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Procurement Methods

“If a man will make a purchase of a chance he must abide by the consequences

 

—Richard Richards”

Procurement methods can impact inventory levels. The EOQ calculation is traditional model to control inventory. Accurate input is required in the EOQ equation. However, based on current operational cost, EOQ method presents the most cost-effective quantity. For further reduction in the ordering cost firms need to increase inventory turns. This can be done by adopting the new methods like e-procurement, vendor-managed inventories, bar coding and RFID. The technology can reduce the costs associated with processing an order. Further enhancement in accuracy level of forecasting and reduction in lead time will help in reduced safety stocks resulting in reduced inventory levels.

INTRODUCTION

Inventory is a critical element in the supply chain. Inventories are maintained for meeting production requirements, supporting the operations, extending customer service and hedge against future uncertainties. The cost associated with inventory was always ignored in the past. However, the investment in inventory has implications on the profitability of the firm. The inventory carrying cost consists of the cost of the funds invested in the inventory, its handling cost, damage and obsolescence cost and opportunity cost. The carrying cost is approximately 18–20 per cent of the investment in the inventory. In supply chain system, inventory is viewed as a liability which reduces both the profits and returns on investment. For making the supply chain leaner, the firms are using selective control techniques such as EOQ, JIT, VMI and inventory control models like MRP, DRP and AITS. For managing the inventories across the supply chain, the policy guidelines have to be framed for inventory procurement, maintenance, positioning and placement with respect to quantity, time and the customer service. The procurement policy decisions are also based on managing the inventory independently or interdependently across the various distribution networks. In a nutshell, inventories should be held only when the benefits of holding the inventory exceeds the cost of carrying the inventory.

The modern approach to control inventories is focused on the following factors:¹

• Flow: It is concerned with the movement of product from supplier to the distribution centres and ultimately to the customer. Here comes the role of logistics operation for planning the material flow across the distribution networks based on the market demand. This is supported by the production planning at the factory.
• Flexibility: It is related to the flexibility in frequency and volumes in delivery of the products to the customers. The role of warehouse management is crucial to manage operations by fine-tuning to the demands of the target customers.
• Balancing: The inventory levels have bearing on the customer satisfaction levels. An inadequate inventory level will create customer dissatisfaction and, on the other hand, an excess inventory will increase the carrying cost. The latest inventory models focus on maintaining a delicate balance between the two polemic goals.
• Integration: The supply chain efficiencies and effectiveness is very much dependent on integration. The inventory models are developed for strategic fit for both forward and backward integration to meet the objectives of lower inventory carrying cost and enhanced customer satisfaction.

PROCUREMENT

To support manufacturing, the support of purchasing department is required. Procurement is buying of raw material or component that a company needs as an input to produce finished goods. The raw material in general constitutes 60–70 per cent of the cost of a product. Therefore, the firm should give greater focus to purchasing. The inventory-related cost can be best managed through better management of procurement. Business firms are looking to procurement as a strategic function to control costs. Cost is also attached to the method of procurement and hence, companies are trying to improve purchasing processes, which is ultimately improving the level of customer satisfaction.

The purchasing is a process covering many steps such as sending enquiries, request for quotations, soliciting quotations, negotiations, issuing purchase orders, shipping advice, invoice and finally issuing payments. This is a traditional process and is time-consuming and not cost-effective. The procedure is same for any item irrespective of its unit price. In this approach, the objective is to get the product whenever it is required at any cost.

The purchasing methods are responsible for inventory cost control. Over the years, there is dramatic change in using the purchasing methods. More sophisticated method are being evolved and practised. The suppliers have come forward to suggest to buyers to reduce their inventory burden. They also look into customer satisfaction and profitability of the buyer. Over the years, many companies have changed their outlook towards purchasing process. Due to competitive pressure, for many companies procurement has become a strategic function and source of cost reduction.

Today companies are focusing on total cost of inventory acquisition and are concerned more with purchasing decisions. To lower total cost of ownership companies are taking a number of steps to improve purchasing methods.

ECONOMIC ORDER QUANTITY (EOQ)

EOQ is an inventory decision model, based on differential calculus. It determines the optimum order size for purchasing an inventory item of stock. The optimum order quantity is that which equates the total ordering cost and total inventory cost. EOQ is the number of units that a company should add to the inventory with each order to minimize the total costs of inventory which covers holding costs, order costs and shortage costs. EOQ is used as part of a continuous review inventory system, in which the level of inventory is monitored at all times, and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages. The basic EOQ formula is as follows:

 

 

where

Q is the quantity to be purchased

c is the cost of processing an order for delivery

d is the demand in the period for that stock item

h is the cost of holding a unit of stock

For calculating optimal order quantities and reorder points, manufacturing companies are using the EOQ model for a long time. This model helps in reducing inventory level and related cost. EOQ will sometimes change as a result of quantity discounts, which are provided by some suppliers as an incentive for customers to place larger orders.

The EOQ model is based on the following two assumptions:

• Demand is constant
• Inventory is depleted at a fixed rate until it reaches zero

At the replenishment point, a specific number of items arrive to return the inventory to its beginning level. Since the model assumes instantaneous replenishment, there are no inventory shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase inventory holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds a quantity that minimizes the sum of these costs.

To go as per the formula will be rarely possible because of the following reasons:

• The ordered quantity figure may be modified to take into account the standard pack size available in the market.
• To avail of the quantity discount offered by the suppliers, the order quantity figure may be modified.
• The availability of funds will force the buyer to go for the less than minimum ordered quantity.
• To take care of the anticipated shortage of material in the market, the higher quantities may be ordered.

The EOQ formula is normally used as a guideline rather than deciding on the exact material requirements. EOQ inventory model works well with accurate product costs, activity costs, forecasts, history and lead times. Today ERP packages (software) automatically calculate EOQ. However, the users do not understand how it is calculated and therefore do not understand the data inputs and system setup which controls the output.

In general, the firms in order to enhance their bottom lines focus on increasing inventory turns. This may clash with EOQ approach. Thus, corporate goals and business strategies clash with each other. Calculating EOQ is a mathematical approach to decide the order quantity at the point, cost related to inventory carrying an order placement are lowest. For every inventory situation, calculating the optimum level of order quantity using EOQ formula may not be always suitable. But the EOQ formula will give some indication on order quantity to proceed for placement of order. EOQ is useful for repetitive purchasing of standard inventory items under make-to-stock manufacturing policy. EOQ gives better results under the situations wherein the demand for item is steady. However, for item with seasonal demand, EOQ calculations are not recommended because they exist for a shorter time frame.

If all the costs associated with purchasing and receiving are included in order cost and all costs associated with storage and material handling are included in inventory carrying cost, the resultant EOQ is likely to be inaccurate. Thus, EOQ may be inaccurate if inputs costs are wrong.

The order cost comprises of all fixed costs applicable on each order. The fixed cost are associated with the frequency of the orders and not on the quantities ordered. The order cost, in other words, is the labour associated with processing the order. In many cases, the other costs such as phone calls, faxes, postage and envelopes are also included.

The carrying cost is the holding cost associated with inventory on hand. The carrying cost covers storage cost, interest on the money borrowed from the bank, insurance cost and the taxes on the value of the inventory. Other costs that are covered in carrying cost are risk cost on transit/handling damages, obsolescence and pilferages.

There are many variations on the basic EOQ model as listed below:

• Quantity discount on inventory ordered
• Fixing quantities for items subject to spoilage or obsolescence
• Determining lot sizes for longer production runs
• Safety stock calculation based on order cycle time

EOQ can be implemented manually. It is done by taking one item at a time. However, if the SKU numbers exceeds 1000, EOQ needs to be programmed in the computers to get the calculation with speed.

JUST-IN-TIME PROCUREMENT (JIT)

In 1990, JIT caught up the attention of manufacturing companies and became one of the biggest trends in the manufacturing industry. With JIT initiatives, companies maintained just enough inventories they need for immediate manufacturing. Parts/components are continuously ordered and reach assembly line immediately after delivered to the manufacturing shop floor. The JIT system has many advantages such as reduction in inventory level, improved quality, reduction in lead time and improved asset utilization. A company adopting JIT manufacturing system, must shift to JIT procurement system. The objective of JIT is to speed up customer response and minimizing inventory. The larger inventories help to respond quickly to changing customer demands, but they also increase inventory carrying cost resulting in increased requirements of working capital.

‘Just-in-time’, is a manufacturing organization's philosophy, pioneered by Taiichi Ohno in Japan at the Toyota car assembly plants in the early 1970s. JIT cuts waste by supplying parts just at the time of assembly process. At the heart of JIT lies the KANBAN which means a card in Japanese language. The KANBAN card is sent to the warehouse to reorder a standard quantity of parts as and when those have been used up in the assembly/manufacturing process. JIT is used primarily for high-volume repetitive flow of manufacturing processes.

The American Production and Inventory Control Society (APICS) define JIT as follows:²

A philosophy of manufacturing based on planned elimination of all waste and continuous improvement of productivity. It encompasses the successful execution of all manufacturing activities required to produce a final product, from design engineering to delivery and including all stages of conversion from raw material onward. The primary elements include having only the required inventory when needed; to improve quality to zero defects; to reduce lead time by reducing setup times, queue lengths and lot sizes; to incrementally revise the operations themselves; and to accomplish these things at minimum cost.

This is a pull type production process based on a good communication between the suppliers and production department and it is initiated by actual demand, rather than by plans based on forecasts. In contrast in a push philosophy, large volumes of materials and components are produced, transported and stored ahead of demand and requirements. The idea behind this is the reduction or elimination of work in progress, that is, large stocks of goods and materials that have been produced and are waiting for transportation or further completion. Typical attention areas of JIT implementations include:

• Inventory reduction
• Smaller production lots/batch sizes
• Quality control
• Reduced complexity
• Transparency in movement
• Flat delegation
• Waste minimization

With the advent of the Internet and availability of the supply chain planning software, companies extended JIT manufacturing externally. They asked suppliers to deliver inventory to the factory only when it is needed for assembly, making JIT manufacturing, ordering and delivery processes even speedier, more flexible and more efficient. They formed integrated supply networks (demand networks) or electronic supply chains resulting into ‘lean production’ system.

Just in time is a ‘pull’ system of production. Here, the actual orders provide a signal when a product should be manufactured. Demand-pull enables a firm to produce only what is required in the desired quantity and time.

This means that stock levels of raw materials, components, work in progress and finished goods can be kept to a minimum. This requires a carefully planned scheduling and flow of resources through the production process. Modern manufacturing firms use sophisticated production scheduling software to plan production for each period of time, which includes ordering the correct stock. Information is exchanged with suppliers and customers through EDI (electronic data interchange) to ensure that data is correct.

Suppliers deliver right quantity of material to the production line only when it is needed. For example, a car manufacturing plant might receive exactly the right number and type of tyres for one day's production, and the supplier would be expected to deliver them to the correct loading bay on the production line within a short time slot.

With the JIT adoption, companies will have lower stock holding resulting in reduction in storage space and consequently save on rent and insurance costs. The working capital tied up in stocks is also reduced. The risk of inventory getting obsolete due to change in demand or technology is reduced. The time spent on checking and re-working the product of others is reduced as the emphasis is on getting the work right the first time.

The disadvantages associated with JIT system are there is little room for mistakes as minimal stock is kept for re-working faulty products, production schedule get delayed if stocks not supplied in time and there is no spare finished product available to meet unexpected orders from the market.

JIT is a philosophy of continuous improvement in which non-value-adding activities (or wastes) are identified and removed for the purposes of:

• Reducing cost
• Improving quality
• Improving performance
• Improving delivery
• Adding flexibility
• Increasing innovativeness

JIT technique eliminates waste thus protecting the environment and simplifying the processes to improve operations. When JIT technique is implemented correctly, significant benefits are accrued leading to competitive advantages. JIT can have applications in all functional areas of management of an organization such as order processing, procurement, production, distribution, sales, accounting, design, etc. JIT usually indentifies seven prominent types of waste to be eliminated:

• Waste from overproduction
• Waste of idle time/waiting time
• Transportation waste
• Handling/motion waste
• Inventory waste
• Waste from product defects
• Processing waste

In JIT, material-related costs are reduced by finalizing on the suppliers and developing long-term contracts with few suppliers. JIT implementation eliminates excess material handling, inspections and storage of parts. The primary goal in JIT is to eliminate non-value-adding activities.

JIT purchasing approach is preferred to the EOQ approach as the JIT purchasing approach helps in space reduction in the manufacturing plant. JIT purchasing requires a nearly total change in purchasing philosophy and company culture. JIT provides reduction in suppliers’ base and zeros down on a few who can deliver high-quality products as and when required. To make JIT a success story, the JIT supplier should demonstrate excellent product quality, make frequent on-time deliveries and provide very large volume commitments.

To implement JIT, it is essential to organize small (quantity), frequent but on-time deliveries. This is possible if suppliers are located in same geographical region as buyers. The example is automobile industry wherein most of the ancillary industries are located near to the main auto assembly plant. The location proximity helps responsiveness of suppliers. In a single sourcing arrangement, the buyer can have a lot of influence on the manufacturing process. In such arrangement, the buyer helps supplier in technical and commercial aspects of suppliers business and in turn expects value-added or extra services from him.

VENDOR-MANAGED INVENTORY (VMI)

Today, most of the firms are concentrating on the ‘core competences’. They want to outsource minor tasks and activities, when it is cost-effective to do so. For a distributor, an example of one of these tasks is the replenishment of less-expensive products. For a manufacturer, it may be the procurement of MRO (maintenance, repairs, and operations) inventory. A popular way to outsource these procurement activities is a vendor-managed inventory (VMI) agreement. Under a VMI agreement, a supplier takes full responsibility for maintaining stock of products at a customer's facility. VMI differs from traditional inventory management, in that the customer is billed for material when it is delivered, not when it is consumed or issued.

Vendor-managed inventory, just-in-time distribution and efficient consumer response (ECR) all refer to similar concepts, but applied to different industries. For example, the grocery and apparel industries tend to use ECR, whereas the automobile industry tends to use VMI and JIT distribution. VMI reduces stock outs and reduces inventory in the supply chain. Some features of VMI include the following:

• Shortening of the supply chain
• Centralized forecasting
• Frequent communication on inventory position
• Inventory fill up in a prioritized order
• Relationship with downstream distribution channels
• Result inventory and stock out reduction

In general, the supply chain is not synchronized to consumer demands. Hence, to secure high service levels, both the wholesaler and the retail chain feel the need to buffer against supply disruption. This in turn, distorts the demand that is communicated to the supply factories. The objective of VMI is to find an effective way for the vendor to take responsibility of the wholesaler's inventory. This way the need for double buffering against supply disruptions could be eliminated and the basis for planning supply request from manufacturers could be improved.

In its simplest form, VMI is the process where the vendor assumes the task of generating purchase orders to replenish a customer's inventory. VMI covers many types of supply chain initiatives. These different VMI activities can vary substantially in purpose and application. VMI is about improving visibility of demand and product flow in a supply chain, facilitating a more timely and accurate replenishment process between a supplier (vendor) and an inventory site (customer, distributor, distribution centre, etc.).

VMI can be applied at any point within a supply chain:

• Manufacturer—Wholesale distributor/retailer
• Manufacturer—End customer/OEM
• Manufacturer—Internal inventory sites

For VMI partnership to be successful and fruitful, the supplier and customer when entering an agreement must agree on the following:

• The specific products that will be covered under the VMI agreement.
• ‘Acceptable availability’ of these products at the customer's site and the corresponding investment required by the customer.

• Mutually acceptable ‘service level’ agreement.
• How often the stock of these products will be replenished.
• Automatic return of material not required by the customer.

The advantages for a customer participating in a VMI programme cover the following:

• Eliminating of transaction cost.
• Reduced inventory capital costs.
• Establishing an extremely reliable source of supply for products.
• Customer does not pay for the inventory until it is sold or used.
• Elimination in inventory stock outs.
• Better financial planning.
• Elimination in ordering errors.

The advantages for a supplier in a VMI programme cover the following:

• Securing the customer's overall business for products it supplies.
• Better planning of its own inventory replenishment needs.
• Better capacity utilization of its plant.
• Better demand management.
• Customer-focused approach leading to competitive advantage.
• Supply chain visibility.
• Better planning.

The risks involved for suppliers in participating in VMI programmes are high administrative cost as it is assuming responsibility for replenishment activity that was previously carried out by the customer's buyers.

The real world implementations of VMI can be broken into three main categories:

• Collaboration
• Automation
• Cost transfer

A collaborative planning model consists of sharing data, and jointly developing forecasts and/or production schedules amongst supplier chain partners. This collaborative process occurs at the tactical or item level. The ‘buyer’ collaborates with the supplier on demand/usage plans in order to develop an agreed upon consensus forecast of future demand that both companies will use to drive their business. This strictly collaborative model is applicable to supply chains where a few, distinct items (SKUs) generate substantial volumes of business. In this environment, it is valuable for people to review and arrive at consensus on forecasting and replenishment plans for each SKU.

In business environments, where thousands of SKUs have to be managed daily, collaboration at the tactical (item) level is impractical, costly and error-prone. The more effective collaborative process is at the strategic level, where overall service and inventory investment goals are agreed upon, along with the constraints within each company. The collaborative stage is critical in establishing the goals and key performance indicators for the VMI relationship. Periodically, this stage is reviewed for current performance and adjusted or reconfirmed with the goals and constraints. When the collaboration and planning stages are done properly, the execution stage becomes automated with very few exceptions, requiring less human interaction on a daily basis. Furthermore, the execution stage can provide suppliers with valuable information beyond the quantity in the purchase order, enabling improvements to the order fulfilment and inventory allocation processes.

In many instances, a VMI relationship is the first time in supply chain where both partners have access to, and are measuring performance using the same metrics. When two companies are focused on the same goals and have access to the same key performance metrics, a true supply chain partnership emerges, resulting in a better performing supply chain.

VMI delivers tangible results throughout the supply chain. As the concepts and practices of ‘lean’ extend beyond the manufacturing floor down through the supply chain, VMI is the enabling process to drive out costs and time. For success of VMI implementation the following are the keys:

• Set, review and maintain performance goals.
• Manage all SKUs through VMI to minimize transactions.
• Ensure data accuracy.
• Utilize automated replenishment system.
• Organize periodic performance reviews.
• Use the metrics to find cost and inefficiencies.

VMI can be made to work, but the problem is not just one of logistics. VMI often encounters resistance from the sales force and distributors. The issues are roles, skills, trust and power shifts.

Effective implementation of VMI depends on smoothly addressing the concerns of various stake holders. Some of the concerns can be addressed as explained below:

• Defining incentive programmes based on partnership and not on sales volume.
• Building partnerships with management commitment.
• Conduct simulations and pilots before actual implementation.
• Organize training sessions before launching VMI programme.
• Getting into service level agreements (SLA)

ONLINE PROCUREMENT

E-procurement system allows businesses to use the Internet for acquiring the necessary goods and services. There are three main categories of e-procurement systems. One type focuses on improving the transactions and the decision-making capabilities of the company. Businesses may deal with hundreds of transactions on a weekly basis, but these applications simplify the process and help to build stronger relationships between buyers and suppliers. The second category of e-procurement system involves managing assets. Systems in this category provide inventory management, maintenance scheduling, in-house product availability, as well as other similar services. These applications are useful for businesses that need to keep a close watch on the quality of materials in stock. The third category includes systems designed to optimize a company's production operations. Many of these applications deal with the entire production cycle, including the procurement of materials when the inventory runs low, the management of supplier contracts and the production scheduling. Because of the differences between the systems, it is important for companies to choose the one that is most appropriate for their industry. For example, an automobile manufacturing company is likely to use systems from the third category. The applications would allow them to maintain minimum level of inventory but they also need to have a system which helps them plan and forecast their production. However, companies such as automotive repair shops, would be more likely to use e-procurement systems from the second category. Since they need to keep track not only of their inventory of car parts, but also in helping them to set repair schedules.

E-procurement system in businesses imparts benefits such as saving money on purchases, improving the timeliness of the purchasing process and eliminating waste. In addition to these benefits, companies can also improve the efficiency of their supply chain. Additionally, using e-procurement to enhance supply chain relationships can make it easier for accounting departments to track and keep a record of payments and invoices.

E-procurement systems do not automatically boost supply chain efficiency. However, the company must select a system that has the capabilities necessary to achieve those benefits first. For example, the system must include applications to assist with contract management, including pricing information, maintaining sales terms and helping negotiations. By having all of this information in one place, the purchasing process is expedited. E-procurement allows buyer to easily compare suppliers (on price) so that the best one can be chosen to meet that company's particular needs. However, choosing the right supplier depends on more than just price: it also involves product availability, customer service, industry reputation and quality.

E-procurement is more than just a system for making purchases online. A properly implemented system connects companies and their business processes directly with suppliers while managing all interactions between them. This includes management of correspondence, on tender bids, questions and answers, previous pricing, and multiple emails sent to multiple participants. A good e-procurement system helps a firm organize its interactions with its most crucial suppliers. It provides those who use it with a set of built-in monitoring tools to help control costs and assure maximum supplier performance. It provides an organized way to keep an open line of communication with potential suppliers during a business process. The system allows managers to confirm pricing, and leverage previous agreements to assure each new price quote is more competitive than the last.

E-procurement helps with the decision-making process by keeping relevant information neatly organized. E-procurement process is template-driven, which makes all transactions standardized and traceable. Keeping track of all tender bids means leveraging firm's knowledge to obtain better pricing. Well managed e-procurement helps reduce inventory levels. E-procurement system allows multiple access levels and permissions and help managers to organize administrative users by roles, groups or tasks.

PURCHASING CARDS

As transaction costs goes up, companies are looking to buy smarter and cut costs. In recent years, many companies are providing to their key employees in procurement department with corporate credit cards/purchase cards that can be used for purchasing materials.

The purchase cards are similar to credit cards. The purchase cards are issued by leading card companies such as VISA, Master-Card and American Express. Generally, the purchase cards are used to speed up the procurement of low unit priced items in small quantities. Like other credit cards, the bill is forwarded to the purchasing department of the company for payments. Sometimes the cards work only between a buyer and suppliers eliminating the bank. The purchase card reduces the amount of paper work. The cards also contain information on sales tax data, customer code, taxpayer PAN and transaction type. The vendors are also benefited by cards at customer end as the vendor receives payment within a short period. There is no transaction cost at supplier end. The supplier prior to effecting transaction through credit card knows the credit worthiness of the customer. Hence his risk is minimized.

REVIEW QUESTIONS

1. Explain EOQ model of procurement and its relevance in today's context.
2. Explain JIT system of procurement and its issues in implementation.
3. Compare and contrast EOQ and JIT system purchasing.
4. Explain VMI and its advantages.
5. Discuss challenges in implementation of VMI.
6. Explain the concept of ‘purchase card’ and its utility.

INTERNET EXERCISES

1. Website, http://Home.Ubalt.Edu/Ntsbarsh/Business-Stat/Otherapplets/ Inventory. html;, is a part of e-Lab learning with objects for inventory decision-making. Visit the above site to study EOQ Models for Inventory Management.
2. Inventory Solutions Logistics Corporation is a full service warehousing, distribution and logistics corporation. Visit http://www.inventorysolutions.org/def_jit.html and study the various inventory solution in practice.

VIDEO LINKS

1. Toyota JIT Concept, http://www.youtube.com/watch?v=OBK2KM0Gmq0&feature=related
2. Global Procurement, http://www.logisticsbureau.com.au/video-supply-chain-logistics.html

PROJECT ASSIGNMENTS

1. Study the ‘JIT System’ of procurement in any automobile manufacturing company and find out the problems they faced initially in implementation of the same. Further study how they have re-engineered their business processes to suit JIT system.
2. VMI is mostly practiced in automobile industry for high value and large consumption SKUs. Take any auto manufacturing firms and study their VMI system in details.