Summit Business - Reaching the Top

Chapter 2: The Fundamentals of Procurement

Now that you have completed the first part of the Summit Business Module, covering the fundamentals of production, you will learn about procurement in the second part of the course.

Procurement or sourcing is the process of acquiring goods or services from external sources. At the end of this chapter, you will know the fundamentals of procurement, including the procurement process, supplier selection, and various sourcing strategies.

1. Procurement Goods

Various types of materials or goods and services are used in business operations. Procurement involves the process of acquiring the following goods needed to support operations.

Raw materials

Raw materials are the basic, unprocessed substances a company needs to manufacture its products. Typical examples of raw materials are cotton for textile manufacturing, crude oil for fuel production, wood for building furniture, and milk for cheese production. They form the primary input for the production process.

Auxilary Materials

Auxiliary materials are secondary materials used in the production process to support manufacturing, such as lubricants for machinery and welding rods for assembling metal parts, as well as the service of cleaning agents in a company.

Operating supplies

Operating supplies are items needed for general business operations and maintenance that are not directly linked to production. For example, office equipment, maintenance tools, and safety equipment. These are necessities to enable the smooth functioning of daily business operations.

Merchandising

Merchandising refers to finished goods acquired for resale to customers without further processing, such as clothes sold by retail stores, food in supermarkets, or electronics sold by distributors. Merchandising generates revenue through direct sales.

2. The Procurement Process

Every organization, whether it is a manufacturer, wholesaler, or retailer buys materials, services, and supplies to support their operations. Traditionally, purchasing has mainly focused on price. Many goods, and services are complex and even the most basic commodity item may have an element of service associated with the procurement and the delivery of it. Imagine you buy a car, it will drive to other costs, such as maintenance, service, and repair costs. This is why it is important not to confuse price with the total cost or “whole lifecycle cost” (the total expense of owning an asset over its entire life, from purchase to disposal – including purchase price, delivery and installation operating and maintenance costs, etc.). As a result, procurement has been elevated to a strategic activity, focused on total cost and the development of relationships between buyers and sellers.

Difference Between Purchasing and Procurement:
Although the terms "purchasing" and "procurement" are often used interchangeably, they represent distinct aspects of the procurement process. Purchasing refers to the operational activities involved in acquiring goods or services, while procurement encompasses the broader, strategic process that aligns these activities with organizational goals. (Bowersox, 2013, p.79)

Value for money (“VfM”) is a principle used in the procurement process to ensure that resources are utilized efficiently, effectively, and economically. It compares the costs and benefits of different options to determine which provides the best value for a company. To identify the VfM, quantify all benefits - both tangible and intangible, and then divide them with all direct and indirect costs over the lifecycle of the product.

Exercise: A company is considering investing in a new software system to increase efficiency. The software is offered at an initial price of $50,000 with an annual maintenance cost of $5,000 for the next 3 years. The software will save $30,000 in total labor costs and increase productivity worth $15,000 per year. What is the VfM, and should the company buy the new software?

The procurement process describes all steps related to the strategic planning and the purchase of goods. In its entity, it is a very long and complex process. You will get to know the key aspects of the procurement process in this chapter. The goal of procuring is to provide the company with all the goods and services it needs in the long and short term while making this process as efficient as possible. An optimal procurement process ensures that the right goods are in the right place at the right time, quantity, quality, and price. (Mangan & Lalwani, 2016, p.153, Bozarth & Handfield, 2016, p.209-225)

1. Requirements Determination

Identify the goods or services required
Define the quantity, quality, and specifications
Ensure alignment with budget and operational needs

2. Market Research

Analyze the market for available options and trends
Identify potential suppliers and evaluate their capabilities
Gather data on pricing, quality, and delivery timelines

3. Supplier Selection

Evaluate potential suppliers based on criteria like cost, quality, reliability, and reputation (see chapter 3)
Negotiate terms and finalize contracts with the chosen supplier

4. Ordering

Issue a purchase order (“PO”) that authorizes the supplier to deliver a product or service and outlines the agreed terms, quantities, and delivery timelines
Confirm the order details with the supplier to avoid misunderstandings

5. Goods receipt

Inspect the delivered goods or services to ensure they meet the specified requirements
Document any discrepancies, damages, or shortages
Record receipts for tracking and inventory purposes

6. Invoice Verification

Match the supplier's invoice with the purchase order and delivery documents
Verify the accuracy of pricing, quantities, payment terms
Approve the invoice for payment

7. Maintain Business Relationship

Treat suppliers as strategic partners
Build trust through reliability and commitment to ensure that both parties derive maximum value (see chapter 4)

3. Supplier Selection and Evaluation

Selecting the most suitable supplier for a good or service is a difficult task, considering multiple factors, for example, cost, delivery rates, management stability, and trustworthiness. The selection process requires good judgement, backed up with great efforts and statistical data. Some of the main criteria for choosing suppliers are:

Watch the following video to gain a deeper insight into the topic and take a look at the linked sample of a supplier questionnaire:

Sample Supplier Questionnaire

4. Supplier Development & Relationship Management

Supplier Development or Supplier Relationship Management (“SRM”) is a strategic approach, that aims to nurture and improve the relationship between an organization and its suppliers, ensuring that both parties benefit from the relationship. Relationships with suppliers are usually seen as long-term investments. As you have learned in the previous chapter, supplier selection is an important part of the procurement process. (Lambert, DM 2008)

1. Supplier Categorization: Once the suppliers are identified, they can be categorized based on their strategic importance, for example, the value they provide (see Chapter 7, Kraljic Matrix). This helps determine appropriate supplier management strategies.

2. Success Definition: An organization must define clear and measurable Key Performance Indicators (“KPIs”) that align with their goals, covering quality, delivery, cost, innovation, and sustainability.

KPI example: A supplier’s on-time delivery rate (OTD) measures the percentage of orders that suppliers deliver on time, according to the agreed delivery schedule.

3. Monitoring and Assessment: Based on these KPIs the company will regularly assess their supplier's performance to ensure smooth cooperation.

4. Collaboration: Working closely with suppliers can drive innovation, improve processes, and reduce costs.

5. Risk Management: Identifying potential risks within the supply chain and developing strategies to mitigate them.

6. Feedback and Continuous Improvement: Encouraging suppliers to enhance their performance and quality through feedback, continually monitoring the supplier’s performance, and adjusting procurement strategy if necessary.

Benefits of effective SRM:

Reduced costs: SRM identifies cost-saving opportunities through better negotiation, reduced transaction costs, and improved efficiencies
Better managed risks: Reduced risks by proactive SRM management, they can be identified in advance and managed cooperatively
Enhanced supplier responsiveness: Good SRM encourages higher responsiveness from the supplier and better communication
Improved visibility: You may receive more detailed information about your order or the supplier.
Use of supplier’s full capabilities: The supplier may provide other values; you might take advantage of in the long term.

Effective supplier management requires well-trained managers with a high skill set, such as communication, negotiation and conflict resolution techniques, and risk or crisis management. Knowing possible supply chain disruptions and unpredictable market changes is crucial to efficient supplier development. (Ideson, P 2024, Art of Procurement)

5. Single, Multiple, and Multiple Sourcing

An essential component of supplier management is deciding how many suppliers to engage for a specific good or service.

In single sourcing, a company relies on one supplier for nearly all its needs for a particular item. Conversely, in multiple sourcing, the business is distributed among several suppliers.

To address the challenges of choosing between single and multiple sourcing, companies often adopt a middle-ground approach called cross-sourcing. With this strategy, a company uses one supplier for a specific product or service and another supplier with similar capabilities for a related product or service. New business is allocated based on each supplier's performance, incentivizing continuous improvement while maintaining a backup option in case the primary supplier falls short.

Another strategy is dual sourcing, where two suppliers are engaged for the same product or service. Typically, the business is split, with 70% for Supplier A and 30% for Supplier B. This arrangement motivates Supplier A to maintain high performance to retain its larger share, while Supplier B remains a viable alternative. Dual sourcing strikes a balance between the cost and efficiency benefits of single sourcing and the risk mitigation advantages of multiple or cross-sourcing strategies. (Bozarth & Handfield, 2016, p.219)

These different approaches come with advantages and disadvantages that need to be considered to find the best solution to meet a business's needs:

6. Procurement Strategies

Just-in-Time

As you have already learned in the Fundamentals of Production part of the module, the expense of holding inventory is a significant cost businesses aim to avoid. It does not only pose risks of obsolescence and damage but also necessitates the construction and maintenance of expensive warehouses. To mitigate these costs, many companies have adopted the just-in-time (“JIT”) inventory control system. JIT minimizes on-site inventory by procuring supplies just in time for assembly line use, ensuring that materials are available at the right place exactly when needed. For JIT to function effectively, it requires a precise schedule (e.g., through MRP) and strong coordination with reliable, carefully chosen suppliers. While JIT carries risks, such as delays in shipments or other supply chain disruptions, it is an effective procurement strategy that reduces warehousing costs and aligns with the philosophy of lean manufacturing. (Nickels, McHugh, and McHugh, p.249)

Make-or-Buy Decision

Businesses often struggle with the decision of whether to handle the production of a product or service internally (insourcing) or delegate it to an external supply chain partner (outsourcing). Choosing to outsource is a strategic choice that involves addressing several considerations, such as:

What are the pros and cons of outsourcing?
Are suppliers meeting our needs?
How many suppliers should be used?

Businesses must consider the costs associated with the make-or-buy decision. Therefore, managers execute a total cost analysis, to identify and quantify all of the major costs associated with their sourcing options, to find the most efficient solution. The costs are often divided into direct costs (e.g., material, labor, or freight costs) and indirect costs (e.g., supervision and maintenance costs, utilities, and quality control). In the analysis, all insourcing costs are compared with all outsourcing costs, to make a justified make-or-buy decision. (Bozarth & Handfield, 2016, pp. 215)

Example of a simplified Total Cost Analysis:

Although Company X is capable of producing a part needed in their production process, their supplier Y offered the supply of that specific item. The management of X compares all costs to make a grounded make-or-buy decision.

Global Sourcing

In today's globalized world, many businesses operate on an international scale. Globalization has fostered international trade, enabling companies to sell products abroad ("export") and source goods from foreign suppliers ("import"). Businesses expand globally to benefit from lower costs, access new markets, secure dependable supply chains, and stay informed about emerging trends and technologies. The World Trade Organization (WTO) has played a key role in opening previously protected industries, such as agriculture, textiles, and raw, scarce materials, to international competition. (Russel and Taylor, 2009, p.9)

Global Sourcing is a strategic approach to procuring goods, services, or raw materials from suppliers located in different parts of the world. Many firms now outsource routine business processes such as call centers and IT processing to lower-cost countries. The decision of whether or not to procure globally requires businesses to balance cost, performance, and risk factors. (Bozarth and Handfield, 2016, p.205; Slack and Brandon-Jones, 2019 p. 427)

Challenges and Opportunities of Global Sourcing:

7. Procurement Controlling

Procurement controlling aims to ensure that procurement activities align with organizational goals and are cost-effective and efficient. Assessing and evaluating suppliers regularly as well as KPIs and benchmarks are powerful instruments used in procurement control.

Key Performance Indicators and Benchmarks

As you have learned in the previous chapter, KPIs (Key Performance Indicators) are important figures and measurements to compare and evaluate suppliers' performances. Benchmarks are the recommended values associated with KPIs, for example, “aim for a 5-15% reduction in procurement costs annually”.

Common Performance Indicators and their Benchmarks:

The Kraljic Matrix

Another tool used to control procurement is the Kraljic Matrix. It categorizes an organization's purchases based on their importance and supply risk. Each quadrant of the matrix requires different strategies and management. Therefore, the Kraljic Matrix helps organizations manage their supplier base, assess supply risks, and determine the appropriate procurement strategy.

Supply risk / Complexity refers to the likelihood of disruption in obtaining the product or service due to factors such as limited suppliers or geopolitical issues. Profit impact means the extent to which the product or service contributes to the organization's profitability.

Leverage items (High Profit Impact, Low Supply Risk) ensure the Value-for-Money is achieved from the most appropriate source. Buyers use their purchasing power to negotiate better prices and terms.
Strategic items (High Profit Impact, High Supply Risk) have complex requirements and limited suppliers. Therefore, the buyer highly depends on the supplier. These items are managed strategically by building strong supplier relationships and investing in these partnerships, as well as preparing contingency plans in case of an interruption.
Non-critical items (Low Profit Impact, Low Supply Risk) are commodities where the source is less important than the continuity of supply. These items are usually available, e.g. office supplies or cleaning services, so buyers focus on efficiency and lowering the purchasing cost.
Bottleneck items (Low Profit Impact, High Supply Risk) have unique and complex requirements that can only be met by a few suppliers, so they must be managed carefully. To reduce risks, buyers must ensure the continuity of supply through long-term contracts and an appropriate relationship with their supplier or by stockpiling. (Mangan & Lalwani, 2016, p.148)

8. Risk Management

A widely reported example of a Supply Chain Disruption:

In 2007, Mattel, the world's largest toy manufacturer, faced a significant crisis by recalling over 21 million toys due to safety concerns. The recalls were primarily due to two major issues: On August 1, 2007, Mattel's subsidiary, Fisher-Price, recalled approximately 1.5 million toys because they were found to have been coated in paint containing excessive levels of lead. Two weeks later Mattel recalled an additional 18 million products because of the possible hazards of children swallowing magnets, which caused an estimated loss of £50 million and affected Mattel’s reputation. Mattel manufactured two-thirds of its toys in China, therefore the recalls highlighted systemic issues with the oversight and quality assurance of outsourcing in Chinese factories. Consequently, Mattel shifted part of its production to company-owned facilities to reduce reliance on Chinese contractors and implemented stricter quality control measures. However, these recalls demonstrate that the safety issues were not solely a global sourcing issue but also tied to Mattel's supplier management and lack of quality control. (Mangan & Lalwani, 2016, p.150)

Possible Supply Chain Risks: (Chopra, 2016, p.158)

Managing Supply Chain Risk:

Many companies are unaware that their suppliers rely on secondary or tertiary suppliers for continuity. Therefore, understanding the complexity of the supply chain is crucial for mitigating and managing risks. It is essential to monitor the performance of immediate suppliers and address any issues they face with their suppliers. Improving the supply chain involves simplifying processes, reducing liabilities, and minimizing complexity. Most supplier relationships develop organically due to their ability to meet demand at lower costs. However, focusing on their reliability is key to minimizing risks.

The supply chain has countless potential risks, so companies must identify and focus on the critical path to ensure supply continuity. The Kraljic Matrix is an effective tool for categorizing suppliers and identifying the critical path. Once the critical path is identified, a company can use Cause-and-Effect Analysis to understand the root causes of problems by asking "why" five times to delve deeply into the issue.

Many supply chains suffer from limited visibility, which can delay the detection of problems, making timely resolution difficult. A control tower is a technology-driven solution that consolidates and analyzes data from various sources across the supply chain, providing a comprehensive, real-time view of operations. This integration of information from suppliers, manufacturers, distributors, and customers enhances visibility at every stage of the supply chain.

Establishing a supply chain continuity team can bolster the resilience and agility of the supply chain, ensuring minimal disruption to operations and maintaining customer satisfaction during unforeseen events. The team’s primary responsibilities include risk assessment, planning, monitoring supply chain activities, and communicating with suppliers.

Lastly, fostering collaboration with suppliers and customers helps develop a deeper understanding of potential risks, enabling more effective risk management. (Christopher, 2016, pp.224)

Example of a Cause-and-Effect Analysis:

test your knowledge: Quiz on Production and Procurement

You have reached the end of the Fundamentals of Procurement chapter and successfully completed the second part of Summit Businesses' Introduction to Business module. Along the way, you gained an understanding of what procurement is, explored the steps in the procurement process, and learned about various sourcing strategies and criteria for choosing the right supplier. You also uncovered common procurement risks and strategies to manage them effectively.

continue with the next chapter: Marketing