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PA R T I I I
Activities in the Supply Chain
This book is divided into three parts. Part I gave a general introduction to the subject of supply chain management; Part II
discussed the planning needed for a supply chain; and Part III
focuses on some specific functions of logistics.
There are five chapters in Part III, each of which describes a
major activity in the supply chain. Chapter 9 looks at the
procurement of materials. Materials are kept in stock, so
Chapter 10 describes inventory management, while Chapter 11
discusses some questions of warehousing. Chapter 12 describes
the transport of materials and Chapter 13 looks at issues of
international logistics.
This is the last part of the book, which relates to our earlier
discussions on specific activities in the supply chain.
CHAPTER 9
Procurement
CONTENTS
■ Aims of the chapter
■ Definitions
■ Choosing suppliers
■ Procurement cycle
■ Types of purchase
■ Chapter review
■ Case study – Arnold Haralson
■ Project – How to buy
■ Discussion questions
■ References
■ Further reading
AIMS OF THE CHAPTER
After reading this chapter you should be able to:
■ D E F I N E the role of procurement
■ A P P R E C I AT E the importance of procurement in the
supply chain
■ C H O O S E an appropriate supplier
■ D I S C U S S the steps in a procurement cycle
■ D E S C R I B E e-procurement and its advantages
■ TA L K about different arrangements for purchasing
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DEFINITIONS
Purchasing and procurement
In previous chapters we have described the planning of a supply chain. This starts with
strategic aims, and moves down to organise the flow of materials, makes sure that resources are
available, and continually looks for better methods. But we have not really discussed the mechanism for initiating the flow of materials. This is provided by purchasing or procurement.
In a supply chain, each organisation buys materials from upstream suppliers, adds value,
and sells them to downstream customers. As each organisation, in turn, buys and sells, the
materials move through the whole supply chain. The trigger that initiates each move is a
purchase. This is basically a message that an organisation sends to a supplier, saying, ‘we have
agreed on terms, so send us materials and we will pay you’.
P U R C H A S I N G gives a mechanism for initiating and controlling the flow of materials
through a supply chain.
Purchasing is the function responsible for acquiring all the materials needed by an organisation. Many of these transactions are not standard purchases, but include rental, leasing,
contracting, exchange, gifts, borrowing, and so on. This is why some people prefer to talk
about the ‘acquisition of materials’ or the more common term of procurement. ‘Procurement’
and ‘purchasing’ are often taken to mean the same thing. Usually, though, purchasing refers to
the actual buying, while procurement has a broader meaning. It can include different types of
acquisition (purchasing, rental, contracting, and so on) as well as the associated work of
selecting suppliers, negotiating, agreeing terms, expediting, monitoring supplier performance,
materials handling, transport, warehousing and receiving goods from suppliers.
■ P R O C U R E M E N T is responsible for acquiring all the materials needed by an
organisation.
■ It consists of all the related activities needed to get goods, services and any other
materials from suppliers into an organisation.
Procurement does not usually move materials itself, but it organises the transfer. It gives
the message that materials are needed, and arranges the change of ownership and location.
But it is another function, such as transport, that actually delivers them. So procurement is
largely concerned with information processing. It collects data from various sources, analyses
it, and passes information to the supply chain.
Importance of procurement
You can easily see why procurement is important. If we take a broad view, procurement forms
an essential link between organisations in the supply chain, and it gives a mechanism for coordinating the flow of materials between customers and suppliers. At every point in the supply
chain, procurement passes messages backwards to describe what customers want, and it passes
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messages forwards to say what suppliers have available. Then it negotiates terms and conditions for delivery.
If we take a more limited view, procurement is clearly an essential function within every
organisation. We know that every organisation needs a supply of materials, and procurement
is responsible for organising this. If procurement is carried out badly, materials do not arrive,
or the wrong materials are delivered, in the wrong quantities, at the wrong time, with poor
quality, at too high price, low customer service, and so on.
You can get a feel for the importance of procurement from the following example. In the
first half of the twentieth century farmers in the US prairies could be fairly isolated. Sears
Roebuck introduced a new way of buying that gave farmers the same access to products as the
rest of the population.
L O G I S T I C S
I N P R A C T I C E
Sears Roebuck
Sears Roebuck is a major retailer in the
United States. Founded in 1886 it now has
annual revenues of over $40 billion. Much
of its early growth was based on delivering
goods to farmers in the remote prairies. In
1913 its catalogue contained 1500 pages,
with thousands of items ranging from
boxes of matches to complete houses. People in any location could post their orders
or send them to agents, and have goods
delivered by post or train. Their customers
were always satisfied, as the company gave
a comprehensive guarantee on their catalogue cover:
If for any reason whatsoever you were dissatisfied with any article purchased from
They have maintained this tradition, and
still advertise, ‘Satisfaction guaranteed or
your money back’.
According to Ackerman and Brewer1 this
kind of mail order business has some
important features for logistics:
■ logistics providers have direct contact
with customers
■ this direct contact allows more precise
ordering
■ an efficient system for exchanging information is essential
■ orders are smaller than normal
■ customers are more demanding and
want better service
■ transport is more complicated.
us, we expect you to return it to us at our
expense. We will then exchange it for
exactly what you want or will return your
Sources: promotional material, company reports
and website at www.sears.com
money, including any transportation charges you have paid.
Not only is procurement essential, but it is also responsible for a lot of expenditure. For a
typical manufacturer, 60% of its spending goes on materials, with companies like General
Motors spending over $50 billion a year. So procurement is directly responsible for most of a
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company’s spending, and a relatively small improvement can give substantial benefits.
Suppose that a company buys raw materials for a60, spends a40 on operations and then sells
the product for a110. It clearly makes a profit of 110 – (60 + 40) = a10 a unit. Now suppose
that procurement negotiates a 5% discount on materials. Materials now cost 60 × 0.95 = a57,
and with the same selling price the a3 saving goes straight to profit. The profit on each unit
now jumps to a13, so a 5% decrease in materials costs raises profit by 30%.
W O R K E D
E X A M P L E
Last year Wiesiek Limited had total sales of £108 million. Their direct costs were £58 million for materials, £27 million for employees and £12 million for overheads. What is the
effect of reducing the cost of materials by 1%? If materials costs are not reduced, how
much would sales have to increase, or overheads fall, to get the same effect?
Solution
■ The actual profit last year was 108 – (58 + 27 + 12) = £11 million.
■ If the cost of materials drops by 1%, it falls to 58 × 0.99 = £57.42 million. Then the
profit rises to 108 – (57.42 + 27 + 12) = £11.58 million. A 1% decrease in materials
costs increases profits by 5.3%. Profit as a percentage of sales rises from 10.2%
to 10.7%.
■ If materials costs do not change, and assuming that other costs remain the same
proportion of sales value, then sales would have to rise by 5.3% to £114 million to get
the same increase in profit.
■ To get the same extra profit the fixed costs would have to fall by £0.58 million
or 4.8%.
In recent years there has been wider recognition of procurement’s position as an essential
function that can control most of an organisation’s expenditure. As a result, the function has
received a lot more attention. It used to be considered little more than a clerical job, buying
materials as they were requested. Now it is recognised as an important management function
in its own right. This trend has been encouraged by changing patterns of procurement. Supply
chains are getting shorter as more customers use the Web or avoid different tiers of suppliers;
alliances are reducing the number of suppliers used by each organisation; amounts purchased
are increasing as companies focus on their core activities and outsourcing more; customers are
more demanding of products and conditions of purchase. These, and other factors, turn a
spotlight on procurement. With this context, it is not surprising that procurement is treated as
a senior management role.
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Aims of procurement
The overall aim of procurement is to guarantee that an organisation has a reliable supply of
materials. With this overriding aim, we can develop the following list of more immediate
goals:
● organising a reliable and uninterrupted flow of materials into an organisation
● working closely with user departments, developing relationships and understanding their
needs
● finding good suppliers, working closely with them and developing beneficial relationships
● buying the right materials and making sure that they have acceptable quality, arrive at the
time and place needed, and meet any other requirements
● negotiating good prices and conditions
● keeping stocks low, considering inventory policies, investment, standard and readily
available materials, and so on
● moving materials quickly through the supply chain, expediting deliveries when necessary
● keeping abreast of conditions, including pending price increases, scarcities, new products,
and so on.
Organisation of procurement
The way that procurement is organised clearly depends on the type and size of the organisation.
In a small organisation, a single buyer might be responsible for all purchases, policy and administration. A medium-sized organisation might have a department with buyers, expeditors, storekeepers, and clerks. A large organisation might have hundreds of people co-ordinating huge
amounts of purchases.
Usually procurement is organised as a single department to get the benefits of centralised
purchasing. These benefits include:
● consolidation of all orders for the same, and similar, materials to get quantity discounts
● co-ordinating associated activities to reduce costs of transport, stockholding and
administration
● eliminating duplicated effort and haphazard practices
● having a single point of contact for suppliers and giving them consistent information and
service
● developing specialised skills and improving procurement operations
● allowing other people to concentrate on their own work without diverting into
purchasing
● concentrating responsibility for procurement, making management control easier.
These benefits can be considerable, but centralised purchasing has its critics. If you work in an
office in Leeds, it seems nonsensical to contact your purchasing department in Milton Keynes
(450 km away) to buy materials from a supplier in Bradford (20 km away). Nonetheless, this
system should give overall benefits. However, organisations that work over a wide geographical area are aware of the problems of centralised purchasing, and may use local purchasing.
This can, of course, bring its own benefits. Local offices are likely to have better knowledge of
local conditions and culture, better relations with suppliers, more flexible operations, lower
transport costs, and so on.
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L O G I S T I C S
I N P R A C T I C E
CN Railway
Canadian National Railways (CN) used to
have a traditional purchasing and materials
management department. At the beginning
of the 1990s this employed 1400 people in
60 locations. The department had been successful in lowering prices (by up to 35%)
through alliances and volume purchasing.
Despite this, the company felt that it could
improve procurement performance. Bob
Gallant, head of supply management at CN,
said that there was a strong push for better
performance at the railway and that: ‘Purchasing is one of the most powerful ways to
enhance economic performance.’
CN’s traditional approach was to buy
each material from the best supplier, negotiating for the lowest price. But they found
that they could get lower overall costs by
purchasing from a few main distributors,
rather than from separate companies. In
September 1994, for example, they
stopped dealing individually with 500 geographically dispersed suppliers in western
Canada. Instead, they formed an alliance
with Acklands, a major distributor who
became responsible for co-ordinating these
supplies. CN replaced 6000 annual invoices
by a single monthly bill and reduced costs
by C$1.2 million a year.
They chose Acklands, and other distributors, by forming a shortlist of companies
who could supply all their main purchases,
and then comparing the companies’ ability
to form productive partnerships. Bob Gallant explained that they were ‘looking for a
supplier that could provide us with a total
package. We also wanted to work with a
company that had a common view and
management commitment’.
The transition to new procurement and
changing culture was difficult for a department that served 23,000 employees. They
changed the department’s name, ran a
series of seminars and workshops to explain
the new philosophy, hired outside people,
formed alliances and actively searched for
new ideas. The most difficult part was convincing people that they were aiming for
the lowest overall cost, rather than the
cheapest immediate price.
By 1995 CN had reduced their supply
management department to 280 people in
25 locations, the total cost of materials purchased by C$14 million and stocks by C$4
million. The following year they looked for
reductions of C$40 million in costs and
C$34 million in stock, with similar improvements in 1997.
Source: Anon. (1996) Buying power, Materials
Management and Distribution, February, 43–5
CHOOSING SUPPLIERS
Qualified suppliers
Arguably, the most important part of procurement is finding the right supplier. There is no
point in having a well-designed product, if the supplier cannot actually deliver it. Imagine that
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you are working on a project and want to buy some important materials – perhaps a prefabricated bridge for a construction project. You will look for two factors. First, a product design
that satisfies your needs. Second, a supplier who can guarantee to deliver the product as
designed. In other words, the supplier must be capable of doing the work, giving high quality,
working to a schedule, with acceptable costs, and so on. An advertised time of four hours for a
train journey might seem a good service, but it has less value if the train operator cannot actually deliver this.
Procurement starts, then, by finding a qualified supplier. This is one who can actually
deliver the materials needed. In general, organisations look for suppliers who:
● are financially secure with good long-term prospects
● have the ability and capacity to supply the necessary materials
● accurately deliver the requested materials
● send materials of guaranteed high quality
● deliver reliably, on time with short lead times
● quote acceptable prices and financing arrangements
● are flexible to customers’ needs and changes
● are experienced and have expertise in their products
● have earned a good reputation
● use convenient and easy procurement systems
● have been used successfully in the past and can develop long-term relationships.
In different circumstances, many other factors might be important, such as convenient location, ability to deal with variable demand, and so on.
Most organisations have a list of approved suppliers who have given good service in the
past, or who are otherwise known to be reliable. If there is no acceptable supplier on file, the
organisation has to search for one. Suppliers for low value items can probably be found in
trade journals, catalogues or through business contacts. More expensive items need a thorough
search, and this can be very time consuming. A useful approach for choosing the best supplier
for a product has the following steps:
● Look for alternative suppliers
● Build a long list of qualified suppliers who can deliver the products
● Compare organisations on this long list and eliminate those who are, for any reason, less
desirable
● Continue eliminating organisations until you have a shortlist (usually four or five) of the
most promising suppliers
● Prepare an enquiry, or request for quotation, and send it to the shortlist
● Receive bids from the shortlist
● Do a preliminary evaluation of bids and eliminate those with major problems
● Do a technical evaluation to see if the products meet all specifications
● Do a commercial evaluation to compare the costs and other conditions
● Arrange a pre-award meeting to discuss bids with the remaining suppliers
● Discuss condition bids, which are specific conditions that have to be agreed
● Choose the supplier that is most likely to win the order
● Arrange a pre-commitment meeting to sort out any last minute details
● Award orders to the preferred supplier.
L O G I S T I C S : A N I N T R O D U C T I O N T O S U P P LY C H A I N M A N A G E M E N T
This is clearly a time-consuming procedure, but remember that a poor supplier can cause more
problems than poor materials. The whole procedure is only used for major purchases, and if
you are buying pencils the shop next door is probably as good as any other supplier. Normally,
an organisation will spend little time looking at alternative suppliers if:
● it is buying low value materials
● there is only one possible supplier
● there is already a successful arrangement with a supplier
● there is not enough time for extended negotiations
● the organisation has a policy of selecting specific types of supplier.
Sometimes, particularly with government work, procurement has to be visibly fair, and all
potential suppliers must be given an opportunity to submit quotations. Rather than forming a
shortlist of qualified suppliers, an organisation will widely advertise that it is seeking quotations for particular work or materials. The organisation compares all the bids submitted and
chooses the one that best meets the prescribed criteria. This is called open tender. A variation
reduces the administrative effort by putting some qualifications on suppliers, perhaps based on
experience, size or financial status. This gives limited tender.
As you can see, we are talking about customers selecting suppliers – and assume that
suppliers are happy to serve all the customers they can find. This is usually the case, but sometimes suppliers have more power and effectively choose their customers. This might happen
when a supplier has a monopoly, or near monopoly, of some material. It might also happen
when there is a temporary shortage of some commodity, such as oil, and suppliers choose the
customers they will supply, perhaps giving preference to larger customers, those who pay
more, or those who have long-term agreements. In these cases the supplier has more power, as
shown in Figure 9.1.2
100%
Amount of customer’s
materials bought from supplier
234
0
Supplier has
more power
Mutually
dependent –
alliance
Little
dependence –
competition
Customer has
more power
50%
Amount of supplier’s materials
sold to customer
Figure 9.1 Relative power of a customer and a supplier
100%
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Number of suppliers
We have already discussed the trend towards long-term alliances and partnerships. This
inevitably moves organisations towards single suppliers, either for each material, or for a range
of different materials. Some organisations say that this single sourcing leaves them vulnerable
to the performance of an individual company, and they have severe problems if something
goes wrong. If the single supplier of a vital component hits financial problems, an organisation
may, through no fault of its own, have to stop production. To avoid this, some organisations
have a policy of buying the same materials from a number of competing suppliers. They might
use rules of thumb such as ‘never let a manufacturer account for more than 20% of total
revenue; never let a customer absorb more than 50% of total resources’.3 The choice must
depend on individual circumstances, but we can list some advantages of policy:
● Advantages of single sourcing:
●
●
●
●
●
●
a stronger relationship between customers and suppliers, often formalised in
alliances or partnerships
commitment of all parties to the success of the relationship
economies of scale and price discounts with larger orders
easier communication, reduced administration and simpler procedures for regular orders
less variation in materials and their supply
easier to keep requirements, conditions and so on, confidential.
● Advantages of multi-sourcing:
●
●
●
●
●
●
competition between suppliers reduces prices
there is less chance of disrupted supplies, as problems can be avoided by switching
suppliers
can deal more easily with varying demands
involving more organisations can give access to wider knowledge and information
is more likely to encourage innovation and improvement
does not rely on trusting one external organisation.
Organisations use more suppliers when they want to avoid potential problems. Another
way of doing this uses forward buying. In its simplest form, this happens when an organisation orders more materials than it currently needs and keeps the excess in stock. Another form
uses contracts to deliver materials at specific points in the future. Both of these bring two
benefits. First, they guarantee supplies for some period in the future and minimise the effect of
possible disruptions. Second, the price of materials is fixed, avoiding the effects of future price
rises or uncertainty. Of course, things can still go wrong. A company that signs a long-term
contract can still go out of business, or a warehouse can burn down, but the chances of a
problem are much smaller. It is probably safest for an organisation to hold spare stock itself,
but this has higher costs; agreeing a contract for future deliveries gives lower costs, but does
not eliminate so much risk (and it is also a poor arrangement when material prices might fall).
Monitoring supplier performance
Most organisations monitor their suppliers to make sure that they continue to give satisfactory
service. This is called supplier rating or vendor rating. Often this is done informally by a
subjective review; sometimes there are complex measures for every aspect of performance. Most
organisations use a compromise that gives a reasonable view of performance, and needs a
reasonable amount of effort. One common approach uses a checklist of important factors and
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checks that the supplier meets an acceptable standard in these. The checklist might ask whether
the supplier is financially sound; whether it delivers on time; if material quality is high enough;
if there is technical support; whether the price is competitive; about relevant trends, and so on.
If the supplier does not meet any criterion the customer has to discuss improvements or look
for new sources. The aim is not really to replace existing suppliers, but to monitor performance,
identify areas that need improving and agree the best way of achieving these improvements.
Only as a last resort should an organisation start looking for new suppliers.
A more useful approach to rating gives the supplier a score for different aspects of performance. They might, for example, give each supplier a score out of ten for on-time delivery, and
if a supplier’s score drifts down below eight the customer can discuss ways of improving
performance. Although this approach sounds convincing, there can be considerable difficulties. How, for example, can you identify the most important factors of supplier performance,
the relative importance of each, the actual performance, and the lowest acceptable performance? Each of these is likely to come from a combination of discussion and agreement, rather
than from more precise measurement. The result is a subjective view that may be useful, but
contains little objective measurement.
L O G I S T I C S
I N P R A C T I C E
Philips Semiconductors, Stadskanaal
Philips Semiconductors’ plant in Stadskanaal, the Netherlands, makes millions of
diodes a year. These are made on an automated assembly line, using just-in-time
operations. Materials (such as glass, wires
and connectors) have to be delivered at
exactly the right time, with any delays
interrupting the process.
Over 65% of the plant’s cost is materials,
and Philips puts exacting demands on its
suppliers. It only tolerates a few defects per
million parts, and typically demands
decreases in price of 7% a year. To monitor
supplier performance, Philips introduced a
Supplier Rating System which measures five
criteria for 12 main suppliers each month.
The criteria measured are as follows.
Criteria
Performance required
Delivery
performance
99.5% delivered on time, with
average deliveries twice a
week
Quality
less than 3–5 parts per million
defective
Price
expected to fall by 7% a year
Responsiveness supplier feedback within two
hours for critical problems
Audit score
compiled score according to
Philips audit system
This system plays a key role in Philips keeping its leading position in an increasingly
competitive market.
Sources: Philips Semiconductors, Stadskanaal,
Purchasing Annual Report (1998) and Supplier
Rating System, manual (1998)
PROCUREMENT CYCLE
Steps in the cycle
Once it has chosen a supplier, an organisation has to follow some procedure for arranging
purchases. Imagine that you want to buy something expensive, like a new computer. You
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probably approach this in several stages, listing the facilities you want, searching for systems
that can provide these, identifying suppliers, developing a shortlist of options, comparing
these, and choosing the best. Your aim is to find the combination of products and suppliers
that best satisfies your needs. The procurement function in an organisation does exactly the
same, and follows a specified procedure for each purchase. This procedure is different in every
organisation, and varies with the type of thing being purchased. You would not expect an
organisation such as the US army, which buys millions of items a day, to work in the same
way as the directors of Real Madrid football club when they acquire a new striker. And the
US army would not approach its decision to buy pencils in the same way as its decision to
buy helicopters.
Despite these inevitable differences in detail, we can suggest a general approach to procurement. This has a series of common steps, which start with a user identifying a need for materials and end when the materials are delivered. Figure 9.2 shows an outline of these steps,
while a more detailed view of a typical procurement cycle has the following steps (with key
documents in bold).
1.
A user department:
identifies a need for purchased materials
examines materials available and prepares specifications
checks departmental budgets and gets clearance to purchase
prepares and sends a purchase request to procurement.
●
●
●
●
2.
Then procurement:
● receive, verify and check the purchase request
● examine the material requested, looking at current stocks, alternative products,
production options, and so on – and after discussions with the user department
confirm the decision to purchase
User department
Procurement
Suppliers
1. Identify need
Requests purchase
2. receive request
process
request quotations
3. receive request
process
4. receive quotation
discuss
send quotation
discuss and process
send purchase order
5. receive order
process
6. receive and check
7. receive and check
authorise payment
ship goods and
invoice
transfer
8. arrange payment
Figure 9.2 Outline of steps in a procurement cycle
receive payment
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make a shortlist of possible suppliers, from regular suppliers, lists of preferred
suppliers, or those known to meet requirements
● send a request for quotations to this shortlist.
●
3.
Then each supplier:
examines the request for quotations
checks the customer’s status, credit, and so on
sees how it could best satisfy the order
sends a quotation back to the organisation, giving details of products, prices and
conditions.
●
●
●
●
4.
5.
Then procurement:
● examine the quotations and do commercial evaluations
● discuss technical aspects with the user department
● check budget details and clearance to purchase
● choose the best supplier, based on the details supplied
● discuss, negotiate and finalise terms and conditions with the supplier
● issue a purchase order for the materials (with terms and conditions attached).
Then the chosen supplier:
receives, acknowledges and processes the purchase order
organises all operations needed to supply the materials
ships materials together with a shipping advice
sends an invoice.
●
●
●
●
6.
Then procurement:
● acknowledge receipt
● do any necessary follow-up and expediting
● receive, inspect and accept the materials
● notify the user department of materials received.
7.
Then the user department:
● receives and checks the materials
● authorises transfer from budgets
● updates inventory records
● uses the materials as needed.
8.
Then procurement:
● arrange payment of the supplier’s invoice.
The first three steps sort out the materials and supplier, and then comes the crucial point
with the issue of a purchase order in step 4. At this point the organisation agrees to buy specified materials from a supplier, and the purchase order triggers the supply (along with necessary
production planning, transport arrangements, finance, and so on). The purchase order is part
of a legal contract between the organisation and its supplier. The remaining steps finalise the
details of delivery.
This procedure seems complicated, and involves many steps and documents. If you are
buying something expensive, this effort is certainly worthwhile – and you may actually follow a
much more complicated procedure to fix product specifications, select the supplier and negotiate terms. But if you are making small purchases, if there are existing relationships with
suppliers, or there is only one qualified supplier, it is clearly not worth going through this whole
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expensive, procedure. Then you will look for more routine methods. For these, a rule of thumb
suggests £80 as the cost of processing a basic, simple order, while Allen quotes figures of $115 to
$150.4 Even this is too expensive for very low value items, where the procurement would cost
more than the materials. Then you will look for even simpler, automatic or ad hoc procedures.
Apart from its cost, another problem with the formal procurement procedure is the time
that it takes. It is too slow to make quick purchases. Paul Sigarro buys material to make
designer dresses for l’Haute Vision in Stockholm, and found that a delivery of materials typically took one day to arrive from the supplier in Nice, but organising this delivery often took
five weeks.5 This supports an earlier survey in the USA6 which found the following average
times for processing orders at manufacturers.
Part of procurement
From customer placing order, to supplier receiving it
Average days
1.9
From supplier receiving order, to finishing administration
2.1
From finishing administration, to shipping order
2.2
From supplier shipping order, to customer receiving it
4.1
Total
10.3
Using a traditional, paper-based system took an average of 10.3 days for a customer to get
