sources. Searching for foreign sources is a specialised matter.A number of directories exist including Kompass, Jaeger & Waldman and the English language version of Wer Liefert Was?. Other sources include the commercial attachés of foreign embassies, the London Chamber of Commercial Information Department and the UK Trade and Navigation Accounts of UK imports.
Of overwhelming importance to the buyer nowadays however is use of the Internet. Use can be subdivided into two categories: (1) e-commerce, meaning literal buying and selling, and (2) the obtaining of information. The success of the world wide web in information gathering is proven and self-evident - it is here that the medium comes into its own. He is also able to search foreign sites through the automatic translation of text.
1.1.3 Source Policy
SOLE v. DUAL / MULTIPLE SUPPLY. A single supplier from whom a comensurately higher volume of material is purchased should lead to better prices, more easily monitored quality (provided all material is from the same physical place) and constant improvement in the product and product quality. In favour of dual or multiple suppliers, however, is that we have coverage of the risk of an interruption of supply and the fact that the supply marketplace is kept more competitive.
PREFERENCE FOR LOCAL SUPPLIERS. Supplies from local stocks may be desirable if the buyer's production programme is subject to very frequent change. (As well, use of local suppliers will help in influencing local authority officials.)
SMALL v. LARGE SUPPLIERS. A claimed and often valid argument in favour of small suppliers is that they are more pliant. They have - or should have - the internal flexibility to change, they may try harder, they may put themselves out. It is likely to be easier to build a close, lasting relationship with a competent small supplier than a large one. Large suppliers, however, are likely to be at the forefront of technological change and to pass advances onto their customers in the form of technically superior products.
RECIPROCAL BUYING. Reciprocal buying, or a policy of "reciprocity", means that the firm purchases from external suppliers which themselves purchase from us. Companies which sell products in a highly competitive market may deliberately seek to purchase required material from its customers as a 'hold' over them. If the market is indeed competitive, it may mean there is little product differentiation except for price, so that the extra leverage is welcome. Deliberately entering into agreements for this reason has many dangers, however, and is, not surprisingly, unpopular with purchasing professionals. By definition it restricts buyers' freedom of action (eg if bad quality is sent) and may result in greater internal loss when the all-round picture is seen rather than just price. The normal circumstances of reciprocity is the purchase of goods within a large, diverse company. Company X of the ABC Conglomerate PLC must buy from Company Y, also within ABC. ABC here consists of limited companies and operating divisions put together with inter-company purchasing very definitely in the corporate strategist's mind. The buyer may be required to source from within the group if at all possible. The arrangement is very rarely beneficial - (internal) suppliers become uncompetitive and inefficient.
1.2.1 Introduction
Vendor appraisal is the assessment of potential new suppliers before any decision is made to place an order or enter into negotiations with intent to do so. The depth of the process will self-evidently depend on the importance of the materials to be bought and the value of the business. The Pareto 80:20, or ABC rule, rule applies here - that is, 20% of the materials bought will merit 80% of the effort allocated to appraisal.
Desk Research
The supplier is informed that his company is to be evaluated with regard to the particular material or service required and written information is requested of him. The information requested should always include the company's principal financial documents, including the annual report, balance sheet and profit & loss account ... It may also include the company magazine, product brochures, price lists and other literature. In addition, it is the experience of company purchasing managers who ask vendors to disclose cost information, that they are generally willing to do so, or at least will disclose information in the closing stages of a sale and when long-term business is at stake.
Field Research
Stage 2 of vendor appraisal is field research. It consists of one or possibly more visits to the supplier by a company team, including the purchasing representative, in order to assess the technical abilities and managerial standards of the firm. Team members besides purchasing may be from production, quality assurance and engineering departments. The visit itself will consist of a factory tour and office discussion afterwards, with the opportunity to talk to and question shop floor operatives, other employees and key top managers. Areas for assessment include the following:
(a) Plant and Machines: The modernity of the plant and machine tools and whether they are well-maintained. The existence and adherence to a strict programme of planned machine maintenance.
(b) Planning and Control: Whether the vendor has effective control over his manufacture through the effective use of such planning systems as MRPII, MRP and JIT. The accuracy of the stock records is a good indicator of ability.
(c) Quality Capability: The employment of SPC (see Section 5) by operators in the production process. The team should expect to see, and should examine, control charts in use. Evidence of the operation of a TQC system throughout the factory should be forthcoming from noticeboards and office charts. Further evidence of TQC is the conduct of a programme of continuous product improvement by the methodical analysis of causes of variation and their elimination one by one.
(d) Shop Floor Technical Expertise.
(e) Meticulous Housekeeping.
(f) Technical Superiority.
(g) Service and Support: Whether the company appears well organised with regard to field service such as installation support, routine follow-up and response to emergencies. Keenness to assist.
(h) Company Commitment: By the end of the visit the team should be able to assess the 'commitment' of the company - ie of the company's personnel - to good customer service.
(g) Standards of Management : The most important element is the commitment, competence and expertise of the supplier's management. These attributes will, of course, be manifest in the factors (a) to (h) above. If our own company is to enter into a close, long-lasting relationship with a supplier, it is important to be as sure as possible of the business and moral integrity of that supplier's management. There are many who regard this last point as the most important of all in the assessment of a potential vendor.
The collection of information on a field visit is normally made on a standard company form. There are as many possible versions of this as there are companies. Many are two-part forms, Part 1 referring to basic facts to be noted on the visit itself and which are indisputable (eg address and telephone number). Part 2 is filled in immediately after the visit, is somewhat judgmental and is highly confidential - for example, personal assessments of the attitude of managers, the state of the factory and the supplier's operational systems. The forms in practice might contain additional material to enable them to do double duty in vendor rating (see next).
1.2.2 Vendor Rating
Vendor rating means the comparative assessment of one vendor with another, typically as the result of vendor appraisal. Vendor rating is distinguished on this on-line course from supplier performance rating dealt with below in sub-section 4. The purposes of vendor appraisal and vendor rating are in many respects an attempt to discern what the performance and performance rating of the vendor would be if he were selected as an actual supplier. One method of vendor rating is to use a quasi-quantitative scoring technique based on weights and marks that works as follows:
(i) Formulate a Standard List of Vendor Criteria
A list of (say) 50 criteria and questions is devised, in which activities and attributes are formulated which are believed to be general and relevant for judging all potential suppliers. Examples of questions are: * The maintenance of accurate records of stock; * The existence of an in-house equipment calibration programme; * The ready accessibility of latest technical drawings; * The installation and use of SPC; * The adoption of Total Productive Maintenance (TPM); ...
(ii) Weights to be applied to the Standard Criteria
The evaluation team must now assign a 'weight' of importance, from 1 to 10, to each of the criteria on the standard list in (i) above to denote its perceived importance. For example, 'Criterion 1' may have a weight of importance of 6 out of 10, whereas 'Criterion 4' has assigned to it a weight of 9 out of 10.
(iii) Vendor Marks
Each vendor being evaluated is voted a mark from 1 to 10 for each criterion, the size of the mark depending on how well the evaluators think he, the vendor, performs, or will perform, the function involved. The mark out of 10 is irrespective of the weight assigned to the question. Thus vendor Smith & Brown may get a mark of 5 out of 10 for 'Criterion 1' and a mark of 6 out of 10 for 'Criterion 4'.
(iv) Rating
Each supplier's mark is multiplied by the corresponding criterion weight to produce a criterion "score". Thus for Smith & Brown and 'Criterion 1', the figures are: weight 6, mark 5 ... score 30. Scores are totalled to give a grand vendor score. The vendor with the highest grand score is deemed the best.
The result of vendor rating in conjunction with specialised technical assessment for a new buy or modified re-buy is likely to be a decision to purchase the material required - the buying decision is dealt with in Section 3 below. Even though only one or two suppliers get our business, many of those not chosen may still have scored most satisfactorily. In short, a result of vendor rating is perhaps not simply "chosen/not-chosen" for a specific new contract, but the classification of all evaluated vendors into four classes: Class A - Approved and Chosen Supplier; Class B - Satisfactory Vendor; Class C - Vendor in Emergencies only; Class D - this vendor not to be used Suppliers, of course, change so that lists developed in this way are soon not only voluminous but also out-of-date. If they cannot be fully maintained, they should be regularly purged, but the original paperwork should be archived to assist in any new, later vendor evaluation.
1.2.3 Negotiation of the Agreement
After due assessment of vendors and products, a decision is made that, subject to a number of points to be discussed, a particular vendor is to become the supplier. If the product is one on which the annual expenditure will be relatively small and the quality/delivery is not critical, or is well-known to be satisfactory, the supplier will doubtless merely be informed by letter or even by the sending of a purchase order for goods, without comment. Otherwise, the supplier will be approached with a view to coming to a mutual agreement as to the terms of supply - price, delivery standards, engineering support, quality levels .... The discussion on such matters between supplier and purchaser is known as a negotiation - a discussion between buyer and vendor intended to produce an agreement, and over which either party has the power of veto. The issues of negotiation will, of course, be different depending on the type of agreement the company intends to reach with the supplier. In particular, if the purchaser wishes to establish his variant of a 'suppler partnership' with respect to the supply of a product, rather than to negotiate merely the plain product price, he may prefer to discuss with the supplier a method of arriving at a price by reference to some costing formula. Negotiations such as these emphasise the modus operandi between the two companies, and can be protracted and complex. When concluded, however, they enable other ventures and purchases between the two firms to be proceeded with quickly and easily. Consent to the final agreement of terms and conditions is, from the definition in red text above, voluntary. But the negotiation itself is not about 'equity' or `fairness', for the simple reason that the two sides have opposing assertions and opposing aims. The supplier has a warehouse full of 12v engines and wishes to replace them with money. The buyer has money and wishes to spend some of it on 12v engines. The supplier's assertion is that one 12v engine (his) is worth £10 (the buyer's). The buyer's assertion is that £6 (his) is worth one 12v engine (the supplier's). Before outlining the normal steps taken in a negotiation, it will be realised that the majority of issues to be settled as part of the final agreement are of a non-contentious nature. The product itself has already been assessed and selected. Details on payment procedures (cheque or BACS method) may have to be settled but are of little real consequence between two firms that are used to trade. In purchasing negotiations, therefore, if not in political or wage bargaining ones, it is possible from the outset to build on these areas of agreement by a collaborative approach. Indeed, a collaborative approach is likely to be essential if the purchaser needs heartfelt, genuine effort in the future from the supplier to meet quality standards and delivery dates. Yet it is also possible for the purchaser to adopt a confrontational approach. By this, the buyer attempts to impose his view about price typically by taking a provocative or abrupt stance, perhaps threatening to break off the discussion if his demands are not met. The steps of negotiation are outlined in the following text, and are covered comprehensively in the separate free on-line course at this Internet site. The negotiation steps are:
Pre-Negotiation: Supply market research of the type covered above;
Meeting Preparation: Deciding on the stance to be taken with the supplier - collaborative or confrontational etc - and the tactics to be used to persuade him that our assessment of price and conditions is the correct one;
Meeting Introduction: Establishing the atmosphere and perhaps recapping on points on which there is no disagreement;
Meeting Discussion: The issues in the negotiation are aired - the supplier's as well as our own. The stance or position of each party becomes apparent. Deceit and quarter truths are endemic in negotiation. It is very common for one side or the other to use a tactic to get his way - a tactic is, essentially, the spinning of a story, or lie, intended to place the opponent in a difficult or impossible position. For example: We cannot pay more than x because there are no more funds left in our budget;
Meeting Agreement: This sub-stage of the meeting is where the specific agreements are made between supplier and purchaser. Variations from the opening stances are known as concessions. For example, suppose that seven of the supplier's standard conditions of sale as printed in his catalogue for the purchase of a machine are: £100 per annum maintenance; 6 months free warranty and the supplier delivers the machine to the purchaser's factory. What is finally agreed, however, is as follows: £90 per annum maintenance; 12 months warranty, and the buyer collects the machine from the supplier's factory. Post-Negotiation: Remember that the written, signed agreement takes precedence over anything that was said or verbally agreed;
1.3 Supply Partnerships
The company's own progress in materials control and the enhancement of quality is likely to be undermined if external supplies are not incorporated. Suppliers must fit into the company's logistical picture, incoming material must be free of non conformancies and what is supplied must to subject to constant improvement. In order to bring these matters about, purchasing professionals are charged with the task of creating so-called close supplier relationships, or supplier partnerships agreements, through which suppliers accept the need to fit into their customer's new environment. Partnerships then can be considered under three broad headings: 1. Logistics; 2. Quality Assurance; and 3. Product Improvement. The five steps necessary to create a supply partnership from the viewpoint of logistics are set out below.
1.3.1 Supply Partnerships Step 1: Production Control
A formal company planning system must be installed within the company, based on the creation and on-going management of a master production schedule (MPS). The master schedule is recreated monthly, taking into account revised forecast sales and the capacity needed to support the required production. The actual mechanics of creating material and purchase plans needed to support the MPS may be by MRP or through an APS System. Whichever of the techniques is employed, purchase plans are created and adjusted in precisely the same way as manufactured material plans. Planning systems such as these are large and difficult to implement. But purchasing should not move forward into the world of supply partnerships until its chosen planning and control method is working satisfactorily (that is, in its own company.)
1.3.2 Supply Partnerships Step 2: Internal Communication
A close working arrangement must be created between purchasing, production control and production, typically overseen by the company's master production scheduler. The crucial data produced by the planning system consists of due dates and quantities. Purchasing must under-stand the need for precision on these matters and work closely with others in the firm to overcome possible problems. Typical problems arise when plans change, causing shifts in purchase order requirements, and when capacity constraints are discovered. Essentially, the internal communications step requires a number of purchasing staff to become schedulers (not expeditors). In many companies, a number of buyers have been transferred from purchasing to a separate scheduling section within the production control department.
1.3.3 Supply Partnerships Step 3: Supplier Base Reduction
One reason for pursuing a supply base reduction programme is that the closeness of the collaboration needed between buyer and supplier, especially with regard to help and involvement in the supplier's quality programme, is so time consuming that it would not be feasible to support a large 'traditional' supplier base. A second reason can be found in the practice - and spectacular success - of Japanese Just-in-Time supplier co-operations. Examples of the supplier base reductions in Just-in-Time environments that have been achieved in just a few years by American companies include: Control Data Corporation, St Pauls, from 900 suppliers to 280; Xerox Reprographic Inc from 5000 suppliers to 300; and IBM Typewriter Division from 640 to 32.
1. Set up a controlled register of suppliers (which is initially empty);
2. Clean up and slim down existing suppliers before transferring them to the Register.
Software to assist in the cleaning up process was referred to as Component Supplier Management (CSM). A CSM package that was widely used and well-spoken of is (was?) available from software house Aspect Development, California.
1.3.4 Supply Partnerships Step 4: Supplier Scheduling
The first and most difficult task in this major step is to ensure that suppliers are indeed capable of responding to changed needs on a frequent basis. This will entail, among other things, the purchaser giving help and education so that the supplier's MPS programme dovetails with the buying company's own needs. The least satisfactory solution, but probably the most common initially, is for the supplier to hold a safety stock buffer. With MRP systems, it is not uncommon to agree to three supply "zones of change" as follows: Freeze Period : The purchaser is not allowed to make any change to plans in this period. The supplier must send material precisely in line with the stated needs. The freeze period may be from 'now' to day 3 ahead inclusive. Semi-Freeze Period : The supplier may manufacture product in this period, though he cannot despatch it until the required date. The purchaser can change plans in the semi-freeze period, but must compensate the supplier for any losses due to cancellations. The semi-freeze period may be from day 4 to day 7 inclusive. Unfrozen Period : Changes may be made freely. The purchase plans in this period may be from (say) day 8 to week 6 to assist the supplier in his own scheduling.
1.3.5 Supply Partnerships Step 5: Technical Communications
EDI stands for electronic data interchange, and is one means by which purchaser and supplier can swop information. It refers to data sent by transmitter or data cable through a so-called value added network, or VAN. The VAN can be regarded as a network of computer 'post offices'. That is, the network subscriber who wishes to send data dials into the system and transmits the data, including the (electronic) address of the intended recipient. The message or data is directed to a computer close to the recipient's geographical address. The recipient accesses his local VAN computer on a frequent basis to see if any message has been sent to him, and, if it has, reads it into his own computer. In order to send via the network, it is necessary to follow strict rules relating to its electronic format, the rules being known as the protocol . The remaining technical issue concerns the software employed by the sender and recipient themselves to translate and interpret the information being sent and received. A number of 'EDI translation' software packages are on the market, such as Gentran. . Increasingly, the Internet is taking over much of the communications role of EDI - it is cheaper by far, and more versatile in the form of the data communicated.
1.4 Supplier Evaluation
Supplier Evaluation means the assessment of a supplier with whom we are actually doing business, rather than vendor appraisal - the assessment of a vendor with whom we might do future business. Supplier performance must be measured on an on-going basis as part of a robust, constantly-maintained recording system. To measure quantity and timeliness ("OTIF" = on time, in full), when an order is placed, it is entered onto the database and subsequent information relating to it is accumulated on the record as the activities relating to its progress are tracked. A marking system for supplier evaluation might record and assess 'Kaizen', cost, OTIF, quality, progress in value analysis, invoice conformance, packing, .... many aspects of the performance of the supplier relevant to the buying company.
1.5 Value Engineering and Supplier Value Analysis
The term value engineering means the consideration of new products under design. Purchasing's role in a multi-disciplinary internal team here is (1) to advise on the state of the supply marketplace, and (2) to note carefully the points required of any new materials to be bought in, so that the company's best interests can be protected in the eventual negotiations which he conducts with the chosen supplier. Value analysis, by contrast, is the term used for the study of a product or material, already part of the company's product range, in terms of its components, functions and constituent costs. The objective is to eliminate or re-specify all constituents of it which add cost but contribute no useful function. Again in company teams, purchasing has a role similar to its role in value engineering. However, the study of bought-in parts in terms of value analysis must of necessity be conducted by suppliers themselves. Here, importantly, purchasing have the tasks of (1) ensuring suppliers conduct vigorous and worthwhile value analysis programmes, and (2) monitoring the results and directions emanating from these programmes.
Two ways in which a supplier's order might originate have already been described, the first being direct through the purchaser's materials planning system, the second directly from a negotiated agreement. In addition, in order to minimise administrative costs, small orders may be placed by phone or fax, perhaps with payment of the supplier effected at once either by credit card or purchasing card (see immediately below). A prelude to order placement may be a request for information (RFI) - a form sent to a number of suppliers containing a brief questionnaire. Suppliers returning promising replies may then be sent a request for a quotation form (RFQ form). The RFQ may be straightforward or complex depending on the item under consideration.
Note that a major advantage of credit and purchasing cards is that the buyer can take quick advantage of ad hoc opportunities (eg Internet buying). Also note the difference between credit and purchasing cards:
Credit Cards: the amount charged has got VAT (value added tax) on it, so that a VAT invoice is needed in order to claim back the tax from HMRevenue & Customs.
Purchasing Cards: VAT is dealt with by the supplier and Revenue & Customs - the invoice is not a VAT invoice.
2.1.2 Invitation to Tender
A special form of request, used by the manufacturing company on occasion but very common in government and government-controlled institutions, and having legal significance, is the invitation to tender. Invitations to tender by the buyer, are, in legal terms, invitations to treat (ie invitations to bargain, or negotiate, or 'form a treaty'). That is, the buyer's invitations to tender are not contractual offers. The suppliers' tenders, however, very definitely are contractual offers, so that acceptance of a supplier's tender by the buyer creates a legally enforceable contract, as described below. The buyer is bound to consider all tenders which comply with the conditions laid down and are submitted by the date specified. He is not, however, obliged to accept the lowest bid, or accept any bid at all, unless there is a specific and unequivocal statement in the original invitation that he will indeed accept it ... that is, where the invitation to tender amounts in reality to a contractual offer. The buyer would therefore be wise to phrase his invitation to tender cautiously, very much in the manner of an inquiry. (Note that the term tendering is used in everyday parlance to describe both the seeking of a tender from a supplier and the proffering of a tender by a supplier to a purchaser.) Note that when tenders are received, they should be date stamped and locked away. The opening of tenders is a formal matter and should always be carried out by the purchaser in the presence of a witness.
Competitive Tendering
The purchasing manager may place an ad in a trade journal or similar, inviting all potential suppliers either to submit tenders as specified, or contact the manufacturing company for further details. The advertisement should be phrased with great care. The tender document (the technical and commercial requirements) should be prepared with even more care, since it will form the basis of the contract if it is referred to in the tender submitted by the successful supplier.
Selective Tendering
Here, the invitations to tender are sent only to preferred suppliers.
Negotiated Tendering (Post Tender Negotiation, PTN)
Negotiated tendering refers to follow-up negotiation after tenders have been received in the course of competitive tendering, before the acceptance of the successful bid, and is synonymous with post tender negotiation, PTN. PTN is undertaken perhaps to clarify certain points, including technical points, but most often to seek a reduction in the price. PTN may seem unfair to those not invited, but it is done and is legal.
The law of contract is not a specific law contained in a particular statute passed by Act of Parliament - instead, it is derived by reference to court rulings in past cases, each such ruling itself taking note of past decisions; the particular circumstances of the case to hand; and the principles that people are free to engage in lawful commerce among themselves, and are obliged to keep the promises they have made. Contract law, therefore, involves the study of past cases which have come before the courts and the principles which have been established and applied in deciding their outcome. For a contract to come into existence, three main essential elements must be present:
First, there must be an offer to sell, such as a tender sent by a supplier, or else an offer to buy, such as a purchase order sent by the buyer without prior discussion. An offer made by one party can be accepted or rejected by the other. A counteroffer, or alternative offer, by the other party is, in effect, a rejection of the original offer. An offer can also later be revoked, provided this is done before its acceptance, and it can lapse "after a reasonable time". An offer is to be distinguished from "an invitation to treat", which is an action by one party intended to initiate the bargaining process. ( For example, items in a shop window are not offers, they are invitations to treat, made by the retailer and intended to induce the shopper to enter his premises and make an offer to buy the goods displayed. Thus an RFQ (see above) is usually an invitation to the supplier to make an offer to supply.)
The second element is that the buyer must accept the supplier's offer, and this must be done without further conditions, or, alternatively, that the supplier must accept the buyer's offer. Acceptance might be quite specific, such as by sending a letter of acceptance. In certain circumstances, the conduct of the other party might be deemed to constitute acceptance (for example, the despatching by the supplier of the actual goods, even though he has sent no formal acknowledgment, would be deemed acceptance). Doing nothing and saying nothing cannot be construed as acceptance.
The third element is that there must be 'consideration'. That is, there must be value to the contract - evidence that a bargain, or deal, has been struck. The most obvious indication that this is so is the stated promise to pay money in return for goods bought, but bargains might also take the form of the exchange of goods by bartering, or the payment for goods by the performance of some service.
There are also a number of conditions, set out below, which must be present in the agreement if it is to constitute a legal contract.
(1) Intention to form legal relations. It is assumed in commercial agreements that the two parties intend to be contractually bound. If this is not the purchasing company's intention, because, say, the dialogue with the external company is purely exploratory, or is merely laying the ground for a further meeting, this should be made clear at the time.
(2) The two parties should each have the authority to contract. Note that agreements reached by users stemming from technical negotiations may be held to be enforceable if the staff concerned have given the impression of having authority. Consequently, the purchasing manager must make it clear to the supplier that the commercial and legal sides of the agreement are to be dealt with exclusively by him, separately from the technical discussions. The principal (ie the company) is bound by the agent's actions.
(3) Within the (criminal) law. A legal contract cannot be made which involves, say, fraud or the non-payment of taxes.
(4) Not unfair. A contract is not legal if it devolves on the accidental death of a user of a machine etc.
(5) Privity of contract. That is, if Parties A & B enter into an agreement, only they are privy to it and only they can take action in law. Thus even if Party C is the subject of the agreement, C cannot take action.
Certainty of Terms, Estoppel & Parol Agreements
There must be certainty of terms ... no residual ambiguity. That is, the offer must contain all the detail necessary for the subsequent agreement to be capable of being carried out in its entirety - for example, technical specifications must be set out, along with quantities, price, dates and the rest. Note also the doctrine of estoppel ... ie the contract relates to what is specifically agreed, usually as it is put down in a written document. It can never relate to what one party or the other intended in his mind, and thought it related to, but who failed to write it down or became confused. For example, if the buyer thought that the supplier would deliver the goods, but delivery was not actually agreed, he is "estopped" from pleading that it was assumed the supplier would indeed deliver.
Note that contracts are equally valid whether made orally or in writing. Oral (or parol) agreements, however, are clearly unsuitable for complex or lengthy agreements, or indeed for modern business generally. Offers, acceptances and the rest should therefore be made in writing, on official company forms, and all paperwork kept on file.
Further reading on Contract Law for purchasing professionals:
Law for Purchasing & Supply, by Margaret Griffiths (Pitman 1994); The Law of Contract (2nd Edition), by J.C.Smith (Sweet & Maxwell, 1993), The Complete Book of Letters, Contracts & Policies, from Indicator Ltd (2007).
2.2.2 Contractual Terms (including representations and misrepresentation)
The contractual terms, or details, of the contract are either express or implied. Before dealing with them, however, a distinction is made between contractual terms and representations. A representation is a statement made about the goods or service by the supplier intended to persuade the buyer to enter into the contract. The representation is distinguished from a contractual term in so far that it is not eventually incorporated in the terms themselves. Misrepresentation can give rise to legal liability and even criminal prosecution, and is divided into three classes:
(i) misrepresentation of fact - the supplier has made an untrue statement about a factual matter;
(ii) material misrepresentation - the fact which has been misrepresented is inherently important, and is not a triviality;
(iii) the misrepresentation induced the contract.
Express contract terms ...
... are those which are put down in the agreement and which give it its unique meaning - that is, they are explicit, unmistakable and not simply implied. Examples are the identity of the materials to be delivered; the date of delivery; the quantity; price; the technical service to be provided; and so forth. (Whether the express contract terms are conditions or not is another matter - see below.)
Implied contract terms ...
... are those which both parties would have agreed to without hesitation, but overlooked or never bothered about. The court reads the implied terms into the contract, even though they were not expressly part of it. For example, '... that the bags in which concrete will be delivered to the buyer's stockyard will be rainproof'. Implied terms also relate to common law and commonsense ... for example, that the supplier's driver will exercise reasonable care when making the delivery and when unloading.
Both express and implied contract terms are either conditions of the contract, or warranties. The importance of these distinctions will be seen in due course, under breach of contract.
A condition of a contract ...
... is a central element of the agreement, such that a failure to fulfil it will seriously detract from the contract's value to the party affected. Usually, the central elements of the agreement will be clearly seen as conditions from the sense and reading of the document, and if it is the intention of the two parties that the performance of some action should be a condition, this should be made clear in the drafting of the text. This is particularly true when timeliness of delivery is concerned. If on-time delivery is vital and is to be regarded as a condition, attention must be drawn to it *.
A warranty ...
... is a term that is not central to the contract, so that the agreement still retains most of its anticipated value, though it is not, in the event, fulfilled to the letter. * Under normal circumstances, the date of delivery of a new machine tool to be installed on the manufacturing company's shop floor would be a warranty, not a condition. If the delivery was two weeks late, this might be annoying, but the detraction from the value of the contract overall would be small, given the machine's expected life, say, of ten years. If the date of delivery is critical, the buyer can make it an express condition simply by saying so. The phrase often used by lawyers to do so is time is of the essence, but it would be quite in order simply to write ".. the date of delivery is a condition of this contract".
Note that although it is not being dealt with directly in this on-line course, a further type of condition is innominate. The word innominate means "having no name", and is used in law when a contractual obligation is either a condition or a warranty depending on the actual effect of an actual failure to fulfil the obligation, rather than on the inherent status of the obligation in the contract. For example, suppose a contract stipulates that the supplier is to deliver 100 items, and in the event he delivers only 80. Two alternative outcomes might result from this: (1) for compelling technical reasons connected with the short delivery, the purchasing company finds it has to abandon its production programme and tear down its set-up ... the delivery term of 100 units in these circumstances now assumes the status of a condition; and (2) the purchasing company is able to proceed with its production programme, although it is forced to make a somewhat smaller batch ... in these circumstances the term now assumes the status of a warranty.
Exclusion Clauses
In agreeing the terms and conditions of a contract, either the buyer or the supplier may seek to insert in it what are known as exclusion clauses. An exclusion clause may take one of two forms: (1) it may attempt to exclude or qualify (ie modify) a contractual obligation, or (2) it may attempt to exclude or qualify a remedy (eg the compensation to be paid on non-fulfilment of a contractual obligation).
Before considering a supplier's exclusion clause, the buyer should satisfy himself that the clause really is part of the contract. For example, if he orders material from a supplier, and on the supplier's delivery note a statement has been added that such-and-such is excluded, this statement is not part of the contract and has no force whatsoever - any exclusion must be stated at the outset when the contract is formed. An exception to this exists if the buyer places repeated, regular orders, and becomes - or should become - well aware of the supplier's exclusion. A second exception exists if both parties are "in the trade" and the exclusion is the custom and practice of business. In deciding whether an exclusion clause is valid, the principal which is applied by the courts is the "main purpose rule". That is, in a written contract, the existence of an express exclusion that excludes one or other of the contractual conditions (but not warranties) appears illogical - if the obligation/condition truly exists, the exclusion must therefore be invalid, and if the exclusion is valid, the obligation/condition does not exist! Consequently, to determine whether an exclusion clause relating to a condition is valid, the context and purpose of the contract as a whole must be taken into account by the court. Generally, exclusions to conditions will not be valid - was the exclusion really meant to exist? Exclusion clauses are also the subject of statute law in the form of the Unfair Contract Terms Act 1977, summarised as follows:
(1) No exclusion or restriction can apply to negligence which results in injury or loss of life;
(2) In excluding or restricting liability, the test of reasonableness must be applied;
(3) Matters cannot be excluded which relate to title in the goods as governed by the Sale of Goods Act 1979 or by the Supply of Goods Act 1973;
(4) A manufacturer or distributor cannot exclude or restrict his liability to the ultimate user of the goods.
Note that an exclusion clause is to be distinguished from one that is legally void. A clause is vitiated (= legally invalidated) if it is held to be in restraint of trade. An example is a contract between Companies A & B not to engage each others staff within a so-many years of their leaving.
2.2.3 The Battle of the Forms
Whose express terms are to prevail in the contract? - The buyer's or the supplier's? If the buyer sends a purchase order to order the goods, the purchase order having his (the buyer's) 'terms and conditions' attached, then if the supplier accepts this without further ado, then the buyer's terms and conditions will constitute the contractual terms. However, if the supplier, on receiving the purchase order, responds by some means, such as email, fax or letter, saying he disagrees with certain aspects of the purchase order (eg the terms of payment) and that he requires alternative conditions, then if things go ahead from that point, the contractual terms are the original purchase order terms modified by the supplier's alternative as stated in his communication. Naturally, this can go on and on. That is, on receiving the supplier's objections by letter (etc), the buyer may repudiate the objections and insist on his original conditions, or even demand completely new conditions. Where there is a dispute such as this, the buyer should keep a writen record of where things are up to* and keep a careful eye on his position. * In particular, note that delivery of the goods by the supplier, or their acceptance by the buyer, implies acceptance of the terms of the contract at that point.
Postscript to 'Battle of the Forms'
In the case in 2007 of Lidl v Hertford Foods Ltd, the judge stated that the stages of offer, counter-offer, acceptance etc are often impossible to determine in the haste to conclude the deal, and that, except in the most straighforward of cases, the courts are no longer prepared to trawl through the evidence to determine who 'won' the Battle of the Forms. Instead, they are now coming to the radical conclusion that neither party's terms and conditions apply. To protect its position, a company should be absolutely certain that the other company has agreed its own terms before proceeding. Three tips are: (1) always send a covering letter both referring to and including its own terms and conditions which are to apply. Finally, request that these terms are acknowledged by the other party, and never conclude the deal unless and until this acknowledgement has been received. (2) If the other party takes issue with a term, deal with it specifically, and arrive at a revised set of terms and conditions which both accept. (3) If the type of transaction still lends itself to a 'Battle of the Forms' situation, add the following text to the covering letter referred to above: Unless otherwise agreed in writing, the terms and conditions of this Agreement shall apply to any order placed by the customer. In the event of any inconsistency between these terms and those passing between the parties, these terms shall prevail. No variation of the terms and conditions shall be allowed unless expressly accepted in writing.
2.2.4 Termination of the Contract including 'Rescission'
The normal termination of a contract occurs, naturally, when both parties fulfil their obligations under it - ie the supplier delivers and the buyer pays. The fulfilment by the supplier must be "substantial". If it is not substantial, payment by the buyer may be on a quantum meruit basis (= Latin for how much is taken). For example, a buyer may pay for only that portion of the work which has been completed, although that may not be acceptable if the contract makes it quite clear that the work must be completed in its entirety. The contract may also terminate when a date stipulated in the express conditions has been reached - say, 19th December, 2009. Alternatively, it may be agreed by both parties that the contract should be brought to an end before the original contractual obligations have been fulfilled. Such an act is known as rescission. In this case, the agreement to terminate is, itself, a separate contract, the consideration being the release of the two parties from having to complete their original obligations (and, doubtless, the settling of any expenses which may have been occurred by one party or another). As stated, terminating the contract in this way is termed rescission. Other reasons for termination are:
Frustration: The main point to make is that a contract is not frustrated - ie void and at an end - simply because it has unexpectedly become very difficult or burdensome to perform. The classic case is the closure of the Suez Canal in 1956 affecting suppliers of goods to the UK from the Far East, who were then faced with shipping their goods via the Cape. The journey via the Cape was long and expensive, but importation was nevertheless still possible, so their contracts to supply were not frustrated. Similarly, a contract is not frustrated because the materials or labour involved have suddenly become scarce or expensive. However, if the supplier's factory is destroyed by fire, making manufacture impossible, the contract is frustrated, since the continued existence of the supplier's factory is held to be an implied condition of the contract. Note that according to the Frustrated Contracts Act 1943, the position of all parties should be restored to their original positions before the frustration. That is, all advance payments are to be returned and so forth. However, if money has been spent 'in anticipation of performance' - eg on initial design and the manufacture of prototypes - the court will order reimbursement of the cost, up to a limit.
Force Majeure: Natural and unavoidable catastrophes, commonly known as acts of God (literally irresistible force). If the reasons for termination due to force majeure are to extend to acts of man - for example, labour strikes, war, embargoes, explosions etc, it is advisable to specify these in the contract - eg there have been recent insurance disputes as to whether or not terrorist acts qualify.
Mistake (common, mutual or unilateral): First, let it be said that the old expression caveat emptor is a powerful argument in denying the claim that a mistake has occurred in a contract such that the contract is void. Caveat emptor is Latin for beware the buyer, and means that the buyer should be most careful in what he purchases. If he buys something unwisely, he has only himself to blame. One might also add the expression caveat venditor, beware the seller. Nevertheless, suppose that the buyer knows that the supplier is making a mistake in agreeing to a contract. In this case, the buyer can enforce the contract only provided the mistake concerns matters of fact. Things are different if the mistake concerns the terms of the contract themselves. For example, suppose the buyer knows the supplier is mistaken as to the terms of the contract - ie the buyer knows that the supplier thinks the contract contains term X, whereas in fact the contract actually contains term Y instead. In such a case, the buyer cannot enforce the contract in the sense of term Y, even though the contract which both parties signed states Y, not X. An example of this was a contract stating a building was to be completed in 30 months, which the contractor thought was 18 months. (The contractor had not read the contract properly.) The court ordered the duration in the contract to be changed from 30 months to 18 months, because it (the court) was satisfied in the circumstances that the written words (30) did not represent the true contract between the parties. This was an 18 month contract because the other party knew at the time that the contractors believed it was an 18 month contract. As a final statement, the buyer should know that whenever it is to be inferred from the terms of a contract that the agreement has been reached on the basis of a particular contractual assumption, and that assumption turns out not to be the case, the contract is void from the start.
Breach of Conditions See immediately below.
2.2.5 Remedies (Damages) in case of Breach
Legal remedies for breach of conditions depend on whether the obligation that has not been performed is a condition or a warranty. If there has been a breach of a condition, the innocent party may terminate the contract and sue in the courts for damages, or may continue with the contract. If there has been a breach of warranty, the innocent party may not terminate the contract. He can, however, sue in the courts for damages. Such damages are either unliquidated or liquidated.
Unliquidated damages mean the financial compensation which is to be awarded to the party suffering the breach, to be paid by the party which has failed to carry out its obligations, has not been calculated and expressed in financial terms beforehand, so that it is up to the court to decide the sum to be awarded. The damages are arrived at on consideration of two factors:
The first is the amount of money needed to compensate the innocent party for the direct loss he has sustained as a result of the breach - for example, the cost to put right a roof following faulty construction work.
The second is the indirect loss to the innocent party as a consequence of the breach.
Liquidated damages are payments stated in the contract itself, and which fall due when various conditions and warranties which constitute the objectives of the agreement are not performed. An example is a condition that states that delivery shall be on 2nd November, 2009, and an accompanying liquidated damages clause that further states that the supplier will pay liquidated damages to the buyer of £1000 per day for every day the delivery is late. The sums nominated in liquidated damages clauses must be arrived at by genuine calculation of the losses to the buyer if the various conditions and warranties are not performed by the supplier. No attempt should be made to turn them into penalties intended to punish or put pressure on the other party, and if they clearly are penalties, the supplier which does not achieve the performance required will, in the event, refuse to pay them, and will be supported in his refusal by the courts regardless of the fact that he signed the contract in the first place. In arriving at liquidated damages, the two parties should scrupulously follow the three guidelines issued by the courts:
(1) Any sum stated in a clause must not be more than the maximum loss that could be suffered by the breach;
(2) the sum must not be more than the consideration attaching to the contract itself; and
(3) a single sum of money cannot apply to every condition and warranty not performed (since this would indicate that a serious attempt honestly to calculate the various potential losses had not, in fact, been made).
Note that suppliers may attempt to insert damage limitation clauses into contracts during the course of negotiations, perhaps disguised as liquidated damages. The buyer should be on his guard, however. It would, perhaps, be better that no mention of liquidated damages and damage limitation was made to tie his hands, and that matters, if necessary, were dealt with in court.
2.3.1 The INCOTERMS
This sub-section concerns the division of responsibility in a particular purchase between the company and its supplier for such matters as the carriage of the goods, their insurance and if, international transfer is involved, the payment of dock dues and duty. The buyer and supplier will normally nominate one of the thirteen standard terms drawn up by the International Chamber of Commerce, used worldwide and referred to as the Incoterms. (The International Chamber of Commerce Terms of Sale.). The 13 standard terms define alternative arrangements, or obligations, of the seller, as the party providing the service of actual transportation and delivery of the goods, and the buyer, the party paying for the service and requiring the goods to be transported, in such matters as: arranging for carriage; payment of insurance; the payment of dock dues; the completion and presentation of customs documents; and customs duty.
For the buyer of service, the least onerous Incoterm is "Ex Works"(EXW, followed by a named place from which the goods are to be collected ). With EXW, the goods merely have to be placed by the buyer of the service, with immediate wrapping only, at his despatch dock, and all subsequent activities involved in the move are the responsibility of the company undertaking it. (Note that there is no obligation to load the vehicle.) As one moves through the 13 terms, the obligations of the seller (ie the company undertaking the move) increase and the requirements of the company wishing to effect the move correspondingly decrease. The maximum obligations of the transport company providing the service are "Delivered Duty Paid" (DDP, followed by a named place within the country of destination). The Incoterms were first formulated in 1936 and are revised about every ten years, the last revision effective from 1.1.00 being end 1999. The year of publication should be quoted on any agreement between seller and buyer involving the Incoterms (eg "FOB the SS Mary Rose, Liverpool, Incoterms 2000"). A booklet published by the ICC is available for about £26 setting out the terms in full, and may be ordered on the Internet through Amazon.co.uk. It is essential that any buyer wishing to become seriously involved in using an Incoterm should consult this booklet, and the commentary on the Incoterms written by Jan Ramberg*, also available from Amazon. The complete list of Incoterms is: EXW ("Departure"), FCA, FAS and FOB ("Main carriage unpaid"), CFR, CIF, CPT and CIP ("Main carriage paid"), DAF, DES, DEQ, DDU, and DDP ("Arrival"). The advantage to buyer and seller in choosing to nominate a standard Incoterm to govern the transfer of goods is that all the terms are well known through ICC booklets and guides, and from their frequent use throughout commerce. The principal publication helpfully makes clear, for each one, exactly what activities each party is responsible for. That is, following a 100 word explanation, the remaining text is divided into two clear sections labelled "The Seller (of the transportation service) Must ... (then the action points necessary)" and "The Buyer Must ... (action points)". Naturally, a specific reference must be made in the contract between buyer and supplier as to which Incoterm (including its published source and year of publication) is to govern the agreement. However, in agreeing it, there is no reason at all why the provisions set out in the standard term should not be modified if some special condition is to prevail. The most common amendment is to Ex-Works, requiring the supplier to load the goods. That is, the agreement states "Goods and delivery to be made Ex-Works at Supplier's factory in Sheffield, in accordance with term EXW of Incoterms 2000, Supplier to load vehicle." Problems for the supplier with EXW are that the buyer may delay in making the collection, so affecting the supplier's storage costs and disrupting his everyday work (for example, the buyer's vehicle may arrive without prior warning, at a difficult time, causing disruption and congestion). *Note that there are traps in using the Incoterms - for example, if the buyer agrees to load the vehicle as a courtesy in an EXW collection of the goods, and the goods are damaged or a person injured in doing so, where does the liability lie? Jan Remberg's book deals with matters such as this, and its study strongly advised.
2.3.2 The Delivery of Goods
Delivery itself is merely the voluntary transfer of physical possession from one party to another. Thus the signing of a delivery note presented by the supplier or haulier simply acknowledges physical receipt of the goods. Section 34 of the Sale of Goods Act 1979 specifically lays down that: "Where goods are delivered to the buyer and he has not previously examined them, he is not deemed to have accepted them until he has had a reasonable opportunity of examining them to ensure their compliance with the contract". (The Act also states that the supplier must, on request, give the buyer reasonable time.) The obligations of the party receiving the goods is simply that reasonable care should be taken in their storage.
Remember from above, that on delivery the supplier cannot attempt to impose new conditions in the contract, such as 'non-conformancies must be notified to the supplier within 24 hours', or 'we will not be responsible if ...'. These statements, perhaps accompanying the delivery note, mean nothing. If the supplier wanted to impose these conditions on the delivery, they should have been stated and agreed in the contract from the beginning.
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The word 'acceptance' here means the legal and commercial acceptance of the goods, not the everyday meaning of physical receipt. Thus the legal/commercial acceptance of the goods by the buyer in effect means the buyer's concurrence that the goods delivered comply with the contract's provisions in a number of vital regards - for example: delivery date; general material state, especially as regards design and quality; and quantity. From the legal viewpoint, since such points of compliance are likely to be central contract conditions, the most important effect of accepting the goods is that the buyer can no longer terminate the contract because of breach of condition relating to these matters (although he can still sue under the Sale of Goods Act for breach of warranty). Section 35 of the Act states: "The buyer is deemed to have accepted the goods when he intimates to the seller that he has accepted them, or when the goods have been delivered to him and he does any act in relation to them which is inconsistent with the ownership of the seller, or when, after the lapse of a reasonable time, he retains the goods without intimating to the seller that he has rejected them".
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Having title to the goods means being their legal owner (cf the 'title deeds' of a house). Absolute ownership of, or title to, the goods, is transferred to the buyer when the terms of the contract specify that it is to be transferred, having regard also to the conduct of the two parties and the circumstances applying. [Before the 1960s, the INCOTERMS specified the point where title transferred from one party to the other. Nowadays, the INCOTERMS make no statement whatsoever about the transfer of title.] One consequence of ownership arises if one party or the other becomes bankrupt during the exchange of goods and money. For example, if the buyer became bankrupt before he had paid for the goods, and the supplier still retained legal title in them, the supplier can claim for their return from the receiver in bankruptcy. If title had been transferred to the buyer, the goods would be seized by the receiver in bankrupcy, and sold to realise the buyer's assets. It is common practice, and advisable from the supplier's viewpoint, therefore, to retain title to the goods until payment has been made. This can be easily assured by stating in the contract that the title of the supplier is retained by him until payment is received.
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Specific goods and specific future goods are goods identified and agreed at the time the contract comes into existence. Thus a machine tool distinguishable by its serial number is a specific good. A product being made to order is a specific future good.
Unascertained goods are likely to be associated with make-to-stock companies. An example of unascertained goods are angle brackets, to be selected from the company's stockholding of 350 brackets, and being the subject of a customer's order. Unascertained goods are said to become ascertained when they are duly selected to fulfil the order - for example, when, say, 80 brackets for our order are picked, ready for packing and despatch.
Bailments: Goods which are free issue material or have been sent for repair or to have a special operation carried out on them, then to be returned, are referred to as bailments, the party supplying them being the bailor and the party receiving them the bailee. A formal definition of bailments is that they are "goods delivered in trust upon an expressed contract that the trust be faithfully executed on the part of the bailee". That is, the bailee must exercise due care in looking after the materials in his charge.
Goods which have been processed. If goods have been processed, so that the original material has lost its identity, it is held that the material has become the buyer's property regardless of any retention of title clause. However, even though the original goods are lost to the supplier, if the buyer is in possession of other goods relating to a separate, second contract with the same supplier, albeit these being already paid for, title in these other goods can be claimed by the supplier against payment for the first contract. Among other things, this obviates the need for the supplier continually to identify and mark the materials sold to the buyer - for example, when materials are being supplied in a succession of repeat orders.
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3.1.1 The Trail of Commercial Information
The trail of data required before the final close out of a purchase order (see 3.1.2 below) is fundamental to the commercial operation of the company, although once more the use of the computer database has simplified it and made it less liable to error. The documents and six steps are:
I Notification of the Order
The order is raised and sent to the supplier, and an official Order Number is attached to it. The order will often be raised electronically, and the order number assigned by computer.
II Confirmation of Despatch (Advice Note)
The supplier sends the buying company a message saying that the goods are being physically despatched.
III The Delivery Note and Consignment Note
A note giving a broad description of the goods will accompany the physical goods. If the actual delivery is being made by a third party (ie by a transport haulier), a consignment note will be raised by the supplier confirming that he has assigned the goods to the haulier for carriage. This note might be forwarded direct to the buyer, but will usually be in the possession of the haulier, for checking if necessary by the buyer.
IV Detailed Unpacking Note
If the load is a large, complex one, it will need to be carefully unpacked and checked.
V Notification of Damage etc
Goods-in staff or those responsible for unpacking must record damaged material, stock shortages and excesses and other errors. A final notification of delivery giving this information is sent to Purchasing etc. Note that the company has a duty of care with respect to goods which are to be returned for reasons of non-compliance. They must be held in good condition until they are collected.
VI Payment
If the goods are satisfactory, payment is authorised, to be made on the contractual date.
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Most orders are placed through the mechanism of the 'purchase order'. The purchase order is a formal company document which conveys the instructions or detail of the required supply. The legal role of the purchase order in forming the contract of supply will vary with circumstances: most usually, it will be an offer, such that the supplier's acceptance of it at the price mentioned seals the contract, but it might alternatively be the acceptance of an offer (say, an order placed immediately against the supplier's tender.) The document itself may also be used by the company simply to convey detail, perhaps being a call-off for material against a yearly contract already in existence. The purchase order might convey a summary of substantial material to be delivered at various times in the future by special order forms under the P.O.'s 'umbrella'. Finally, a particularly important role of the purchase order is to superimpose onto the contract certain express contractual conditions required by the purchaser, such as conditions of payment and such others as those in Section 2 (see The Battle of the Forms, above). These conditions are typically printed on the reverse of the document itself. In formulating the terms and conditions, the buyer must beware of making them one-sided or onerous. Firstly, if he does, they will be resisted by suppliers and his aim of having a single, standard set of express conditions governing the majority of his contracts will be defeated by requiring to incorporate in numerous contracts individual letters of objection. Secondly, where a supplier deals on the buyer's standard terms, he should beware that under the Unfair Contract Terms Act (see above), the buyer cannot use a standard contract term to exclude or restrict his liability in the event of breach on contract. (By the same token, of course, where the buyer deals on a supplier's standard terms, the supplier cannot incorporate a standard term to exclude his own liability in the event of his own breach.)
In summary, the roles of the purchase order are as follows:
a. To make it clear what is being bought - the specific detail of the contract;
b. To superimpose onto the contract certain express conditions;, usually printed on the reverse of the document;
c. To act as a formal control, so that the purchaser can readily ascertain its supply position and its financial liabilities.
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3.1.3 Progressing and Expediting
Progressing means checking and communicating with suppliers at critical milestones in the order's life - fabrication, assembly, testing and despatch, perhaps. Progressing will normally be confined to major purchases such as capital acquisition and purchases involving novel, potentially uncertain technology. When it takes place it will amount to no more than communication and recording of events by purchasing as part of a joint supplier/purchasing team. Expediting by contrast has another connotation - the chasing up of orders which are late, the chivvying of suppliers to perform to their delivery promises and the mitigation of damage to the company by orders which are becoming increasingly behind. As such, expediting is a dirty word in the modern purchasing vocabulary. One of the purposes of better supplier relationships is to impress on suppliers the need for timely deliveries - the requirement for material to fit into its time slot as part of the company's master schedule. Note in expediting that the buyer is just as entitled to use the planning system to solve his problems as is the production manager - ie is the stock really needed? An example of what is meant is as follows, in which raw material B is used in the manufacture of product A:
the original need for raw material B is 20 units, based on a minimum order quantity of 20 units to add to existing stock of B of 6 units. The total need for B is 15 units, required in production. However, by modifying the planned production of A, the net need for B is modified to only 8 units. The supplier is persuaded to send 2 units only, which, with the existing stock of B (2 units), is sufficient to allow the revised production plan to go ahead without the need for a minimum order.
Expediting should be seen as a small part of the purchasing task, not a major departmental activity. Constant expediting will lead to extensive raw material stocks as buyers build stocks at the company's expense to protect it from the uncertainty created by its inadequate supplier base.
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3.2 The Order Quantity to Minimise Cost
Planning systems tell us when orders should be placed with suppliers, but it is up to the purchasing function alone to determine how much material is then to be ordered ... ie the planning function or individual buyers must specify what the replenishment quantities for the various materials are to be, these quantities then being entered into the planning and purchasing system. The replenishment quantity of a product (traditionally denominated as 'R') is clearly vital in inventory control, since the average stock of raw material held is (R / 2 + S), where S is the safety stock. The order quantity R is also important in operating efficiency, since it determines the number of orders to be handled each year and influences the flexibility of response to external demand. Desirably, the ideal amount to order, R, is that quantity which minimises the total cost of ordering, stockholding etc.. The ideal quantity is generally referred to as the economic order quantity, or EOQ. What the word 'economic' means is simply 'least cost'. Calculations of order quantities are relevant to the buyer in a number of circumstances ... for example, in ordering basic replenishments from suppliers as specified in the planning system, in deciciding whether or not to accept a bulk discount offered by a supplier, in delivering material to customers against blanket orders, in consignment stocks and perhaps in distributing consolidated loads. The two sets of costs are involved in arriving at a product's EOQ are ...
(i) Ordering Costs
The costs of transferring stock from the source to the point of delivery, including physical transfer, despatching and purchasing administration, handling and accounting. The more orders that are placed per year and the more deliveries that are made, the higher the unit order cost. Unit order cost is the total of all the ordering costs divided by the total quantity ordered.
(ii) Stock Holding Costs
A great deal of attention has been focussed on stockholding in recent years. Costs include the notional interest on the money invested in the stock itself, valued at a rate of interest equal to the company's target return on investment, the cost of storage space occupied by the material, the cost of the warehousing operations needed to manage the stock, the cost of insurance etc...
Derivation of the least cost quantity is given in every book on materials management. If the quantity which minimises the total cost is "q", it is given by the following equation:
q = SQRT{{2 x A x O} /( i xV),
where q =economic order quantity (ie the EOQ), A = annual usage in units, O = order cost per delivery, i = rate of interest, and V = unit value of the material. If a graphical representation of the trade-off of costs were to be drawn, it would be found that the point on the curve which represents the minimum cost (ie the EOQ) is very shallow, such that there are numerous other points on the curve close by this point which are also very low cost. What the curve indicates is that any quantity that is close to the precise EOQ point will nevertheless result in an order quantity not very far from the ideal value. In other words, in calculating the EOQ using the formula above, precision is not necessary, and good results will be obtained from an approximate value.
As an example of the calculations, consider a product costing £10 each, annual quantity 50,000 units, order placement cost £30 and rate of interest of 25% (ie i = 0.25). Then the quantity to order is the square root of (2 × 50,000 × £30) / (0.25 × £10), or the square root of 1,200,000 = 1095 units. As discussed in the paragraph above, in everyday operation, provided the calculated EOQ is approximately correct, the degree to which it is in reality incorrect will make very little practical difference in total cost terms.
A matter of considerable interest is why so few buyers ever use the EOQ formula, since it is in so many books and has been known for almost 100 years. (Even when the buyer is constrained by a supplier's standard package sizes or delivery quantities, it is not used to find the size or quantity nearest the ideal.). Perhaps the buyer should calculate the EOQs of all his purchased materials, so that he is at least aware of the theoretical penalties he pays when he goes against such quantities (if he orders more than the EOQ, he pays in stockholding; if he orders less, he pays in order costs). The EOQ also shows why concentrating solely on inventory and inventory control is misguided. Taking the rounded view reveals other costs (not least quality costs). Excessive concentration on inventory, or on simply price, or on simply supplier response, is not the way forward - the buyer should look at the round picture.
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3.3 ABC Analysis and Bought-In Parts
3.3.1 How to Perform ABC and ABCD (Pareto) Analysis
ABC analysis, or Pareto analysis, can be applied to the management of raw materials. It can readily be shown that about 20% of bought in parts account for 80% of the total spend. (That is, 80% of the remaining parts account for only 20% of annual spend.) This being so, it seems to make sense to pay most attention to the 20% of expensive 'A' products, perhaps by controlling them through more elaborate techniques and paying greater attention to their stockholding. The remaining 80% may be relegated to control by simpler, less controlled methods.
Before accepting the above conventional supposition, however, the buyer should reflect that if he makes savings of 5% on the 20% of B products, this is equivalent to 1¼% savings on the 80% of A products. (5% × 20 = 1, and 1.25% × 80 = 1.) The buyer may think it is easier to obtain a 5% reduction on the B products than 1¼% on the A products).
The application of ABCD analysis to a group of ten products is illustrated in the two Tables below. In the first table, the identity of each product in the group is shown in column 1 ... P1, P2 ... P10. The quantity of each bought in part purchased annually is given in column 2. The unit cost V of each product is given in column 3. Column 4 is the annual value, or quantity × value, ie £Q × V. Note that the total annual value of all 10 products has been calculated (£4875). The figures in column 4 enable the ten products to be ranked in descending order of annual value. The ranking of each one is given in column 5. To make things clearer, the ten ranked products have been rearranged in order of their ranks, and transferred to the second table further below. The first, or top, product is Product P8. The annual value of P8 represents 45.1% of the total annual value (last column of the right hand table). The annual value of the second product P5, plus P8, accounts for 73.4% of the total annual value. The third product P7, plus P8 and P5, accounts for 82.7% ... etc. The bottom product in the table (P1) represents only 0.4% of the total annual value and might be relegated to Class D. A computer printout in the format of the second table is all that is required for ABCD analysis. (That is, it is not necessary to draw graphs) To create the A Group, simply take the top 20% of the products. They will account for, say, 80%, or perhaps 75% to 65% , of the total value. After the A products, take the next, say, 15% of the products, and call these the B products. They may account for 25% of the total annual spend. Next take the bottom 5% of the products, accounting for less than, say, 0.3% of the total, and relegate these to Class C. The products at the bottom of Class C can be reclassified as Class D.
Table 1
(1) Item (2) Annual Quantity (3) Unit Value (4) Annual Value (5) Order or Rank
P1 .......................10..........................£2.......................£20..............................10
P2 .......................40 .........................£1.......................£40 ..............................8
P3 ........................15 ........................£10 ...................£150..............................6
P4 ........................50 ........................£4 .....................£200 .............................5
P5 .......................115 .......................£12 ..................£1380 ............................2
P6 ....................... 5 ...........................£5 .....................£25 ..............................9
P7 ....................... 30 ........................ £15 ..................£450 ............................ 3
P8 ........................275 ...................... £8 .................. £2200 ............................1
P9 ....................... 15 ........................ £4 ...................... £60 ........................... 7
P10 .......................50 ....................... £7 ..................... £350 ...........................4
Total ...........................................................£4875.....................
As stated above, the ten ranked products in Table 1 have been rearranged in order of their ranks, and transferred in order to Table 2 below. Note that 'Cumulative % Value' means the value of this Product expressed as a percentage of the total (ie a percentage of £4875), but as a cumulative figure. That is, the entry in the Table for, say, P5 (second in the table) is added to the entry for P8 (first), and the total of these two (£1380 + £2200) expressed as a percentage of £4875 (ie £3580 / £4875 = 73.4%). Similarly, the entry in the Table for P7 (third) is added to the entries in the Table for P8 (first) plus the P7 (second), so we have a total of £4030, which is 82.7% of £4875. Note that the bottom product in the table (P1) represents only 0.4% of the total annual value and might be relegated to a fourth class, Class D.
Table 2
(1) Item (2) Order or Rank (3) Annual Value (4) Cumulative % Value
P8 ........................1..........................£2200.......................45.1
P5 ........................2 .........................£1380.......................73.4
P7 ........................3 ...........................£450 .......................82.7
P10 .......................4 ..........................£350 ...................... 89.9
P4 .........................5 ..........................£200 .......................93.9
P3 ........................ 6 ...........................£150 ......................97.0
P9 ........................ 7 ............................ £60 ......................98.2
P2 .........................8 .............................£40 ..................... 99.1
P6 ........................ 9 ............................ £25 ..................... 99.6
P1 .......................10 ............................ £20 ..................... 100
Total ......................................£4875...............100
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3.3.2 Managing The A,B and C Class Items
For A Class items, use the EOQ Formula - these items have a big effect on costs.
B Class items need a well-thought out system, but do not merit individual attention.
C Class items might be ordered in larger lots, to minimise the management and buyer time otherwise necessary.
D Class items - see Section 3.3.3 below.
3.3.3 Managing The D Class Items
For Class D items, where the value of stock is so low that counting and control, while perhaps feasible, are simply not worthwhile, it will often be better to give up record keeping altogether and revert to a simple two-bin system. The two-bin system is not a method of counting but a method of replenishment. The stock of an item is kept in two locations L1 and L2 side-by-side, but stock picking is strictly confined to one location only (say, L1). When the stock is literally visibly seen to be used up at location L1, a replenishment lot is ordered from the supplier at the same time that picking is switched to L2. The replenishment of L1 arrives before stock at L2 is used up. The scheme is familiar to everyone. Note the statement in the foregoing that the new replenishment is ordered when the stock at L1 is seen to be used up. Two-bin systems which rely on completing and handing in cards simply do not work!
3.4.1 Purchasing Membership of a Team
Purchasing must be involved in a capital purchase from the outset as part of the company team. Besides contributing knowledge of the supply marketplace generally, the buyer's tasks will include investigating suppliers' maintenance performance, perhaps investigating the availability of spares and defining measures of technical performance for inclusion in any final contract. In some instances technical members of the team have made their minds up on the equipment they want. Even in these circumstances, full early involvement is essential - it is purchasing who are responsible for the commercial soundness of the final agreement, not engineering or production. The company and MD must demand the function's involvement early on to ensure that the best deal possible is obtained - say, with regard to payment provisions - and that safeguards on eventual equipment performance are inserted in the contract. The prior creation of arbitration arrangements will save time and money.
3.4.2 Leasing, Hiring and Hire Purchase
3.4.2(a) Leasing
The definition of a lease is a contract between lessor and lessee for the hire and use of a specific asset over an agreed period of time, the asset being in the ownership of the lessor but selected from the original supplier by the lessee. The Buyer may contact one of some 200 finance houses and merchant banks providing lease arrangements to industry, to arrange a lease. The establishment of a lease involves the three simultaneous activities below. Note that in the arrangement, the buyer is the lessee and the finance house is the lessor.
(i) The finance house buys the equipment at the price agreed between the Buyer and Supplier;
(ii) The Buyer leases the equipment from the new owner, ie the finance house;
(iii) The Buyer takes physical possession of the equipment from the Supplier and has right of use.
One important reason for leasing is that it permits the buyer to acquire the use of goods and pay for such use out of revenue, not capital. Depending on the circumstances, this will usually have tax advantages, since payments from revenue will reduce taxable income, and thereby reduce the amount of tax which would otherwise have to be paid. A second reason to lease is that it permits the lessee to have access to perhaps technically state-of- the-art equipment which he might not otherwise be able to afford. As stated, the payments are made from (taxable) revenue, not from capital. Importantly also, the lessee is protected to a very large extent from the eventual obsolescence of the equipment. This is a paramount feature in considering the acquisition of computers and similar technology. For the lessor, the advantages are guaranteed returns with very little risk of direct loss. The risk of obsolescence is covered by specifying repayments and lease periods accordingly.
There are two types of lease, financial and operating as described below.
Financial Leases
The lessor is a finance house with no interest whatsoever in the lease except financial. The rental paid by the lessee will cover the cost of the capital put up, at an agreed or implied rate of interest, and administration and profit. By the terms of the agreement, the lessee is obliged to maintain, service and insure the asset. After a certain number of years when the capital outlay has been covered, the contract will usually provide for a greatly reduced rate of payment or for the asset to be purchased outright, often for a nominal sum. The buyer must investigate and negotiate the final purchase option most carefully. He should also investigate the liability of the lessor and himself during the lease period.
Operating Leases
The original supplier itself leases the equipment as a means of marketing its goods. The supplier (= the lessor, in these circumstances) must itself find the capital, of course. Often, the lessor in these cases will undertake service and maintenance for a fee related to the capital cost of the equipment. In many instances also, there will be a significant residual value in the asset at the end of the lease period. If this is expected to be the case, the rental paid by the lessee may be correspondingly lower, and the lessor will sell or re-lease the second-hand equipment in a specialised market such as the Third World. As stated above, the buyer negotiating terms for an operating lease should pay great attention to the difference between the outright purchase price and the residual value of the equipment at the end of the lease. The large computer companies have been outstanding examples of lease operators since the early 1960s.
3.4.2(b) Hire Purchase
A variation on the financial lease above is hire purchase, or lease purchase. The important difference, however, is that for tax purposes the party purchasing the equipment by HP is deemed to be the owner of it from the date the agreement is made. As a consequence, it is he who is permitted to depreciate the value of the equipment in his accounts, not the supplier or finance house. The supplier/finance house thus charges a higher rental on the equipment to compensate for this reduction in benefit.
3.4.2(c) Hire, or Rent
The company owning the equipment hires it on a daily, weekly, monthly or other basis to the company requiring its use. Payment of the rental charge is an expense set against profit in the normal way. However, since the renting company chooses the equipment to stock, the choice is necessarily confined to a small number of types of eqipment - cars, popular building equipment etc..
3.4.3 Managing Stage Payments
It is common for the buyer to agree to make stage payments where substantial contracts are negotiated, the delivery or construction of what is being bought taking place over a long time. For example, the buyer may agree to pay 20% of the price on the contract date, and then three payments of 25% at three monthly intervals thereafter. The buyer may "retain" the outstanding 5% of the price for, say, 6 months after completion, the payment being finally made only if the purchase proves satisfactory. Three important points should be noted by the buyer in relation to such payments:
(1) Every payment, credit, retention or incentive amount must be linked to a precise date and/or a precisely defined event;
(2) The making of every payment by the buyer should be subject to his receipt of a specific, separate, satisfactory invoice (so placing the onus for meeting payments correctly on the supplier);
(3) The buyer should closely involve the finance department in negotiating the dates of payments, so that the company's position regarding tax allowances, cash flow, government grants etc. is optimised.
Where stage deliveries of raw materials are concerned, it should first be said that the buyer is not obliged to accept stage deliveries if they have not been previously agreed and specified in the contract. If they are agreed, and the buyer is required to pay for each delivery separately after receipt, the contract is likely to be severable (legal jargon indicating it comprises a series of semi-independent actions). One consequence of this is that if any stage delivery is refused by the buyer (eg on quality grounds), the contract nevertheless continues. If payment for all deliveries is to be made in a single lump sum, the contract is likely to be non-severable (ie each stage delivery is part of a single, overall delivery activity). Consequently, if any stage delivery is refused by the buyer, he has the right to terminate the contract.
The price paid for material is a matter of high and continual importance to both purchaser and supplier and is a critical factor in the profitability of both companies. Economic theory talks of price being determined by the balance in the market of demand and supply. When price is low, the supplier is unwilling to make supplies available. When price is high, the supplier will make material available, but the buyer is unwilling to pay his price. The point where supply and demand balance is the equilibrium price - the "right" price from the market economy's point of view.
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The equilibrium price applies under the theoretical conditions of 'perfect competition'. When there are many suppliers and there is competition between them, there is said to be monopolistic competition, also known as imperfect competition. Monopolistic competition is very similar (structurally) to 'perfect cpmpetition'. Examples of distortions to a perfect market by contrast are: a monopoly : one supplier controls whole the market; an oligopoly : a small number of relatively large suppliers which sell to many small buyers, often with high 'barriers of entry', making it difficult for new suppliers to emerge; a monopsony : a single buyer in the market; an oligopsony: a small number of large buyers confronting many small suppliers (eg the position of the grocery supermarkets); a cartel : an (illegal) price-fixing agreement between suppliers. Important as the supplier is, he must still take heed of the buyer's power to withhold business. A monopoly supplier which charges 'unfairly' high prices will restrict his own market and provoke a search for substitute material. Under British law, any company controlling 25% or more of the market as either buyer or seller can be referred to the Monopolies and Mergers Commission under the Fair Trading Act of 1973. The Director of Fair Trading, the courts and others can order price cuts when it has been found that prices have been rigged or tenders made by It is argued, however, that it is not the static structure of the market which matters but its dynamic structure. Static structure refers to a snapshot of companies and their market shares, prices and products on offer. Dynamic structure recognises the continual change of market shares and prices, and the continual introduction of new or at least 'differentiated' products. And of course, purchasing can be a profound influence on change - for example, by encouraging small suppliers, finding product substitutes and through effective price negotiation.
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One way of studying the effect on sales of a product's price is through the economic notion of 'price elasticity of demand'. This is made up of two interrelated ratios 1 and 2 as shown below.
(1) the change in the quantity sold compared to the quantity sold before the price change, or dQ/Q
(2) the change in price compared to the price before the price change, or dP / P
The price elasticity of demand 'e' is the first term (1) divided by the second term (2). That is, dQ/Q divided by dP/P ............ or dQ/Q x P/dP
For example, using the formula, suppose Material A has sales of 100 / month at a price each of £100. When price is increased to £102, sales drop by 4 to 96 / month. On this basis, the price elasticity e of Material A is: 4/100 x 100/2 = 2.0. Having established the value of the price elasicity e for Material A, we can now use this value to estimate the sales per month that would result if the price were changed from £100 to (say) £96. In other words, we wish to determine dQ, where, using the formula, dQ/100 x 100/4 = 2.0. From this, dQ is 108. In other words, the sales of Material A would rise to 108 per month if the price was lowered to £96.
Certain product types are known to have high elasticities of demand. This means they are considerably affected alternately by economic recessions and economic upturns ... examples of items with high elasticities of demand are cars, furniture and foreign holidays. [Materials bought by the buyer in industry may seem to him to be price inelastic in so far that he is obliged to buy a particular product in the quantity specified by the production programme!] Others products are 'price inelastic' - they have low values of e and sales are relatively insensitive to recessions and economic upturns ... examples are staple groceries such as bread and milk, refrigerators and others.(Note that real life calculations on actual products are considerably affected by the existence in the market of substitutes and competitive pricing.) 'Unfair' prices can usually be asked for only when market competition is working poorly. If the circumstances of them appear long-term or at least likely to reoccur, the buyer will retaliate in one or more ways. For example, he may attempt to change the market structure by encouraging small companies to develop in the direction required. He may attempt to buy the supplying firm. He may decide to make the required product himself. Guarding against unfair pricing by suppliers and against potential situations in which unfair prices might be levied are primary strategic tasks of the purchasing manager.
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4.2 The Buyer, Costs and Costing
4.2.1 Assigning a Cost to a Product
All manufacturing costs and expenditures incurred within the company are assigned to the production cost centres. A production cost centre is a definable area within the factory where physical production takes place. Examples are the assembly department, the machine shop etc.. Note that for convenience, the various individual costs themselves within a production cost centre are grouped under three traditional headings: materials (eg raw material payments), labour (eg wages) and expenses (eg electricity payments). Naturally, costs must also be accounted for that are incurred in overhead and service cost centres - ie in cost centres other than the production cost centres. The usual way of doing so is to allocate them to the production cost centres in one or other of three ways, depending on their nature. Thus (i) allocate rates and lighting costs on the basis of the production cost centres' areas; (ii) allocate administrative and general management costs on the basis of the number of people employed in the production cost centres; (iii) allocate engineering and technical services on the basis of the capital employed in the production cost centres.
For example, suppose that the costs of the administrative block were £100,000, and it was decided to allocate these costs to the three production cost centres A, B and C on the basis of the number of people employed in each one. The numbers employed are ... A 9 people, B 11 people and C 15 people (total 35 people). The allocation would then be as follows:
To Cost Centre A: 9 / 35 x £100,000 = £25,750
To Cost Centre B: 11 / 35 x £100,000 = £31,450
To Cost Centre C: 15 / 35 x £100,000 = £42,800
(B) Allocating Costs to Products
First, direct costs incurred directly in relation to a specific product can be allocated to the product immediately. For example, suppose that a specialised drill in the machine shop was only ever used in the manufacture of a particular component P. Then all of the material, labour and expense costs associated with the special drill can simply be assigned to Component P. If the drill costs amounted to £10,000 and 5,000 units of Component P were produced, the direct cost element of P's final cost is £2.00 each (£10,000 / 5,000). In the unlikely event that the costs associated with the drill were the only ones directly associable with P, the resulting cost (£2.00 per unit) is referred to as P's prime cost.
The production cost centre costs which cannot be directly assigned to specific products are allocated in one or other of two ways.
(1) If manufacture generally in the production cost centre is deemed to be labour intensive, then according to the number of labour hours occupied in each product's manufacture.
(2) If manufacture generally in the production cost centre is deemed to be machine intensive, then according to the number of machine hours occupied involved in each product's manufacture.
The method of allocation is referred to as the cost driver. For example, suppose that the total indirect costs in a production cost centre amounted to £80,000, and three products P1, P2 and P3 were made there, together involving a total of 10,000 labour hours. Then the £80,000 is divided according to the relative number of labour hours involved in each product's manufacture. If the number of labour hours involved were: P1 2,500 hours (10,000 units manufactured), P2 3,500 hours (7,000 units manufactured), and P3 4,000 hours (24,000 units manufactured), then the allocation of the £80,000 cost is:
Product P1: £80,000 x 2,500 / 10,000 = £20,000
Product P2: £80,000 x 3,500 / 10,000 = £28,000
Product P3: £80,000 x 4,000 / 10,000 = £32,000
Dividing each of these allocated costs by the number of units manufactured gives the product's production overhead. That is, for P1, £20,000 must be allocated to 10,000 units, giving a production overhead of £2.00 per unit; for P2, £28,000 must be allocated to 7,000 units, giving a production overhead of £4.00 per unit and for P3, £32,000 is allocated to 24,000 units, giving a production overhead of £1.33 per unit.
The final make-up of a product cost is the prime cost, being the sum of the three categories of direct cost (ie direct materials + direct labour + direct expenses) plus the production overhead (the sum of the indirect materials + indirect labour + indirect expenses). In addition, corporate overheads such as general administration, distribution, sales & marketing and R & D must also be assigned in some way. Because all direct and indirect costs, and overheads, have finally been assigned by one means or another to the product cost, the cost is termed a fully absorbed cost.
At this point, the buyer should ask himself whether there can be any credence in the supplier's contention that the "cost" of his product is £X. From above, we see that "cost" is anything we want it to be. What cost driver has the supplier used to allocate indirect costs - labour hours, machine hours ... - and was it reasonable to do so? What overheads have been incorporated into the cost - for example, has the supplier's fleet of directors' cars been included? Probably, about the only cost that is unarguable is a prime stage cost (see below for an explanation of stage costs).
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4.2.2 Calculating Standard Costs
The costs incurred as described above - materials, labour and expenses - are the responsibility of the manager having charge of the production cost centre. However, the activity for which he is responsible represents only one stage of the manufacturing process whereby raw materials are eventually converted to our company's sales products. To find a product's final, full cost, it is necessary to start at the bottom of the bill of materials and work upwards, accumulating the costs incurred at every stage of the way. The procedure might be illustrated by a diagram similar to a traditional bill of materials sketch, showing the raw material ot the bottom level, and then successive materials involved in manufacture at higher and higher levels, culminating in the sales product at the top of the diagram. In costing, the raw material cost is added to the cost of the manufactured product at the next level up, and the accumulated cost of these two added to the cost at the next level. In other words, to find the cost of the final (top) product, "roll up" the lower costs - ie accumulate the stage costs upwards.
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Before the start of each financial year, it is necessary to set budgets for the various departments within each production cost centre. As the year progresses, budget is compared to actual expenditure and if necessary remedial action is taken. Clearly, however, in order to set a budget involving expenditures on materials, expenses and labour, it is necessary to gauge how much production it will be required to make of each of the components in the cost centre. The quantities of each one are estimated by "exploding" the year's sales forecasts down through the bill of materials, starting at the top (the master schedule) and finishing at the bottom (the raw materials). The quantities so worked out are referred to as the production forecast. (The bill of materials explosion is very similar to the materials explosion performed in MRP.)
It was stated above that budgets are compared to actual expenditure for financial control. In fact, of course, the two sets of figures cannot be directly compared for two reasons. First, the actual quantities made will not be the same as the quantities in the production forecast, for the simple reason that actual sales will be different from forecast. Secondly, actual prices and rates paid will not be those assumed when the budget was prepared, because of changes in the market. On each count therefore, it is necessary to make an allowance. If AQ = Actual Quantity, AP = Actual Price, SQ = Standard Quantity and SP = Standard Price, then:
Price Variance = AQ (SP - AP), and
Quantity Variance = SP( SQ - AQ).
An example of Raw Material Price Variance :
The budgeted purchase of RM1 for the month of April is 2000 units at £2.00 each. The actual purchased quantity was 1930 units at £2.02 each. Then, from the price variance formula above, Price Variance = AQ (SP - AP) = 1930 ( £2.00 - £2.02) = £38.60 A *
(* Note that A = adverse, F = favourable)
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The breakeven point is costing jargon for that point where the profits from sales are just sufficient to cover a company's fixed costs. If the buyer can estimate elements of the supplier's costs, it may be most useful in a negotiation to work out his approximate sales breakeven point. If he has passed this point, he may be particularly amenable to a reduction in price. Thus if, over a particular period, ...
Q = quantity sold in units;
s = selling price (£/unit);
v = variable cost price (£/unit)*;
F = total fixed costs for this period;
P = net profit for the period.
Then Q ( s - v ) = F + P
For example, suppose that the variable cost = £7/un, the selling price = £15/un and the fixed costs over the period are £1000. Then the breakeven quantity (at which profits = zero) is as follows:
Q (15 - 7) = 1000 + 0 ..... whence Q = 125.
That is, after selling 125 units at £15 each, the supplier will have covered his fixed costs. Perhaps he will now sell below £15.
(* The variable cost price is the direct cost - ie what it takes actually to make one unit, regardless of overheads.)
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4.2.4 Alternative Types of Costing
A distinction should be made between job costing, batch costing, contract costing and process costing. Although the accounting principles are, naturally, the same for all four, there are differences between them in practice and procedure.
Job Costing
As the name says, job costing is the identification and assignment of those costs incurred in completing a specific, individual job or works order on behalf of the customer commissioning it. Manufacture is usually, though not necessarily, of a single object. The job to be costed must be assigned a unique job identification number, to be recorded on all transactions relating to it, such as stores issues, labour hours expended, tools usage ... (A particular difficulty here is the seeming need to record such data as set-up and job duration, the incidence of scrap and the rest, through a complex shop floor data collection system.) Standard values for indirect costs must be attached to the job cost, based on direct labour hours or machine hours.
Batch costing
Batch costing is similar to job costing except that the cost value arrived at is divided by the number of units in the batch to obtain the unit cost.
Contract Costing
Contract costing is associated with building work and civil engineering. One small complication here is the need to account, say at month end, for work which has been started but not completed. Very close liaison is required between all parties in contract costing, because of the substantial timescales, the parties being purchasing, accounts and the contractor.
Process Costing
Process costing might be better termed period costing. Process costs are calculated from the units of product output achieved over a specified time period and the costs expended during that time to produce them. The period cost divided by the number of units produced gives the process cost per unit. Although process costing has been named as such because of its association with the process industries and continuous manufacture - paper, chemicals, packing lines - its use is equally valid in engineering batch manufacture when output volume is substantial. There are three principal differences from job costing: (1) cost data collection is focussed directly on the costs of operating the production process itself over the time period chosen; (2) there is a definite need to adopt a system of apportioning cost centre or work centre costs between products; and (3) the cost accountant must become deeply involved in such particularities of production as scrap, component usages, rework and set-ups.
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4.3 Prices and Large Contracts
Prices are obtained by buyers in a number of ways - from price lists and catalogues published by suppliers; on request from suppliers; from electronic databases; and from trade journals. As explained in 2.4 above (Breakeven Analysis), low prices and special offers may be due to high success by the potential supplier, rather than a desperation for cash or because of a willingness to cut corners with quality. Low prices may also be offered as an inducement for a first-time buy. High prices should similarly be regarded with care rather than with dismissal or suspicion - if the supplier has limited manufacturing resources, he may demand high prices so that the few contracts he gets because of it are, at least, profitable. As well, the long-term cost to our own company of a high purchase price may be less when service, quality and product effectiveness are taken into account.
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4.3.1 Major Contracts and Fixed Price Agreements
The chief problem with a fixed price agreement is likely to be the difficulties the contractor will have in forecasting his own costs, unless he is very familiar with recent similar undertakings. There are dangers here to the purchaser as well. If the seller wants to insure himself against unexpected costs, he must overstate the sum asked for. If he pitches the price too low, to be sure of the business, he may need to be baled out with ex gratia payments if the work is to be completed in normal fashion. Note however that a fixed price contract could refer to fixed prices (plural) for different categories of cost such as labour and materials, and even fixed rates. Fixed price contracts are usually popular with purchasers (less work and greater certainty of the outcome financially), and resisted by suppliers (because of uncertainty and risk). Variations on a straight fixed price are:
(a) Redetermined Fixed Price
The price is agreed for the whole job, but not until some time after work has started, when experience has been gained - for example, after the start up of a mining operation.
(b) Incentive Contracts
An incentive contract is one where both parties agree to a target cost, but recognise that uncertainty of outcome exists. The incentives may be as follows. (1) If there is an under-run of cost, ie the project costs less than target, the contractor is awarded, say, 3% of the under-run amount; (2) If there is a cost over-run, the contractor must bear, say, 2% of the actual over-run himself.
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4.3.2 CPA (Contract Price Adjustment)
A CPA contract is one stating specific prices as at the contract date, but where clauses have been inserted allowing the supplier's prices to be increased relative to increases in costs between this date and the completion date. The increases in costs may be based on: (a) a retail or wholesale published price index, such as the government's monthly RPI; (b) a wholesale index specific to the purchase involved (eg petroleum); or (c) a rate of exchange of a foreign currency.
It is essential that the buyer and supplier should carefully split the price to be indexed into its component parts, so that the correct index can then be applied to the appropriate cost elements of the total cost. (1) The first split might be to separate fixed and variable elements. Fixed elements might include profit, freight rates, insurance and import duties. (2) The remaining cost elements might then be split between labour and materials expenses. (3) The final split will be the sub-division of the material part of the cost into different categories as appropriate - steel, rubber, copper .... Each category should be separately indexed to a corresponding published index, or, if none is available, to an indicator agreed by buyer and supplier as being representative. The important point is that the indexation should be full and detailed. The buyer must not leave matters to chance or goodwill. For many CPA agreements, especially those involving the purchase of electrical and mechanical plant, the buyer would do well to involve the Federation of British Electrotechnical and Allied Manufactures Association (BEAMA). For £165 pa, BEAMA will provide legal and commercial advice related to CPA agreements. They will provide precise information to enable buyer and supplier to update indexes concisely and precisely. Visit the BEAMA website or phone 020-7793-3000, or fax 020-7793-3003.
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Discounts are familiar to everyone. They are standard reductions in a published price offered by a supplier as an incentive to the customer to take special action such as:
* to pay promptly (known as a cash discount);
* to buy larger volumes of the material;
* to buy in special periods of the year;
Discounts can also be offered to specially selected customers (often called a trade discount). Before the easy regeneration these days of price lists by computer, generous discounts may have been offered on all items on a price list immediately after its publication, with the discounts becoming less generous after inflation and the passage of time had eaten into the supplier's margins.
Discounts are typically offered by the supplier as a percentage of money off a price. They are also shown this way on invoices. Thus:
Price : £100.00 - Cash Discount 5% : the discount is £ 5.00, so that there is £ 95.00 to pay.
But when using a pocket calculator, perhaps at a negotiation, it is best not to work out the discount and then subtract it from the price, as just illustrated. Instead, calculate the new price directly as a (large) fraction of the old price. That is, if the discount is 5% of the old price, the new price is 95% of the old price ... for example, £100.00 x 95%. An example is as follows:
a price is £100.00, but you are entitled to a trade discount of 20% and a cash discount of 5%. VAT must be added to the final bill. What is this final bill (including VAT) if the VAT rate is 17.5%?
Calculation: £100.00 x .80 x .95 x 1.175 = £89.30 3.4
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Suppose that it is economic to finance a substantial buffer of stock and that material can be bought flexibly. If so, then the total sum of money to be spent on the material over the year can be used to formulate a fixed weekly spending budget. Suppose this was £200 per week, and the price was expected to vary from £100 per ton to £300 per ton (average £200).
Week 1 Price £100/t Spend £200 Buy 2.0 tons;
Week 2 Price £200/t Spend £200 Buy 1.0 tons;
Week 3 Price £300/t Spend £200 Buy 0.67tons
Average Price £200/ton
Average Price Paid £600 / 3.67 t = £163.5 / ton.
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4.4 The Cost of Technically Novel Items (The Learning Curve)
When the buyer enters into an agreement to pay a certain price for a novel component, designed and manufactured by the supplier on his behalf, he must recognise that whatever the initial cost of manufacture to the supplier, as more and more of the components are made, the supplier's costs will steadily reduce. The relationship between the cost to manufacture and the number produced can be summarised as follows:
Each time the total quantity of items manufactured doubles, the average cost to produce each one of them (ie the average of all of them made so far) decreases by the same fixed percentage.
For example, suppose that we complete an initial manufacture of 10 aeroengine blades for £100 - the average cost per blade is thus £10.00. Now suppose we make another 10 blades. The cost to make them turns out to be £60.00, so that the total cost to make the first 20 blades is £160.00. The average cost per blade for the first 20 is thus £8.00. If the rule above applies (the learning curve rule), then the fixed percentage rate referred to is 80% -
ie £8.00 (Average cost for 1st 20) x 100% / £10.0 hrs (average cost for 1st 10)
This means that if we were to manufacture 40 blades in total (ie a further 20 blades, doubling up from the present total of 20), then the average cost for all 40 blades will fall to £6.40 (£8.00 x 80%). Now if the average per blade for all 40 blades is £6.40, the total cost for them all is £256.00. But the first 20 blades cost a total of £160.00. Consequently this last 20 will cost £96.00.
Use of the learning curve can be most valuable to the purchasing professional both in the negotiation of price in contract extensions and in strategic planning (ie the long-term trends of prices of increasingly mature products). Because the definition and formula are not especially handy however, it is useful to have a practical means of making the calculations. There are two methods.
1. G r a p h P a p e r S o l u t i o n
As soon as a number of points have been obtained relating to real total costs and total quantities made, a graph can be drawn on log-log graph paper, fitting the best straight line to the points plotted. Use of graph paper might be illustrated by considering the requirement to negotiate a future parcel of work for 15 aeroengine blades from the example above, starting when it is calculated that 60 blades will have then been made. From the graph or from the calculations exemplified above, we can calculate that the average cost per blade (1) when 60 blades have been made, and (2) when 75 blades have been made. Without going through the individual calculations, we find (1) when 60 blades have been made, the average per blade is approximately £5.70 each. Consequently the total cost to make all 60 is 60 x £5.70 ... £342.00. (2) Next we perform the calculations when 75 blades have been made - the average per blade is approximately £5.30 each. Consequently the total time to make all 75 is 75 x £5.30 hours ... £397.50.
From (1) and (2) we see that the cost to make the last 15 blades is the difference of the two totals, ie £55.50 in all. (On average £3.70 each, though this is not mathematically significant.) The price to be paid can now be negotiated by the buyer.
2. C o m p u t e r / C a l c u l a t o r S o l u t i o n
Computer solutions are based on the mathematics of the learning curve as follows:
T n = t 1 x n sup {- r} where T n = the average cost per unit to make the first n units; t 1 = the cost to make the 1st unit; n = the number of units made; r = an expression for the learning curve, derived by logs as follows r = logL/log2 where L is the learning rate as defined above, but expressed as a fraction rather than a percentage. Buyers are reminded that the leaning curve is a well-established and widely used technique and that spreadsheet programs incorporating it are available in engineering spread sheet libraries.
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Many basic raw materials such as agricultural produce, metals, oils and minerals are used worldwide and therefore bought and sold in a vast market. Because of ever fluctuating economic conditions, droughts and plagues, gluts and incidences of political unrest, shortages and excesses can occur in supply. When shortages occur, it is not possible in the immediate term for suppliers to increase production, since this often involves fixed capacity sources such as mines and estates. Consequently, global prices soar. When excesses occur, or when demand falls, agricultural produce or mining stocks can only be depleted gradually, and prices plummet.
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4.5.1 Private Bargains and 'Physicals'
Large swings in price are disliked by supplier and purchaser alike. For the manufacturing company incorporating commodities in its products, price changes, except in the long-term, are difficult to pass on to customers. Considerable effort may consequently be made by the purchasing manager to stabilise price and ensure his own company's supply by entering into private agreements with suppliers, outside the immediacy of day to day world markets. For example, he may come to an agreement to take the whole of the output of a certain mine for a one year period ahead at a fixed rate. The bulk of world trade in commodities is carried out in this way. The prices agreed in such private deals are reached by reference to those prevailing in the global market at the times the deals are struck, and it is to the global market the buyer must turn if he has not secured such an agreement or if he wants additional material to supplement a private agreement he has already made. In the UK, the global market finds its expression in one or other of the marketplaces, or exchanges, in the City of London, given below. A broker in the relevant market will arrange the trade with a supplying company, shipment taking place direct from the supplier's country of origin to the purchaser's factory. The authorities regulating the market specify certain standards which are to apply as to physical condition. Examples are: the lot sizes of supply, quality or purity; physical form; packaging; and the INCOTERM which is to prevail. If the exchange is to be effected immediately, the price paid is the spot price (or cash price).
The Principal Exchanges within the City of London
The London Futures & Options Exchange ........................ Coffee, Tea, Cocoa, Sugar
The London Metal Exchange ............................................Non-Ferrous Metal
The International Petroleum Exchange .............................Oil
The Grain and Feed Association ....................................... Agricultural Produce
The Baltic International Freight Futures Exhange ...............Shipping Freight
The London International Financial Futures Exch ................Bond and Currencies
The London Stock Exchange .............................................Company Stocks and Shares
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A buyer who requires a commodity at a specified date in the future is able to protect himself against a price rise occurring between the current date and the future date through the purchase of a commodity future. A 'future' is a contract to buy a specified quantity of a particular commodity at a specified date in the future. Futures contracts can themselves be bought and sold.
For example: On March 1st, a buyer realises he will require 100 tonnes of additional wheat in three months time. At the time, the current spot price of wheat is £70/tonne, and the forward price for "June 1st" wheat is £74/tonne. Accordingly, the buyer buys 100 tonnes of "Wheat June 1st" futures at the current forward price. He is now locked into this price. This is what he will pay and it is on this basis that he can now plan. By the time June 1st is reached, however, the spot price of wheat has in fact declined to £65/tonne. (The price of Wheat June 1st futures is also, therefore, £65/tonne, since on the expiration date, the contract price and the spot price converge.) The buyer now sells his futures (100 tonnes, June 1st) for £65/tonne, closing out his position in the market, and showing a futures loss of £900 (£7400 - £6500). He is now, however, able to buy 100 tonnes of wheat at the spot price of £65/tonne, rather than £74/tonne, so his position overall is unchanged - in effect, he has paid £74/tonne, the lock-in price.
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4.6 The Price of Foreign Purchases
Since 1979 in the UK, all government controls regulating foreign exchange ('forex') have been removed, and forex has been available to buy and sell without restriction. Although foreign exchange is a specialised subject, the buyer involved in foreign purchases must not merely abrogate the payment of such purchases to the company's accounts department or to its bankers. On the contrary, he must understand the options available and instigate and concur with the operations taken to effect the purchase.
Because of the large number of unpredictable factors which affect them, forex rates cannot be accurately forecast in either the short, medium or long term. It should be a central company policy on foreign purchases and sales, therefore, that the very substantial dangers in attempting to do so are forbidden and prevented. In this context, taking no action at all with regard to a foreign purchase must count as forecasting, since the buyer who takes no action to protect himself against the volatility of the forex market immediately a foreign purchase is agreed is in effect leaving matters to chance. Chance is risk; risk is speculation.
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By far the most widely used mechanism for the purchase of goods and services in foreign currency is the forward market, offering the buyer a risk-free means of obtaining his future requirements at a rate agreed in advance. The market is operated by forex dealers direct on the London 'Fox' ( slang for = London Foreign Exchange Market) and is used by them and dealers in the foreign exchange departments of the high street clearing banks, all of whom will undertake ...
either ...
to sell the customer foreign exchange for delivery at a specified date in the future, in exchange for sterling, at a given rate quoted at the time the deal is made,
or ...
to buy foreign exchange from the customer, to be delivered from customer to dealer at a specified date, giving sterling in return (again at a rate quoted at the time the deal is made).
The future date is any date required by the customer in the short or medium term - next Wednesday, in six months time, on August 30th ... Instead of a specific date, a range of dates may be specified - say, August 30th to September 20th - so that a range of exchange rates is agreed, the actual rate depending on the exact date the forex is finally required. The forward rates quoted in newspapers relate to1-month ahead, 3-months ahead and 1-year ahead, and are intended as guidelines only.
The forward rates of exchange for a country's currency quoted in the forward market are based on two factors and two factors only. These are (1) the spot rate of exchange with sterling at the instant the deal is concluded, and (2) the rates of interest prevailing in the UK and the country in question (or in the case of EMU, set by the European Central Bank). Thus although the spot rate of exchange at any moment is influenced by economic and many other factors, as mentioned previously, forward rates are not further and separately influenced by them.
The central mechanism by which the market works is simplicity itself. The forex dealer, or the clerk in charge of foreign exchange at the foreign exchange department of the buyer's own local bank, will buy the foreign currency in question from the national bank concerned in the City of London. The currency will lie on deposit in the foreign bank for the length of time specified by the buyer in the transaction. Thus if the buyer wants the currency in 46 days, time, it will remain on deposit for 46 days. Note that the buyer does not exchange any cash or money for the deal at this point. When the length of time specified is reached, the foreign currency is then made available to the buyer for his purchase. However, there are two possibilities:
First, if the rate of interest offered by the foreign bank is lower than the rate of interest offered by the Bank of England, the forex broker or the buyer's local bank will have lost money by the amount concerned being on deposit at a rate of interest rate lower than sterling. Consequently, the buyer will have to pay the bank a premium over the spot rate of sterling that prevailed at the moment the transaction was made to make up for the difference. That is: the buyer will obtain the currency at the original spot rate per £, minus the premium.
Second, if the rate of interest offered by the foreign bank is higher than the rate of interest offered by the Bank of England, the forex broker or the buyer's local bank will have gained money by the amount concerned being on deposit at a higher rate than sterling for the length of time specified. Consequently, the buyer will obtain a discount from the spot rate of sterling at the time the transaction was struck, to make up the difference. That is:the buyer will obtain the currency at the original spot rate per £, plus the discount.
There are a number of methods of quoting the forward exchange rates of currencies so that the buyer can get an idea of the sterling rate concerned. One says "get an idea" ... since the quotations in the newspapers are simply 1- month, 3-months and 12- months ahead guidelines. The dealer or bank will quote the exact rate for him when he enquires. One method is simply to quote the spot rate and the premium (denoted by pm) or the spot rate and the discount (denoted by dis) ... ie being one or the other depending on the country's interest rate relative to the that of the Bank of England. The premium or discount is often quoted in the foreign country's minor currency. For example, cents for the US Dollar. Three examples are now given (all rates of exchange were as given some years ago):
1. The Buyer wishes to obtain 50,000 Euros in One Months Time
The rate at which the dealer will sell Euros for delivery in one months time is 1.4030 euros per pound. The working out undertaken by the buyer's bank is as follows:
Spot rate for purchase of Euros now ....... 1.4068 /£
Premium for 'one months' euros ....... 0.0038 /£
thus Future rate (spot less premium) ...... 1.4030 /£
Cost of 50,000 euros in one month is £( 50,000/1.4030) = £35,638
(The sterling cost of the protection offered by the forward market is thus £97.) Note that when the transaction is agreed with the dealer or the bank, it cannot be revoked (although the currency can be retained, at interest, for use at a later time). Also note that the payment of the sterling by the buyer is not made until the date when the forex is due to be made available. That is, the buyer's company has use of its money until that time. Commission to the bank is either not payable or is very small (say, 0.025%).
2. A company Salesman wishes to make a firm quote in Euros for a machine priced at £10,000, to be delivered in three months time
Spot rate now (for dealer buying Euros) ....... 1.4068 /£
Premium for buying 'three months' euros ....... 0.0101 /£
Future rate (spot less premium) ...... 1.3967 /£
Value of £10,000 in three months is (10,000 x 1.3967) = 13,967
The sterling cost of the protection of the salesman's value in the sale is thus £269.
3. A Buyer wishes to obtain 750,000 Norwegian Kroner in three months time to pay for forestry products from Norway to be delivered then
Spot rate for dealer selling Norwegian Krone now ....... 12.4534 NKr/£
Forward discount on 3-month Norwegian Krone 0.0559 dis/£
Future rate (spot plus discount) ...... 12.5093 NKr/£
Cost of 750,000 N.Krone in 3 months is £ (750,000/12.5093) = £59,955
The gain to the buyer stemming from use of the forward market is £269 (by coincidence!).
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4.6.3 Other Foreign Exchange Payment Methods
There are other alternatives to the payment of foreign suppliers besides the forward market. Example are as follows:
The Financial Futures Market:
The market, operated by LIFFE, is based on the buying and selling of so-called 'contracts', each valued at £25,000. At the time of purchase, a contract will be offered at three alternative forward dates, each having its own sterling rate of exchange as specified against the US dollar. The forward dates are the 'next' three of the series March, June, September and December. For example, a buyer in April would be offered three rates of exchange with the US dollar for June, September and December. In the fullness of time, June will 'go off the board', and the three dates will be for September, December and the next March.
Immediate Purchase of Forex
The Traded Options Market
Traded options are dealt with on both the London Stock Exchange and LIFFE, and are a valuable alternative to both futures, above, and the forward market, when large sums are involved .. say, over £250,000. They enable the buyer to profit from an appreciation of sterling potentially at any time between the date of the deal and the date the foreign exchange is wanted, and at the same time to 'insure' himself against a depreciation. The insurance is not insurance as such, but takes the form of the commission payable to the traded option dealer.
Currency Pools
UK international businesses need not repatriate profits made overseas, so that the foreign currency retained is available to pay suppliers in those particular countries.
Currency Swaps
For major purchases of very high value over very long periods of time, the buyer may approach specialised firms in the City to arrange a 'currency swap'. If (say) £2m of US dollars are required in 3 years time, the broker will undertake to find a third party who is able to provide US dollars and requires £2m at about that time in the future.
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4.6.4 Exchange Controls Abroad
A small number of other countries besides the UK also have no exchange controls - for example, the US, Canada and countries belonging to the European Monetary Union (EMU). Many other countries have exchange controls but are able to maintain a trade deficit if necessary, and so have no difficulty buying and selling abroad. Certain currencies, especially those relating to sub-Saharan African countries, are "non-convertible", meaning they have no value outside the own countries. In order to obtain foreign goods, therefore, such countries must either barter their own produce in exchange ( known as counter-trading) or else must obtain hard currency in the form of sterling or dollars. The UK buyer, therefore, paying in sterling for goods from such countries, should bear in mind the value of the deal to the supplier for this reason alone. The buyer buying from such countries as Albania or Turkey intending to pay in sterling should press very hard for extra discounts for this reason. However, the buyer should also be aware that foreign exchange control mechanisms which prevent an agreed deal going ahead can invalidate agreements on the ground of force majeure.
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4.7 Effecting Foreign Payments (& Letters of Credit)
Because of geographical distance, foreign language and differences in culture, law and even time, as well as possibly complex customs regulations and the possibility of political unrest, the purchase of goods from overseas carries many more commercial risks than from within the UK.
In order to minimise risk to both buyer and supplier, the bulk of international trade is carried out via the letter of credit, a means by which the buyer is assured of receiving the goods he contracts for and by which the supplier is assured of receiving the payment that is his due.
The procedures involved in the use of a letter of credit have been standardised by the International Chamber of Commerce (ICC). The current version (issued in 1993) is referred to as the Uniform Customs and Practice for Documentary Credits - UCP for short, being ICC Document Number 500. UCP 1993 contains 49 sections under seven headings, such as liabilities and responsibilities, transferable credit, documents, assignment of proceeds and so on. (It is as well for the buyer to refer specifically to UCP 1993 in the contract with the supplier.) Note that letters of credit are also referred to as documentary credits, letters of commercial credits and documentary letters of credit. Since the bank issuing a letter of credit commits itself to payment and takes on a number of risks not covered by insurance, letters of credit can be relatively expensive.
Although letters of credit are increasingly nowadays in computer form [see * below], in paper form the letter has the appearance of a standard document and contains the following information: the beneficiary; the amount of the credit ; the dates when valid; beneficiaries' bank; type of payment; documents required; address of notification; and description of the goods. The detail specified should be no more than is required for the purposes of confirmation and identification. Over specification of detail by the buyer will meet resistance by the supplier. The L/C is not equivalent to the original contract. Note, by the way, that the details must be exactly correct, especially in regard to company and bank names. It is not unknown for customs' officials to hold up shipments on finding minor discrepancies in paper details, and it is not unknown for the customs' personnel of some countries to be paid cash bonuses by their governments for the number of discrepancies they manage to find.
A letter of credit may be irrevocable or, less usually, revocable. As the names say, an irrevocable L/C is one which obliges the issuing bank to make payment when all terms and conditions have been met. No term or condition can be altered without the express permission of the supplier. An irrevocable L/C may be either irrevocable, confirmed or irrevocable, unconfirmed. A revocable L/C is subject to possible recall by the buyer without the approval of the supplier.
[Footnote: although letters of credit are usually associated with international trade as described here, they can also be usefully used to overcome cash flow difficulties: a bank will often be prepared to issue and honour a letter of credit on evidence that a buyer will be capable of providing funds in the near future. For example, production by the buyer of a purchase order from a customer (ie relating to its own sales) may be accepted as evidence by the bank of future ability to pay.]
Procedures opening a Letter of Credit:
*After the parties are agreed on the terms of purchase, including the dates of payment and delivery, the buyer arranges for his bank to open a letter of credit on behalf of the supplier;
*The buyer's bank (the issuing bank ) prepares the L/C according to the buyer's instructions. The buyer's instructions specify what the supplier is to provide by way of documentation;
*The buyer's bank sends the letter of credit to the advising bank in the supplier's country This could be the supplier's own bank or it could be another;
*The advising bank forwards the letter of credit to the supplier;
*The supplier now studies all conditions and detail in the letter of credit. Any errors and objections must be notified immediately;
*The supplier makes the goods ready and despatches them with all documentation as required in the letter of credit;
*The supplier presents the documents to the advising bank indicating full compliance with the terms of the letter of credit;
*The advising bank reviews the documents, and forwards them to the issuing bank. If it is an irrevocable confirmed L/C, the supplier is now guaranteed payment;
*Once the issuing bank receives the documents, it notifies the buyer, who then reviews them. If they are in order, the buyer effects payment to his bank and takes possession of the documents which in turn enable him to take physical possession the shipment;
*The buyer's bank initiates payment to the advising bank, which pays the supplier.
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4.8 Buying from Goverment (UK)
The UK government has provided a website to assist buyers and suppliers involved in low value contracts (ie under £100,000) with the public sector. Registration is necessary. Visit http://www.supply2.gov.uk.
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The subject of quality, especially as it affects purchased physical supplies, is encompassed by the term Statistical Quality Control (SQC). Within the subject of SQC there are two sub-divisions: (1) Statistical Process Control (SPC), dealing with material actually under manufacture, and (2) Raw Material & Product Control, dealing with material which has already been manufactured and the quality of which, therefore, can no longer be changed. Within the subject of SPC, there are two further sub-divisions, namely Sampling by Variables and Sampling by Attributes. Within Raw Material and Product Control, there are three sub-divisions: Breakeven Point Analysis, Sampling by Attributes and Sampling by Variables. Because of the astonishing effectiveness of the technique of statistical process control for products actually under manufacture, the buyer's best interests are to insist that the supplier adopt SPC, and to lend him help, support and guidance in setting up an SPC programme within his factory.
The buyer, in understanding the subject of 'quality', must realise that 100% inspection of incoming material will not achieve for him 100% conforming items - inspection is a fallible process, and it can be guaranteed that a small number of defects will be passed. The only means of achieving 100% quality, therefore, is by the adoption, by the supplier, of statistical process control (SPC). Consequently, the best way forward for the buyer who requires 100% quality is to insist or persuade his supplier to adopt this technique, and then to monitor his continued practice of it either by periodic visits or by requiring regular data to be forwarded from his (the supplier's) factory (or factories*). (* There will be separate, independent levels of quality from each of the supplier's manufacturing centres. Control must be exercised at each centre separately.) Under SPC, the supplier must check the stability of his process by taking a sample of production and completing a 'control chart'.
The buyer should remember that just because the supplier's process is under control and stable, this does not mean it is actually capable of producing 100% conforming products. To compare process capability to the required specifications of an item, buyers can use the formula as follows, where Cp is the capability index; USL is the upper specification level; LSL is the lower specification limit; and s is a statistical measure related to of the process limits (ie USL - LSL):
Cp = USL - LSL / 6s
The supplier's process is 'capable' if Cp is greater than 1.0. Most buyers in the past have looked for a value of Cp greater than 1.33 from their suppliers. More recently, especially in the automotive industry, buyers have demanded a Cp value of 1.66. If Cp = 2.0, this is referred to as 6 sigma quality. Over the years, the supplier's progress and quality improvement can be easily monitored through the Cp readings.
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Failing adoption by the supplier of SPC, or if there is a delay in effecting its adoption, the buyer must rely on 'raw material and product control' (see above). There are three actions that can be taken with regard to incoming parts (ie supplier parts which have already been manufactured):
1. To inspect all incoming units;
2. To allow incoming units into production without inspection and to bear the cost later of correcting non-conforming production (ie to correct the parts we ourselves have manufactured, having used the non-conforming raw material parts);
3. For borderline cases between 1. and 2, to sample incoming goods.
The decision making process in deciding between actions 1. and 2. is based on cost. Two factors are involved. The first is the calculation of the breakeven point, BEP. This is defined as follows:
BEP = k1 / k2
where k1 is the cost (£) to inspect one item of the raw material, and k2 is the cost (£) to correct/repair an item made with a non-conforming raw material item.
The second factor is the standard fraction of non-conforming items in the in-coming material, p. (The standard fraction p will be agreed between the supplier and buyer, or else established after some time.)The decision making rule that is now applied is as follows;
if p is greater than BEP, it is economical that the in-coming parts be 100% inspected, and if p is less than BEP, it is economical that the parts be admitted into production without any inspection.
For example, if the cost to inspect is 15p per item, and the cost to correct an item in production is £10.00, then the breakeven point BEP is 0.15/10.00 = 1.5%. If the percentage of non conforming parts coming in is 1.3%, p < 1.5%, so accept the parts straight into production. If the quality of the incoming parts = 1.9%, p > 1.5%, so 100% inspect.
It is important that the breakeven point rule and the cost argument above be always considered carefully, especially before proposing the use of any sample plan (see below). It is not at all uncommon in raw material goods receipt to find sampling undertaken as a quite unnecessary expense. It should be remembered that the purpose of sampling is to make a decision either to accept an in-coming lot, including necessarily the non-conforming items therein, entailing subsequent correction on non-conforming parts, or to reject an incoming lot, forcing 100% inspection of the parts anyway. If a sample plan always leads to the acceptance of incoming material, why sample in the first place? And if it always leads to rejection, again why sample?
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If the breakeven point is very close to the standard level of the incoming quality (ie p), or if the incoming quality level from one delivery to another is erratic, or perhaps if the incoming items are destroyed by inspection (eg ammunition), it may be best to use a sampling table. Sampling tables are well-established . Their contents and associated instructions have been devised by mathematical calculations involving the binomial theory, and their use involves a five stage procedure as follows:
1. Chose the Sampling Table 'Set'
2. Specify the size of the incoming lot N and the target quality p%
3. Read the size of the sample to be taken n and the "acceptance criterion" c, from the Table. [The acceptance criterion c means the number of non-conforming units which might be found in the sample when it is inspected, but which would still permit the incoming lot to be accepted. For example, if the acceptance criterion was 5, then if 4 or 5 non-conforming units were found, the lot would still be accepted. But if 6 or 7 non-conforming units were found, the incoming material would be rejected.]
5. Select the sample from the incoming material and 100% inspect it;
6. If the number of defects (non-conformancies) in the sample is greater than n, reject the lot.
The Principal Sampling Tables
If the incoming lot is worse than x%, there will be a 95% chance that the plan selected from the LTPD Tables will result in that lot's rejection;
If the incoming lot is better than y%, there will be a 95% chance that the plan selected from the AQL Tables will result in that lot's acceptance.
The Operating Characteristic of a Sample Plan
The probabilities of acceptance and rejection of incoming lots containing various fractions of non-conforming units (ie the probability of acceptance when p = 1.0%, 2.0%, 3.0% ... etc.) is known as the plan's operating characteristic. The nature of a plan's operating characteristic depends very strongly on the size of the sample, n. The bigger n, the more useful and powerful the operating characteristic. The operating characteristic of a plan can be plotted as a curve, referred to as the OC curve. To simplify, if the OC curve is shallow, this indicates that the sample plan is poor. An example of a poor sample plan with a shallow OC curve might be one that is intended to give a high probability of accepting an incoming lot with fraction non-conforming of 1.0%, and which gives a probability of acceptance of 90% (which is obviously very satisfactory), BUT which also gives a probability of acceptance of about 75% if the incoming quality level were 1.5% and still gives a probability of 58% acceptance even if the incoming quality is 2.0% (a quality level that is twice as poor as the 1.0% rate). In other words, such a plan cannot distinguish good lots from bad! In contrast, an OC curve which is steep sided, produced, perhaps, from a sample plan in which a larger lot size n has been specified, is vastly more powerful and suitable. As an example, the probability of acceptance of lots with 1.0% non-conforming items might be 98%, BUT if incoming quality is 1.5%, the probability of acceptance might fall to 75%, and if incoming quality were 2.0%, the probability might fall then to only 17%. [As an aside, as far as the late Harry Romig was concerned, the justification for sampling was that if a supplier's batch of parts failed the sampling test, the whole lot would be returned to him, not just the failing components. The pressure on the supplier at that point to sort out his own problem is then very considerable.]
Note: taking a sample equal to a particular fraction of the incoming lot size (say, a 5% sample, or a 10% sample) is meaningless. If the buyer finds that this is being done, it would be advisable to re-appoint the company's quality manager, or to obtain outside consultancy assistance from a firm with proven expertise in this area. What matters is the sample size. The proportion of n to N is completely irrelevant.
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The ISO 9000 2000 family of standards is a prescription of controls and requirements which the International Standards Organisation believes must be adopted by a company to give effect to its quality management system (QMS). There are three family members. The first is ISO 9000 : 2000 itself ("Fundamentals and Vocabulary"), comprising general guidelines and definitions, and used as a reference in interpreting the specifications in ISO 9001 : 2000. The second is ISO 9001 : 2000 ("Requirements"). This is the centre of interest, constituting the actual specification describing the company's QMS, and laying down a number of requirements in eight clauses described below. Of these, Clause 7 (Product or Service "Realisation") is perhaps the most important to the purchasing manager. Product realisation, which was termed "process control" under the 1994 standard, includes the steps involved in designing, manufacturing and delivering the product or service to the customer. The third member is ISO 9004 : 2000 ("Guidelines for Performance Improvement"), which is intended for the company that wishes to expand the scope of its QMS beyond the 9000/9001 limits.
Certification in ISO 9000 means that the company's quality system has been subject to audit through its documentation by an ISO 9000 assessor and that the documentation and its correspondence with the activities carried out indicate that it complies with the standard's requirements - ie that the company is capable. What is the direct interest of the purchasing manager or buyer in ISO 9000? Two reasons suggest themselves and are commented on below.
1. The buyer believes that a company having ISO 9000 will supply better quality than one that does not. The buyer should understand that ISO 9000 has no bearing whatsoever on product quality or total quality as it is defined by experts. Total quality means quality mindedness, dedication to the customer, constant improvement and competence. ISO 9000 means documenting what you do. A company that produced appalling quality items could easily obtain ISO 9000 if it did so consistently, and diligently documented its procedures. Reliance on a supplier's possession of ISO 9000 is an abrogation of the supplier selection process.
2. The buyer's company has been forced by an ignorant but valuable customer to gain ISO 9000, and believes that to keep the certificate, it must buy from ISO accredited suppliers. There is nothing whatsoever in ISO 9000 that requires an accredited company to buy from similarly accredited suppliers. What ISO 9000 does require of the accredited company is that the choice of its suppliers should be made by a formal process (of its own devising), in the manner suggested in Section 1 of this on-line Course, and, naturally, that the procedure adopted should be documented. Also note that ISO 9000 - 2000 requires that a formal supplier evaluation scheme should be in place... Buyers who have been exposed to ISO 9000 are recommended to read In Pursuit of Quality : The Case against ISO 9000 (2nd Edition) (1999), by John Seddon, Oak Tree Press.
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One might suppose that the organisational arrangements to be found in the purchasing function might be as diverse as the diversity within industry itself. For example, Company A may be particularly concerned with issues of quality and incoming supplies. Buyers in A spend considerable time in operating supplier partnership schemes as described in Section 1. Company B on the other hand seems to focus mainly on logistics and on-time deliveries. Company C is concerned with commodities and the futures market. However, what seems to mark out true effectiveness in purchasing is not the administration of procedures relating to process capability analysis or the documentation of supplier performance, but the effectiveness of the original negotiations with suppliers in the first place (especially as to price paid). It is suggested that the department therefore should be organised so that its most senior and experienced members are placed in the position of front-line, principal negotiators. And, apart from carrying out his necessary managerial role, the purchasing manager himself should be the lead negotiator in the most critical negotiations. The criticality of negotiation to the purchasing function will be seen by other, more junior staff in the organisation and will influence their attitudes and the conduct of their jobs. These other staff must also support the senior staff. By "support" is meant that the necessary administrative tasks such as order progressing, the actual placement of orders, reviews etc should be undertaken by them, leaving the senior buyers and manager the time they need to do the best job possible in negotiating agreements.
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6.1.2 Centralisation v. Decentralisation
A perennial question in purchasing when a large, multi-factory company is involved is whether the purchasing function should be centralised or decentralised. If buying were, literally, to be all completely done by a central purchasing organisation fully located at the centre, delay, exasperation and inefficiency would result as local users passed instructions to head office. (In practice, users would rebel and bye-pass the system.) At the other end of the organisational scale, if all buying were to be done locally by autonomous purchasing functions, lucrative opportunities would be missed, otherwise apparent in large, single negotiations on behalf of multiple locations with single suppliers, and clashes might result in 'purchasing philosophies' among the different managers.
One popular solution is to set up a single central purchasing function, with certain large-scale or specialist purchases made by a comparatively small staff resident centrally, and other purchasing staff dispersed into groups, one at each locality. Rules about who buys what are then comparatively easy to formulate ... the centre simply buys products A, B and C, and all items valued over £x or over £y per annum. A variation on this theme is where (1) local group X buys all of a certain class of materials or commodities, mainly for its own manufacturing unit or factory but also for fringe use in other locations, and (2) local group Y buys another class of materials.
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6.2 The Split in Purchasing / Technical Responsibilities
In the great majority of companies, buyers must procure a vast range of items. The buyer however cannot be a technical expert, except in a small number of specialised instances. Consequently, it is essential that the purchasing task be split into technical and commercial halves as follows.
Technical users are responsible for specifications and design, for the correct recording of specifications and for any changes that might be made. Discussions with potential suppliers are likely to be held separately, well before final negotiations (so that users must be aware of the dangers of disclosing information that would be prejudicial to the commercial buyer later in a negotiation).
Purchasing have sole responsibility for commercial details and the soundness of the contract, and it is purchasing alone who have the sanction to buy.
T h e P u r c h a s i n g J o b R e m i t
The Marketplace.
Purchasing must keep an eye on the marketplace in which the company's existing goods and services are bought, so that anticipated difficulties in supply or anticipated significant price increases can be communicated to user management and plans formulated to deal with them. Purchasing will constantly research the supply marketplace to identify superior products and alternative sources, will evaluate them in terms of commercial attractiveness (continuity of supply, price, delivery etc.) and, if they are technically complex, will draw them to the attention of users.
Contractual Responsibilities.
Purchasing have sole authority for the ultimate placing of orders and the signing of contracts, and are duly responsible for the soundness of agreements from the legal, financial and commercial viewpoints.
Operation of Agreements.
Purchasing are responsible for the correct, timely delivery of raw materials by the company's suppliers in accordance with the company's master plan, and for such supporting arrangements as blanket orders, consignment stocks, delivery quantities, leadtimes and raw material stock levels.
The Split of Responsibilities with Technical Functions.
While purchasing are solely responsible for the identification and buying of a large range of incidental items and services, it is agreed with user departments that the purchase of other items with significant technical characteristics will be made as joint ventures with users under the following rules:
(a) Purchasing will buy precisely what is specified by the user, and will refer back any supplier proposal different from specification;
(b) Purchasing accept the need for separate technical discussions between the user and the potential supplier. Users are aware of the need for circumspection in matters of commercial sensitivity;
(c) Purchasing will invite user representatives to any negotiation where their presence would be advantageous to the company.
Administration.
Purchasing will run its own operation efficiently and effectively, among other things paying attention to internal budget limits, continuous improvement and staff development. The function will deal fairly and legally with the company's suppliers, and will ensure that invoices are paid promptly. And finally, Purchasing and its staff, collectively and separately, will adhere to the company's ethical code and the ethical code published by the Institute of Purchasing & Supply.
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6.3 Measures of Buyer Performance
"Measures of performance" are much misused tools of management, whereby some quantitative (ie exactly measurable) output from the job is recorded, and a target is set to reduce or increase the measured output over time. Measures of performance are supposed to indicate how well or how badly the job has been performed. Thus for the buyer, the volume of material bought over the year or the number of orders placed may be a poor reflection of job performance: the buyer buys what is required to service the production programme.
The reason measures of performance are frequently misused is that if personnel are being judged by the figures recorded, they are likely to take action purely to effect the figures themselves, without regard for the overall picture. For example, if a buyer was being measured on the basis of order placement costs (ie the fewer orders, the better), he might start to order excessively large quantities of material at very infrequent intervals, to reduce his costs, regardless of the stockholding or quality consequences of his action in doing so. [The lamentable current fixation of the Labour Government, and especially the NHS, with 'targets', is an excellent case in point.] However, four legitimate measures of performance that have been suggested for buyers as follows.
1. Supplier delivery performance - "on time, in full".
2. Standard quality per material bought, expressed as a percent non-conformance.
3. The quality capability index Cp , as described in Section 5. 1.
4. The cost of materials - the price paid.
On the questions of cost and price, if the buying company eliminates the elements of inflation and exchange rates when considering price, it is surely reasonable that the supplier over time will be capable of reducing his price as his manufacturing experience grows and the results of his value analysis programme begin to bear fruit. See the price variance expression "AQ ( SP - AP)" , Section 4.
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My word is my bond
Ethics are rules of conduct governed by the values of organisations and professions, values being what are held to be "right" and what held what are held to be "wrong". The rules are usually written down in what are referred to as ethical codes. (It is sobering to reflect that the Ethical Code of Enron Corporation ran to 68 pages.) Ethics, then, spring, originally, from organisational, professional and personal values - central virtues encompassing such complex topics as honesty, fairness, lawfulness, motivation and integrity. Ethical codes interpret these values and serve as practical guides to behaviour. It follows from this that until the values themselves have been identified and agreed - by way of corporate and personal introspection - it is meaningless to begin the formulation of an ethical code.
By contrast, organisational ethical codes, are able to be backed up by practical procedures at the direct level. Organisational codes are formulated by individual companies to advance the values they hold and to assist staff in the maintenance of the standards set. They are intended to be helpful guidelines, even though it is recognised that every practical situation is different. For this last reason, the enlightened company supports its ethical code with proper procedures and systems, such as by the provision of an advice and counselling channel and by guaranteeing the anonymity of members of staff requiring help. Also, "to police the policemen", a means of appeal to higher management is put in place.
Ethical statements and procedures alone are not enough. Training is also required in the form of group examination of moral issues and group discussion on how to interpret the code, such training to include all levels of management including the most senior. [See The Hand-book of Good Business Practice - Corporate Codes of Conduct, W.W.Manley, Routledge, 1992.] Difficult questions that can be posed in training include:
Is it always wrong for a buyer to accept a valuable gift - say, from a foreign supplier?
If an action is legal and is in the company's `best interests', how can it ever be wrong?
Are ethics meaningful if they depend for their interpretation on the moral character of the buyer?
Although one purpose of training is to raise the moral consciousness of purchasing staff, another is to give practical guidance, especially to younger buyers. For example, advice can be given on the dangers of becoming too familiar with suppliers or the tricks unscrupulous suppliers might play to ensnare the buyer. Purchasing department standards can be discussed, such as the requirement, say, to refuse point blank all gifts and favours from UK suppliers from the very outset, and to report any such offers to management.
In repeated studies involving purchasing staff, factors found to influence the positive adoption of a high ethical stance and, contrarily, to influence most the falling into unethical behaviour, are as follows, in descending order of their impact: Positive Ethics : 1. own personal code; 2. the behaviour of management; 3. company policy; 4. the behaviour of other staff. Unethical 1. the behaviour of management; 2.the ethical climate in the industry; 3. the behaviour of other staff; 4. lack of company policy; 5. personal financial problems.
The professional ethical code adopted by the buyer in the UK will, naturally, be that of the Chartered Institute of Purchasing & Supply. This code is reproduced on pages 7 & 8 at the end of this Section, and is taken from the Institute's handbook (December 1999 Revision).
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6.5 CIPS (The Chartered Institute of Purchasing & Supply)
Buyers studying this on-line Course who are not already members of the Institute are urged to become student members, associate members or affiliates, to attend its regional evening meetings and to attend its annual conference. Numerous specialised training courses are also organised by the Institute. The Institute also publishes an excellent fortnightly magazine Supply Management (with general articles, legal updates and job ads). Buyers are also urged to study for and pass the Institute's examinations and thereby qualify for full membership (MIP&S). There is a small joining fee for students and associates, with annual subscriptions of about £40.00. There is no joining fee for affiliates, and subscriptions are about £95.00pa. Subscriptions and fees can be claimed against income tax. The address is The Institute of Purchasing and Supply, Easton House, Easton-on-the-Hill, Stamford, Lincolnshire PE9 3NZ, phone 01780-756777, fax 01780-751610, web site http://www.cips.org. One way to study is by evening class or day-release attendance at one of the many colleges in the country holding CIPS courses. Another, relatively hassle-free way, is to prepare for the examinations by 'distance learning' - ie by what used to be known as a `correspondence course'. Two alternative organisations providing correspondence courses are: (1) The Cheltenham Tutorial College, 292 High Street, Cheltenham, Glocs GL50 3HQ (tel 01242-241279, fax 01242-234256); and (2) RRC Business Training, 27/37 St Georges Road, London SW19 4DS (tel. 0181-947-7272, fax 0181-944-7099). Note that the exams are highly modular, and that members with passes in certain subjects in other examinations may obtain exemptions. As with membership fees, the costs of study courses are deductible against income tax. Note finally that there are numerous books on purchasing available from CIPS and Amazon - see especially Negotiating Commercial Contracts, by David Sheridan (ISBN 0-07-707348-7).
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6.6 The Ethical Code of The Chartered Institute of Purchasing & Supply
The Ethical Code set out below was revised by the Institute in December 1999 and is binding on all members.
Introduction:
Members of the Institute undertake to work to exceed the expectations of the following code and will regard the code as the basis of best conduct in the purchasing and supply profession.
Members should seek the commitment of their employer to the code and seek to achieve widespread acceptance of it amongst their fellow employees.
Members should raise any matters of concern of an ethical nature with their immediate supervisor or another senior colleague if appropriate, irrespective of whether it is explicitly addressed in the code.
Principles:
Members shall always seek to uphold and enhance the standing of the purchasing and supply profession and will always act professionally and selflessly by:
(a) maintaining the highest possible standard of integrity in all their business relationships both inside and outside the organisations where they work;
(b) rejecting any business practice which might reasonably be deemed improper and never using their authority for personal gain;
(c) enhancing the proficiency and stature of the profession by acquiring and maintaining current technical knowledge and the highest standards of ethical behaviour;
(d) fostering the highest possible standards of professional competence amongst those for whom they are responsible; (e) optimising the use of resources which they influence and for which they are responsible to provide the maximum to their employing organisation;
(f) complying both with the letter and spirit of:
(i) the law of the country in which they practice;
(ii) Institute guidance on professional practice;
(iii) contractual obligations.
Members should never allow themselves to be deflected from these principles.
Guidance:
In applying these principles, members should follow the guidance set out below:
Declaration of interest - Any personal interest which may affect or be seen by others to affect a member's impartiality in any matter relevant to his or her duties should be declared.
Confidentiality and accuracy of information - The confidentiality of information received in the course of duty should be respected and should never be used for personal gain. Information given in the course of duty should be honest and clear.
Competition - The nature and length of contracts and business relationships with suppliers can vary according to circumstances. These should always be constructed to ensure deliverables and benefits. Arrangements which might in the long term prevent the effective operation of fair competition should be avoided.
Business Gifts - Business gifts other than items of very small intrinsic value such as diaries or calendars should not be accepted.
Hospitality - The recipient should not allow him or herself to be influenced or be perceived by others to have been influenced in making a business decision as a consequence of accepting hospitality. The frequency and scale of hospitality accepted should be managed openly and with care and should not be greater than the member's employer is able to reciprocate.
Decisions and advice When it is not easy to decide between what is and is not acceptable, advice should be sought from the member's supervisor, another senior colleague or the Institute as appropriate. Advice on any aspect of the code in available from the Institute.
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The End
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