DMM-9

COURSE - I
PURCHASING MANAGEMENT
SYLLABUS

LESSON -1

Purchasing functions as a sub system of the integrated Materials

Management -Objectives and scope of Purchasing -Role of Purchase
Managers -Organisation for Purchasing.

LESSON -2

Concept of Right Quality -Determination and description of quality

-Methods of description.

LESSON -3

Concept of right source -Source of information of potential

suppliers -Need for evaluation-Different methods of evaluation
Categorical method -Weight point method -Cost ratio method
-Illustrative problems.

LESSON -4

Concept of right Price -Price analysis Tendering systems -Different

methods of tendering.

LESSON -5

Pricing tools -breakeven analysis -Learning curve -Illustrative

Problems.

LESSON -6

Purchasing under fluctuating prices-optimal strategy-examples.

LESSON -7

Concept of right time -Buying policies -Hand to mouth buying

-Forward buying -Average cost buying-speculative buying.

LESSON -8

Buying

practices

in

fluctuating

markets

volume

timing

of

purchasing -Rupees budgeting-concept of Hedging illustrative

examples.
LESSON -9

Purchasing

under

uncertainty-Statistical

criteria-Illustrative

examples.
LESSON-10

Creative purchasing-Negotiations in purchasing- purchase budget

-Bill market system -Insurance.

LESSON-11

Make of buy decisions Influencing factors-use of Breakeven

analysis -Role of Pert in make/buy decisions illustrative problems.

LESSON-12

Value

analysis

-Importance

as

a cost

reduction technique-

application Practical cases or examples.

LESSON-13

International purchasing -Import orders - Payment through" LC

and Foreign currency -Foreign exchange regulations.

LESSON-14

Legal aspects of purchasing-Law of agency-law of contact-Break of

contract -Sale of goods act.

LESSON-15

Buyer-Seller relationship and ethics Evaluation of purchasing

performance-Methods of performance appraisal-various indices of

performance appraisal.

1
LESSON 1

PURCHASING FUNCTION
OBJECTIVES
1. To know about materials management
2. To know the scope of Materials management
3. To know the objectives and scope of purchasing
4. To know the Role of purchase manager
5. To know about organizational structure for purchasing
CONTENT
1.0 Introduction
1.1

Materials Management An introduction

1.2

Objectives of Materials management

1.3

Scope of materials management

1.4

Objectives of Purchasing

1.5

Scope of Purchasing

1.6

Role of purchase Manager

1.7

Organisation for Purchasing

1.8

Revision Points

1.9

Intext Questions

1.10 Summary
1.11 Terminal Exercises
1.12 Suggested Reading/Reference Books/Set Books
1.13 Key words
1.0 INTRODUCTION
Materials Management was recognised during the World Wars and its utmost
importance was very keenly felt in the defense and military operations. The concepts
of planning, sequencing, programming, production, inspection, storage, transport
and delivery were very carefully thought of and an awareness was created.
Consequent to such a need for proper supply of materials, equipment, spare parts
etc. the total Materials Management was evolved. The Materials Management

embraces in its field, essentially the material planning till its end use, like the
concept of 'cradle to cremation'. Therefore, in its sphere, material planning,
procurement, inspection. Transport, storage issue and accounting etc. are all
covered.
The Material Management therefore is grouped broadly as under:
Material planning, indenting, budgeting, material proerurement, purchase and
delivery, inspection, storage, preservation, stock verification, material accountingnumerical and value, bills, payments.
Further for the purpose of studies and in-depth knowledge, it could be
classified as below:
-Material planning and control
-Purchase management
-Stores management
Purchase management is the key area of the materials management. It is
looked up very critically by the management of the Company/Organisation, as it is
this area wherein about 60 to 70% of the company's finances are ploughed. In fact in
many companies, public enterprises, State enterprises. This area is very critically
and closely followed and monitored. The Purchase Management has to face lot of
opposing divergent forces from different internal departments like production, stores
and finance but yet to show good results. Great amount of skill, strategy are needed
in this vital department so that it serves all these internal departments without any
friction or production loss. Again it is this part which faces the suppliers and
expected

to

solve

their

problems

carefully

maintaining

good

rapport

and

relationship. It is also a public relation job. It is so critica1 and sensitive area as it is

always under the close watch of the top management audit section and vigilance
section. Against all the controls and critical review Purchase Management has to
function and fulfill all its end objective in the interest of the Company and achieve
the targets/goals set by the management. Therefore, it can be easily understand as
to how important the purchase management is.
One of the basic functions of any management is to employ its capital efficiently
so that maximum return on it is obtained. Materials Management is a body of
knowledge which helps the Manager of the Company to improve its productivity of
capital by reducing material cost, preventing large amount of capital being locked up
for longer periods, reducing inventory and improving the capital turn over ratio. Lots
of techniques were evolved during Second World War and now those are fully

followed in the industries. Within the ambit of materials management, the Purchase
Management is one of the basic functions and forms a major part of it. The moment
the purchaser places an order he commits a substantial part of the funds of the
Company thereby working capital and cash flow are to be regulated. The purchase
department is associated with commercial and finance departments, closely tied up
with purchase actions. If purchase commitments are chosen wrongly, the Company
may end up with losses and even turn out to be its burial. Proper policy of the
company on the purchase are to be formulated and then goals/objectives of the
purchase department duly drawn out with reference to the company's end product,
its acceptability in the market. Carefully drawn out procedures, policy and deploying
the right Executive in the purchase department shall prove to be a most successful
organisation.
1.1 MATERIALS MANAGEMENT AN INTRODUCTION
Materials management a comparatively new concept at has now been
recognised as a part of the total management of any Company in order to achieve
best results and best return on investments. Terms such as purchasing, storing,
transport, preservation, legalistic supports known in a very elementary and vague
manner have all now being accepted as a major element that plays a key and vital
role in the' integrated Materials Management. Like advanced countries of the west
Japan in the east who have made giant strides in the successful use of material
management techniques, India has also emerged as one to adopt such techniques.
Indian Institute of Materials Management and its functions are similar to American
Materials Management Association and Japan Materials Management Association.
The Material Management in a fast developing country like India is quite unique and
with peculiar problems of its own. Materials are the largest single expenditure in any
Company and the other areas of expenditures are establishment including salaries,
allowances, perks, traveling, contribution to pension fund, leave travel concessions,
bonus, incentive, extratia payments expenditure due to auditing, payments to
statutes etc. While the materials account for 60 to 70% of the sale in value of the
product, the others shall range between 30 to 40% only. It will be very difficult to
make any change or alternatives in the area other than materials as all these involve
human and industrial relations point which is very sensitive as men speak and
claim

their

rights

while

machines/materials

do

not

speak.

Under

these

circumstances changes/savings are always needed on the material side. A small

change in materials cost can result in large sum of money saved. Materials
Management is therefore considered as a function of prime importance for any
industry and its economy. The importance of materials management very much lies
in the fact that any significant contribution made by the materials manager in

reducing the cost of the material will go a long way in improving the profitability and
the rate of return on the investment.
Materials management offers a wide scope for reducing costs, savings in foreign
exchange, conserving scarce raw materials. Improving productivity and increasing
profits. It will be much easier to reduce the materials cost than the cost in the other
areas as narrated above as materials cost predominate in the total cost of a product.
1.2 OBJECTIVES OF MATERIALS MANAGEMENT
a.

Maintaining continuity and steady uninterrupted production, operations by

ensuring a uniform/ desired flow of materials, spares, consumables,
bought-outs, semi finished products of high/ desired quality.

b.

Reducing cost of such materials by use of scientific methods, techniques,

tools etc.

c.

Purchasing the right quality, right quantity at a light price from a right
source and at right delivery.

d.

Releasing of working capital for productive purposes by efficiently and

effectively controlling the inventory.

e.

Savings in foreign exchange through most economic use of imported

purchases and import substitutes by a proper indigenisation.

f.

Establishing a good buyer-seller relationship.

g.

Keeping the departmental charges as low as possible by high efficiency.

h.

Setting high ethical standards.

1.3 SCOPE OF MATERIALS MANAGEMENT

The scope of integrated Materials Management shall indude:
Material planning, budgeting
Purchasing stores, inventory control
Material handling, dispatch, shipping and disposal
Stock verification and accounting
In addition, Materials Management as a function in the total overall
management is responsible for the planning, sourcing. Purchasing, transporting,
handling, staling, controlling, co-ordination with other inter departments in an
efficient manner as to provide the agreed service to the inter departments at a least
cost. It could therefore be grouped broadly as:

(i)

Materials planning and control: Materials planning and control are action
based on sales forecast and production planning. This involves estimating
the individual requirements of parts, preparing material budget, forecasting
in the level of inventories, scheduling the orders, monitoring, follow up and
expediting.

(ii)

Purchasing: Includes selection of supply sources, finallisation of terms and

conditions, specification for the purchase, placement of orders, follow up,
maintenance of smooth reactions with the suppliers, payment to suppliers
evaluation and rating of suppliers.

(iii) Stores and inventory control: include receipt, storage, preservation and
issue

of

materials,

accounting,

efficient

handling,

declaring

surplus/unserviceable materials, keeping stores records. Inventory Control

covers all aspects of maxima/minima -Recorder level. ABC analysis,
economic order quantity -setting safety stocks, lead-time analysis and
reporting.
(iv) Materials

accounting,

finance,

budget

and

Management

reports:

Integrated materials management has the advantage of better accountability,

better co-ordination better performance as it has in its fold all the sections,
interfacing of various activities of the materials from planning stage till their
use and end product.
1.4 OBJECTIVES OF PURCHASING
As discussed earlier, purchasing is one of the important and basic functions of
the integrated materials management. It involves many decisions on what to buy,
when to buy, what quantity, what specification, where to buy, how much to buy, how
much to pay and how much to stock. Therefore, it naturally involves many creative
functions such as development of new sources, introducing new materials, import
substitution. In the process, it further involves in variety reduction, standaridsation
and value analysis. Therefore, To meet all the above functions. It needs considerable
expertise not only in skills and negotiating, but also in the mechanics of
competitiveness. A very close study of the materials available, new materials
developed due to advancement of science and technology, research thereon,
economic trend are required and are to be closely watched to take the best
advantage in the purchase.

By placing supply/purchase orders, the purchase

department makes a commitment legally to supplier towards accepting the materials

if found technically acceptable and make payment at the agreed rate and at the
terms of payment agreed upon. Therefore, it is a spending function and therefore will
be watched critically as every Rupee saved shall naturally go to add the profit. Being

such a delicate/sensitive area and job, person of very high caliber, integrity, honesty,
determined to save the Company funds, high quality, character beyond any
temptation shall be entrusted with this function.
Every organisation or company, be it a public sector enterprise, state sector
enterprise, private sector, partnership firm or family concern of any industry such
as agricultural, power, chemicals, textiles, agro, heavy machineries, roadways,
telephones, rubber etc. needs raw materials of some kind/variety or other,
depending upon the plant/factory design and end product, consumables like
building materials, timber, paints and varnishes, oils, lubricants, petrol, hardware,
steel, structurals etc., tools, spare parts as needed for the machineries installed,
supplies and services of others. Services from others are needed as no single
company can make all the products due to its own economies, skills, technologies
etc. Procurement of articles is therefore a basic need for every company and its
timely and scientific action shall meet the objectives of the Company.
The objectives of purchasing can be stated as below:
to maintain continuity of production,
to contribute to the competitiveness of the end product.
to contribute towards higher productivity.

to buy the best material.

to reduce the cost of the end products

to improve the quality of the end product.

to eliminate extra material cost.

to contribute towards standardization, variety reduction.

to increase profit of the company

to maintain good relationship and understanding with the inter
departments like planning, production, sales and finance not sacrificing
the scope and objective and importance of the Purchase department.
to maintain good rapport with the suppliers.
to maintain good and cordial relationship with the statutory /taxation
authorities.

to avoid any dispute, legal action.

to feed back informations and data on the performance of the
firm/company.

Therefore, the objective of the purchasing as mentioned above, is rather very

extensive and needs very careful and close approach by the Executives engaged in
the Purchase department so that these objectives are met with.
1.5 SCOPE OF PURCHASING
material specification, quantity required with complete technical data,
drawings in support and complete and correct description.
Purchase requisition -Preparation & Forwarding.

Procurement methods and procedures.

Negotiations if need be.

Technical and commercial analysis of the offers/bids selection of the
supplier.
Placement, of purchase/supply order.
Follow up, expediting, stage inspection approval for shop drawings
quality control during manufacture.
Test reports, insurance, transport arrangements.
Receipt, inspection, preservation, storage.
Rejections, discrepancies.
Bills payments, invoices.
Completion of the supply order, report to management.
The above can be broadly grouped as under:
Pre-purchase activities/systems.
Purchase activities/system.
Post-purchase activities/systems.
All these aspects are discussed in the subsequent paragraphs.
1.5.1 Material Planning
Material planning is the basic first step towards purchase. It is generally
carried out by the Engineering department. Depending upon the company's end
product and the forecast by the Sales department production targets are set by the
management. This process is carried out on an annual basis at a joint meeting of
the heads of the various departments like Sales, Production, Planning, Purchase,
Finance and Marketing. On the basis of market studies, demand, competition by
other similar agencies. Sales department fixes its own sales targets. But such a

target will be discussed jointly by all the heads of various departments specifying
their portion as well as their inputs needed. For example, the production head may
say that machines are of such condition that they cannot deliver beyond certain
quantity per day or per month.

Finance department may say that the function

position is such that to meet the sales target envisaged by the Sales department,
they may need to borrow or float shares or over draft from Banks and so on. On the
basis of the viewpoints by various departments in their function, a reasonable target
is fixed which is achievable, marketable and fetch returns and profits.
On the basis of the target fixed materials of various items, spare parts
consumable, tools are prepared based on engineering norms or standards or on the
basis of observed data or earlier experience. These are listed out on the basis of the
codification of materials. Such a list will show details as under: Description of the material, total quantity required Quantity on time basis like
monthly, quarterly based on the production schedule and storage position, technical
specification of the material required, supported by drawings, if any.
Such a list is sent to Material Controller, who in turn raises the demand on the
purchase department. While sending the list, The Material Controller takes into
account the stock on hand, goods in transit. The Material Controller converts such a
list into a Purchase requisition to the Purchase department. Upto this activity it can
be said as Pre-purchase.
SALES

PRODUCTION

FINANCE

FORECASTS
CAPACITY OF THE
MACHINES

FUNDS
AVAILABILITY
(BUDGET)

DISCUSSION

TARGETS FIXED

STOCK
INCOMING
GOODS
MATERIAL
PLANNING
FINALISED

ITEM QTY

MATERIAL
PLANNING

1.5.2 Make/Buy Decision -Economies

On the basis of the material planning any remanufacturing company has to
decide one of the followings based on various factors:
Whether the goods are to be purchased from the open market.
Whether some parts or components can be purchased from the open
market and the balance manufactured in the factory or plant of its own.
Whether the goods are to be manufactured in the factory or plant itself
completely.
However, it may be extremely impossible in real practice to manufacture the
goods completely and totally in its own factory/plant. There are many issues
involved in the decision to make or buy. Some firms, with small addition of
machinery and capital investment can make some parts/components and in many
cases, it cannot produce them without additional installation of equipment at an
expensive capital investment. Then it calls for investment analysis.
(i) Factors in favour of making it in the plant itself
Less cost than purchasing it.
Additional/ spare capacity of the plant available.
Skill/Labour available to spare.
Particular technical process know-how.
Close quality control, quantity needs.
Design secrecy which cannot be parted with.
(ii) Factors in favour of buying it from market.
Less cost than manufacturing it in the plant.
A Ready availability in the market, thereby reduction in procurement
lead-time.
Special skill and technical' know-how available only with the suppliers.
Quantity may be small and it may not be economical to manufacture it.
Reliable and dependable sources are available.
Economic consideration shall be made in respect of cost of each element
in the process and best decision to be taken either to buy or make it.

10

1.5.3 Purchase Activities

Each company management shall prepare a purchase manual which shall
inscribe in detail the procedure to be followed in respect of purchase of
consumables, spare parts, materials, raw materials, capital goods, replacements etc.
The procedure shall also lay down inventory norms, control measures, delegation of

11

powers, tendering methods or evaluation process, procedure and selection of the

source, placement of order, follow up, transport, taxes & duties, receipt of goods,
inspection, acceptance and payments. It will also contain the general conditions
under which the purchases are to be made, in respect of transport Taxes, duties,
insurance etc. These terms and conditions shall be generally followed by the
Purchase department. This Purchase Manual shall be the guidelines on the
purchases by the management.
Generally purchases of any item are affected on the basis of anyone of the
following:
i.

Global Tender or Internatioanl Competitive Bidding (ICB)

ii.

Advertised tender or Domestic

iii.

Competitive Bidding (DCB)

iv.

Limited Tender Enquiry (LTE)

v.

Single Tender

vi.

DGS & D. Rate Contract

vii.

Repeat Order

viii.

Negotiation

ix.

Local purchase

The mode of tender enquiry depends upon the item to be procured, its
estimated value, quantity, time at which it is required, availability in the market etc.
However,

in

any

method

adopted,

there

is

necessity

to

have

detailed

supply/purchase order issued.

(i)

Global Tender or International Competitive Bidding is resorted to, in the

case of items/materials not indigenously available, but available abroad
only and therefore to be imported. Besides terms and condition currency
in which payment will be made, any credit availability, foreign exchange
release, import-export policy public notification, customs duties have to be
spelt out in the enquiry. Local taxes, shipping arrangements, insurer's
name, Letter of Credit, price basis with suitable formula for price variation
to take care of escalation have to be clearly indicated in the tender enquiry.

(ii)

Press/Advertised tender is resorted to generally if the value, quality,

sources available are more and to draw competition by many bidders
participating in the tender. The Press Tender Enquiry shall consist of
technical specification drawings, quantity required, and delivery schedule,
Taxes & duties payable, payment terms and its conditions, guarantee on

12

performance and time, liquidated damages clause if any delay is caused,

Time extension, force majeure, excise duties, sales tax, octroi and such
other duties imposed from time to time by Governments transport
methods, conditions, payment, insurance aspects, risks to be covered and
payment for such charges as premium. The enquiry shall also include
inspection methods and procedure and quality standards. Both in the case
of Global Tender as well as Press Tender, press advertisement shall be
issued broadly indicating the scope of work, quantity to be supplied,
tender schedules availability etc. price due date of submission of the offers,
date and time of opening of the offers/bids. Generally these tender
documents are priced. In the case of Global Tender inviting competitive
offers from different countries abroad, it is a condition that the tender
documents are made available in the Embassy of the country in India and
Indian Embassy in other countries to enable wide publicity. Sufficient time
must also be given to prepare the tender proposals and bid submission.
(iii) Limited Tender Enquiry is resorted to where the quantity of the material
required is not considerable and is needed urgently. The tender documents
as per press tender needs are prepared and sent to the list of
suppliers/vendors in the approved list.

The time for submission and

opening of the tenders can be kept less as this type of tendering is resorted
to only standard products.

For this method, there should be a list of

suppliers whose performance rating has been assessed and such suppliers
listed for that item.
(iv) Single Tender enquiry is resorted to in the case of items which are
proprietary nature and there is only one source available for this item. For
example for Petrol, Diesel, Steel etc. generally the tender enquiry shall
contain all the clauses. Terms and conditions except Liquidated Damages
clause.
(v)

D.G.S. & D (Director General of Supplies & Disposals) concludes contracts

for common items like furniture, tools, A.C. units, refrigerators, fans,
certain electrical goods and rates/prices and payment terms are fixed up
on an annual basis. A rate contract for a particular item is thus fixed up
and published. Such a publication contains the items, Sources and
rate/price. On the basis of this rate contract. Supply order can be placed
for the item coming under the purview of rate contract. This method will
reduce the lead time for purchase and purchase can be done very quickly
as much part of the work like tender enquiry evaluation selection of the

13

suppliers sources are already prepared and kept ready under Rate
Contract (RC).
(vi) Repeat Order is resorted to in case there is already a supply order which is
under execution and suddenly a demand is received for the same item. In
such cases in the same current order the quantity is increased by a Repeat
Order while all other terms and conditions including prices are same.
Except the quantity. This type will help and vasten the supply.
(vii) Negotiations: For very urgent requirements for any item, a known, reliable
and dependable firm is called for negotiations on price, terms and
conditions and supply order issued after due agreement on all the issues.
Care must be exercised in selecting the firm in this case to avoid any
failure.
(viii) Local Purchase For emergency needs, purchases are made locally in the
market without resorting to any tendering procedure, this will be on the
basis of 'cash and carry' but involves risk as rates are not obtained on
competitive basis and no guarantees are made.
Under any system of tendering, the bids/offers submitted in due stipulated
time are opened in the presence of those bidders or their representatives and
important technical and commercial parameters are openly read out. Care should be
taken to see that no discussions are encouraged, as it is not 'negotiation' but only
'tender opening', Proper records and documentations are carried out so that any
bidder raises any issue, it can be duly answered.
A Tender Committee will examine all the offers, facts, technical suitability and
evaluate them taking into account all costs involved in getting the material to the
stores of the firm, Generally lowest technically suitable offer is recommended for
purchase and in few cases it could be negotiated also, On the basis of the Tender
Committee's recommendations and with the approval of the competent authority
delegated with such powers, supply /purchase order is placed.
1.5.4 Supply/ Purchase Order
A

supply/purchase

order

is

prepared

on

the

basis

of

tender

specifications/documents, offers, points negotiated and agreed upon and on the

basis of the agreed tends and conditions including price. It is a very important
document

as

it

makes

lot

of

commitments

on

both

sides,

namely

supplier/purchaser. The obligations on both the purchaser and supplier are

mentioned therein and it is a legal document of commitments agreed by both the
parties. All the terms and conditions mentioned in the supply order shall be clear

14

and without any ambiguity and shall not lead to different interpretations. It shall
contain:
Name and address of the buyer.
Name and address of the supplier.

Description of the item to be supplied.

Quantity to be supplied.
Place per unit.
Payment.
Delivery -rate of delivery -terms like F.O.R. Ex.Works etc.
Time schedule.
Time guaranteed by way of liquidated damages.

Warranty -period and condition.

Excise duty.
Sales Tax.
Octroi and other taxes. If any.
Inspection and acceptance.
Insurance during transit.
Force Majored.

Settlement of disputes.

Termination.
In addition to the above clauses, in the case of an order for imported item
against a firm abroad, the following shall also be included.
Currency of payment.
Import license details.
Letter of Credit.
Marine insurance.
Marine transit.
Customs duties
Port handling

15

Such a detailed supply order shall be prepared and get vetted by legal' and
finance departments before release. After release, it must be get signed in one copy
by a representative who has a power' of attorney issued by the management.
Sometimes, to save time, a Letter of Intent is issued so that manufacture can be
started as in many cases it takes sometime to prepare the order and release it. An
order copy is sent to finance, stores and the user department for follow up action in
their respective areas.
Many companies issue supply orders on Ex.Works'basis to avoid Excise Duty on
transport charges and insurance charges payable by the buyer. The buyer enters
into a contract for transport of goods through bank approved transport carrier.
Therefore, the buyer arranges the transport through such transport carrier and pays
it directly. In the case of insurance many companies take an Open Policy on annual
basis and make payment direct to insurance department.
In some cases, even the inspection, expediting, follow up to the receipt of
materials are attended to by the Purchase Executive. It depends upon the policy of
the company. But it is a post-purchase activity and it involves co-ordination with
transport, stores and accounts departments.
1.6 ROLE OF PURCHASE MANAGER
The role of the Purchase Manager in any Company, Public or Private or State
sector, Small scale industry, partnership concern or any is becoming more and more
difficult and complex due to the factor, he has to satisfy various departments
internally and statutory authorities, suppliers, transport agencies, insurance
companies, banking sector and the like.

The role is more complex as each

department looks upon its needs only and is not able to appreciate the problems
faced by the purchase executive. Scarcity of the goods in the market, uncertainty in
the supply of raw materials; frequent changes in the taxes and duties, acts of Good,
acts of Governments, power failure, transport problems industrial relationship, low
productivity etc. have been conquered with and goods procured. There are many
opposing forces. Above all, queries/audit, objections have to be answered.
Purchase Manager is a most key person in the company as it is he who
commits on behalf of the company to outside forms. Since he makes a
financial commitment he has a very great responsibility. He has to interact
with the production department so that the production needs are met with in
respect of quality and quantity by timely supplies. He has to interact with the
finance department in respect of budget allocation, payment of bills. He has
to, interact with the stores department so that incoming goods are properly
organised and inventory is held at the desired level.

16

The Purchase Manager shall maintain good rapport with the suppliers. He is,
to some extent, Public Relation Officer (PRO). He must visit the factories as
often as possible to acquaint himself of the development taken place.
Sometimes, reciprocal buying is also adopted. That means against what is
sold,

some

other

items

required

are

purchased.

Good co-operation,

understanding can help both the buyer and seller.

The Purchase Manager has to keep a close watch on the duties and taxes and
is expected to meet the Excise authorities and sales tax personnel. A close coordination and relationship is to be maintained with the Customs authorities
and banks and insurance departments and shipping department.
Under all these conditions the Purchase Manager has to ensure quality.
Goods are supplied in the required quantity at the required time and a
competitive price and from a good source. To meet this, he has to develop
additional sources also. It could be on trial order basis, additional sources
can be developed.
1.7 ORGANISATION FOR PURCHASING
An organisation shall be established or created to meet the end objective or
goals set by the company. Various major functions needed to perform and
achieve the end objective are to be clearly set out and defined. Generally, the
functions involved in any production of a product shall be production,
materials, personnel, sales and marketing, finance and audit. Therefore,
these functional groups are to be headed by a senior executive and duly
supported by staff down below. A system of relationship between functions is
also to be defined. Work to be carried out under each function is to be drawn
out clearly. Then it should be assigned to individuals. Care should be taken
to

see

that clear line

of

authority

adequate

delegation of

powers,

responsibility and span of control are established.

One of the functions is Materials Management. It embraces all activities like
'cradle to cremation' viz. Material planning to its use. The purchase is one of
the major activity in the materials management function. In some big
organisations, it is Central Purchase organization and in few cases it is unit
purchases. It very much depends upon the location of the factory and
corporate office. If factories are located at different places like BHEL with
Corporate Office at New Delhi, it can have unit purchase organisation.
A purchase organisation is to be headed by a Purchase Manager and assisted
by Assistant Purchase Managers and Purchase executives. The Purchase

17

Manager will be reporting to the Chief Materials Manager. A typical

organisation shall be as under:

PURCHASE MANAGER

PRIVATE
SECRETARY

APM

RAW
MATERIALS
&
CONSUMABL
ES

APM

APM

PLANT AND
MACHINERY

SPARES AND
TOOLS

APM

OIL
LUBRICANTS
IRON AND
STEEL &
BEARINGS

APM

CO-ORDINATION
MONITORING &
REPORTING
COMPUTER

1.8 REVISION POINTS

Scope of Materials Management
Objectives and Scope of Purchasing
Purchasing organisation
1.9 INTEXT QUESTIONS
1.

Discuss the scope for an integrated Materials Management.

2.

Purchase management is a key function in a Company -Discuss.

3.

Describe in detail, the points in favour and against 'make or buy'

decision.

4.

Explain the relationship between the, Purchase Manager and other Inter
departments Company.

5.

Discuss the scope of purchasing in materials management.

6.

Explain the functions of Materials Management

18

7.

Give the organizational Structure of a purchase department and explain

their functions.

1.10 SUMMARY
In this lesson, concept of materials management and their scope are given in
detail.
Scope and objective of purchasing, role of purchase manager and purchasing
organization are explained in detail.
1.11 TERMINAL EXERCISE
1.

Define concept of materials management?

2.

Define purchasing?

3.

Explain the role of purchase manager

4.

Draw a flow chart for purchase organization.

1.12 REFERENCE BOOK/SUGGESTED READING/SET BOOKS

1.

P. Gopalakrishnan, Purchasing and materials Management Tata

Mc Graw-Hill, 2000.

2.

S.C. Sharma, Materials management and Materials Handling Khanna,

3, 2000.

1.13 KEY WORDS:

Materials

Management,

purchasing,

material

Planning,

Make-or-Buy

Decision, Purchase activities, Tender, Purchase order.

19
LESSON-2

CONCEPT OF RIGHT QUALITY

OBJECTIVES
1.

To review the concept of quality

2.

To understand the basic considerations in the purchasing of the right

quality of material.

3.

To know about description of Materials by specification

4.

To know the advantages and Disadvantages of specification.

CONTENT
2.0.

Introduction

2.1.

Concept of Quality

2.2.

Right Quality

2.3.

Determination and Description of Quality

2.4.

Describing the Quality

2.5.

Advantages and Disadvantages of specifications

2.6.

Principle Disadvantages of specification Buying

2.7.

Responsibility for Quality control

2.8.

Determining quality-inspection

2.9.

Revision Points

2.10.

Intext Questions

2.11.

Summary

2.12.

Terminal Exercises

2.13.

Suggested reading/reference books/set books

2.14.

Key words

2.0 INTRODUCTION
In the Industry, today, there are number of products, end products, semifinished products developed which are needed for various uses and functions. The
products are manufactured depending upon the use from different raw materials,
additives, different process technology adopted. The products are used in the
various sectors like domestic appliances, agricultural sector, mining, chemical
industry, power generation, utilities, heavy machineries, railways, ship building,
aviation sector, automobile industry, office equipment tele communication sector,
transport and handling sector and so on. In each of this sector, different end

20

functions are called upon and the product has to meet and match with. These
products are to withstand dynamic loading, stress and strain, temperature,
pressure, impact, shocks and other engineering characteristics. Failure in anyone
area by any product/ component may end up in a break down which will cause loss
of production and affect the profits. But a quality product shall function and
perform well and shall not cause a failure and help the industry in its operation.
Quality is a function of use and shall meet the technical specification and
requirement.
The need for the quality in any product need not be emphasized. It is the
quality that makes the product to perform very well to the desired level and such
products of quality will have a great demand in the market. Once the quality of a
product is proven. The Company's name is well established in the market and many
time people demand that product only.

To produce such quality products and

maintain its quality, many manufacturing firm have created a quality control
department. The Quality Control department functions independently and has full
authority and powers. In recent management principles, even a Quality Circle is
created. This Quality Circle consists of executives from different departments like
production planning, quality control and inspection. The executives meet frequently
and discuss the production methods. And methodology, standards, order, quality
control checks and measures and inspection procedure to ensure quality. Areas
where there is weakness and improvement called for, remedial measures are
suggested and carried out.
2.1 CONCEPT OF QUALITY
Towards
departments

the

manufacture

prepare

design

of

and

any

product,

drawings.

The

Planning

and

department

Engineering

also

prepares

materials/components required for the manufacture of the product and draws out
technical specification for these items. These include chemical and physical
properties and other parameters. These details shall act as a guidance in deciding
and procuring these materials/components. To produce the good quality material
and components of right quality as per technical and engineering specification are to
be procured and used. Also the correct process of manufacturing is to be adopted so
that quality can be maintained in the end product. The machines installed in the
manufacture, consumables used in the manufacture, tools, jigs, vices etc., used in
the manufacture shall also be of good quality so that the end product and storage
and preservation of the product certain quality standards are to be adhered to, so
that they are kept in the quality as manufactured without any deterioration. The
Supervisors, Foremen, Skilled workers engaged in the manufacture of the product

21

shall also of quality conscious people and shall not sacrifice or compromise the
quality in production at any cost.
The systematic control of quality and development of standards had their
inception with the industrial revolution and the production technique that
accompanied it. In earlier days, such quality control was relatively a simple matter
as the variety of products were not there and many usage under different climate
were not envisaged. For example, in the surface transport, we had only bullock carts
or jutkas. These were relatively, small with few parts and were not used for high
speeds with heavy loads. There was also not much risk/damages caused in case of
failure. But today we see lot of buses, lorries, two-wheelers, tractors, etc. moving on
the road at a high speed carrying heavy load of passengers/cargo. In case of any
accident due to any failure of any part, the risk involved is considerable and the
damage to life and property are unexplainable. In these cases. Therefore all the
parts/components shall be of quality product to ensure non-failure at all. Due to
technological revolution all over the world, the old conventional methods are getting
changed to machine methods and also due to the heavy demand. Therefore it means
clear and precise description of products to be manufactured and this led to the use
of samples, brands and specifications. Such description is made in the form of
standard which is an acceptable level of quality design. Standards are evolved as a
result of experience and are widely published and are readily available to any buyer.
Such standards are prepared and Indian Standards Institute (ISI) publishes them.
2.2 RIGHT QUALITY
The design and engineering department generally specifies the quality of the
material needed for the manufacture of the product. This quality will always have
some tolerances and allowances. Such specifications of the quality means that the
quality should be just enough and right to meet the specification requirements. It
shall be neither too high or too low. Such a quality standard is called the 'right
quality'. It is the role of the Purchase Manger to bring it to the notice of the user
department the different qualities available. Wherever possible, the user department
can carryout the shop tests or on-line tests to determine the right quality.
Specification can be really worked out and drawn on the basis of these tests. For
example, where a Galvanised Iron bolts will meet the technical function and
specification requirements, there is no need to use Stainless Steel bolts. When the
purpose can be achieved/ensured by a cardboard case, there is no need to provide a
plastic box or wooden box. Therefore, right quality is the one which meets the
technical specification and can function well and should just right one either too
high or too low. Such a right quality product will definitely be of reasonable and just
price, which will ultimately control the cost, and unit price of the product.

22

2.3 DETERMINATIONS AND DESCRIPTION OF QUALITY

The following are the basic considerations in the purchasing of the right quality
of material. They are
Determination of the quality.
Defining, the properties of the same clearly correctly and
Controlling it through certain methods.
Out of these above, the 'determination of quality' is considered the relationship
to technical suitability. Physical availability and economic considerations. The other
two viz. controlling it through certain method are purely procedural.
2.3.1 Determination of Quality
Quality of any material, spare parts, components, consumables etc. have a
very direct relationship to the function to which it is intended. Quality can therefore
be said in terms of the ultimate functions, the material has to perform and must be
procured at the least cost so that the price of the end product will be competitive.
The purchase department is particularly is in an advantageous position to
contribute its share to the profits of company, at it brings out quality material at a
least cost. As it is well known that materials constitute about 60-70% of the cost of
the end product and savings is only possible in the purchase as other costs are less
besides touches the human demand. The engineering and technical departments are
mainly concerned with the technical aspects, specifications, parameters and the
user department is mainly concerned with its suitability. The Purchase department's
concern is only that the technical suitability of the material is ensured. The
Purchaser becomes concerned about the price on the technically suitable product
only. There is no use in selecting a material which is less costly but not technically
suitable. To some extent, therefore, the required quality determines the price. Since
the quality is foremost, even before the price, the purchase department can then
anlayse the availability source etc. Purchase department cannot question the
requirement and the quality but it is prerogative of the user and engineering
department. It is those area of responsibility and domain. Purchase department has
a secondary role in the matter of quality. For the required function or performance
the engineering department will examine the various products and choose the best
suited only to meet the requirement and function and quality so determined shall be
the one to be purchased. Purchase department is to ensure the availability of such
quality material in a steady and continuous manner without any interruption and
on competitive basis.

23

2.3.2 Quality Control

On the basis of the quality requirement fixed and determined, the purchase
department steps into activities and places order after following all the procedures
laid down by the Company. The Purchase Order shall contain the technical
specification and quality control measures. Scientific methods are adopted to check
the quality of the product like Dimensional checks, Physical properties, chemical
properties, sample tests, engineering tests like tensile strength, compression
strength, impact tests, hydraulic tests, x-rays for welded joints, continuity tests, heat
run tests and so on depending upon the material. Indian Standards Institute has
specified different tests at shop level, acceptance tests for various materials,
components, equipments.
Many times, in the case of equipments, during testing and inspection, the
representative of the purchaser shall witness and approve the same. All these tests
are to ensure that the quality of the product shall conform to the requirements and
no defective or faculty materials reaches the production shop floor.
Much importance is given in these days on the quality for the product. If the
quality is poor and not up to the standards or requirements. Naturally the
production will be upset and the quality of end product will also be poor. Thereby
the profitability will be affected besides the credibility in the market and the name
shall be tarnished. Many companies in these days have created a quality control
department. Executives with knowledge in the quality standards, quality control
measures, educated as well as experienced are deployed with full authority. They are
independent of the Production and Materials Management departments. Their words
are final in this matter. Such a rigid control on the quality of the product shall
ensure that standard and quality products are allowed to proceed to the market for
sale and shall ensure reliability of the product.
2.3.3 Availability of Quality Material
Not all the companies manufacture all the materials, spares, consumables
requirep to a product. In many cases, there are number of 'bought-out- materials.
Bought out means materials purchased from outside the factory. The availability of
the materials, raw materials and bought outs depend upon besides many factors.
Certain standards. Based on the technical specification, the Purchase department
may send out a Press Tender enquiry to locate the product meeting the technical
specification and its source. Standard products like M.S. steel rods, A.C. sheets,
cement doors and windows, hardware like nails, bolts & nuts, washers etc. paints,
varnishes, oils, lubricants like grease, pipes & pipe specials like elbows, 90 bends,
couplings etc. domestic products oil, gas stove, cosmetics like, soaps are readily

24

available as per ISI. So, there may not be any difficulty, in meeting the quality
standards. But in practice, there could be no manufacturer at all for a particular
product of a particular design/ specification. But in the market alternative may be
available but it will also meet the end function designed. In such cases, the quality
requirements may be suitably changed with the materials available in the market.
This would be a practical and realistic approach. The other alternative would be to
develop a source for the item so designed and desirable. Where quality standards
cannot be altered, but has to be maintained, then a new source has to be developed.
Many times, it is achieved by a trial order. In few cases, the modifications may not be
acceptable at all. Many companies, through their Sales and Marketing department
personnel, collect data of the available material in the collected data and
informations to the design department and even Production planning department.
The departments may then take care on the design, the available material and fit it
into the designs. This way will be very easy to locate the source for a material of a
particular specification which is really needed.
2.3.4 Development of New Sources
If it becomes necessary that material quality standards cannot be altered and
the material of the same specification is needed and not available in the market.
Then the Purchase department has to procure the material only; a Tender enquiry
has to be issued for this material with specification and special condition to be
carried out. Since it is a new source for this material, there shall be enough
encouragement and motivation to undertake the job. In many cases certain amount
of incentive is also considered like supply of shop drawings, parting with the knowSUPPLIER
how etc. exclusively for this purpose, deletion of penalty clause and advance
payment etc. Many times a clause is added that once the product is found
technically suitable, a long-term contract will be reached between the buyer and
seller for this item. Such
a clause
will ensureREQUIREMENTS
the prospective seller to evince more
SUPPLY
ORDER-QUALITY
interest in developing the product as he may get a long-term business. In the same
CREDIBILITY

GOOD MARKET
& RETURN

way, Even alternate materials can be found, such suitable substitute materials are
put to tests and accepted. Costs also has a role to play. Cost/price being one of the
PROCESS OF
most vital factors, the purchase department
has a large role to play. Once a new
MANUFACTURE
source" and the alternate materials are found and acceptable, and then they can be
put in the list of approved suppliers
2.3.5 Vendor Co-operation
RIGHT
INSPECTION
VendorsRIGHT
co-operation is
very essential RIGHT
in the purchase
of a product/
QUALITY
TECHDURING
SKILLED
machinery/ spare
In the case of purchase
order for MANUthe manufacture of
RAWparts etc. NOLOGY
PERSONAL
MATERIAL
FACTURE
major equipment
like Boilers, Turbines, Transformers, Condensers,
Reactors,
QUALITY
SEND
PRODUCT

INSPECTION
ACCEPTANCE

25

Compressors, Handling equipment Mining machineries like dozers, dumpers, loader,

excavators etc. the supplier/vendor may suggest alternate material or even points
which may be technically suitable and acceptable. It may not also have any effect on
the output/end function. Perhaps, there will be cost reduction. It has to be accepted
by the purchaser. Such an adjustment may' create a healthy trend and tie up in
buyer-seller relationship.

Quality Control and its Benefits

26

(a) Standardization: Rightly it has been said that principle of scientific

management control lies in planning standardization. Standards formulated at the
national and the company level generally defines the quality clearly and often
prescribes the means to evaluate the specified quality. When standardization at the
national level is firmly developed and a large number of standards have been
formulated by a national body or bodies, these standards lead to the specification of
quality, reduction in sizes and varieties, interchangeability of parts and products
and efficient utilization of materials. Standardization thus is introduced here in
order to emphasize its role in relation to total materials costs. When a firm's
requirements of materials are highly standardized, it is more likely that it will get the
suitable materials readily available in the market at reasonable prices. Thus the
need for non-standard materials and justifying higher prices to be paid for them
should never be assumed and all such requests should always be verified and
challenged by the, Purchasing Department.
(b) Cost factors: Either individually or collectively, technical and economic
considerations highly influence quality. In terms of costs, economic considerations
are seldom accorded the same analysis as considerations that govern technical
suitability and as such, unnecessarily profits are sacrificed as a result. Value
analysis is probably one of the most powerful cost-saving techniques which focus
attention on cost side of the quality problem. Price paid for materials cost payments.
Transportation, receiving delivery, materials handling etc. (including costs of storage,
upkeep, maintenance etc.) are also included in the costs of materials used, in
production. Incremental costs arising out of the use of certain materials in the
manufacturing process are also included. There are also some materials which are
easier to work than others, which permit easy machining and save men and
machine hours, and thus reduce costs. Therefore, the primary aim of the purchase
department should be to strive constantly for integration of the technical and
economic factors of quality.
2.4 DESCRIBING THE QUALITY
Describing the quality is more difficult manner as that a vendor an easily
understand the buyers quality needs.

Industrial purchasing is entirely different

from personal buying. Often routine personal discussion is rendered impossible by

virtue of vendors being away at some distant place from the purchaser's place of
business. As such personal negotiation is often out of question, while at the same
time the vendor must understand the buyer's needs from a written statement on the
purchase order, which describes the quality. Under such circumstances, the
purchase order must describe in writing all the quality characteristics the vendors

27

may like to know about the desired item. The main purpose of the quality.
Description is three-fold: (1) to describe the quality of the item or items in as clear
tenns as possible, (2) to let the vendor know all the factors that he may want to know
about the item ordered, and later on (3) permitting inspection by specified
measurements or quality test which can verify that the material or materials
received are infact the materials described on the purchase order and conform to the
quality requirements of the vendor.
The description may take a variety of form or a combination of forms, but the
general practice is to describe the quality of the purchase order by the following
methods:
1. By brand name or trade name in case of branded products.
2. By commercial standards in case of standardized products, components or
materials.
3. By specification: (a) by specifying physical or chemical characteristics, (b) by
specifying performance characteristics and (c) by specifying materials and
methods of manufacture.
4. By using blueprints of engineering drawings followed by descriptions.
5. By market grades and samples in case of graded commodities.
However, in many cases one of the above methods is quite inadequate to
describe the quality properly and clearly. In such cases, a combination of two or
more of the above methods is used. Each of these, methods is discussed briefly as
below:
2.4.1 Brand Name or Trade Name
A manufacturer in deciding to market a product-market generally decides to
brand it. A brand name or trade name is put on the product in order to identify its
origin, which ultimately creates goodwill for the manufacturer. By branding it, he
protects it against substitutes, gains repeat sales, maintains, price-stability and
simply

competes

with

other

manufacturers

in

the

market.

By

repeated

advertisements and sales promotional efforts, he differentiates his product from

others in the market and the buyer also puts reliance upon the inequity and
reputation of the manufacturer. There are circumstances under which such product
differentiation is not only desirable, but also necessary for various reasons.
Brand or trade names are easiest to describe on a purchase order. But the
buyer is confronted with questions. How to select on the basis of a brand and why?
Only testing can provide an answer. The original selection of a brand may be based

28

on a specific test or preliminary trial' and it may not be necessary to put it to

periodic test.
2.4.2 Commercial Standards
A commercial standard is a complete quality description of the standards item.
Such' description includes quality characteristics, workmanship, methods of testing
both for materials and workmanship. Repeated necessity for the same materials
leads the industry and government to develop commercial standards which may be
said to be the keystone of the mass-production and mass-consumption industrial
system. Materials ordered by standardized specifications have certain definite
advantages. There is no room for doubt about what is wanted. Either on the part of
the seller or the buyer and the materials is readily available. Standard specifications
are developed carefully on the basis of study and experience and substantial effort is
expanded to promote them. More on the outer hand, these standard specifications
are so broad that some of them may be unsuitable to the requirements of particular
users.
However, they generally contribute to the simplification of design. Purchase
procedures and lead to cost-reduction and inventory control in a variety of ways.
2.4.3 Description of Materials by Specifications
(a) Physical or Chemical Characteristics Description of materials on the basis
of specifications is one of the best-known methods employed, by industry. While
preparing its own specification a manufacturer should however make it as close as
industry standard as possible. Describing quality by physical or chemical
characteristics, however, involves some risk, as for example, by specifying the
tolerances or exact chemical specification the buyer assumes complete responsibility
for the performance of the material. The cost of inspection may also be high, as the
very nature of the purchased materials under such descriptive methods needs
special inspection efforts.
(b) Performance Characteristics Performance characteristics method is
employed when it is thought desirable to throw the whole responsibility back on the
seller. It is result and use oriented method, and this enables the supplier to take
advantage of the latest technological developments. But at the same time, it is highly
conditioned by securing a right supplier who can assure satisfactory performance
and the price paid for this may prove to be very high.
As such, performance specification method is used only for complex and
complicated items which require reliable performance over time. The buyer secures
assurance of actually obtaining the desired performance and if the vendor is
competent enough he can assures inclusion of all new developments.

29

(c) Materials and method of manufacture This type includes both materials
used and method of manufacture

and is generally applied when special

requirements exist and the buyer is willing to assume the responsibility for product
performance. There are two distinct advantages; one is securing of competitive bids
and since the item is generally a non-standard one. The supplier cannot charge
arbitrary -price if the costs of materials and manufacture are known to the buyer.
2.4.4 Specifications
Specifications are a detailed description or listing of the characteristics of an
item. Compiling specifications often requires considerable time and may prove costly
by comparison with other methods of communicating to the supplier what is
desired. Nevertheless, buying by specifications is one of the commonest methods.
Since a great majority of business purchases require its use.
(a) Dimensional and Material Specifications: Specifications may take the
form of a listing of the physical or chemical properties desired in the product. These
are sometimes called dimensional specifications because they state the desired
properties in measurable terms. Such commodities as metallic raw materials, oil,
and paint are examples of items for which this type of specifications are frequently
used. Conformity to dimensional and material specifications can usually be checked
quite simply.
Another form of specification is the minute prescribing of both material and
method of manufacture. This method is sometimes used in military purchasing, but
in industry it is rarely used except when unique requirements exist. Ordinarily, if the
vendor knows the use of the 'good, he is in better position than the buyer to
determine what materials and methods of manufacture are necessary. The buyer
assumes a heavy responsibility under this procedure, since he- has no recourse if
the products are unsatisfactory, so long as his specifications were met by the
supplier. The buyer incurs the methods of production with which he may not be
familiar. Also, costly inspection at the vendor's plant may be involved.
(b) Performance Specification Specifications may detail the performance or
use of the purchased item. Here the purchaser indicates his interest in the service
that the product will give, and he tests the end result rather than the product. If the
vendor accepts the specifications, the responsibility for a satisfactory product is' his.
For example, a part may be specified as capable of being bent to a 90-degree angle
and subjected to an 80-degree temperature. These are the least difficult
specifications to formulate. The method is especially suitable for purchase of
machines or tools about which the purchaser has little technical knowledge. It leaves

30

the seller free of restrictive prescriptions of materials and processes, and he may
take advantage of the most up-to-date knowledge to provide the best product at the
lowest cost. Satisfactory use of performance specifications requires securing reliable
suppliers and developing competition. Otherwise the seller's responsibility for results
may cause him to suggest better but more expensive item than is needed.
2.4.5 Blueprints
Use of the blueprint, or dimension sheet is an important corollary of many
specifications. The blueprint usually accompanies some descriptive text in the
purchase order. It is the most precise and probably the most accurate of all forms of
description, and is applicable where close tolerances or a high degree of mechanical
perfection is required. Its use is expensive, not only because of the cost of the
blueprint, but also because it usually describes items of special design that is costly
to manufacture. However, for items such as casting, forgings: tools and fixtures,
purchings, and machine parts, which call for extreme accuracy, it is the most
feasible method of description. Blueprints also provide the basis for an accurate
check on compliance with specifications by the inspection department when
material is received.
It is important to remember that an inspector will be governed only by the
purchase order and any drawing or specifications indicated thereon. He may only
inspect to see that the items comply with the drawing and the written specifications.
Therefore, any verbal agreements that have beep made may become a source of
difficulty when a shipment is received, and care should be taken to make sure that
all special conditions and agreements are made a part of the purchase order.
Specifications should be revised as conditions change. In one instance, in the
purchase of steel, a situation developed in which a purchasing agent and supplier
informally agreed that steel supplied under certain specifications could vary from
the specifications. The specifications called for a thickness tolerance of 0.003. The
informal agreement was that the supplier would aim at this tolerance but that
actual shipments might occasionally vary up to 0.005. The agreement worked
successfully for 8 years, but when a new buyer was apprised of the agreement by the
supplier, he was unable to get the using department to accept the terms of the
informal agreement. After considerable time however, the specifications were
changed because adherence to the stated requirements threatened to raise the cost
so much that the company would have been unable to compete in the sale of the
final product. All this could have been avoided if the informal agreement had been
expressed in revised specifications

31

2.4.6 Market Grade

Another method of describing quality is by the use of market grades. This
method is largely confined to primary materials, such as cotton, wheat, and lumber.
The market grade indicates the relative purity, lack of defects, or differences in
quality of a particular class or kind of material. For example, The purchaser knows
that, when "No.1 Pine" is the specification, he will get lumber that differs from other
grades in that it has fewer knots and imperfections.
This type of grading must be suitable to the purchaser's need to be useful to
him. Difference within a single grade of wheat make it necessary for millers to buy
only after examining a sample of the wheat itself. Similarly cotton-exchange
contracts, which permit delivery of various grades of cotton with subsequent
adjustment of price according to a prescribed scale of premiums and discounts, may
suit the cotton merchant, but not a textile manufacturer. The accuracy of the
grading, confidence in the ability and honesty of those responsible for grading. And
the ability to ascertain differences in grade by inspection are important factors in
determining the suitability of this method of purchase description.
2.4.7 Samples
Where none of the preceding methods of defining quality satisfy, the purchaser
may submit a sample of the item desired. Difficulties may arise if the sample is
subject to physical or chemical change. However, for replacement of mechanical
parts, where age or use has obliterated the identification marks, it may be the only
feasible way of assuring receipt of the correct item.
In one instance, difficulties in the proper shape and fit of a brake band for a
tractor were overcome by attaching a sample brake drum to a metal template
indicating the proper placer lent of the band. By using this pattern as a guide the
vendor was able to provide the length, shape, and conformance needed.
A large proportion of commercial orders employ a combination, of the venous
methods of describing quality. The method must be adapted to the product that a
company makes and to the importance of quality in the item being purchased.
2.5 ADVANTAGES AND DISADVANTAGES OF SPECIFICATIONS
The following points summarize the primary advantages and disadvantages of
purchasing according to specifications.
The main advantages of specification buying are:
1.

Drawing up the specifications requires careful thought and a review of

the buyer's needs. This frequently results in a simplification of the

32

variety of products purchased and often reveals the possibility of using

less costly items. Both factors result in economics.
2.

Buying according to specification frequently induces more suppliers to

bid on an order because all suppliers know exactly what is wanted and
that their chances are as good as those of other suppliers because they
are bidding on identical items.

This increased competition for the

business often results in lower prices.

3.

Specifications ensure the identical nature of items purchased from two

or more sources. Where the purchaser has more than one supplier of
an item this identifies its essential, and specification buying is a virtual
necessity.

4.

Puraching to specification gives the buyer's inspection department an

exact standard against which to measure the incoming materials and
results in accurate inspection and a uniform quality of materials.

5.

If specification buying is combined with quality control on the part of

the supplier, it may be possible for the buyer to save money by doing a
less complete inspection.

6.

Specification

buying

is

necessary

step

toward

industry-wide

standardization, and standardization programmers hold the promise of

substantial savings.
2.6 THE PRINCIPAL DISADVANTAGES OF SPECIFICATION BUYING ARE
1.

It is not economical to prepare specifications for small lot purchases.

These rules out the possibility of specification buying for many items.

2.

Specification buying adds to the purchaser's responsibilities. He must

be able to state precisely, what he wants, and the supplier's obligation
extends only to complying with those terms. If the product does not live
up to expectations, the liability rests with the buyer. This disadvantage
does not apply to performance specifications.

3.

In specification buying the cost of inspection is greater than in

purchasing items by brand. Items purchased to specification must be
examined, whereas branded Items need little more than a casual- check
and count.

4.

There is always the danger of becoming over refined in preparing

specifications and as a consequence, paying more than necessary for
items.

33

5.

There is also the danger of assuming that, after specifications are

established, the characteristics of the item have been permanently set.
Unless specifications are reviewed periodically. There is the chance that
the buyer will lose out on product improvements.

Some products defy specification buying. Certain products are patented or

manufactured by patented processes, and others depend so largely on the unique
skill of the maker that specifications are inappropriate.
2.7 RESPONSIBILITY FOR QUALITY CONTROL
With the growing importance of quality control, the question of organizational
responsibility is a paramount consideration. The responsibility for defining the
quality of purchased materials should rest with that department whose function is
to establish the standards of quality to be maintained in production. Ordinarily, this
is the engineering department or the production engineering department. Where the
decisions involves equipment and supplies not used in production process, the
responsibility usually lies with the department that will use the material. For
example, office equipment and supplies are largely the concern of the office manager
or general management whereas laboratory equipment and supplies are of primary
interest to the laboratory director, and these officials should be responsible for
defining quality for their own equipment.
In large companies where responsibilities may be divided aiming several
departments the joint interests of sales, research, production, purchasing,
inspection and engineering may enter into the decision. The same considerations
must be taken into account in smaller companies, but the number of individuals
conceded will be smaller.
2.8 DETERMINING QUALITY- INSPECTION
At this point we shall assume that the purchaser had determined the proper
quality of the item to be bought, that he has satisfactorily defined this quality in
terms of specifications, blueprint, part number, market grade, or sample and that
the purchasing agent has accordingly placed an order with the chosen supplier.
However, since the supplier has not certified, the quality of this shipment, it now
becomes the duty of the inspection department to ensure compliance with the
standard of quality. The inspectors are the monitors who see to it that incoming
material is of the proper quality.
Places of inspection: Inspectors responsibilities sometimes take them into the
vendor's plant. If the product is complicated and manufactured to very precise
standards, its high cost may justify stationing an inspector in the vendor's plant to
oversee the process and the product during manufacture. Or, if the cost of

34

transportation is great in relation to the value of the goods, final inspection may be
made before shipment in order to avoid return transportation costs in the event of
rejection. Some large companies find it economical to maintain inspectors at or near
the source of subcontracted items, special items such as heavy forgings and
castings, and goods bought in large quantity. Perhaps the most extensive use of
inspection at the source is by the Department of Defense for military purchases.
Few companies have centralised inspection department. The benefits of this
arrangement are described as follows:
1.

Special skills required for proper product inspection involve the training
of fewer people than would be the case if each operating area were to
inspect its own incoming shipments.

2.

In case of new products or new suppliers, relatively little information

may be available upon which to formulate proper inspection procedures.
In such cases, a preliminary review by the inspector of the supplier's
plant facilities, formation upon which to base suitable acceptance
inspection plans. In some instances, they have disclosed the prospective
supplier's inability to produce products at satisfactory levels of quality
and, hence, his inability to justify the placing With him of a purchase
contract for a product.

3.

Uniformity of inspection methods and acceptance criteria, especially in

the case of Judgement items, is more easily maintained a feature
necessary from the users and fair the suppliers standpoint.

4.

Shipping costs; and to a large extent service delays arising from

rejection of nonconforming material at destination, are eliminated by
rejection at source.

5.

For any given value of protection (in respect to both producers and
consumers risks) a smaller sampling ratio is required for the larger size
lots inspected at the source as compared with the smaller size lots
which would be inspected at destination.

6.

Irregularities in product are earlier detected and corrected.

7.

Optimum flexibility and efficient use of inspection manpower is

facilitated.

In most instances the size and nature of a companys. operations will preclude
the use of such an elaborate system. Where conditions dictate inspection at the
source, independent testing laboratories or inspection agencies can sometimes be
employed. When the cost of securing and maintaining specialized inspection

35

equipment is prohibitive, the purchaser may also choose to rely on an outside

agency for inspection. One possible drawback is that an outsider, not having
complete and accurate knowledge of the application or needs, may not be able to
exercise informed judgment in borderline cases. The cost involved in hiring an
outside agency and the level of quality needed usually will be the determining factors
in deciding whether to employ an independent inspection agency .
In the usual situation purchased material is inspected when shipments arrive
at the purchaser's plant, with, detailed practices varying depending upon the nature
of the product and the production processes involved.
2.9 REVISION POINTS
Concept of Quality
Materials Specification
Advantages and Disadvantages of Specification
2.10 INTEXT QUESTIONS
1. Quality standards is essential for any product. Discuss.
2. Describe as to how the quality for any product is determined.
3. Define the method of description of a product.
4. What are the advantage and disadvantages of specifications?
5. Discuss the role of supplier and Buyer in Design and specification of right
quality.
2.11 SUMMARY
A slogan that has grown up with the quality control movement is: "Quality
cannot be inspected into a product." This being true, the desired quality of
purchased material must be in the material when it arrives. Reasonable assurance
of this comes through careful attention to all responsibilities in the purchaser's
organization. When careful consideration has been given to the exact quality desired,
to the development of adequate description or specification of that quality to making
certain that the supplier understands what is needed and is equipped to do the job,
and to the application of a suitable inspection program. there is little possibility of
failure to achieve the desired results.
2.12 TERMINAL EXERCISES
1.

Define the concept of Quality

2.

List the Benefits of quality control

36

2.13 SUGGESTED READING/REFERENCE BOOK/ SET BOOKS

1. P.Gopalakrishnan, Purchasing and Materials Management, Tata Mc-Graw
Hill, 2000.
2. S.C. Sharma, Materials Management and Materials Handling Khanna
publisher, 2000.
2.14 KEY WORDS
Quality,

Specification,

Description,

Commercial

Standards,

Performance

Specification, Blueprints, Market Grade., Samples, Quality. Inspection.

37
LESSON-3

CONCEPT OF RIGHT SOURCE

OBJECTIVES
1.

To have a clear view regarding the source of information of potential

suppliers.

2.

To know about the factors to be considered in supplier evaluation.

3.

To analysis the different method of evaluation.

CONTENT
Introduction
Source of Information of potential suppliers
Need for Evaluation
Factors to be considered in supplier Evaluation
Different methods of Evaluation
Revision points
Intext Questions
Summary
Terminal Exercises
Suggested Reading/Reference Books/ Set Book
Key word
3.0 INTRODUCTION
The main objective of a purchase function is to procure the required material,
component, spare parts from the right source, at the right quality, right quantity,
right price and at right time. If the source is selected properly, naturally all aspects
will be fulfilled. If the supplier is a dependable, reliable, proven and guaranteed the
supplies will meet the technical specification and timely supplies can be ensured. If
the source selected is not so, the supplies made may not be on time, may not meet
the technical specification and if used, may cause damages and thus there will be
loss of production which in turn will adversely affect the financial position of the
company. Such a wrong selection of a source may lead to disastrous consequences.

38

3.1 SOURCE OF INFORMATION OF POTENTIAL SUPPLIERS

Source selection : A Basic For Buyers
The primary aspect of good buying is to determine suitable sources of supply in
order to secure and maintain active interest and co-operation of the suppliers. The
efficiency a buyer exhibits in vendor selection brings forth healthy competition
which results in the development of better products and materials services to a
manufacturing company.
Selection of sources of supply being the essence of buying process it becomes
imperative that the final authority should rest with the purchase department so as
to avoid possibilities of inter-departmental conflict. Supplier development is a
continuous task, changes in production technology and materials development
require periodic review of existing and potential sources of supplies.
The procedure involved in source selection is the preparation of an exhaustive
list of suppliers and then sorting out the one or ones with whom to do the business.
In preparing a list of prospective suppliers the buyer may use anyone or more of the
following sources of supplier information:
1. Past experience with the supplier.
2. Interview with salesmen.
3. Technical and descriptive catalogues.
4. Trade directories and trade journals.
5. Trade fairs and conventions.
6. Trade representatives and agencies.
7. Open and limited tenders requesting for quotations and
8. Periodical advertisements in the press call1ng for registration of suppliers.
The above procedure is one of searching and sorting out of the likely proven
sources depending upon the product needed. A good vendor documentation is to be
prepared and upto dated periodically so that the report is current and correct.
3.1.1 Past Experience with the supplier
Past experience with suppliers is perhaps the most available and widely used
source of Information about prospective suppliers. Since so much purchasing is
respective in nature, a wealth of information is available to the buyer on the basis of
which he can judge the performance of suppliers. When a new item is under
consideration, a buyer should therefore first of all inquire whether any of his present
or past suppliers are likely prospects.

39

Most purchasing departments maintain vendor files which contain the names
and addresses of all vendors with whom the company has delay throughout its
history as well as a notation of the classes of goods that have been purchased from
each vendor. Frequently the files are set up to include additional data on such
things as the reliability of the supplier in meeting commitment dates, willingness to
handle emergency and rush orders and defect or reject ratios on shipments received
in the past.
Some companies expand their vendor files to include information on all
suppliers investigated, as well as the ones with whom the company has done
business. Such information may be useful, provided it is still current enough to be
pertinent.
3.1.2 Interview With Salesman
The salesman who call on purchasing agents are extremely valuable sources of
information about suppliers for particular products. In most cases their information
relates to their own companies and their own products, but often a salesman is also
able to tell the buyer about a source of supply for an item that his company does not
make.
In an attempt to provide visiting salesman with the greatest possible amount of
information about their requirements, many firms display their finished products
and purchased components in reception or special display rooms. The salesman is
then able to determine items he call supply and provide technical assistance.
Supplementary information relating to standards of quality expected are also
provided. The more a salesman knows of his prospective buyer's needs, the better
are his chances of being a good source of supply.
3.1.3 Technical and Description Catalogue
The catalogues published by vendors in which they list and describe the
various items they make for sale constitute a valuable source of Information about
possible suppliers. For standard production items such catalogues frequently are
one of the most effective and efficient sources of potential suppliers. A number of
studies have been made In order to learn the extent to which purchasing agents use
their catalog files. These studies show that almost all buyers make some use of their
catalogues and a substantial percentage of buyers use them extensively.
The usefulness of a catalogue, file depends to a large extent on how up-to-date
it is kept. Many of the larger companies appoint a librarian who maintain the
catalogue file as one of his official duties.

40

3.1.4 Trade Directories and Trade Journals

A trade directory is a publication that lists and classifies suppliers according to
the products they make. Frequently it also gives a minimum amount of Information
on such matters as the financial status of the companies their method of
distribution, and location of sales offices. Usually a trade directory is prepared and
published by some private company as a commercial undertaking, and it includes a
large amount of advertising by the listed firms, designed to call attention to their
offerings.
Trade journals or business magazines are other very fruitful sources of supplier
names. There are thousands of such publications, and no purchasing department
can subscribe to more than a small fraction of the total numbers.

A companys

choice must be limited to those fields in which it has a primary interest.

As sources of information on suppliers, the value of trade journals depends on
the regularity and thoroughness with which they are read. In general, they are not
useful as directories to be consulted as the need arises. Rather, they are general
sources of information on new products, developments, and methods which are
described in the editorial and advertising pages.
3.1.5 Trade Fairs and Conventions
Industrial trade fairs and conventions are gaining popularity in recent years in
order to build up buyers interest. It is another indirect source which a buyer can
utilize.
Practically all important industrial groups hold such shows at various times
during the year. At the trade show the members of an industry display their wares in
an attempt to attract buyers, build up their interest, and, if possible, make sales.
The convention, by contrast, is usually a trade association meeting designed
primarily as a forum for the exchange of ideas. However, many such conventions
arrange to have display space which they rent to suppliers of their trade fair the
display of equipment and materials of interest to members. Such conventions are
ideal places for a supplier to show his line to a concentrated group of interested
prospects and, at the same time, offer a convenient way for a buyer to find out about
new products and suppliers.
Some of the local associations of purchasing agents sponsor industrial shows in
their cities. At these shows one can find items ranging from office supplies to heavyduty equipment. A buyer attending such shows can talk to representatives of many
firms making similar products and get a good idea of whether the suppliers are
worthy of further investigation.

41

3.1.6 Trade Representatives and Agencies

Many foreign countries and companies appoint their trade representative or
agents in India. These people either publish or circulate the products manufactured
in those companies or countries giving full and complete information about its
specification uses functions etc. Such information will be very useful to the
purchase department to locate the source of materials needed. Generally these
representatives or agents are located in important cities for purpose of quick
communication and transport.
3.1.7 Open and Limited Tenders
Finally, information on prospective suppliers can be secured through, a
request for quotation form. A written request to a supplier to quote price and
delivery on a named part is referred to as a request for quotation or request for bid.
Such requests contain a blueprint or written specifications including quality
requirements and estimated usage. This procedure is usually used annually on all
significant parts and services that are being purchased. Bids are solicited from at
least three potential suppliers, thereby providing an opportunity for equitable
comparisons among competitors.
3.1.8 Periodical Advertisement in the Press
Periodical advertisements in the press calling for registration of suppliers will
also throw some light on newly developed firms who may be potential suppliers in
future.
3.2 NEED FOR EVALUATION
Having located the sources of supply of the particular material, components,
spare parts etc. needed for the particular industry, it is necessary to make sure that
such source is capable, reliable, dependable, shall raise, up to emergencies, shall
maintain good relationship and shall be financially sound. Therefore it becomes
necessary evaluate the supplier.
3.3 FACTORS TO BE CONSIDERED IN SUPPLIER EVALUATION
After the list of possible suppliers has been compiled the next step is to
evaluate each supplier so that the list may be narrowed down to the predetermined
number with whom the buyer chooses to place his business. This process of
evaluation is conducted by comparing the suppliers in terms of their ability to
provide the desired quality, quantity, price, and service.
In the purchasing context, quality refers to the suitability of an item for its
intended purpose. In purchasing, therefore, the best quality is not necessarily the
highest quality; in fact, sometimes the best quality may be the lowest quality. Quality
must always be judged in the light of the use of which the product Will be put. In

42

purchasing parlance, quantity also has a somewhat specialized meaning. It refers

not only to the total amount required but to the schedule according to which the
goods are required. Thus a supplier who might be able to supply the desired
quantity during the time period specified but could not supply that quantity on the
dates specified would not be a satisfactory supplier from the point of view of
quantity. In purchasing, as in all economic activity, price is a measure of value. The
important thing to keep in mind is that price is meaningless considered by itself. A
price is a good price only if it is the lowest price and accompanied by sufficient
useful services. When talking in general terms about comparing quality, quantity,
and price, it is difficult to say much more than that it is highly important for a buyer
to make certain that he has considered these three factors carefully and in
combination with each other. The exact comparisons that are made will depend to a
large extent on the commodity at issue. However, it is possible to discuss the service
factor in greater detail and to draw some generalizations about service that are
pertinent to all purchases.
3.3.1 Location
The geographical location of the suppliers is an important consideration in
evaluating service. Shipments from a supplier located at a great distance from the
buyer's plant are subject to more and greater risks of interruption such as
accidents, strikes and floods, transportation. At the same time the possibility of
using substitute modes of transportation is lessened as distance increases. For
example, if there has been a disruption to rail transportation on a short haul, it is
easier to substitute truck transport than if the shipment involves a long haul. This
difficulty of finding substitute transportation for the long haul is still greater if the
commodity to be transported is bulky or heavy.
3.3.2 Reserve Facilities
The reserve facilities that a supplier has available are another consideration to
be taken into account in evaluating a potential supplier's service. This issue is of
special importance during periods of high industrial activity. A supplier with a good
reserve of productive facilities is in the best position to meet increased demand and
to assure his customers that their demand will be met in terms of both quality and
quantity. In evaluating reserve facilities one should consider technical and
managerial skills as well as physical plant and facilities. If a potential supplier's
engineering and management staff is spread thin, it is questionable whether he
could make use of extra physical capacity in a seller's market when manpower is
often at more of a premium than goods. Thus, in comparing suppliers, it is

43

important to analyze in detail the facilities that the various companies have to offer
as a criterion of the service they will supply.
3.3.3 Internal Facilities
The

stage of a suppliers technological development

and his interest in

keeping up with current method are also considerations affecting service. While it
might be argued that a, buyer is interested only in whether a supplier can supply
the quality requested, this is a short-sighted attitude. As improvements and
developments are made by competitors, the buyer is certain to want better products
from his suppliers, and, if their technological capabilities do not enable them to keep
up with competitors, the buyer will suffer from having chosen a technologically
inferior supplier.
The inspection methods and the quality-control standards maintained by the
prospective supplier are also important in evaluating service. Since assurance of
supply means not only that the goods will be delivered, but also that they' will be
usable condition, it is important that these two criteria-inspection and quality
control be carefully checked before the choice of supplier is made. A supplier who is
careless about inspection will ship many items that must eventually be rejected and
returned because they are not satisfactory for the purpose. If such a supplier is also
lack in his production quality control, the problem is aggravated because of some of
these, imperfections which many not be discovered until after the item has been
incorporated into the finished product.
A closely related consideration that bears on supplier service is the
"housekeeping" or plant-maintenance standards carried out by the supplier. A
supplier who is careful and thorough in his plant-maintenance practices is likely to
suffer from a minimum number of production disruptions resulting from machinery
breakdowns and similar mishaps. Since production disruptions frequently lead to
delays in shipments to customers, they decrease the assurance of supply which is
an important consideration in service.
3.3.4 Labour Relations
Another possible interference with the continuity of production in a supplier's
plant may originate with the workers themselves. These stoppage may be in the form
of strikes or slowdowns and are the by-product of the labour relations of the
supplier. To a considerable extent, the possibility of such delays can be determined
by observing the morale of the working force the labour policies as expressed by
general management of the prospective supplier, and the degree of responsibility of
the leadership of the union associated with the plant. The history of past strikes will
reflect the labour management climate. A final important point is to determine the

44

length of time remaining on the present labour contract. The possibility of labour
difficulties can then be assessed taking all these factors into consideration.
An indirect clue to anticipate service may be gained from noting the kind and
form of warranty and service that the supplier offers with his products. One should
consider the willingness of the supplier to give an adequate express warranty with
his products, his offer to install where necessary and to replace where indicated and
his willingness and ability to make available replacement parts as needed.
Assurance of supply means not only that, deliveries are made as promised but also
that the product delivered should be usable throughout its normal life. A supplier
who does not stand behind his product or who is not equipped to service his product
satisfactorily cannot be rated high on the point of service.
The vendor relations of the supplier must also be evaluated in determining his
service rating. A good supplier on this score is one who will meet occasional unusual
requests, such as the need for emergency shipments or a sudden slight change in
specifications. A buyer needs assurance that a supplier will willingly accept such
situations if he can be satisfied that the emergency is a real one and that such
emergencies do not arise with undue frequency. It is as important that the buyer do
not subject the supplier to a succession of emergencies as it is that the supplier
accept an occasional emergency graciously.
A visit to the plants of prospective suppliers is an important means of
evaluation. Plant visitation is also important in the periodic reexamination of
present suppliers. It is quite customary for a representative of the production
department or the engineering department to accompany the buyer on his plant
visitations. This is especially desirable if the supplier makes technical products. By
having a technical expert with him the buyer is able to arrive at a sounder judgment
on the equipment and capabilities of the supplier.
3.3.5 Plant Visitations
Although there is no one list of things to be considered on all plant visitations,
it is possible to generalize somewhat with regard to the things that should be
observed and examined on such visits.
I. Facilities: The examination should include not only production machinery
and plant layout but also such facilities as the receiving room where the supplier
handles his incoming shipments, the shipping room where he prepares his own
products for delivery, the internal materials-handling system, the supply rooms and
tool rooms where he maintains his reserve stocks, and the office facilities where he
processes the necessary paper work and records.

45

2. Personnel: The survey should include observations bearing on the degree

and type of supervision by foremen and other supervisors, state of morale of the
workers as it may bear on possible work stoppages or strikes and degree of technical
competence shown by all individuals whose work in any way has a bearing on the
purchased goods. Particular attention should be paid to union relations. If a
supplier is having labour trouble, this will affect his ability to meet required delivery
dates.
3. Housekeeping: The inspection should include plant maintenance and
general cleanliness, as these provide useful clues to the efficiency and steadiness of
output that may be expected of the supplier.
4. Procedure: It is well to study the manner in which the supplier processes an
order from the time it is received until the shipment leaves his plant. Such an
analysis will establish the level of efficiency that is maintained and will also acquaint
the buyer with any special procedural problems the supplier may have that could
affect service.
5. Production Specialization: The buyer should attempt to determine a plant
visitation if there are any areas of production in which the supplier tends to
specialize. It is in such specialized areas that the supplier is likely to prove to be the
most satisfactory source.
3.3.6 Credit and Financial Analysis
Another method of evaluation of suppliers, which is sometimes over-looked by
purchasing agents, is the analysis of credit reports. Most concerns have available,
through their comptroller's offices, reports of the, pun and Bradstreet credit service
At little or no additional cost to the company, the purchasing' agent is able to secure
information from this source that will assist him in supplier evaluation. Credit
report,

contain information on

a supplier's

facilities

where

the

report is

unfavourable, a trip to a suppliers plant can be saved. The reports often given an
insight into the experience and character of a potential vendor. By establishing the
credit character of a potential vendor. By establishing the credit rating of vendor,
the purchasing agent is able to estimate the financial risk of dealing with that
vendor.

The reports also list the products made by the

vendor, giving the

purchasing agent some insight into his capabilities. Since the reports show the
vendor's profits, the purchasing agent has a clue to the efficiency of the vendor's
operations.
A supplementary related procedure involves independent analysis of the
vendor's financial statements. Although accounting statements vary with fiscal
periods, and details of accounting procedures, the purchasing official can obtain

46

information regarding the financial stability, pricing cushion, and general operating
efficiency by applying the tools of ratio analysis to the balance sheet and income
statements of the vendor. A short account of the more popular ratios and their uses
are follows.
Current ratio relates current assets to current liabilities. The usual "rule of
thumb" acceptable ratio is 2:. As current assets and liabilities are those that can be
turned into cash within short period of time (one year or less). this ratio measures
the financial ability of the firm continue in the short-run. Acid test ratio is a variant
of the current ratio in that it relates current assets less inventories to current
liabilities. Inventories are omitted from current assets because they often are
difficult to turn into cash readily. A "rule of thumb" acceptable ratio here is 1:1. Like
the current ratio, it is a reflection of the ability of the firm to function in the short
run.
Sales-receivable ratio is determined by dividing sales by accounts receivable; it
indicates whether customers are paying their bills promptly or whether too much of
the vendor's assets are tied up in receivables.

This ratio is related to the sellers

standard terms of payment. For example, if the terms are 90 days, not much more
than this amount of total sales should be in receivables. A firm with sales of $6
million and 90-day terms should not have much more than $1 million in accounts
receivable.
Net profit to sales is an overall measure of the profitability of the firm after all
expenses have been deducted, The size of the profits gives an indication of the
possibility of successful price negotiations.
Cash flow is obtained by adding net profit after taxes to depreciation charges. It
measures the amount of dollars the firm is receiving. Cash flow assists profit
evaluation, as an increase or decrease in profit may be caused by changes In
depreciation accounting.
Inventory turnover ratio is the cost of goods sold divided by average inventory. It
indicates efficiency in inventory management, and freshness and salability of the
inventory. If the ratio is low, the firm is either over inventoried or undersold. A
high turnover ratio is usually preferable to a low one.
3.4 DIFFERENT METHODS OF EVALUATION
The most important measure of a suppliers performance is his record of earlier
supplies of similar items made to various purchasers. Recently increasing attention
is being paid to make the evaluation objectively by standards and procedure. There
are three evaluation techniques developed and they are, the categorical method, the
weighted point method and the cost-ratio method.

47

3.4.1 The Categorical Method

The categorical plan is the least precise of the evaluation techniques. It relies
heavily on the experience and ability of the individual buyer. Essentially is consists
of a procedure whereby the buyer keeps a record of all vendors and their products.
After establishing a list of factors for evaluation purposes, the buyer assigns a grade
indicating performance in each area. A marking system of plus, minus, or neutral is
usually used. In addition, evaluation lists are given to all departments involved with
the suppliers merchandise, such as the quality control production. and receiving
departments. At periodic evaluation meetings the buyer discusses the ratings with
representatives of these departments. Later, those suppliers with composite high or
low ratings may be notified. and future business allocated accordingly.
Although this system is non quantitative, it does provide a means of systematic
record keeping of performance criteria. It is also inexpensive and requires a
minimum of performance data. However, it relies heavily on the memory and
judgment of the individuals doing the rating and the possibility exists that rating
will become a routine chore performed with a minimum of critical thought.
3.4.2 The Weighted-Point Method
The weighted-point method provides for quantifying the evaluation criteria. Any
number of evaluation factors can be included and their relative weights can be
expressed in numerical terms so that a composite performance index can be
determined and supplier comparisons made.
For example, assume that it has been decided to use the following evaluation
criteria: quality of shipments, accuracy of delivery promises, frequency of cost
reduction suggestions and price. Assuming that quality and delivery are the most
significant, a point rating system such as the following might be used: quality 40
points, delivery 30 points, cost reduction suggestions 20 points, and price 10 points.
Based on hypothetical performance figures. An evaluation might be as shown in
Figure3.4.2.1
Acceptable and unacceptable ranges could be applied to the composite rating.
such as: excellent-85 up: acceptable-84 to 70; unacceptable-69 under.

shipments
Received

Quality
Percentage

Rating

Accepted

(%
30)

Percentage
on
Schedule

Deliver
y
Rating
(% 30)

Parentage of Total

Total

No. Cost Reduction

Suggestions

Figure 3.4.2.1 Composite Rating Schedule

Cost
Reductio
n Rating
(% 20)

48
Vendor
A
Vendor
B
Vendor
C

100

90

36

80

24

20

60

80

32

90

27

20

50

70

28

100

30

60

12

Vendor A
Vendor B
Vendor C

Average

Lowest Price

Price Rating

Total composite rating (Quality,

Price/ Unit
40.00
50.00
60.00

Actual Price
40/40
40/50
40/60

(Price % 10)
10
8
7

Delivery, Cost Reduction and Price

74
71
77

Composite Rating Comparison

Vendor A
Vendor B
Vendor C

Quality

Delivery

(40 points)

(30 points)

36
32
28

24
27
30

Cost
Reduction
(20 points)
4
4
12

Price

Composite

(10 points)

Rating

10
8
7

74
71
77

Among the advantages of the weighted-point plan is the fact that a number of
evaluation factors can be included and they can be assigned relative weights
corresponding to the needs of the firm. Subjective evaluation is minimized. Finally, if
the weighted point plan is used in conjunction with the categorical plan, suppliers
can be evaluated on a quantifiable basis without overlooking the intangible aspects
of service.
3.4.3 The Cost Ratio Method
The third evaluation technique, the cost-ratio method, relates all identifiable
purchasing and receiving costs to the value of shipments received from respective
suppliers. The higher the ratio of costs to shipments, the lower the rating applied to
the supplier.
The choice of cost to be allocated depends somewhat on the specific products
involved. However, quality, delivery, service, and price are the usual categories. Costs
associated with quality usually include costs of visits to vendor's plants and sample
approval, inspection costs of incoming shipments, and costs associated with
defective products such as unusual inspection procedures, rejected parts, and
manufacturing losses attributed to defective parts. The costs associated with routine
qualifying of a supplier and routine inspection tend to be approximately equal for all
vendors of like products. However, the costs associated with defective products will
vary substantially from vendor to vendor.
Quality costs can be tabulated by the quality control department, with the aid
of information from production regarding the possible reworking costs associated
with defective parts. An alternative procedure is to have a specific account

49

established departments forward, for posting to this account, their excess costs
incurred as a result of the defective shipment. In either case, total quality costs are
related to total dollar purchases to determine the quality-cost ration as shown in
Table 3.4.3.1.
Table 3.4.3.1 Quality Cost in Rupees
Vendor

Month of Rs.

Visits to vendor plant

200

Sample approval

300

Incoming inspection

75

Manufacturing losses

Reworking costs

Value of rejected parts

425

Other

Total costs

1,000

Total value of purchases

100,000

Quality-cost ratio (total costs/purchase)

1%

The usual costs associated with delivery include expediting, telephone,

telegrams, emergency transportation (e.g. air shipments), and miscellaneous. The
same tabulating procedure would be followed as described for quality costs. A typical
tabulation is shown in the following Table. 3.4.3.2.
Table. 3.4.3.2 Delivery Costs in Rupees
Vendor

Month of Rs.

Telephone calls

300

Telegrams

175

Expediting (visits to plant)

200

Premium shipments

125

Miscellaneous

200

Total delivery costs

1,000

Total value purchases

100,00

Delivery-cost ratio

1%

Measuring the intangible aspects of a supplier's services is the most difficult

part of any evaluation procedure, but these considerations are at least as important
as delivery and quality. The cost-ratio method of evaluation reduces the subjective
element common to other methods, establishes a "norm" of supplier services, and

50

evaluates suppliers above and below the norm in relation to price. The following
procedure is suggested to integrate service into the cost ratio:
1. Determine the subjective service factors that the buying company thinks it
should evaluate, such as research and development facilities, capacity for future
production expansion, field service facilities, stability of labour relations, warranty
provisions, geographical' location, financial stability, inventory-storing service, and
flexibility in providing short lead times.
2. Assign numerical weights to each factor in accordance with its importance to
the buying firm.
3. Establish a premium over quoted price that the total subjective service
"package" is worth. A firm producing highly technical electronic components might
value this "package" at 10% of quoted price, whereas a buyer of standard fasteners
might value it at only 1 %.
4. Determines an acceptable norm. For example, out of a total of 100 possible
service points, 70 might be considered as acceptable.
5. Rate the suppliers according to the service factors.
6. Apply this percentage to the value of the total service package to determine
the cost ratio of service. For example, if the total service package is valued at 10% of
price and total possible points are 100, with 70 being acceptable, a vendor with 90
service points would have a service-cost ratio of -3%, whereas a vendor with 50
points would have a service-cost ratio of + 3%. This final value is obtained by
relating the actual number of service points earned to the acceptable level and
subtracting the result from 100%. In this example 90/70 = 130% -100% = 30% over
norm. This value (30%) multiplied by 10% (the total value of the service package)
equals the service ratio of 3%1 .As the final value is over the average, the serviceratio cost is -3%.
A tabulation chart such as the Table given below could be used.
The quality, delivery, and service cost ratios are now combined with the
vendor's quoted prices to detailing the net cost. Assuming that the rating procedure
already described has been applied to four competing firms, the comparison would
be as shown in the Table 3.4.3.3.
Table 3.4.3.3 Service Rating
Vendor

Month of

51

Maximum point
value

Factors

Rating

20

Financial stability

10

Field service facilities

15

Research and development facilities

10

10

Flexibility in providing short lead time

10

10

Labour stability

10

Geographic location

10

Potential expansion of capacity

Warranty provisions

Inventory-storing service

10
100

20
9

Miscellaneous

10

Total points

90

Maximum value service package 10% of price

Acceptable service rating = 70
Present rating = 90
Over acceptable by 30 (minus)
Under acceptable by (plus)
Service cost ratio = -3% (over acceptable of value of package.10%)
The flexibility of the cost-ratio method allows It to be adopted by any company
for any products. The relation of evaluation criteria to quoted price provides for
complete vendors selection.
Table 3.4.3.4 Summary: Cost Comparison
Month of
Quality
Cost
Ratio%

Delivery
Cost
Ratio%

Service
Cost
Ratio%

Total Cost
Penalty%

Quoted
Price/Unit

Net
Adjusted
Cost

Z Company

-3

-1

87.00

86.13

F Company

+3

+7

83.25

89.08

W Company

+6

+10

85.10

93.61

P Company

+2

+1

+4

85.00

88.40

Part

52

3.5 REVISION POINTS

Source of Information of suppliers
Factors to be considered in supplier Evaluation
Categorical Method
Weighted point method
Cost ratio method
3.6 INTEXT QUESTIONS
1. Describe the concept of right quality for the material to be procured and
purchasers role unit.
2. Discuss the various methods by which source information can be collected.
and compiled.
3. The necessity of evaluation of the supplier will help in the choice of the
correct supplier -Discuss.
4. State the evaluation techniques available and compare them & bring out the
best method.
Three vendors namely A,B and C are supplying products and they have to be
rated based on quality, price and service. The corresponding weights are 65%, 20%,
and 15% Based on the following information, Rank the vendors.
Fraction of

Number

Number

Unit

Supplier

Accepted

Price

7,000

6,700

7.00

0.86

2,500

2,300

6.50

0.97

3,400

2,900

4.50

1.00

Supplier

Commitment
fulfilled

3.7 SUMMARY
All three evaluation techniques designed to aid buyer judgment, and in some
cases quantify what would otherwise be subjective analysis. However, they are
suggested to be used as aids to. and not a replacement, for, buyer judgment.
Important supplier variables such as integrity initiative and ethics are not
quantifiable. In addition many of the quantifiable, variables are dependent initially
on subjective decisions. Properly used these techniques can make supplier selection
more scientific and rational.

53

3.8 TERMINAL EXERCISES

1. Explain the necessity of Evaluation
2. List the factors to be considered in suppliers evaluation.
3.9 SUGGESTED READING /REFERENCE BOOKS /SET BOOKS:
1. P.Gopalakrishna, Purchasing and materials Management, Tata Mc-Graw
Hill, 2000.
3.10 KEYWORDS:
Catalogues,

Trade

Directories,

Trade

journals,

Trade

Fairs,

Supplier

Evaluation, Categorical.

54
LESSON 4

CONCEPT OF RIGHT PRICE

OBJECTIVES
To understand the concept of right price.
To know about Discounts
To know the tendering system and methods of Tendering.
CONTENT
Introduction.
Concept of right price
Market as developed
Buyers Role
Right Price
Discounts
Price Analysis
Tendering System
Different Methods of Tendering
Revision Points
Intext Questions
Summary
Terminal Exercise
Suggested reading/reference books / Set Books.
Key words
4.0 INTRODUCTION :
The materials executive is concerned mostly with the right price of the product,
determination of which is very difficult. There is hardly anything in the world that
some one cannot make a little cheaper and the man who considers price alone is the
lawful prey, according to John Ruskin. Thus the lowest price need not necessarily
be the best price, but the lowest responsible price is the right price. Even the
orthodox

conservative

agencies,

government

departments,

Public

sector

undertakings want the lowest responsible price. At the same time, we should not be
blinded by the idea that the higher we pay, the better will be the quality.

55

4.1 CONCEPT OF RIGHT PRICE

Price is expressed universally in terms of money. Anything has a cost or value.
Value means to different people in different way like utility value, esteem value,
aesthetic value, function value etc. For Purchase executives and in Purchase, value
is the worth for a particular commodity, material, spare, equipment etc. A
commodity or material or spare part expressed in terms of Rupees. Therefore. such
an exchange of payment of a price in Rupees to a material, spare etc. shall be fair
and reasonable. It is the value which is considered as right price. A question is
always raised by the Purchaser whether the price quoted for a particular material,
Spare, equipment or service is reasonable and an accurate measure of the material,
spare etc, or goods. It becomes a task of the Purchaser to relate the price to the
value worth of goods or services. It is a very difficult task and there is no clear cut
standard method or set of principles available by which a price of goods or materials
or services can be assessed. In fact, in the market, prices of same product which has
same end use or function vary from vendor to vendor, place to place, time to time
and so on. There are number of variables which constantly vary and alter the price
structure of any item. Pricing of an item, becomes very complex in many cases as
the elements that go into the particular product are varying and fluctuating from
time to time.
Under the circumstances, the Purchaser/Buyer in determining the right price
must naturally look at the price of the product objectively. The different price quoted
by different bidders/suppliers must be examined carefully with reference to all other
features and services which will yield the best return to the Company. Quality of the
product, dependability and reliability of the supplier technical capability and other
performance and timely delivery shall have a price but it may not be the lowest.
Every part of service, the best to be rendered has a price tag attached to it as they
all mean cost to the supplier. In order to get the best in the purchase, price alone
need not be the criteria but quality, service, performance, reliability, financial
stability, technical know-how,

professionals engaged, and responses are to be

considered. As the purchaser has very vital role and responsibility to see that the
goods he buys have best value for the price paid as he, the purchaser, is one who
incures expenditure on behalf of his company gain, knowledge of Law of Contracts,
Sale of Good Act, Excise Duty, Customs Duty, Local rules and regulations. ImportExport policy will help him to carry out his job successfully. His familiarity with the
common law of the land, banking regulations, insurance aspects will be an
advantage since he commits the company's funds by way of a supply/Purchase
order which are legally binding bilateral contracts and the knowledge as above will
help him to have the funds of the company and troublesome litigations.

56

4.2 MARKET AS DEVELOPED

There are large number of firms, companies, State sector, Public sector, small
scale industries, ownership,

partnership firms etc. established under, the Indian

Company's Act. Many times, the same item/product is manufactured by different

firms. The end use of these products may be the same, in other words, functionally
they are same. For example, a non-return valve of a particular size. Specification
manufactured by L&T and BHEL may be technically, functionally are one and the
same. But the, price will be different as it depends upon the manufacturing
technology adopted, known how used, quality factory installed capacity, overhead
expenditure etc. A buyer or purchaser must have full knowledge of the market.
There are some items/goods manufactured by only one firm. This Is a
monopoly Item of a particular firm only. It is defined in the market 'where one
producer controls the entire supply of this particular Item/goods, product for which
there is no substitute in the market'. Therefore, the producer is free to charge any
price. Sometimes, It is done by regulating the output of the product and forcing the
market mechanism for a demand. The demand Is created by less production thereby
the market is controlled and the producer takes the best advantage of the price for
the product.
Availability of a product In the market depends upon the availability of raw
materials needed for that product, trouble free manufacturing process, good
industrials relations, availability of power and water. The prices do fluctuate in the
market with reference to the availability of the product. Prices are steady without,
changes if incoming supplies are ensured. A scarcity is created to the product if the
incoming goods in the market is affected or less due to many reasons as stated
above including transport arrangements and problems. Many times, acts of
Government do playa very significant role on the price of the product. For example,
in the budget month (February) every year, producer/manufacturer/ stockiest await
the budget announcement before selling. It is common at that period the goods are
nil stock or out of stock.
4.3 BUYERS ROLE
The Purchaser /Buyer can positively exert " tremendous Influence on the prices
fixed/demanded by a producer/manufacturer/seller if only the buyer understands
how the prices are determined and arrived at and at what conditions. The supplier's
best price is the one he thinks competitive enough and has a perfect margin. In
mixed economy, the buyer can always take the role of regulatory force through price
negotiation and through competitive bidding. In such a process, the seller's best
price is revealed and the buyer can take note of it and accordingly proceed with,
Whenever the buyer/purchaser decides to negotiate the price. It is, very evident, it

57

may not be the best price according to the buyer. In such a process, naturally, the
buyer exerts pressure on the supplier/seller to recheck his cost and review again the
method adopted and possible reduction in price. To a large extent, by this process,
the buyer induces a low cost and efficient production method and technology.
The pricing process of any product is generally determined by the following
factors which has an influence on it.
Direct cost -On materials on labour & Supervisor, overheads, cost of machines
Indirect cost -Overheads due to other expenses like services, purchase,
marketing, finance, personnel and corporate/Head office expenses.
The seller tries to estimate the unit price of the product as accurately as
possible but many times it becomes very difficult due to various elements and
variables involved.
Profit margin -This is also worked out on assumption basis so as to be
competitive.
(A) DIRECT COST:
This shall be the cost of the materials, raw materia1 consumables, spares,
purchased and used in the process of the manufacture of the product. There are
engineering standards and norms for the product manufactured on which the
quantity of each material, spares and other inputs are specified. On these items the
unit price as purchased and the cost incurred thereon are added and the direct cost
so arrived at. Due allowance are taken into account due to wastage, shrinkage, shell
life, productivity of the labour engaged.
On labour, the cost of the entire skilled, semi skilled labour, technicians is
engaged in the direct product manufacture are calculated and included. But the
labour engaged in the services part like inspection, material handling etc. are not
included.
(B) INDIRECT COST:
The expenses incurred in all the services department are grouped together and
charged on the unit cost as overheads. These include all indirect charges incurred,
establishment, personnel, finance, purchase material management, sales etc. and
also includes payment of statutory levies, maintenance of factory, civil and electrical,
distribution system etc.
4.4 RIGHT PRICE
From the foregoing, it will be very difficult to work out the right price as it
depends upon various factors, conditions and situation. But broadly through cost

58

analysis and value analysis, one can assess the price of an item should cost.
Thereafter, the purchaser's skill in negotiating, his relationship and rapport
developed will determine the actual price. Forecasting is done at + 10% of the
previous price. Sometimes, the prices can be arrived at on the basis of the published
indices for the prices of raw materials and Reserve Bank of India's (RBI) indices for
Labour. There are certain standard formulae available. But here again, the exact/
accurate price cannot be arrived at as only few selected items are taken as subject to
variation.
In deciding what is the right price, the Purchase executive must take a broad
and objective view of the company. He must examine the prices quoted by different
vendors/suppliers and attempt to determine which price in relation with the quality
features. standards of the product and the service aspects by the vendor/supplier
will offer his company the greatest ultimate value. The purchase, executive is
spending a substantial proportion of the funds of the company. As it is known
generally

that

materials

are

about

70%

of

the

total

product

processing/manufacturing involved. Therefore, the decision by the Purchase

Executive shall have a great influence on the profits of the company and working
capital. He has a great role and responsibility to his company to see that it gets a full
measure of value for the money he, spends. This responsibility can be duly
discharged only by a constant and careful review of all the prices he can obtain.
4.4.1 Cost Approach
This method of pricing a product is more accepted and is commonly adopted.
The basic idea of this method is very simple. The costing/pricing department adds
together the individual costs of items as determined, by Cost Accounting methods
the unit cost shall include such item as raw material, direct labour, indirect labour,
machine time, factory overheads, warehousing, sales, advertising, publicity,
transport office costs and general overheads. To all these total, profit margin is
added and the figure thus arrived at the unit selling price.
4.4.2 Administrated Price
During the Depression period, an innovative thinking was developed to price
pattern to contain the inflation. Few suppliers who controlled few industries
administered the prices rather than allowing the free play of supply & demand to
determine the level of price. Now Government has adopted this method. For many
controlled products, Government fixes the price and it is known as administered
price. Presently, Iron & Steel, as and fertilizers are under this group.

59

4.4.3 Market Approach

The 'Market Approach' to the pricing consists of essentially putting a price on
the product that market can

pay. It is generally done on the basis of market

research designed to reveal through questionnaire or market test as to what volume

can be sold at various possible prices. This technique is mostly adopted in consumer
goods. Many times, in this method, the prices are fixed following Leader. The prices
shall be just less than the price of its leader so that it gets more business. There is
also a method by which the prices are fixed so that desired volume of business is
ensured. All these methods are adopted and possible in consumer products only.
4.5 DISCOUNTS
An important part of the price determination very much revolves around the
Discounts that are available or can be secured and given in the purchase proposals.
The Purchase executive must be familiar with the discounts that can be offered by
the seller and also the various discounts available in a commercial business
deal/transaction.
4.5.1 Cash Discount
In the sellers point of view 'cash and carry' is most acceptable. This means, you
pay the money due and carry the material. But it is not possible in all business sale
transactions as a number of procedures and activities are involved besides many
agencies. Since the Seller wants to generate money faster, he gives -a cash discountif
the payment is made -say -within 10 days. This discount is generally between1 and
2%. If the purchaser pays within 10 days he can deduct this percentage discount
and pay the balance.
4.5.2 Trade Discount
There is certain price reduction allowed to various classes of buyers to perform
certain distributive and selling functions and this ranges from 5 to 15%. This Trade
Discount is given Just to protect the channel of distribution of the product. The
manufacturer gives the Trade Discount to the Wholesaler who is expected to sell the
product to small consumers. The discount is granted towards maintaining the
market distribution system and making such arrangements as may be needed. A
Purchase Executive shall try to obtain this trade discount and get the product
directly from the manufacturer.
4.5.3 Seasonal Discount
Mostly, in case of consumer goods certain seasonal discounts are provided. For
example sale of Air Conditioners, Refrigerators, fans etc'. During the winter season,
there may not be a great demand for these products. So to influence the market,
these seasonal discounts are offered by the manufacturers.

60

4.5.4 Quantity Discount

Quantity discounts are offered to the buyer who buys large quantity. The seller
gains by a bulk order for a large quantity, his business will be more, the factory is
fully loaded, less expenditure in sales, marketing

billing and paper work. Bulk

orders carry less cost on transport, reduction in the handling dealing on all matters
with one buyer only. The buyer must consider the inventory carrying cost with
reference to the discount on large quantity. The economics must be worked out and
compared.
4.6 PRICE ANALYSIS
As earlier mentioned, the right price of a product cannot be easily determined.
There are certain information/ data which will be useful in making a very accurate
price of a product. These are indicative but not definite and final.
The Purchaser has to investigate in the market, the fair and reasonable price of
a product, For standard products the price can be collected through price lists and
catalogues. Such price list and catalogue are to be investigated whether they are the
current list, whether any discount announced later or any Excise/Sales Tax benefits
to be passed on to the buyer and so on. Many times a discussion with the Salesman
will bring forth many useful information on the price of the product. These salesman
are well informed about the product price, changes announced, discounts possible,
For controlled items like Iron & Steel metals the authorities concerned like Steel
Authority of India Ltd, (SAIL) and Minerals & Metals Trading Corporation (MMTC)
publish the prices of various items/materials under their purview periodically so
that the buyer is kept informed of the commodity prices offered. By the Seller such
as trade discount, seasonal discount, quantity discount and cash discount.
4.7 TENDERING SYSTEM
As soon as the purchase demand is received in the form of purchase
requisition, the purchaser should decide the mode of purchasing it in due time
depending upon the type of material, component, spare part machinery etc., time at
which it is needed for the production department, quantity needed, the estimated
cost etc. The purchaser should decide the mode of procurement for this item
whether through direct call or negotiation or repeat order or by tendering. More
often, tendering to the open market is resorted to for high value or critical items of
any raw material, spare, machinery and the like.
While there are many different methods of tendering which we shall discuss
later in this lesson, the steps to be taken on the tendering process are as under: Entry of the purchase Requisition

61

Preparation of tender documents.

Preparation of tender enquiry -details.
Selection of the tender enquiry
Sale of tender document
Clarification, if any
Pre -bid discussion.
Receipt of bids and opening thereon.
Analysis of the bids -technical & commercial.
Selection of the supplier -approval thereon.
Negotiation with the selected supplier.
Placement of supply order.
Documentation.
4.7.1 Purchase Requisition
purchase Requisition is the most vital basic document on which the purchase
action starts. Some standard forms may be devised to prepare this Purchase
Requisition. Depending upon the Company's policy it may be prepared by the
Material Planning department or Production department. Sometimes it is prepared
by the purchase department also. The information and basic data needed which may
be furnished on a standard form are as under: Description of the goods needed
Quantity of the goods
Delivery schedule desired.
Code number
Last purchase source
Last purchase price
Last purchase order
Quantity in stock
Quantity in transit
Rate of consumption.
Critical/Non-Critical.
Supporting documents, if any

62

Technical specification in detail

Such a purchase requisition as received,

is entered in a register called

'purchase Requisition Register or Demand/Indent Register. The register maintained

in the purchase department shall indicate all the activities involved in the process
upto placement of order with, reference to time schedule for each activity and time
actually taken. This Will help to review the time element take such remedial action
as may be necessary to avoid delay in the activity/activities:
4.7.2 Preparation of Tender Documents
The tender document is most vital Source of details/data information to any
prospective buyer and intended tendered/bidder so that on examining these
documents he can prepare his most competitive bid, technically suitable and
acceptable one and commercially most competitive. Any ambiguity in any,
condition/clause may mislead the bidder which may end up in defective bid/tender.
Therefore, due adequate care is necessary in the preparation of those documents.
These have legal sanctity.
4.7.3 Notice Inviting Tender (NIT)
Whatever be the mode of

tendering -say Advertised Tender, Open tender,

Limited tender or Single tender, a notice of the intention of the purchaser must be
prepared, and communication so that the firms/companies manufacture will come
to know the demand and act later. Essentially, the Notice inviting Tender is to draw
the attention of the supplier, the intention of the purchaser. The NIT is broad based
and shall contain the following: Name of the Company, Organisation and address.
Tender number
Scope of work
Cost of tender documents
Sale period of tender document
Earnest Money Deposit/Bid Guarantee
Time and date of submission of bids/offers
Time and date of bid opening
Other details like extension for sale/bid/opening/delays in transit by
post/officer to whom bids to be submitted etc. shall also be there.
In the case of major equipment, terms of even pre-qualification requirements
are mentioned on the Notice Inviting Tenders. Generally standard printed forms are

63

available for easy follow up and proceeding with. In the case of Advertised Tender,
the above NIT is published in the approved Dailies. In the case of Limited Tender
Enquiry (LTE) it is modified slightly and sent to such bidders/vendors in the
approved list.
4.7.4 Terms And Conditions
The Purchaser must specify in the tender document tends and condition under
which he desires to receive the bids. The commercial part of the bid documents shall
contain brief description on the terms and conditions and shall include:
Scope of work
Commissioning/Delivery schedule
Price and price variation
Performance guarantee
Payment terms
Insurance/Transport
Excise Duty/Sales Tax/Customs Duty
Liquidated Damages/Force Major
Delivery basis (For/Ex. Works/CIF/C&F/FOB etc)
Termination/Arbitration Limits of legal jurisdiction.
4.7.5 Submission of Bids and Tender Opening
The intending bidders/suppliers shall purchase the tender documents on
payment of the cost prescribed for it. On going through the tender documents,
clarification, if any, may be sought by the bidder. All such clarification will be
examined by the purchaser and suitable reply/clarification shall be issued to all the
bidders/suppliers who have purchased the tender documents. The intending
bidder/supplier shall carefully prepare the tender document is line with the
instruction of the bidders/suppliers issued by the p-purchaser and submit the
tender document in due time as prescribed. Tenders so submitted by the various
bidders/suppliers are registered and duly accounted. These are opened in public in
the presence of the representatives of the bidders/suppliers. Generally late tenders
are not accepted and rejected. Salient terms and conditions of- the various bidders
are read out for the benefit of the other bidders. Generally a Committee shall open
the tender documents though the custodian is the purchase department.

64

4.7.6 Evaluation
The offers/bids so received are examined and analysed in depth. The
comparative statement on technical aspects and commercial aspects are prepared.
The prices are evaluated taking into amount all elements of cost involved in arriving
at the site cost. The details of calculation, are checked very carefully and placed
before the tender committee. The Tender committee will examine these report and
submit its recommendations. On the basis of the financial delegation of powers the
approval to the recommendations are accorded and supply order placed and
acknowledgement obtained from selected supplier.
4.7.7 Supply Order/Purchase Order
This is a most important document which binds the Purchaser and the
Supplier under certain agreed terms conditions and price. On the basis of this
document only an inter department follows and acts. It is a legal document and
claims, disputes etc. that may arise may have legal bearing on the terms and
conditions set in the supply order. Care should be taken to prepare the supply order
and it shall contain to prepare the supply order and it shall contain mutually agreed
clauses terms and conditions and prices. Generally, it is get checked by Finance
department and vetted by Legal department.
4.8 DIFFERENT METHODS OF TENDERING
The objective of the purchase is to get the material/goods of right quality, right
time, right source, right price. To meet this objective, tendering is resorted to,
4.8.1 Global Tender
For procurement of imported materials /goods, a Global Tender is issued. The
Notice Inviting Tenders are -published through Indian Embassy in, other countries
and other country's Embassy in India besides the press advertisement and
publication in the Indian Trade Journal, a publication widely circulated carrying
only such tender notices.
The documents in the case of Global Tender shall, indicate the Foreign
Exchange details, funding agency and its terms. More time is to be given for
submission of bids as bidders are from outside the country.
4.8.2 Press Tender/Advertised Tender
The

Notice

Inviting

Tenders

are

published

in

Dailies

so

people/suppliers can participate which will enable more competition.

that

many

65

4.8.3 Limited Tender

Few firms have registered vendors in the list for standard products. For such
items, a tender notice is issued to limited vendors only. These are proven sources
and fully pre-qualified and dependable suppliers.
4.8.4 Single Tender
In the case of proprietary items, the tender notice is issued to the particular
supplier only. Hence it is called as Single Tender. All other procedures are the same
irrespective of the type of tendering.
4.9 REVISION POINTS
Concept of price
Direct Cost
Indirect Cost
Right Price-cost approach, Administered price and market approach.
Tendering procedure and methods.
4.10 INTEXT QUESTIONS
1. Discuss the concept of right price and the Purchaser's role therein.
2. Describe the procedure and sets involved in the tendering system.
3. Write short notes on:
-Global Tender procedure. .
-Price analysis
-Price discount.
4.11 SUMMARY
In this Lesson, Different methods of approach to fix the right price on the
materials are discussed in detail. Various types of Discount and their influence are
given. Tending system and their method are reviewed.
4.12 TERMINAL EXERCISE
1. Give a short notes on direct cost and indirect cost.
2. List the different types of discount
3. Briefly describe the Notice Inviting Tender
4. List the methods of Tendering.
4.13 SUGGESTED READING/REFERENCE BOOKS/SET BOOKS
1. P. Gopalakrishnan, Purchasing and materials Management, Tata Mc GrawHill 2000.

66

4.14 KEYWORDS
Right Price, Administered Price, Trade discount, Seasonal Discount, Quality
discount, Tender notice, Tender documents.

67
LESSON -5

PRICING TOOLS
OBJECTIVES
1. To know about forecasting Techniques in purchase management.
2. To know about concept of Break-even analysis and their mechanism.
3. To understand the learning curve concept.
CONTENT
5.0 Introduction
5.1 Direct material cost
5.2 Direct Labour cost
5.3 Indirect expenses
5.4 Price Forecasting
5.5 Break even analysis
5.6 The learning curve
5.7 Revision Points
5.8 Intext questions
5.9 Summary
5.10 Terminal Exercise
5.11 Suggested reading/reference books /set books
5.12 Key words.
5.0 INTRODUCTION
The pricing process of the supplier is not exact and he does not work rigid cost
estimates. He also has a flexible profit that is determined by the market conditions.
The reason for this is not far to seek. He does not, simply know his exact costs till
such costs are actually incurred, and the supplier's price quotations are based on
further estimates of costs, which may be broken into the following for major cost
components.
1. Direct expenses Direct materials Direct labour
2. Indirect expenses Manufacturing overheads
Selling and administrative overheads
He tries to estimate such elements of cost as accurately as possible, but the
pricing process is less exact because of many variables present in the system, which
are briefly discussed below.

68

5.1 DIRECT MATERIALS COST

Direct materials cost include those of the purchased materials and or parts
and components which enter into the product directly. All other costs on materials
used and consumed are part of the indirect expenses and from part of the
manufacturing overheads, since they are not incorporated into the product directly.
It is not always easy to calculate materials usage correctly. Sometimes due to
unit-price change, estimates for direct materials cost vary. More often, the estimates
are wrong because of bad usage and proper allowance for scrap, shrinkage, etc.. are
also difficult to determine accurately.
5.2 DIRECT LABOUR COSTS
Direct labour costs include performed on a product, but do not include indirect
labour performances such as inspection, materials handling, supervision and
maintenance, etc. Actual labour hours differ because of variations in time required
to perform various operations which are, therefore, calculated by fixed set standards.
Even if the estimator knows correctly the labour hours expended on a job, his
estimates will go wrong if the workers do not work up those standards.
5.3 INDIRECT EXPENSES
These expenses are often termed as overheads, which cannot be assigned to
any particular 'product directly, but are lumped together and charged on unit costs
as manufacturing overheads, which ale generally associated with factory expenses
and Selling and Administrative Overheads, which are generally associated with office
and management services etc., and are generally expressed as percentages. This is
deceptively simple and essentially arbitrary. In many cases, it is not possible to
accurately measure the overheads and therefore, allocation is made on arbitrary
basis as percentages of direct labour cost to total cost.
Types of overheads are fixed costs, variable overheads and non-variable
overheads. Fixed overheads are what the term 'fixed' means. It includes costs which
are right regardless of the volume of quantity of production. Non-variable overheads
are not so rigid, but vary slightly with the changes in the volume of production.
Variable overheads, on the other hand, vary directly with the volume of production.
Tools of pricing: Thus we may see that pricing depends on Fixed Costs, Direct
Materials, Direct labour, Various Overheads and Non-variable Overheads, plus profit
which depends on total sales revenue.

69

5.4 PRICE FORECASTING

Approaches Many techniques are available in Forecasting. Each from will have
to carefully assess its data processing facilities, skills and the operating environment
so as to select a technique that is most suitable. In inventory systems, factors which
influence forecasting systems, are the number of items involved, the nature of their
markets, and the data handling system. Techniques which are normally used are
moving

averages

method,

exponential

smoothing,

regression

analysis,

etc.

Sometimes Delphi techniques are used for long- term forecasts. Basic issues, such
as forecasting technique, forecast time detail, and review frequency must be finalized
in consultation with top management.
Price Forecasting Techniques : One of the important activities in materials
management is the forecasting of prices of materials to be procured. The forecast of
material prices forms the basic of purchase budgeting, product, stocking policies,
etc.
Materials Research provides the basic infrastructure and information for the
forecast of prices, The research activity helps in predicting some sudden changes in
prices due to environmental causes. Executive brain-storming sessions can also help
anticipate

sudden

price

changes.

However,

even

without

any

observable

environmental cause, prices do rise and they need to be forecasted on the basic of
statistical analysis. This statistical analysis for prices and any observable cause for
their variations have to accounted for by applying suitable correction factors to the
statistical forecast.
Thumb Rule for Price Forecasting: A general practice rise in price as a basis
for forecast. This is all right for an economy in the grip of inflation. However, the
prices of some products vary randomly both within one year between years and the
prices of these can be predicted by using statistical methods.
The forecasting techniques can be broadly classified as those based on (1) the
extrapolation of the same price series, and (2) relation with another price series.
Extrapolation of the same Price Series (Time series)
The following two methods conform to the above title:
(1) Moving average methods, and (2) Exponential smoothing. These are
explained by means of an example.
5.4.1 Moving Average
Consider the price of linseed oil in the years 1970, and 1971. The monthly
prices 'of linseed oil per quintal are indicated below:
EXHIBIT 1

70
MONTH
January'

1970
454.0

1971
481.0

February

445.0

456.0

March

440.0

439.0

April

384.0

413.0

May

396.0

406.0

June

414.0

393.0

July

404.0

389.0

August

405.0

401.0

September

432.0

421.0

October

422.0

425.0

November

464.0

432.0

December

469.0

412.0

By using the five month moving average methods, the prices from June 1970
up to December 1971 could have been predicted. This predicted value for June 1970
would be the sum of the actual prices for the months January, February, March,
April and May divided by 5. The predicted price value for July 1970 would be the
sum of the actual prices of February, March, April, May and June divided by 5.
Hence, the predicted price for June 1970 would be: 454+445+440+396/5 which is
Rs.423.80

per

quintal

and

the

predicted

value

for

July

would

be

445+440+384+396+441/5 which is Rs.415.80 per quintal proceeding in the same

manner, the predicted prices for the other months could be worked out. This is
shown in Exhibit 2.
EXHIBIT 2
Months

Predicted Price

Actual Price

June

423.80

414.00

July

415.80

404.00

August

407.60

405.00

September

400.60

432.50

October

410.30

422.00

November

415.50

464.00

December

425.50

469.00

January

438.50

481.00

February

453.70

456.20

March

458.44

439.50

1970

1971

71

April

461.94

413.80

May

451.90

406.00

June

439.70

393.80

July

422.26

389.00

August

408.82

401.70

September

401.26

421.70

October

403.84

425.00

November

407.64

432.50

December

415.38

412.30

In the moving average method, the weightages given to the price of each year is
l/n where n is the number of months over which the average is taken. In the
illustrative example, the number of months was 5 and the weightage given to each of
the last 5 months prices was 1/5 or 0.2.
The moving average method requires a lot of data preservation and this
becomes tedious if the number of months over which the average is taken as large.
Another aspect for consideration is the equal weightages given to all the previous
'month's prices. These two aspects, viz., data preservation and giving equal weights
to previous months' prices, is overcome by using what is known as Exponential
Smoothing Method.
5.4.2 Exponential Smoothing Method
In the exponential Smoothing Method, forecast for the next month is based on
the forecast for the previous month and the actual, price of the previous month. The
weightages given are dependent on the nature of changes in prices. Forecast of
month (m) = 1/n (Actual price in month (m-D) + (l-l/n) (Forecast for month (m-D).
If n=5 (n has to be chosen based on experience) then the forecast for the month
July 1970 = 0.2(414.00) + 0.8 (423.80) = 82.80 + 339.04 =421.84 per quintal.
The Forecast price for August 1970 would be = 0.2 (404) +0.8 (421.84) = 80.80 +
= 337.09 = 417.89/Quintal.
The Forecast values and the actual prices up to December 1971 are shown in
the table below.
EXHIBIT 3
1970
June

Predicted

Actual

423.80

414.00

1971
April

Predicted

Actual

444,52

413.00

72

July

421.84

404.00

May

438.38

406.00

August

417.89

405.00

June

431.90

393.00

September

415.31

432.00

July

24.28

389.00

October

418.75

422.00

August

416.22

401.00

November

419.40

464.00

September

413.32

421.00

December

427.32

469.00

October

414.00

425.00

January

435.66

481.00

November

416.20

432.00

February

444.73

456.00

December

419. 46

412.00

March

447.02

439.00

1971

In the above illustration the weightage given to previous month's is 0.2. The
prior month get weightages (0.2 X 0.8), (0.2X 0.8X O.8); and so on, The weightages
given to months is inversely related to their age.
5.5 BREAK EVEN ANALYSIS
Cost-Volume Relationship and Break-even Chart
A Break-even chart shows profit or loss of any of output. If a series of cost
volume relationship is calculated and plotted on a graph. The resulting point which
shows that costs are equal to revenue, is the break-even point. At this point of
output, revenue exactly covers costs of production, below this there is a loss and
above this there is profit. Thus break-even point is the dividing line between profit
and loss and as such, break-even analysis is often used for planning production,
pricing etc. Break-even point is thus what the term implies, because at this volume
of output the firm's total revenue begins to rise and it makes profit at a progressive
rate is the output increases.
In the following chart break-even point is show although in the chart the lines
are shown as straight lines these may not be so in actual practice. Below the volume
of 3.800 units of production, there is loss, and above it, there is profit. The breakeven chart thus graphically illustrates the relative changes in costs and revenues as
the volume of production changes, However, it may be noted that unit cost of a given
product does not only depend upon the volume of production alone, it is also
affected by the overall efficiency of the producer and by the amount of business he
gets, a point which every purchaser has to note.

Cost and Revenue (Rs 000)

73

Figure 5.5.1
5.5.2 Cost-Volume Profit
Analysis helps in finding out the relationship of cost and revenues to output. It
enables the financial manager to study the general effect of the level of output upon
income and expenses and therefore, upon profits. This analysis is usually presented
on a break-even chart. It helps in understanding the behavior of profits in relation to
output. Such an understanding, among other things, is significant in planning the
financial structure of a company. There are two elements to consider the level of the
break-even point and the rapidity (Volatility) with which profits change in relation to
output.
The cost-volume profit analysis is used to answer many of the questions faced
by management. As profits are affected by the interplay of costs, volumes and selling
prices, management must have at its disposal analyses that can allow reasonably
accurate presentation of the effect a change in anyone of these factors would have
on the profit performance. When plans are formulated for a given period, certain
questions of the following type have to be answered. Should emphasis be placed on
increasing sales volume? If so, to which of the may products marketed should it be

74

applied? Would an increase in selling prices, even thorough accompanied by a

decrease in volume, result in more profitable operations? Should efforts be made to
reduce costs instead of increasing volume or selling price as a step towards
increased profits? If cost reduction is the answer, should pressure be exerted to
reduce variable or fixed costs?
Not all of these questions would be asked by management in every industrial,
enterprise since the elasticity of demand and the- extent and nature of competition
would have a varying impact in different industries. Cost-Volume-Profit analysis is of
great assistance in obtaining answers to the above questions. Cost-volume-profit
analysis break-even analysis And profit- graphs are interchangeable words. A profitgraph has been defined as a "diagram showing the expected relationship between
the cost of revenue at various volumes," Similarly C-V-P analysis furnishes complete,
picture of the profit structure which enables management to distinguish between the
effect of sales volume fluctuations and the results of price or cost changes upon
profits.
5.5.3 Cost Analysis
There is a growing complexity of costs incurred by a company in its efforts to
attain sales volume that can permit a satisfactory level of profits.
An important segment of profit forecasting revolves around a determination of
how costs change with output. This information can be presented in chart form after
making a distinction among the classes of costs: fixed and variable.
Fixed costs: For manufacturing and selling a product or service, every
business has to incur costs. Some of these are fixed which may represent financing
outlays to be made regardless of sales. They may also consist of depreciation
charges, property taxes and insurance which arise because of the mere existence of
a pland Equipment and office space. They may be salaries of the company's
principal officers. It is worth noting that these costs tend to be related to the
creation of capacity rather than to the conduct of an activity within an existing
productive capacity. These costs are also a function of time. They would be the same
during any designated period regardless of the level of output accomplished during
the period. They are prescribed by contract or are incurred in order to ensure the
existence of an operating organization. Their inflexibility is maintained within the
framework of a given combination of resources. From stage to stage of a company's
capacity to grow, the fixed costs rise, thus when they are considered over a long
enough time the feature of immobility disappears. However, within each capacity
stage, such costs remain fixed regardless of the changes in actual production.

75

Absorption, or full costing system seeks to allocate the fixed (period) costs to
products. It creates the problem of apportionment and allocation of such costs to
various products. By their very nature, the fixed costs have little relationship to the
volume of production or sale. They are allotted to products on some fair or
equitable basis. But any such decision is bound to be subjective and reliability of
allocated cost is naturally very low. Even if the basis for allocation of fixed expenses
is settled, there is still a problem. The actual total cost is distorted not only by
fluctuation-in volume of production but also by variations in the amount of
expenses incurred at irregular intervals. Allocation of overhead expenses, is usually
fraught with considerable technical and accounting difficulties and apportionment
of fixed costs on an arbitrary basis is of limited value and can even be dangerous.
Variable costs: Variables costs are related to the activity itself rather than to
the physical and administrative framework which makes the activity possible. These
costs expand or contract as the activity rises or falls. For instance, the number of
items produced in a period directly determine the amount of material used in their
production. Similarly, the volume of output establishes the direct workers required
and the hours they must put in as well as the amount of certain supplies and other
direct factory expenses. Over the long run, all costs tend to be variable. But within a
given time span, covering an established level, of capacity, distinction has to be
drawn between costs that are relatively free of the ups and downs of production and
those that vary directly with these changes.
As fixed costs do not change with production, the amount per unit declines as
output rises. On the other hand, variable costs react proportionately with
production

changes.

The

amount

per

unit is

constant

with

output.

The

decomposition of costs into fixed and variable class proves to be a trying task.
Relationships often are not clear-cut or may be obscure by unusual circumstances.
Because of the numerous technological changes in recent years, it is difficult to
establish a static period when output and costs can be measured over time with a
reasonable assurance of accuracy. Decisions may have to be made by executive fiat,
although in most cases satisfactory results are likely to be obtained through a
statistical or engineering analysis.
5.5.4 Mechanics To Break-Even Chart
On a break-even chart, the volume is indicated on the x-axis as number of
units produced and sold.

The total cost(y) at any volume(x) equals a fixed

component (F) plus a variable component (v) times the number of units of volume (x)
i.e. for cost y = F +vx.

76

Revenue is plotted on the assumption of a constant selling price per unit.

Assuming that volume can be measured as units of product and designating the
unit selling price as (p), total revenue (y) at any volume(x) equals the unit selling
price (p) times the number of units of volume. i.e. for revenue y = px.
y = F+vx
y = px
px = F+vx.
These relationships can be illustrated by assuming the following situation:
Fixed cost

Rs.

500

Variable cost
Rs. 1 per unit
Selling price
Rs. 2 per unit
Normal Volume 750 units

Figure 5.5.2

Figure.5.5.2

In this situation, total cost (F=vx) at normal volume would be Rs. 500 (fixed
cost) + Rs. 1 x 750 (variable cost) = Rs. 1, 250/=
The revenue (px) by selling 750 units at Rs. 2 per: unit would be Rs. 1, 500.
Thus the profit would be Rs. 1,500 -Rs. 1, 250 = Rs. 250. At the break-even volume
cost is equal to revenue and the break-Even volume is px=F +vx. If we use the above
figures in this equation, the result would be as follows:

77

2x = Rs. 500 + Ix
x = 500 units.
We, therefore, find that the break-even volume is 500 units. These results have
been shown in Figure 5.5.2
Mathematical

formulae:

The

point

of

break-even

can

be

determined

mathematically with the formula as given below:

F
F
or
1 Vr
C/S
where, x = Break-even in rupee sales, F = total fixed costs at the present level of
x

sales, Vr = ratio of variable costs (per unit) to selling price (per unit),
C/S = percentage of contribution to sales.

Substituting, x =

Rs.500
= Rs. 1,000
0.5

To get the number of units instead of the sales value at the break-even point,
use the following formula:
F
pv
where, x=number of units at the break-even point, F = total fixed costs at
x=

present level of sales, p = selling price per unit, and v = variable costs per unit.
Substituting, x =

Rs.500
Rs.500

500 units
Rs.2 Re .1
Re .1

The calculation of break-even point thus can take two forms: (1) in terms of
physical volumes and (2) in terms of rupee value of sales. The second calculation
emphasizes the approach of marginal income analysis. The marginal income is the
difference between the selling price per unit and variable cost per unit. If the
objective is to find out the break-even volume in units the formula would be:
F
pv
On the other hand, if the break-even point has to be determined in terms of
x=

rupee sales value, the formula is: F F

F
F
or
1 Vr
C/S

5.5.5 Profit Planning Break-Even Analysis

Break-even analysis is an important tool of profit planning in the hands of
management, It is usually desirable to have a low break-even point than a high one,"

78

The higher the break-even point, the less chances are of operating the business, at a
profit over the years, For example, in managing a hotel, a comfortable position can
be had if the break-even point is at 60 per cent of capacity than if it is at 90 per cent
of capacity, Further, if an undertaking is operated close to the break-even point,
slight changes in business environments are likely to result in losses.
There are four ways in Which profit performance of a business can be improved.
a) by increasing volume.
b) by increasing selling price
c) by decreasing variable costs, and
d) by decreasing fixed cost.
(a) Increasing volume: Considering our original illustration where selling price
and variable costs per unit were set at Rs. 2 and Re. 1 respectively and fixed costs
amounted to Rs. 500, the company had to sell 500 units to break-even. The normal
volume of production for this company had been assumed at 750 units. The amount
of profit at different volumes is shown in Table 4.1.
Table 4.1. Profit at various volume levels

Volume
(units)

Percentage increase from

Profit (Rs.)

previous levels
Volume%

Profit%

500

..

..

600

100

20

Infinite

750

250

25

150

900

400

20

60

1000

500

11

25

It is worth noting that a 25 per cent of sales increase (from 600 units to 750
units) would result in an increase of 150 per cent in operating profits. But the
additional increase of 20 per cent, .i.e. from 750 units to 900 units, would result in
an increase of 60 percent of profits. This shows that as the sales move away from a
break-even point, the percentage increase in profit Is proportionately lower than the
increase near the break- even point.
(b) increasing selling price: Profit performance can be improved by increasing
the selling price. An increase of 10 per cent in selling price (Rs. 2+0.20= Rs. 2.2 per
unit) would add Rs. 150 to revenue and would, therefore, increase profit at current

79

volume of 750 units from Rs.250 to Rs. 400. i.e. increase of 60 per cent. With this
price

increase of 10 per cent the amount arid percentage of profit at different

volumes would be as shown in Table. 4.2.

Table 4.2 Profit at various volume levels.
Volume
(units)

Percentage increase from

Profit (Rs.)

500
0
600
100
750
400
900
580
1000
700
(Break-even point= 416.6 units)

previous levels
Volume%
..
20
25
20
11

Profit%
..
120
82
45
21

It may be noted that the break-even point with an: increase in selling price at
10 per cent would be reached at 416.6 units instead of 500 units. However, with an
increase of 25 per cent in volume (from 600 units to 750 units), the percentage of
profits (after an increase of 10 per cent in selling price) would go to 82 as compared
to 150 in the example (a).
(c) Decreasing variable costs: If the company is able , to reduce its variable
costs by 10 per cent (Re. 1-0. 10 = 90 paisa). it would increase "contribution margin"
(selling price-variable cost per unit, i.e. Rs.2-0.90 = Rs.l.10) and the break even
point would decline to 454.5 units and thereby the operating leverage characteristic
would also change. A.25 per cent increase in volume from 600 units to 750 units
would produce a profit increase of 103 per cent as shown in Table 4.3.
Table 4.3. Profit at various volume levels
Volume
(units)

Percentage increase from

Profit (Rs.)

previous levels
Volume%

Profit%

500

61

..

..

600

160

20

220

750

325

25

103

900

490

20

51

1000

600

11

22

(Break-even point = 454.5 units)

80

This increase deserves special notice as there is a common belief that changes
in fixed costs alone can result in a favourable operating leverage. This analysis
demonstrate that changes in the contribution margin due to changes' either in
variable costs or in selling price are very significant.
(d) Decreasing fixed costs: Profits can be improved by reducing fixed costs. A
10'per cent decrease in fixed costs would amount to Rs.50. and break even point
would decline from 500 units to 450 units. A 25 per cent increase in volume from
600 units to 750 units would produce a profit increase of 100 per cent and a 20 per
cent increase from 750 units to 900 units would result in an increase of profit of
only 50 per cent (Table 4.4)
Table 4.4 Profit at various volume levels
Percentage increase from

Volume

previous levels

Profit (Rs.)

(units)

Volume%

Profit%

500

50

..

..

600

150

20

200

750

400

25

100

900

450

20

50

1000

550

11

22

(Break-even point = 450 units)

Looking at some of the inter-relationships of the four possibilities to improve
profit performance, we can verify that a 20 per cent increase in fixed costs would be
offset by a 6.67 per cent increase in selling price, a 13.34. per cent increase in
volume or a 13.34 per cent decrease in variable costs.
5.5.6 Limitations of Break-Even Analysis
The limitations of the break-even analysis have to be kept in mind while making
use of this tool. Many costs and their components do not fail into neatly
compartmentalised

fixed

or

Variable

cost

categories

as

they

possess

the

characteristics of both types.

An increase in selling price often is accompanied by a decrease in volume, The
above calculations assume that each of the four possibilities is independent of
others which is rarely the case. The assumption of consistency in unit selling prices.
technologies; and the operation environments is unreal.

The changes in these

factors must, therefore, be studied simultaneously rather than separately as was

done above.

81

It was assumed that the company sold only one product. In several products
with different marginal incomes were sold, the break-even chart for the whole
company would show the average marginal income for all products and would be
affected by changes in the mix of products. Under such circumstances break-even
charts for each product or for each group of homogeneous products are more useful
for analysis than is the single overall graph. In a company having multi-plants,
management may bring about a reduction of the break even point by increasing
sales of a product with a high profit margin at the expense of a less profitable item.
To get around this condition, the financial manager may have to prepare and
evaluate a number of profit-graphs covering integrated segments of independent
activities.
The break-even analysis assumes that changes in the four factors are not
accompanied by changes in amount of capital employed. If a decrease in variable
costs raised because of the purchase of new machines, effect in the return of
investment is not given by the profit-graph. Partly the effect may be shown by an
increase in the fixed depreciation cost but one can hardly tell from this alone what is
the effect on the overall rate of return.
Break-even chart represents short-run static relationship of costs to output. As
it is based mainly upon historical experience, variations in costs of material and
labour and introduction of new equipment or methods will change these relations.
Firms that are growing rapidly find that break-even charts become obsolete very
quickly. Their situation is too dynamic for a static analysis. .
In many cases, it is difficult to measure output, particularly in a multi product
firm. One way of constructing a break-even chart for such a firm is to measure
output in terms of per cent of capacity. Instead of showing number of units product
on the X- axis of the break-even chart, per cent of capacity ranging from 0 to 100 per
cent can be shown. Alternatively, machine hours or standard labour hours can be
used as measured of output. The aim should be to find out a factor that serves as an
equally satisfactory measure of the level of output of all product. The relations
indicated in the break-even chart do not help for all levels of operations. Costs tend
to be higher than shown on the static break-even chart when the plant's operation
approaches 100 per cent of its capacity. Second and third shift payments usually
involve extra payments to the workers and may be more inefficient. As production
moves closer and closer to capacity, it is likely that variable cost per unit would rise
fairly sharply. Under such circumstances, break-even chart probably cannot be used
to establish profits at such extremes. It is assumed in the preparation of break-even
charts that total costs shown are those incurred to produce the sales revenue

82

indicated. This is often not the case. There may be research and development
expenses which, are incurred in one year but whose benefits occurs over a number
of years. The difficulty of matching expenses to income increases when an attempt is
made to apply, break-even analysis to short periods.
The break-even chart assumes that items produced are sold at the same price
regardless of output while reductions in price are expedient in order to maintain
sales. These frequent changes" in the selling price of the product after the reliability
of the break-even analysis.
Linear break-even analysis is especially weak in what it implies about sale
price. Therefore, in order to study profit possibilities under different prices, a whole
series of charts is necessary, one chart for each Price, Alternatively, non-linear
break-even analysis can be used. Lineal break-even analysis is useful as a first step
in developing the basic data required for price and for financial decisions.
The cost of securing funds to expand is disregarded in the chart. Thus, beyond
a certain point in short-run borrowings, the interest charges may go up sharply or
funds may not even be available to the business causing a liquidity position.
5.5.7 Uses of Break-Even Analysis
The above limitations have been elaborated not with a view to minimising the
usefulness of the tool of break-even analysis. In fact, it is a very important and
useful tool of financial management and control. The simplicity of these charts is
one of their great values. As they are easy to understand, they constitute a helpful
mechanism for showing the top management the problems inherent in cost-volumeprofit relationships. They are extremely useful in planning devices. By focusing
attention on marginal income, break-even studies avoid the controversial problems
of locating fixed costs which do not change with volume or price variations.
In planning, short-term strategies, the cost-volume-profit studies helps in
determining the nature and magnitude of sales efforts and establishing volume
requirements. Marginal income analysis, a by- product of break-even analysis, places
emphasis on cost differentials and these, rather than total cost, are influential in
deciding alternative course of action.
5.6 THE LEARNING CURVE
The learning curve concept is developed in connection with new products. That
the costs of production per unit of a new item decreases as additional units of that
product are manufactured is the basis of it. Because the supplier becomes more
skilled as the worker repeats an operation and improves his speed and efficiency,

83

this causes him to reduce the labour and supervision costs. The following are the
factors that bring down the cost:
a) (i) job familiarization,and
(ii) task learning (both worker and supervisor)
b) improvement in shop organization and production control,
c) type of work and method,
d) the ratio of assembly hours to machine hours,
e) tooling quality and coordination, and
f) product.
By way of illustration, if the buyer knows that it takes a supplier 100 hours of
direct labour to make the first unit of a new product and 80 hours to make the
second unit, the average labour hours would be 90 hours. When the production
doubles to four units, the average labour hours would be 90 hours. When the
production doubles to four units the average labour hours would progressively fall.
When the production doubles to four units. The actual average labour hours for four
units are 81 hours per unit of item. If production doubles the average labour hours
declined by about 10%.

At large volume of production the reduction in labour

hours, however, becomes negligible.

84

Figure.5.5.3
Because of this, the learning curve concept has its greatest application in costanalysis of new products only.

When there is aspare capacity in the buyers plant.

application of learning curves for purposes of comparison separately both for the
buyer's firm and the supplier's firm, to determine whether his firm has the lower
average cost than the vendors Will help him to decide whether to make or buy a
particular item. And since learning curve can also be used to forecast required
labour time, it can be used to estimate the vendor's capacity to deliver specified
quantity Within a specified time With the given labour force, which can be extremely
helpful in scheduling deliveries.
5.7 REVISION POINTS
Direct and Indirect Expenses
Price forecasting
Moving Average Forecasting
Exponential smoothing methods
Break even analysis
Learning curve.
5.8 INTEXT QUESTIONS
1. Describe the essentials of pricing tools and price forecasting.
2. Explain fully the break-even analysis concept and its applications.
3. Explain the uses and advantages of learning cure in developing a new
product.
4. With an example explain the Learning curve.
5.9 SUMMARY
Price forecasting is an important function of purchase management. Two
different methods were discussed with examples. Break-even analysis and their
limitations and applications were discussed in details. Learning curve concept were
also included in this lesson.
5.10 TERMINAL EXERCISE
1. Discuss the break-even analysis.
2. List the types of forecasting Techniques
3. List the Limitations of Break even analysis
4. Define learning curve.

85

5.11 SUGGESTED READING/ REFERENCE BOOKS/ SET BOOKS

1. A.K. Datta, Materials Management.

Procedure, Text and Cases,

Prentice-hall of India, 2004

2. S.C. Sharma, Materials Management and materials Handling, Khanna
Publishers, 2000
5.12 KEY WORDS
Pricing tools, Forecasting, Break-even analysis Learning curve.

86
LESSON -6

PURCHASING UNDER FLUCTUATING PRICES

OBJECTIVES
To know about buying Techniques under fluctuating price
To understand optimal Buying strategy.
CONTENT
6.0 Introduction
6.1 Why do prices fluctuate
6.2 Buying Techniques
6.3 Indifference expenses
6.4 Optimal Buying Strategy
6.5 Revision Points
6.6 Intext questions
6.7 Summary
6.8 Terminal Exercise
6.9 Suggested reading/reference books /set books
6.10 Key words.
6.0 INTRODUCTION
The primary commodities are natural products rather than manufactured
products and this affects the prices at which they are sold even though they
normally enter into trade in processed or partly manufactured form rather than just
as harvested or mined. Coffee and tea for instance are dried and processed before
they reach the market. Many primary commodities are brought and sold, locally
without, entering into world trade. The main purchasing problem in buying such
commodities is due to the large fluctuations in price, which occur, often in short
time periods. Coping with this price variability presents a real challenge to any
purchaser needing large quantities of commodities to support production in factories
whose products are sold at prices which cannot be varied in the same way. It can
also have serious effects on the material costs of producers using secondary
products which incorporate price variable primary commodities.
For example, cable manufacturers buy copper, carpet manufactures buy wool,
tyre manufacturers buy rubber. All these materials

are traded in organized

commodity markets which offer facilities for hedging by means of future contracts.
Specialist commodity buyers are experts in these markets. But other buyers who are

87

not specialists and do not have the opportunity to become experts still have to make
occasional purchases in these markets. Or buy products at prices which are affected
by the cost of the commodities used in their manufacture. Thus it is most desirable
for buyers to understand why commodity prices fluctuate and to have some
appreciation of the buying strategies which can be used in such conditions.
6.1. WHY DO PRICES FLUCTUATE?
Anyone who buys food for a householder a restaurant is familiar with the way
prices change for farm products. The first asparagus reaches the market at
astronomical prices, there is not a lot to sell, but at those prices there are not many
who are willing to buy. Supply and demand are brought into equilibrium by means
of these price changes. Price also changes from year to year due to weather or some
other reason. Exactly the same considerations affect the prices at which the soft
commodities are traded in commodity exchanges, but there are also additional
considerations.
In addition to producers and consumers, participants in these markets include
speculators, dealers and jobbers. Prices react continually to expectations of present
and future supply, or present and future demand of stock situations etc.,
Consequently, even though prices of some commodities stay much the same for
long periods of time,

the typical commodity price changes are much larger in

amount and occur in much shorter periods of time, than changes in the prices of
manufactured goods. Also commodity prices have in the past been almost as likely to
move downwards as upwards, which has not been the case for manufactured goods.
The high amplitude and short period of the price changes which can occur can be
illustrated from the commodity price boom which occurred in 1973-74. ExampleCopper sold on the London Metal Exchange for 450 pounds a ton in January 1973,
by April 1974 the price reached an unprecedented peak of 1400 pounds a ton, yet
only five months after it was back down 600 pounds. Price fluctuations of such
amplitude are unwelcome both to consumers and to products. A major producer of
copper is the developing country of Zambia in Africa, whose main export revenue is
derived from the sale of copper. The Government of such a country faces an
impossible task in planning capital investment programs such as the construction of
school, highways etc. which will take years to complete, when the export revenue
required to finance them can increase by over 300 per cent in a year, only to be cut
in half in a few months. It is generally agreed that consumers and producers alike
would prefer a more stable level of prices, although they might take different views
as to what level is appropriate.

88

Price stability, however, desirable, has not in practice proved easy to achieve.
Commodity price changes reflect changes in the supply of commodities and in the
demand for them. The 1973-74 price boom was unusual in that most commodity
prices rose; usually, some rise while others fall. It was attributed partly to a
considerable increase in demand from the major industrial economics. which were
all expanding, and partly to shortfalls in supply because of poor harvests and crop
failures of agricultural commodities and shipping delays and production problems
for mineral commodities. Flood, drought, plant disease and crop failure can produce
a shortfall of agricultural produce, while good harvests can produce a glut on the
market, and natural results are high prices and low prices respectively: Wars,
strikes, revolutions and changes in Government policy have also had serious
repercussions on the supply of commodities. Changes in economic activity in the
industrialized countries, which are the main customers, have immediate effects on
demand, and changes in taste or technology or the availability of substitutes have
long- term effects on demand. In the case of many commodities, the effect on price
of any changes which occur in supply or demand is increased by the length of time it
takes for any attempt to adjust supply to demand to take effect. Newly planted
rubber trees take years to come into full production. Small changes in metal output
can be made with existing facilities, but a large increase in output might require a
lengthy process of re-opening old mines or digging new mines and providing
housing. transport and shipping facilities to exploit them. A large reduction in
output is equally difficult to achieve because of the serious effects on employment
and export revenue which would result.
6.2 BUYING TECHNIQUES
Time budgeting or averaging is a cautious policy which ensures that the cost of
commodities consumed is the same as the market price. The exact quantity required
is purchased at the time of requirement and no stocks are held. If stocks have to be
held, as is often the case. This simple policy cannot be used. An ingenious formula
approach known as rupees cost averaging or budget buying, does even better by
ensuring that the cost of commodities consumed is less than market price, Provided
that average market price can be predicted successfully and that actual prices
fluctuate in random fashion about this average. The idea is to spend a standard sum
based on the average price at regular intervals of time. This budget amount buys a
larger amount when actual price is below average and a smaller amount when price
is above average. This can be illustrated by taking simple, exaggerated figures. Let us
suppose that one ton a week is required of a commodity of which the average market
price is Rs. 100/- a ton, and that in three successive weeks, actual market price is
Rs: 150/-, Rs. 50/- and Rs. 100/-. With the back to back or averaging policy, 1 ton

89

would have been bought each week: but with the budget buying policy, Rs. 100/would be spent each week, the budget amount to obtain 1 ton at the average market
price. In the first week, Rs. 100/- would buy two thirds of a ton at Rs. 150/- a ton.
In the second week, it would buy 2 tons at Rs. 50/-. In the third week, it would buy
1 ton. Over the three week period, budgeted buying would have resulted in 3 and
2/3 tons being bought for Rs. 300/-, at an average cost below the average market
price. The averaging policy would have resulted in 3 and 2/3, 3 tons being bought
for Rs. 300/- at cost equal to the average market price.
A more sophisticated approach has been developed by operations research
workers and is known as dynamic programming. To illustrate this technique, let us
suppose that 100 tons a week are required of a commodity the price of which
fluctuates randomly between Rs. 200/- and Rs. 300/- a ton, and that the buyer is
authorised to purchase upto ten weeks' supply (i.e., 1000 tons). We will also assume
that future contract are not available. Having found a method of determining each
week how much to buy, we will then reconsider these simplifying assumptions. In
order to establish a yard stick, by which we can measure how well the dynamic
programming technique works, let us first see how well we could buy if we knew in
advance what the market price would be each week. Over a fifty week period, let us
assume that prices each week are going to be as shown in table 6.2.1. Assuming we
start with no stock, we must buy 100 tons in the first week to meet the first weeks
requirements, but as price is falling we buy only one weeks supply. The same applies
in weeks 2 and 3, but in week 4 the price of Rs. 209/- is the lowest until week 8, so
we buy 400 tons to last until week 8. In week 8 the price of Rs. 202/ -is the lowest
which is going to apply for a considerable time, so we buy 10 weeks supply, the
maximum authorised. Each week we look ten weeks ahead and buy as little as
necessary to meet requirements until we can stock up at a low price with the
advantage of advance. Knowledge of price we would be able to supply the fifty week
requirement at an average price of just below Rs. 210/- a tons Known in table 6.2.2.
Table 6.2.1 Actual Market Prices
Weeks

Weekly prices in Rs./ton.

1-5

277

265

220

209

280

6-10

234

246

202

205

204

11-15

215

240

206

287

288

16-20

217

218

277

266

214

21-25

268

227

285

211

217

90

26-30

226

295

268

297

273

31-35

275

264

227

245

201

36-40

287

220

202

219

236

41-45

245

242

296

272

298

46-50

278

281

252

231

288

Table 6.2.2
Week Number

Opening
Stock

Price Paid

Amount
Bought

Total Expense

nil

277

100

27,000

nil

265

100

26,500

nil

220

100

22,000

nil

209

400

83,600

nil

202

1000

2,02,000

10

800

204

200

40,800

13

700

206

300

61,800

20

300

214

100

21, 400

24

Nil

211

1000

2,11,000

25

900

217

100

21,700

35

Nil

201

1000

2,01,000

38

700

202

300

60,600

39

900

219

100

21,900

49

nil

231

200

46,200

Total

5000 tons

10,48,200

Average price paid Rs. 209.64/ton.

If on the other hand, we book no chances and had no advance knowledge, and
simply bought 100 tons a week at the going price, the average cost would be
Rs. 248/- a ton.
6.3 INDIFFERENCE PRICES
In order to decide a buying rule for the practical situation in which advance
knowledge of market prices is not available, the procedure is to determine a piece of
indifference at which it does not matter if an order is placed or not. If market price is
above the price of indifference, we make a further calculation to decide how much to
buy clearly the price of indifference is affected by the amount of stock in hand; with
nil stock we cannot afford to be indifferent but must buy whatever the price. We will

91

denote the prices of indifference by Po, P1, P2, P3, .. P10 where the suffix denotes the
number of weeks' stock in hand. These prices can easily be calculated on the simple
assumptions we have made that
1. Demand is 100 tons a week
2. Orders are for multiples of 100 tons
3. Maximum stock is 1000 tons
4. Price varies random}y and evenly from Rs. 200/- to Rs. 300/- a ton.
With nil stock we must buy whatever the price; but as price will not exceed
Rs. 300/- (i.e., P0 is Rs. 300/-).
With one weeks stock, the price of indifference is determined by the fact that
we must buy next week if we do not buy this week. Next weeks price we do not
know but on the average will tend to be half way between Rs. 200/- and Rs. 300/-.
So we should buy this week if the actual price is below Rs. 250; and this gives the
value of P1 as Rs. 250. With two weeks' stock. the situation is more complicated. If
we do not buy this week, next week we will be down to one weeks' stock and P 1 = Rs.
250/-. The changes are even that next weeks price will be below Rs. 250/- and if it
is on the average it will be Rs. 225/- consequently.
P2 = (Probability of price below P1 x (expected price if it is) +
(Probability of price being above P1) x P1 = 0.5 x 225 + 0.5 x 250.
P2 = Rs. 237.50.
With three weeks' stock similar calculation can be made.
P3 = (Probability of price being below P2 x (expected price) + Probability of price
being above P2) x P2.
Since the prices are assumed to be evenly distributed, if the price is below P 2 it
will be on the average half way between 237.5 and 200.
So. P3 = 0.375 x 218.75 + 0.625 x 237.5 = Rs. 230.58
Proceeding in this way we obtain the following prices at indifference:
P0 = Rs. 300.
P1 = Rs. 250.
P2 = Rs. 237.5
P3 = Rs. 230.5
P4 = Rs. 225.8
P5 = Rs. 222.5

92

P6 = Rs. 220.0
P7 = Rs. 218.0
P8 = Rs. 216.4
P9 = Rs. 215.0
P10 = Rs. 214.0

Fig. 6.3.1 in difference prices.

Now we can work though the 50 weeks prices previously given once more. In
week 1, with nil stocks, P1 applies and we must buy. The quantity to buy is also
derived from the above list; if the market price was Rs. 218/-, equivalent to P 7' we
should buy enough to supply 7 weeks requirements. But in week I, market price is
Rs.277.5, higher than P2 so we buy just one weeks' supply. In week 2 we again buy
just 100 tons. But in week 3, price is Rs. 220/-, corresponding to P 6 so we buy six
weeks' supply, in addition to our requirement for the current week. Proceeding in
this way, by the end of the year our buying record is shown below.
It can be seen that the 5000 ton requirement would have been bought for an
average price of Rs. 214/- a ton. This is much better than the average market price
of Rs. 248/-, which is the best that could have been achieved by the risk reducing
policy of averaging, in this case buying 100 tons a week. Although it is not quite as
good as the price of Rs. 210 which is the best possible obtainable with complete
advance knowledge, it really is pretty close to it.
6.4 OPTIMAL BUYING STRATEGY
In building up this optimal buying strategy the following assumptions are
implicit.
1. Time has been divided into successive periods example-weeks.

93

2. A planning horizon of N periods is arbitrarily taken. In this example, a

storage capacity of 10 periods is imposed. Note that even with infinite storage
capacity a company cannot have infinite periods as the knowledge of prices will be
diffused after a certain number of periods.
3. Demand is known for all the periods in the planning horizon.
4. No shortages are allowed. Whatever be the price a company has to buy at
least one period requirement.
5. No storage cost has been assumed. If, however the planning horizons are
available in the market during anyone of the periods.
6. There is only one price offer in a period. If this opportunity of purchase is
foregone, a company has to wait for the next period to purchase its requirements.
7. There are no supply restrictions. Quantities upto the entire requirement of
planning horizon are available in the market during any one of the period.
8. The prices fluctuate randomly and are independent of each other, atleast
during the planning horizon.
9. Delivery is assumed to be instantaneous.
10. Stock once bought cannot be resold.
It is imperative that a company should hold off when the prices are high and
buy when the prices are low. Such a decision is very much dependent on the stock
on hand. If the stock on hand is low, a company might decide to buy even at
reasonably high prices and if it is high, it might not buy at relatively lower prices.
The optimal technique that a company should use is based on the price of
indifference. i.e., given the stock on hand, there should be price when the company
would be indifferent, between buying and holding off. The nature of such prices of
indifference will. be as shown in fig 6.4.1

94

Stock

Prices

Figure 6.3.2
Having plotted the price of indifference curve a company has only to go to
market, checkup the price and raise the stock to the level of indifference. Thus if P 0,
P1. P9 are the prices of indifference when stocks are for zero week. 1 week, 2 week,
. 9 weeks, what a company needs to check these prices against the stock levels.
(1) Calculation of P0
If a company has no stock on hand, it has to buy atleast one weeks'
requirement no matter what the price is since the highest price is Rs. 6,000/- ton.
Po = Rs.6,000/-.
(2) Calculation of P1
The company has one week's stock on hand. It has to decide whether it should
buy or hold off. We are essentially looking at what the price would be next week. The
prices vary randomly (assume prices to be uniformly distributed between
Rs. 5,000/- and Rs. 6,000/- per ton) and the expected price in the next week would
be Rs. 5,500. Therefore PI = Rs. 5.500/-. i.e., buy with one week's stock on hand if
the price is below Rs. 5.500 per ton say buy the next week's requirement as well in
this week if the price is below Rs. 6.500 per ton.
(3) Calculation of P2
The company has stock for two weeks. It has to decide whether to buy third
week requirement now or hold off.
requirements are:

The possible ways of buying the third week

95

Suppose the decision is to hold off. Next week (i.e. second week) the company
will buy if the price is below P 1 i.e. Rs. 5,500. The chances of the price being below
Rs. 5,500 is 0.5 (50% of the times) and its expected value is Rs. 5,250. There is
again 50% of chances of the price in the second week being above Rs. 5,500 and in
such a case the company will buy in the third week. The expected price in the third
week is Rs. 5,500.
Therefore P2 (price of indifference)
= 0.50 (5250) +0.50 (5500)
= 2625 + 2750
= Rs. 5,375/-.
i.e.. If the price in this week is below Rs. 5,375/- ton buy the third week's
requirement now.
(4) Calculation of P3
The company has 3 week's stock on hand. It has to be decided whether or not
to buy the fourth week's requirement. The alternatives are

Therefore P3 = 0.375 (5187.50) + 0.925 (0.5) (5250) + 0.625 (0.5)

(5000) = Rs. 5305/-.
Proceeding along the same lines the company can calculate all the prices of
indifference.

96

The company can estimate the average price paid in the long run by applying
these prices of indifference to the price of the 50 weeks which is forecast.
In week 1, the price is Rs. 5,770. Therefore, buy only on week's requirement.
Opening

Week No.

Price

Stock

nil

Amount
bought

5,770

Closing stock

100

Nil

In week 2, the price is Rs. 5,650/-, therefore the company should buy a weeks
requirement.
Opening

Week No.

Price

Stock

Amount
bought

Closing stock

nil

5,770

100

Nil

nil

5,650

100

nil

In week 3 the price is Rs. 5,200. This is equal to P 6 the company should raise
the stock to 6 weeks requirements (Note if the price is below Rs. 5,200/- the
company would buy a weeks requirement even if the stock on hand was six weeks
requirement).
Opening

Week No.

Price

Stock

Amount
bought

Closing stock

nil

5,770

100

Nil

nil

5,650

100

Nil

nil

5,200

600

500

In week 4, the price is Rs. 5,090. This is even below P 9. Hence the company
should raise the stock to full capacity.
Opening

Week No.

Stock

Price

Amount
bought

Closing stock

nil

5,770

100

Nil

nil

5,650

100

Nil

nil

5,200

600

500

500

5,090

500

900

Proceeding on these line for all the 50 weeks, the amount purchased and price
paid for each of the purchases made is listed below.
Table 6.4.1

97

Week No.

Opening Stock Amount Bough

Price

Total
Expenses

nil

100

5,770

5,77,000

nil

100

5,650

5,65,000

nil

600

5,200

31,20,000

500

500

5,090

25,45,000

600

400

5,020

20,08,000

900

100

5,050

5,05,000

10

400

100

5,040

5,04,000

13

700

300

5,060

15,18,000

16

700

100

5,170

5,17,000

20

400

600

5,140

30,84,000

24

600

400

5,110

20,44,000

33

100

300

5,270

15,81,000

35

200

800

5,210

40,08,000

38

700

300

5,020

15,06,000

49

nil

100

5.520

5,52,000

49

nil

200

5,310

10,62,000

The average price paid = 2,56,96,000/5000 = Rs. 5, 139,20

The results obtained are conservative policy = Rs. 5, 480,00
Hind sight policy = Rs, 5,096,40
Optimal policy = Rs. 5,139,20
The difference between Hind sight and optimal policy is Rs. 42,50 per ton can
be viewed as cost of uncertainty.
The annual cost of optimal policy is Rs. 2,56,96,000 and that conservative
policy is Rs. 2,74,00,000 for 50 weeks or nearly one year.
6.5 REVISION POINT
Reason behind price Fluctuation
Buying Techniques
Indifference Prices
6.6 INTEXT QUESTIONS
1. Describe the buying technique with suitable example.
2. What are the assumptions made for optimal buying strategy?

98

3. A company has no stock on hand, it has to buy atleast one weeks

requirement no matter what the price is. The highest price is Rs. 8,000/ton. Assume prices are uniformly distributed between Rs. 7,000/- and
Rs. 8,000/-. Calculate all the prices of indifference upto 12 weeks and draw
the price of indifference curve for it.
6.7 SUMMARY
Two different methods of Buying Techniques were discussed in detail.

With

examples, to make purchase under fluctuating prices.

6.8 TERMINAL EXERCISE
1. Why do price fluctuate?
2. Explain in detail the indifference prices.
6.9 SUGGESTED READING/REFERENCE BOOKS /SET BOOK
1. S.C. Sharma, Materials Management and Materials handling, Khanna
Publishers 2000.
6.10 KEY WORDS
Fluctuating prices, Commodity market, Commodity Bayer, Indifference Prices.

99
LESSON-7

CONCEPT OF RIGHT TIME

OBJECTIVES
To know the different type of Buying policies based on Market conditions
or current requirements.
CONTENT
7.0 Introduction
7.1 Buying Policies
7.2 Hand-to-Mouth Buying
7.3 Forward Buying
7.4 Average cost Buying
7.5 Speculative Buying
7.6 Buying to Current Requirement
7.7 Revision Points
7.8 Intext questions
7.9 Summary
7.10 Terminal Exercise
7.11 Suggested reading/reference books /set books
7.12 Key words.
7.0 INTRODUCTION
Severe problems occur if goods are not delivered or if work fails to be completed
at the right time. Sales may be lost, production lines may grind to a stand still,
penalty clauses may be invoked by the customers. Purchasing departments can lose
a great deal of good will built up with colleagues in user departments if they are
seen as in any way to blame for failure of suppliers to complete on time. And there is
little doubt that if suppliers fail to deliver on time, ways will be found to lay the
blame at the door of the purchase department, even though it may not be the only
department at fault. It follows that the purchasing department must take whatever
action is required to ensure that other departments are clearly and constantly aware
of lead times and any other necessary information. Large numbers of purchasers
throughout industry and commerce have very few problems in this connection and
would regard late delivery as an exceptional event, to be dealt with, if it occurs, by
crisis measures. But some purchasers do have problems, perhaps because some
suppliers quote delivery dates which they cannot achieve. Purchasers suffering from
delivery problems can also themselves be the source of the problems, by issuing

100

inaccurate delivery schedules, continually amended, or by allowing insufficient time

for delivery. The first step to obtain delivery on time is to decide finally and precisely
what is required and when it is required. Purchasing should work on the problem of
getting shorter lead times and should ensure that relevant departments know what
they are. There is a definite time lag between the identification of the need for an
item, till it is approved for use after placing an order, manufacturing, transport,
shipping and inspection. The total duration that elapses between the recognition of
the need for an item and fulfillment is known as the lead-time for that item, which
plays an important part in identifying the right time. Longer the lead-time, more will
be working capital commitment. A vital step in achieving on-time delivery is to
ensure that suppliers know and are fully aware that on-time delivery is an important
element in their marketing mix. When making a choice between alternative
suppliers, the purchaser gives a lot of weight to their actual delivery performance.
Delivery performance in many instances has improved significantly when recorded
performance is used as a basis for talks with suppliers. In fact experience shows
that when suppliers come to realize that requirement dates as stated on orders and
call-off schedules are accurate and firm, and that whenever they fail to deliver on
time they will have to explain it, and that on-time delivery counts for a lot in the
future allocation of business, then 99 per cent on-time delivery is often achieved.
Right time delivery reduces the inventory cost and production will be continued
without any interruption.
7.1 BUYING POLICIES
The purchasing executive must make a fundamental policy decision concerning
the timing of purchases for certain major materials. Basically he can choose one of
two alternatives: (1) Purchase according to current requirements, or (2) Purchase
according to market conditions. If he adopts the first policy, he bases his purchasing
schedule strictly on the volume of his firm's current needs, and largely disregards
the action of the market in which the purchase is made.

This is the more

conservative of the alternatives and is considered by many companies to be the

soundest approach when dealing in a market involving price risks. If the manager
adopts the second policy in addition to considering anticipated needs, he bases
purchase timing decisions. In part, on the action of the market. In this case he may
engage in three types of buying activity (1) Hand-to-mouth buying (2) Forward
buying and (3) Speculative buying. The length of time coverage afforded by each of
these buying activities is the element which distinguishes one from the other. In
business practice, no clear-cut dividing line exists between those different types of
buying. Variation in operating conditions, types of material used, and lead time

101

requirements among. various plants cause purchasing executives to define them

slight differently.
7.2 HAND-TO-MOUTH BUYING
Hand-to-mouth buying is the practice of buying material to satisfy current
operating requirements in quantities smaller than those normally considered
economical. As the term indicates, the production operation literally exists on a
hand-to-mouth supply of materials. In the case of some high-value materials, it is
difficult indeed to draw the line between a hand-to-mouth purchase and a purchase
made to satisfy current operating requirements. In general, however, many firms
consider a purchase quantity that provides from one to three month's coverage as
one which normally satisfies current operating requirements. For purposes of
discussion, this rather arbitrary definition will be used, correspondingly, a hand-tomouth purchase can then be defined as one which provides operating coverage from
a bare minimum upto approximately three or four weeks. There are three basic
reasons for purchasing a -hand-to-mouth buy policy.
1. If material is purchased in an unstable market, hand-to mouth buying saves
money when prices are dropping, because the buyer does not accumulate a high
priced inventory. Conversely, it loses money when the market is rising. But when
conducted over the duration of the entire price cycle, hand to-mouth buying
permits purchases to buy their total requirement at approximately the average
market price for the cycle.
2. In the event that a firm plans an engineering design change which renders
some materials obsolete, hand-to-mouth buying prevents inventory losses.
3. Occasionally, firms require additional cash for operating purposes. They may
also be forced to reduce the indirect expenses of carrying inventory. These demands
can be satisfied temporarily by reducing inventories and using hand-to-mouth
buying.
Concomitant disadvantages of hand-to-mouth buying appear in two areas.
First, the placement of numerous small orders is more costly in terms of buying and
administrative expenses. Second, there is a danger of running out of stock if anyone
of the activities in the supply chain fails to perform exactly as scheduled.
7.3 FORWARD BUYING
It is the practice of buying materials in a quantity exceeding current
requirements. The distinction between speculative buying and forward buying is that
in the latter case a definite" production need for the material exists, while in the
former case it does not. Even so, the discriminating observer will recognize that
most forward buying involves a certain element of speculation as far as price is

102

concerned. While he may have a definite need for the material, the forward
purchasers assumes a risk regarding future price fluctuations of the material. When
he extends his coverage much beyond a years requirements, in most industries the
buyer has entered the real on of speculative buying. For some materials the time'
period is less than a year. The main objectives of forward buying are as under:
i) The buyer is assured of regular delivery of materials. He can save his firm
from facing shortage of materials which may arise as a result of strikes or go slow
tactics adopted by workers in suppliers plants or transportation problems or
reduction in total supply in the markets or irregularity on the part of suppliers. It
protects the firm against the risks of prospective shortages of materials.
ii) A buyer can purchase the materials of right quality at the right time by
following forward buying policy. Certain materials are available during a certain
season of the year and certain materials available from certain sources only. A buyer
can make advantageous purchases only when the materials are available in large
quantity or materials are offered by the suppliers. A buyer must have detailed
market information for better decisions. If a buyer does not know, when materials
are offered he cannot take advantage of a favourable supply position and reasonable
prices. A buyer takes the advantage of favourable price situation by following the
forward buying policy.
iii) Generally quantity discount or trade discount is allowed by suppliers, when
purchases are made in large quantities. A buyer follows forward buying policy to
take the advantages of large purchases.
iv) Cost of transportation per unit can be reduced by purchasing in large
quantities, some times special reduced freight rates can be obtained for
transportation of material in large quantities.
v) Cost of buying and work load of purchasing- and receiving department can
be reduced by forward buying. By excessive purchasing frequency of orders can be
reduced, which results in decreasing the work of inspection department also.
vi) Some times a buyer wants to know the price of the products of his firm in
advance, because he may have to quote the price for the products yet to made. Now
the cost of material used in such products can be calculated in advance only if the
materials required for such products are purchased in advance. This is true so far as
the unstable market is concerned. In the case of stable market, a buyer can estimate
the cost of materials in advance without purchasing them, but in the case of
unstable market, prices fluctuate very widely and therefore, a buyer cannot estimate
the cost of materials without purchasing the material in advance.

103

A buyer doing a forward purchasing involves a great price risk. He purchases at

present for the future requirements considering the present price as the best price
or more favourable price. If a buyer is not skilled enough or an efficient purchasing
expert to judge market position or to forecast future price, his decision regarding
estimated price may do more harm to the firm. Present price considered to be lower,
may prove to be higher. Second point is that purchasing in excess of requirements
requires investment of a large sum in inventory. Moreover, risk of deterioration
during the period of storage and risk of obsolescence. A buyer should use his
experience while analysing the information obtained and then should take the
decision regarding purchasing very carefully. The buyer has to consider the market
position for the materials to be purchased, capacity of the firm to invest the funds in
building up inventory, availability of storage space, etc... before he determines any
policy for purchasing.
7.4 AVERAGE COST BUYING
In this method, the buyer keeps the stock of materials at the lowest possible
level during the year.

The buyer purchases the materials regularly which are

required for current production. The requirement of a certain period is purchased

regularly at the market price. Example suppose a firm requires 1,20,000 units of
certain materials during the year. Here the firm will purchase 10,000 units of that
material every month at the prevailing price at the time of purchasing. Under this
method total purchases are averaged and only required quantity is purchased at a
certain interval at the prevailing market price. This method can be used under the
following circumstances.
i) When the price of the materials used remains generally the same or
fluctuates in a very very narrow range during the year or a given period. i.e., when
the market is stable so far as the material is concerned: or
ii) When the materials used by the firms are easily and regularly available from
the domestic market at a short notice; or
iii) When the cost of materials firms a very small part of the total cost of the
product: or
iv) When an increase in the cost of raw materials can be passed on to the
customers easily, without any resistance from them in the firm of higher selling
price of that product. While using this method of purchasing it is estimated that the
price of materials or articles to be purchased will remain more or less the same
during a given period and therefore the average cost of materials used in production
will also remain more or less same for each purchase. Suppose a firm estimates that
the total requirements of a certain material will be 120.000 units for the period of

104

one year and the average price of the commodity will be about Rs. 10/- per unit,
which may fluctuate within the range of 20%. The cost of materials, for the half year
may be a under.
Cost of materials when price fluctuates in narrow range: (Ref.Table .7.1)
Table .7.1
Quantity
Month

purchased in

Price per unit Rs.

Total Amount Rs.

units
1

10000

90,000

10000

10

1,00,000

10000

80,000

10000

11

1,10,000

10000

12

1,20,000

10000

10

1,00,000

Total

60000

600000

Thus the firm gets the required quantity of materials at an average cost of
Rs. 10/- per unit and has not to suffer loss due to price fluctuations. When the
price fluctuations are violent, this method may hot prove useful. A buyer can
save money by purchasing in large quantity when price is moving around the
average level.
Cost of purchasing, when price fluctuations are violent: (Ref. Table 7.2)
Table 7.2.
Quantity
Month

purchased in

Price per unit Rs.

Total Amount Rs.

units
1

10000

10

1,00,000

10000

15

1,50,000

10000

16

1,60,000

10000

11

1,10,000

10000

80,000

10000

60,000

Total

60000

6,60,000

105

Here the average price comes to Rs. 11 per unit. The firm has to spend
Rs. 60,000 more. When the price shows continuous decline, this method can
only prove to be useful.
Cost of purchasing, when price trend shows continuous decline: as shown in
table 7.3.
Table 7.3
Quantity
Month

purchased in

Price per unit Rs.

Total Amount Rs.

units
1

10000

2.50

25,000

10000

2.45

24,500

10000

2.40

24,000

10000

2.35

23,500

10000

2.30

23,000

10000

2.25

22,500

10000

2.20

21,500

10000

2.15

21,000

10000

2.10

20,500

10

10000

2.05

20,000

11

10000

2.00

19,500

12

10000

1.95

2,67,000

Total

120000

600000

Here the average price covers to Rs. 2.23 approximately. But if the materials
are purchased in large quantity for three months requirements, each time the
average price per unit will be more, which can be seen from the Table 7.4.
Cost of purchasing, when materials are purchased in a big lot equivalent to
three months requirements, in case of declining trend of prices.
Table 7.4
Quantity
Month

purchased in

Price per unit Rs.

Total Amount Rs.

units
st

30,000

2.50

75,000

4th

30,000

2.35

70,500

106

7th

30,000

2.20

66,000

10th

30,000

2.05

61,500

Total

1,20,000

2,73,000

Here the average price per unit comes to Rs. 2.28 approximately, which is
higher than the price calculated under Table 7.3. It is advisable to increase the
Frequency of purchases, when price is falling continuously.
The savings generated from purchasing by this method depends on (i) the
timing of purchases, (ii) Range of fluctuations in prices, (iii) duration of the price
swing and (iv) accuracy in buyers' forecasting. It is very difficult for the buyer to
estimate what the average price will be and what the highest price will be and also
when the peak level will be reached. Moreover, a buyer may not makes twelve equal
purchases as stated in Tables 7-1 to 7-3. Under this method of purchasing, the
volume of purchases depends on the timing of purchases. When price of the
material is on the upswing, forward buying is used. i.e., purchases are made in
excess of the current requirements and when prices is on downswing hand-tomouth purchasing policy is used as stated in Table 7-3. In both cases the purchases
are averaged i.e. the total requirements for certain period is bought in equal
installments which depends on the price trend. In case of rising trend of price the
frequency of purchasing will be lower, i.e., purchases will be made in large quantity,
equivalent to 2 to 4 months requirements while in case of declining price trend, the
frequency of purchases will be more, i.e., purchases will be made in comparatively
smaller quantity equivalent to 2 to 4 weeks requirements. It is assumed that the
quantity of each purchase remains the same, which may be for weekly requirements
or monthly requirements or quarterly requirements etc. When the prices rises to a
great extent, purchase of the same quantity require more funds, which may not be
possible for the firm to provide for.

7.5 SPECULATIVE BUYING

Strictly speaking, a speculator is a person who buys an item at one price with
the intention of profiting on the transaction by selling it at a higher price. A
speculator adds no value to the purchased item and provides no service to
customers, beyond the intrinsic in supplying the item itself. This type of purchasing
activity has no place in the normal functions of an industrial purchasing
department, If a firm wishes to engage in this type of speculation, such activity
should be organized and administered apart from the normal purchasing activity.

107

A second type of speculative buying is conducted by some; purchasing

departments, and many authorities argue that it is a legitimate functions of the
purchasing office. This type of buying involves the purchase of material in excess of
forceable requirements, in anticipation that a need will arise for the material and the
firm will profit by making the purchase at the current price. Opportunities for
purchases of this kind arise during periods of inflation, or when a market drops
temporarily, and the buying firm has sufficient working capital to finance the
speculative investment. Whether or not speculative activity of this kind should fall
within the province of the purchasing department appears to depend upon the
degree of risk involved. If the risk is substantial, the view taken here is that the
activity should be conducted by a high level staff group outside the purchasing
department. As the risk decreases the activity approaches a legitimate purchasing
function. In any case, the final decision should rest with top management. A
manufacturing concern presumably is in business to profit from the production and
distribution services offered its customers, not from speculation in the materials
market.
A purchasing executive cannot be a good speculator because speculation is not
his business. A manufacturing firm should earn profit from production and sales of
the products. A speculator does not add any value to the goods purchased and thus
does not serve the customers and therefore speculative purchasing function cannot
be considered as a part of the normal functions of the purchasing department of any
firm. Sometimes a firm is forced to follow speculative buying policy. It becomes
possible for them to sell their products at comparatively low price. Low selling price
puts them in a stronger competitive position for a short period. In such case, the
firm, which has not followed speculative purchasing policy, stands at the
disadvantage and has to follow the policy of speculative purchasing.
7.6 BUYING TO CURRENT REQUIREMENTS
If a purchasing manager decides to follow a policy of buying certain
commodities according to market conditions. most timing decisions will reflect either
hand-to-mouth or forward buying. Within this frame work, the manager may, in
some 'cases, also have an additional alternative-that of buying to current
requirements. The purchase of copper can be used as an illustration. Although
copper is purchased primarily in a fluctuating market, during certain periods the
price of copper remains fairly stable. During periods of fluctuation the manager may
decide to purchase copper using hand-to-mouth and forward buying techniques,
according to his analysis of the market. During periods of relative price stability,
however, the wisest course of action may be that of buying, to current requirements.
In practice, buying to current requirements is the policy most firms follow in buying

108

a majority of their important production materials. When dealing in unstable

markets, however, the perceptive purchasing executive may use another policy. It is
impossible to generalize about the wisdom of such action. Each case must be
studied in the light of its own individual peculiarities and the validity of market
forecasting data available. It is clear that such decision must be made by an
individual who is intimately familiar with the market in question. with general
economic condition, and with his or her own firms' probable needs. Moreover, since
forecasting is a complex activity,

the decision maker must either be skilled in

forecasting or have complete person available to provide assistance.

7.7 REVISION POINT
Purchasing according to current requirements
Purchase according to Market conditions
7.8 INTEXT QUESTIONS
1. What are the major reasons for forward buying? Discuss each briefly.
2. Discuss the concept of Right time purchases.
3. Explain the average cost buying with some example.
4. What is meant by hand-to-mouth buying?

What are the reasons for

purchasing a hand-to-mouth buying?

5. Name and explain the various Buying techniques.
7.9 SUMMARY
Two different methods of purchase policies are discussed in this lesson.
Purchase according to market condition, includes Hand-to Mouth Buying, forward
Buying, Average cost Buying and Speculative Buying reviewed in detail.
7.10 TERMINAL EXERCISES
1. List the different type of Buying Policies
2. Give short notes on speculative Buying
3. Briefly explain policy of buying to current requirements.
7.11 SUGGESTED READING/REFERENCE BOOKS/ SET BOOKS:
1. P. Gopalakrishnan, Purchasing and Materials Management, Tata McGraw Hill, 2000.
2. A.K. Datta. Materials Management Procedure, Text and cases, Prentice
Hall of India 2004.
7.12 KEY WORDS
Hand-to-Mouth Buying, Forward Buying, Speculative Buying.

109

LESSON 8

BUYING PRACTICES IN FLUCTUATING MARKETS

OBJECTIVES
To reduce the average price paid for the materials purchased by using
fluctuations of the market.
To reduce the financial risk resulting from market fluctuations.
CONTENT
8.0 Introduction
8.1 Deliberate volume timing of purchase
8.2 Rupees Budgeting of Purchase
8.3 Revision Points
8.4 Intext Questions
8.5 Summary
8.6 Terminal Exercises
8.7 Suggested Redding/ reference Books/set books
8.8 Key words
8.0 INTRODUCTION
Two basic approaches can be employed when purchasing materials in an
unstable market. The objective of the first approach is to reduce the average price
paid for the material by using fluctuations of the market to purchasing advantage.
The objective of the second approach, contrary to the first, is to reduce the financial
risk resulting from market fluctuations. By purchasing proportionately more of their
material requirements during periods when market prices are below their average
level buyers can capitalize on the fluctuations of the market. Two techniques are
used in attempting to achieve this objective are (1) deliberate volume timing of
purchase and (2) Rupees budgeting of purchases.
8.1 DELIBERATE VOLUME TIMING OF PURCHASES
Deliberate volume timing of purchases utilises a forward buying policy when
the market price cycle is on the upswing, and hand-to-mouth buying when the price
cycle is on the downswing. The technique is illustrated in the following simplified
example. Assume that a firm uses a material which is purchased in a market that
exhibits small weekly price fluctuations and rather large price swings over a period
of one to two years. Usage of the material is approximately 20,000 units per month.
Fig. 8.1. shows a smoothed market price curve for the material for a two-year period.

110

imposed on the curve are the purchases made during the period. Horizontal arrows
near the base of the chart indicate the time coverage afforded by each purchase.
Examination of the buying pattern in the example shows that near the rough of the
curve, in January, a four months supply of 80,000 units is purchased. As prices
continue to rise, similar purchases are made in May and September. At the peak of
the cycle, during January month's supply of 20.000 units is purchased. During the
period of price decline, Similar monthly purchases are made for the next eleven
months. Illustration of the deliberate volume-timing technique of purchasing in a
fluctuating market

Fig. 8.1
The result of this purchasing pattern becomes clear upon further examination.
During the period of rising prices three purchases are made. The average unit price
for this purchased material is slightly above the May price and clearly below the
average market price during upswing. On the downswing, the average unit price for
the material purchased is slightly above the average market price during downswing.
If purchase prices are averaged for tile total cycle then the unit price paid is
significantly below the average market price during the complete cycle. The
computation shown in table 8.1. verify this analysis. Thus the average price of
purchases made during the upswing of the cycle is Rs. 0.22 per unit less than the
average price of purchases made on' the downswing. Considering the entire cycle.
this method of buying yields a price saving of approximately Rs. 0.07 per unit or 2.9
percent, over the average price which would have been paid and all purchases
during the two year period been made in quantities of one months' average.
Savings from volume timing of purchases
Date

No. of units

Cost of per unit

Rs. Ps.

Total cost Rs.

111

January

80,000

2.00

1, 60,000

May

80,000

2.15

1,72,000

September

80,000

2.60

2,08,000

2,40,000
Average cost per unit = 5,40,000/2,40,000 = Rs. 2.25

5,40,000

112

Table 8.1
Downswing Purchase Cost
Cost of per unit

Total cost

Rs. Ps.

Rs.

20,000

2.86

57,200

Feb.

20,000

2.83

56,600

March

20,000

2.80

56,000

April

20,000

2.75

55,000

May

20,000

2.65

53,000

June

20,000

2.55

51,000

July

20,000

2.45

49,000

August

20,000

2.35

47,000

September

20,000

2.25

45,000

October

20,000

2.15

43,000

November

20,000

2.05

41,000

December

20,000

2.00

40,000

Total

2.40,000

Date

No. of units

January

5,93,800

Average cost per unit = 5,93,800/2,40,000 = Rs. 2.47

Total Cycle
Average cost per unit total cycle = 11, 33, 800/4,80,000 = Rs. 2.36
Savings Total cycle = (Average market priceaverage price paid)/Average market
price x 100 =

2.43 2.36
100 = 2.9%
2.43

Whether other purchases made using this technique yield greater or lesser
savings depends upon the magnitude and duration of the price swing and upon,
timing of the specific purchases. In actuality, the buyer in the example probably
would not have made three equal purchases on the upswing and twelve equal
purchases on the downswing. Savings clearly would have been greater if purchases
made below the average market price on the upswing had been larger and those
made above the average market price had been some what smaller. But in practice
the difficult problem is that of estimating what the average market price will be and
when the peak and, the trough of the cycle will be reached consequently. The
purchasing pattern for an actual purchase probably would be much less uniform as

113

a result of the buyers anticipation of these two critical factors. The risk involved in
using this technique should now be apparent. The less predictable the price
movement, the greater the risk becomes. For this season, the importance of accurate
forecasting cannot be over emphasized.
8.2 RUPEES BUDGETING OF PURCHASES
This technique is similar in concept to the volume timing technique, but in
practice it is operated some what differentially. Rupees budgeting is also based on
the idea of buying in large quantities when prices are low and reducing purchase
quantities when prices rise. The objective is accomplished in an automatic manner
by budgeting a constant number of Rupees to be spent for a given material each
operating period. The quantity to be purchased 'each operating period thus varies
inversely with market price. This technique is analogous to the Rupees cost
averaging method of buying financial securities in the stock market. Using the same
example as in the preceding section. Fig. 8.2 shows a buying pattern determined by
the dollar budgeting technique imposed on the same market price curve. The
quantity is to be purchased each operating period is determined as follows: (i) First
the buyer must estimate the average market price of the current price cycle based on
previous forecasting investigations. In this example the average market price is
predicted to be Rs. 2.50 per unit. (ii) Next buyer computes approximate usage of the
material for the duration of the price cycle. In the example. usage is estimated to be
20,000 units per month throughout the entire cycle. (iii) From these data, the buyer
computes the number of Rupees to be spent each operating period. In this example.
for convenience, it is assumed that purchases will be made on a quarterly basis.
Thus the quarterly expenditure for material will be 20,000 units per month x 3 x
Rs. 2.50 per unit =Rs. 1,50,000. (iv) As each purchase date arrives, the buyer
computes the number of units to purchase as Rs. 1,50,000 current market price per
unit.
The following results are obtained.
Jan = 1,50,000 = 75,000 units

Jan = 1,50,000 = 52,450 units

Apr = 1,50,000 = 71, 770

Apr. = 1,50,000 = 54,545

July= 1,50,000 = 63,830

July = 1,50,000 = 61,224

2.86

2.75

2.45

114

Oct. = 1,50,000 = 55, 550

Oct= 1,50,000 = 69,800

2.70

2.15

Illustration of the dollar-budgeting technique of purchasing in a fluctuating

market.
Results of the order quantity calculations can be observed in Fig. 8.2. During
the first, second, third, seventh and eight periods, the purchase quantity exceeds
period operating requirements, increasing inventory. During the fourth, fifth and
sixth periods, purchase coverage is less than requirements, causing a drain on
accumulated inventory, Note also that total purchases over the duration of the cycle
exceed operating requirements by 24,196 units. This is the result of over estimating
average market price by several paisa per unit. And had this price been under
estimated, total purchases would have been some what less than operating
requirements.
Purchase cost ,Total Cycle
Date

No. of
units

Cost
per unit
Rs. Ps.

Total
cost Rs.

Date

No. of
units

Cost
per unit
Rs. Ps.

Total
cost Rs.

Jan.

75,000

2.00

150000

Jan.

52,450

2.86

150000

April

71,770

2.09

150000

April

54,545

2.75

150000

July

63,830

2.35

150000

July

61224

2.45

150000

Oct.

55,550

2.70

150000

Oct

5,04,169

Average cost per unit total cycle = 1200000/504169 = 2.38

Savings, total cycle = 2.43 -2.38
2.43

100 = 2.1%

150000

115

In this example,

the average unit price paid during the cycle duration is

Rs.0.05 less than average market price, yielding a saving of approximately 2.1 per
cent. Again in actual practice, savings might be more or less, depending upon the
contour of the price cure and to some extent, upon the purchase period selected.

one month period is probably more realistic for most materials.

Generally speaking, this technique is some what less practical than the volume
timing technique. In the first place, effective use depends upon reasonably accurate
estimation of the average market price. This is usually a difficult task if the cycle is
erratic or lengthy. This factor introduces risk; not so much from the stand point of
price, however, as from the possibility of developing an over or under supply
situation, second, if cycle duration is lengthy, it may also be difficult to estimate
future production requirements accurately.
8.3 REDUCING MARKET RISK
Using a second or more conservative approach, a buyer may choose not to
attempt to capitalize on the fluctuations of an unstable market.

Markets for some

materials behave so erratically that this is often the more prudent course of action.
In these situation, a buyer is usually interested in mineralizing the risk resulting
from fluctuations. Two techniques that may be used in attempting to accomplish this
objective are (i) time budgeting of purchase and (ii) Hedging.
8.3.1 Time Budgeting of Purchase
Using this technique buyers can frequently purchase a material over the long
run at an average price very close to the average market price existing throughout
the cycle. They do this by purchasing small quantities of material over short
operating periods of equal length. Consider again, for a moment, the preceding
example of the volume-timing of purchases.
Note that on the downswing cycle. 20,000 units of product were purchased
every month until prices began to turn up. The result was that the average price
paid was neat, but some what above, the average market price during the
downswing. Had the volume of each purchase been reduced to a two week or a week
or a single day's coverage, the average price paid would have moved successively
closer to the average market price. If a buyer who makes small equally spaced
purchases on the cycle upswing, it will produce the same result except that the
average price paid will be some what under the average market price. Consequently,
by employing this technique over the duration of entire cycle, a buyer can be
reasonably sure of paying an average price which is very close to the average market
price. The smaller the purchases and the more frequently they are made, the closer
the average price paid will be to the average market price. When purchases are small

116

this procedure affords good protection even if the price cycle behaves extremely
irregular. The Disadvantage of this technique are the high costs of buying,
administration and materials handling as well as the risk of possible stock outs.
8.3.2 Concept Of Hedging
It is a technique used to minimize the risk associated with fluctuating market
prices. However, It can be use only in buying materials for which an organized
commodity exchange exists. An organized commodity exchange is a market place,
usually located in a large city, where a particular commodity is bought and sold in
substantial quantities. At many of the exchanges, both cash transaction and future
transactions take place. A cash transaction involves a current exchange of cash for
the physical commodity. A future transaction involves a current purchase, at a
quoted price, for which the physical commodity will be delivered at a specified date
in the future. With the passage of time the current cash price for a commodity and
its futures price often fluctuate together, approximately paralleling one another. It is
the future transaction that is essential in a hedging operation. The most important
single factor to the hedger is the difference between the cash price and futures price
commonly called the basis. In a completely competitive situation where supply and
demand are in balance, the futures price would be expected to exceed the cash
price: by the total cost of carrying the commodity in storage until the future date.
Because supply and demand typically do not remain in balance long for free market
commodities, the difference between futures and cash prices is influenced
considerably by the way buyers evaluate present and anticipated supply demand
conditions. This explains why futures price exceed cash prices for some commodities
at times 'and why at other times cash prices exceed futures prices.
Hedging, for the industrial buyer, is a technique which can provide protection
against market price declines during the period when his firm is processing a raw
material preparatory to selling it In some form as a finished product. With this
financial worry removed, the manufacturer is free to concentrate on normal
production and sales activities. For example suppose chocolate manufacturer has
signed a contract to sell a large candy manufacturer ten car loads of refined
chocolate syrup each month for the next year. The contract stipulates that chocolate
syrup Will be sold at a price based on the market price of raw cocoa at the time of
delivery of the chocolate -syrup. What happens to the chocolate manufacturer, then,
if he buys raw cocoa at Rs. 26 per kg., and one month later, when he delivers the
refined chocolate made from this cocoa, the market price for raw cocoa has fallen to
Rs. 21 per kg. He has to sell the chocolate at a lower price than he intended to when
he purchased the cocoa. Consequently his profit margin is reduced, or perhaps
entirely eliminated. To protect himself against such an occurrence, the chocolate

117

manufacturer might choose to engage In a hedging operation. His hedge consists of

the following market transactions.
(i) First he buys raw cocoa in the cash market. At the same time, he sells a
futures contract in the futures market for the same quantity of raw cocoa, to be
delivered Shortly after he expects to sell the refined chocolate. (Note that he does not
own any cocoa which he could deliver at this future date).
(ii) At the time he sells, the refined chocolate, he also buys a futures contract
for cocoa to cover the futures contract he originally sold and: would soon have to
deliver.
The protection offered by the hedge is based on the premise that should raw
cocoa cash market prices drop during the manufacturing period (resulting in a
reduced selling price for chocolate), futures prices will also drop proportionately.
Thus although the producer takes a loss by selling his chocolate at a reduced price,
he makes an approximately equal profit by covering his futures contract at a
similarly reduced price. Bear In mind that in this example the sell1ng price of
chocolate maintains' a constant relationship to the purchase price of raw cocoa. An
important prerequisite to the use of hedging requires that the purchasers finished
product be sold in a market where prices move approximately parallel to the prices
of the purchase raw material. These concepts are illustrated numerically in the
following simplified example. See Fig.8.3.
Cash activities
January 15

Cash

market

purchase

of100,000 kg of raw cocoa at

Rs. 0.26 per kg.
January
to

15

February

15

Purchaser

= 100,000 x 0.26
= 26,000

incurs

= 100,00 x 0.43 = 43,000

manufacturing cost (including

normal profit) of Rs. 0.43 per
kg.

February 15

Sells

refined

chocolate

= 100,00 x 0.64 = 64,000

(equivalent 100,000 kg of
cocoa) to customer at Rs. 0.64
per kg.
Net gain on

= 64,000 -(26,000+ 43,000)

manufacturing activity

=-5000

Futures market activities

January 15

Sells a March futures contract

= 100,000 x 0.275

118

for 100,000 kg of raw cocoa at

= 27,500

Rs. 0.27 per kg.

February 15

Buys a March futures contract

= 100,00 x 0.225

for 100,000 kg of raw cocoa) at

= 22,500

Rs. 0.225 per kg.

Net gain activity in March

= 27,500 22,500

futures cocoa market

= 5,000

Thus, while the chocolate manufacturer lost Rs. 5000/- on his manufacturing
activity because of the drop in cocoa prices, he was able to offset this loss with a Rs.
5000/- gain by hedging in the futures market, had the price of cocoa risen from
January 15 to February 15, the situation would have been reversed. He would have
shown an extra profit in his manufacturing operation because of the price increase,
but he would have suffered a loss on his futures transaction; thus he would still
experience no net gain or loss as a result of fluctuating market prices. The preceding
case is simplified example of a perfect hedge, which, to reiterate, is based on two
assumptions.
(1) The selling price of the buyers' finished product will move exactly parallel to
the cash market price of his major raw material. (2) Futures prices will move exactly
Parallel to cash market prices.
In practice these conditions exist only imperfectly. The degree of perfection
found in the relationship depends largely upon specific market conditions and upon
the characteristics of each specific sellers market. The hedger nearly always gains or
loses some money on a hedging transaction because the spread between futures and
cash prices and the spread between product selling price and material purchase
price both vary with time. However, this by no means invalidates the technique.
Provided the relationships show reasonable stability, hedging can in many cases
provide good protection against risk of wide piece swings.
To use hedging successfully, buyers must be skilled enough to estimate the
magnitude of possible gain or loss through basis variation. Their decision to hedge
or not to hedge rests on a comparison of this factor with an assessment of the
probable magnitude and direction of cash market fluctuation.

Price, Cents per pound

119

Jan

Feb

Fig 8.3 Simplified illustration of perfect hedge.

8.4 REVISION POINTS
Deliberate volume timing of Purchase
Rupees Budgeting of Purchase
Time Budgeting of Purchase
Hedging
8.5 INTEXT QUESTIONS
1. Explain the Rupees budgeting technique with some example.
2. Explain how the deliberate volume timing purchasing technique works.
3. Explain how the time budgeting of purchase works.
4. Explain how a hedging activity is conducted.
5. Explain the Buying practice in fluctuating markets.
8.6 SUMMARY
Two different approaches were discussed to purchase the materials in an
unstable market.

The first approach is to reduce the average price paid for the

materials and the second one is to reduce the financial risk.

8.7 TERMINAL EXERCISES

1. Give short notes on deliberate volume timing purchasing

120

2. Explain about Heading

8.8 SUGGESTED READING/REFERENCE BOOKS SET BOOKS
1. A.K. Datta, Materials Management, Procedure, Text and Cases, Prentice
Hall of India, 2004.
8.9 KEYWORDS
Deliberate volume timing, Rupees Budgeting, Time Budgeting, Heading.

121
LESSON-9

PURCHASING UNDER UNCERTAINTY

OBJECTIVES
To make purchasing decision under conditions of uncertainty by adopting
criteria such as rationality, minimax, maximax, optimum and regret.
CONTENT
9.0 Introduction
9.1 Uncertainty situation
9.2 Revision Points
9.3 Intext Questions
9.4 Summary
9.5 Terminal Exercises
9.6 Suggested Redding/ reference Books/set books
9.7 Key words
9.0 INTRODUCTION
The primary task of the materials manager is to decide on the acquisition of the
necessary raw materials and supplies to support orderly production at the lowest
ultimate cost. The essential features of all purchase decision making problems are (i)
recognition of the existence of several possible strategies. (ii) prediction of the pay-off
of each one of the strategies. and (iii) assessment of the order of preference of the
strategies. It may be noted in this context that atleast for some of the strategies, the
amount of profit is unknown 'because it will be determined by some event which
cannot be, predicted with certainty. All decision making problems can be classified
into three categories certainty, risk and uncertainty; depending upon the
information available to executive in a particular situation.
9.1 UNCERTAINTY SITUATION
Purchasing decision making under conditions of uncertainty arises when the
information of various strategies to be adopted in a case are neither logically
available nor is it possible to estimate the probability of occurrences of each of these
strategies. The situation should not be confused with tota1ignorance. The executive
will surely have some knowledge of the strategies though this knowledge is not
sufficient to obtain explicit data on which the calculation of probabilities of different
strategies could be based. Such problems are often encountered while buying a new
product, procuring from a new source and speculative purchases. Thus, decision
making problems under conditions of uncertainty occurs because the information

122

available to the executive is unavoidably inadequate. Several statistical criteria are

available to the executive to face any such situation with optimism. A few are (1)
Principle of rationality. (2) Principle of minimax (3) Principle of maximax, (4)
Principle of optimum. (5) Principle of regret. The application of these criteria
depends upon the attitude of the decision maker in a problem situation and these
are illustrated with the help of the following example.
The necessity for a special kind of new laboratory apparatus is expected to
continue either for four years or for five years. But the probabilities cannot be
estimated because due to technological development, the apparatus , will be
replaced after four or five years. Two types of apparatus x and y are available in
India.
Each apparatus consists of an important part and this part will need a
complete overhaul in either the fourth or fifth year. No data are available which
permit the estimation of the probabilities that the overhaul will occur in the fourth
or fifth year. The relevant figures of costs in rupees after obtaining pertinent
information from the supplier are given in the Table 9-1.
TABLE 9-1
Types of cost

Apparatus X

Apparatus Y

Capital investment cost

5000

7500

Operating cost per year

1000

500

Preventive

Maintenance

P1

P2

P3

Year 1

200

200

200

Year 2

200

200

100

100

Year 3

300

300

150

160

Year 4

700

300

902

200

Year 5

200

700

98

990

expenses

P4
100

Two sets of figures are given in this table for each apparatus depending upon
whether the overhauling is done in the fourth or fifth year. Under the of uncertainty,
viz. requirement in years and overhauling period, the problem is to decide on the
purchase of one apparatus.
For each apparatus there are four possible alternatives corresponding to two
periods of use and two periods of overhauling. The average annual costs incurred
may be calculated in any case by the following steps. For simplicity, the scrap in this

123

case and other sophisticated costs have been assumed to be zero and due to
arithmetical adjustments can be made if scrap value is to be considered. This
illustration may be suitably extended if there are Increased number of apparatus or
any other' similar kind of uncertainty situations.
Apparatus X

Life 4 Years

overhauling.

Investment

Rs. 5,000

Total operating cost for four years

Rs. 4,000

Overhauling expenses 200 + 200 +300 + 700

Rs. 1,400

Total cost

Rs. 10,400

Average expenses per year

Rs. 2, 600

Similarly, all permutations and combinations can be worked out for the
different alternatives and the average annual expenses in rupees can be tabulated
as shown in Table 9-2. After having obtained the given information, the following
principles help the executive In choosing one apparatus.
Table- 9.2
Life in Years

P1

P1

P2

P2

P1

P1

P2

P2

P3

P3

P3

P3

P4

P4

P4

P4

Preventive
Maintenance X
Preventive
Maintenance Y
Apparatus

2600

2320

2500

2340

2600

2320

2500

2340

Apparatus

2713

2290

2713

2290

2513

2310

2515

2310

(Regret matrix concept explained)

Apparatus

30

50

87

10

30

Apparatus

113

213

15

9.1.1 Principle of Rationality

The criterion of Laplace is useful to an executive when he does not have any
preference in choosing the alternatives in a given decision making problem. This
assumes that all possible strategies are likely to occur with the same chance or with
equal subjective probability in the absence of adequate information on them. The
decision rule to be followed then is, to choose that strategy which maximises the

124

average or expected gain. In the given illustration the average expense for all
combinations of X or E (X) -expected value of X is-2,440 and Y or E (Y) is Rs. 2,456.
E(X) = 2,440
[i.e. 2,600 + 2,320 + 2,500 + 2340 = 9,760/4 = 2,440)
E (Y) = Rs. 2,456/Since the average expense of X is expected to less. the apparatus X is to be
preferred in this situation.
This principle is usually adopted by practicing managers.
9.1.2 Principles of Minimax
The second criterion which was established, by Abraham Wald is known as
minimax criterion or criterion of pessimism.
This criterion is suited to a problem situation which forces the attitude of the
executive to be very conservative, pessimistic, unadventurous and compels him to
play too safe in order to protect him from the falling of the Damocle's word. In such a
situation, the decision rule is to examine the minimum profit or maximum cost
associated with each strategy and choose that strategy which maximizes the
minimum profit or minimise the maximum cost so that the worst out come is made
as desirable or possible. It is observed that worst X is Rs.2,600/-, where as worst Y
is Rs. 2,713/- and the best of the two, namely, apparatus X is to be chosen in this
particular situation.
9.1.3 Principle of Maximax
It

may be noted that on the other extreme end of the minimax rule is the

maximax criterion. This deals with a problem situation which forces the attitude of
the executive in that situation to be rash and optimistic thinking that the
circumstances are going to be benevolent always. In such a case the executive
chooses that strategy which maximises the maximum profit. The best X is
Rs. 2,320/-, best Y is Rs. 2,290/-and so apparatus Y is to be preferred under these
circumstances.
9.1.4 Principle of Optimum
Hurwicz's criterion of optimism is brought in to avoid extreme conservatism of
minimax principle or extreme radicalism of maximax principle. The criterion allows
for the varying degrees of moderation according to the variation in optimism or
pessimism of the attitude of the decision-maker in a specific problem situation. If
the index of optimism L= 1, the criterion reduces to the maximax principle. A
knowledge of L will enable one to choose the best strategy in such a specific

125

situation. The following equation may be obtained if there is no preference between

the two apparatus, then
2,320 L + 2,600 (1 -L) = 2,290 L + 2,713 (1 -L)
143 L = 2,713 2,600 = 113.
when L = 0.79; X or Y may be chosen.
When L is less than 0.79 apparatus X is preferred (to coincide with minimax
-principle) when L is greater than 0.79, apparatus Y is preferred (to coincide with
maximax principle).
9.1.5 Principle of Regret
Savages criterion of regret is particularly useful to an executive who is likely to
oscillate or vacillate in his choice of different strategies in a specific uncertainty
situation. From the pay-off the possible strategies, the loss or regret, incurred in
average expenses or profits by selecting particular strategy instead of others under
the same background conditions, are calculated and arranged in the form of a regret
matrix.
Life in Years

P1

P1

P2

P2

P1

P1

P2

P2

P3

P3

P3

P3

P4

P4

P4

P4

Preventive
Maintenance X
Preventive
Maintenance Y
Apparatus

2600

2320

2500

2340

2600

2320

2500

2340

Apparatus

2713

2290

2713

2290

2513

2310

2515

2310

Apparatus ( Regret matrix concept explained)

Apparatus

30

50

87

10

30

Apparatus

113

213

15

The decision rule in such a case is to identify the maximum regret for each
strategy and choose that strategy for which the maximum regret is least. In the
above example maximum regret for X is 87 and for Y is

Rs. 213. Choice of

apparatus X minimises the maximum regret and apparatus X is to be preferred

under these conditions. Those principles help material manager to minimise the
ignorance associated with any purchasing decision-making problem under condition
of uncertainty.

126

9.2 REVISION POINTS

Purchasing under uncertainty Situation
Principle of rationality
Principle of minimax
Principle maximax

Principle of Optimum

Principle of Regret
9.3 INTEXT QUESTIONS
1. Explain the uncertainty situation with a suitable example.
2. Describe briefly the different statistical criteria available to the executive to
face situation with optimism.
3 Two equipments are under consideration by, purchase department. The prices
are Rs. 10,000/- and Rs. 12,000/- respectively. The brand names are FXZ -48 and
FXZ -50. The purchase department collected information from four previous users of
these equipment. (Two users for each type). According to them the equipment
requires major overhaul in fifth or 6 th year. Their figures of maintenance costs for
each year are given below.
FXZ -48
Amount of operating cost

FXZ -50

2000

Maintenance cost per Year V1

1200

V2

V3

V4

200

200

175

200

200

190

200

225

250

260

200

250

300

300

250

250

200

300

600

300

250

200

175

600

4. Under two conditions of requirements and overhauling uncertainties, the

problem is to decide as to which machines should be purchased.
9.4 SUMMARY
Buying under uncertain conditions is peculiar to new machinery or in the R
& D area In this context, the decision problems are analysed with an example of
decision under risk.

127

9.5 TERMINAL EXERCISE

1. Define the principle of rationality
2. Explain the principle of optimum
3. Define the principle of regret.
9.6 SUGGESTED READINGS/ REFERENCE BOOKS/ SET BOOKS
1. P. Gopalakrishnan, Purchasing and materials Management, Tata Mc-Graw
Hill, 2000. Pp 308-312.
9.7 KEY WORDS
Rationality, minimax, maximax, optimum, Regret, uncertainty.

128
LESSON-10

CREATIVE PURCHASING
OBJECTIVES
To know the parameters such as right price, Right Quality, Right
Quantity, Right time, Right terms, Right Source, Right Place, etc. to
ensure continuity of supply of raw materials and spare parts.
To understand the concept of negotiation, purchase budget, bill market
system and insurance.
CONTENT
10.0 Introduction
10.1 Creative purchasing
10.2 Negotiation in purchasing
10.3 Purchase Budget
10.4 Bill market system
10.5 Insurance.
10.6 Revision Point
10.7 Intext Questions
10.8 Summary
10.9 Terminal Exercises
10.10 Suggested Redding/ reference books/set books
10.11 Key words
10.0 INTRODUCTION
Purchasing has come to stay as the most important, function on materials
management. The moment a buyer places an order he commits a substantial portion
of the finance of the organisation which affects the working capital and cash flow
position. He is a highly responsible person who meets various salesmen and thus
cap be considered to have been contributing to the public relations efforts of the
company. Thus, the buyer can make or mark the companys image by his excellent
or poor relation with the vendors.
10.1 CREATIVE PURCHASING
The basic objective of the purchasing function is to ensure continuity of supply
of raw materials, sub-contracted items and spare parts and at the same time reduce
the ultimate cost of the furnished products. For ensuring this, there are a large
number of well known parameters such as Right price, Right quality, Right quantity,

129

Right time, Right terms, Right source, Right place, Right mode of transportation and
Right attitude.
10.1.1 Right Price
It is the primary concern of any manufacturing organisation. But right price
need not be the lowest price. It is very difficult to determine the right price, general
guidance can be had from the cost structure of the product. The tender system, of
buying is normally used in public sector organisations but the objective is to identify
the lowest responsible bidder and not the lowest bidder. The technique of laming
curve also helps the purchase agent to determine the price of items with high labour
content. The price can be kept low by proper planning and not buy rush buying.
10.1.2 Right Quality
It implies that quality should be available measurable and understandable as
far as practicable. In order to determine the quality of a' product, sampling schemes,
inspection etc.. will be useful. The quality particulars are normally obtained from
the indents, and experience indicates that a substantial portion of the indents
prepared by user departments are invariably incomplete. Such incomplete indents
often cause unnecessary delays in procurement as the indent or has to be referred
to, and if Rot referred results in heavy rejection.
10.1.3 Right Time
For determining the right time, the purchase manager should have lead time
information for all products and analyse its components for, reducing the same.
While determining the purchases. the buyer has to consider emergency situations
like floods, strikes etc. He should rave contingency plans when force majored classes
become operative. However, rush purchase should be resorted to only in exceptional
cases.
10.1.4 Right Source
The source from which the material is procured should be dependable and
capable of supplying items of uniform quality. The buyer has to decide which item
should be directly obtained from the manufacturer. In emergencies, open market
purchases and buyer purchases are resorted to Techniques such as value analysis
will enable the buyer to locate the right material. Right modes of transportation have
to be identified as this forms a critical segment in the cost of the shipping of ore
gravel sand etc., is nominally more than cost of item itself. Specifying the right place
of delivery, say head office or works, would often minimise the handling and
transportation costs. Similarly, packaging forms an important aspect in the cost of
an item; for instance. In tooth paste the tube is costlier than the paste it holds.

130

10.1.5 Right Quantity

It is the most important parameter in buying. Concepts such as EOQ,
Economic purchase quantity, fixed periods and fixed quantity systems, will serve as
broad guide lines. But the buyer, has to use his knowledge, experience, and common
sense to determine the quantity after considering factors such as price structure,
discounts, availability of the item, favourable reciprocal relations, and make or buy
consideration. Developing right attitude, too, is necessary as one often comes across
such statements Purchasing knows the price of every thing and value of nothing; We
buy price and not cost; When will our order placers become Purchase Managers.
Purchasing acts like a post box. Purchasing should therefore, keep progress as its
key activity and should be future oriented. He should not follow the safe and welltrodden path; he should be innovative and his long-term objective should be
minimised the cost of the ultimate product. He will be able to achieve this if he aims
himself with techniques such as value analysis, purchase research, materials
intelligence, purchase budget etc. The buyer has to adopt separate policies and
procedures for capital and consumer items. He should be able to distinguish
between indigenous and international purchasing procedures. He should be aware of
the legal and contractual aspects in international practices.
10.2 NEGOTIATION IN PURCHASING
Negotiation is one of the most important as well as one of the most interesting
parts of professional purchasing. It is primarily used for high Rupees-value
purchases. It is interesting to note that the circumstance which presently dictate the
need for more long ten contract purchasing, concurrently dictate the need for greater
use of more negotiation. Negotiation involves vigorous study and training for those
who truly master it. Negotiation is a process of planning, reviewing, and analysing
used by a buyer and seller to reach acceptable agreements or compromises. These
agreements and compromises include all aspects of the business transaction, not
just price. In successful negotiations, both sides win something. The winnings,
however are seldom equally divided; invariably, one side is more than the other.
Negotiation is the appropriate method of purchase when competitive bidding is
impractical.
There are many factors that influence negotiations. If the item is standardised
and is readily available from stocks, then the negotiations will enter around quantity
discounts, staggered deliveries and payment terms. In such cases, both the buyer
and seller will have a clear understanding of their respective positions and
negotiations can be finished quickly, depending upon the culture of the respective
firms. The buyer will have to bring out his utmost negotiation skills, if he is dealing
with monopoly source, selling in sellers' market under scarce availability conditions.

131

He may be forced to contract to whatever terms and conditions that are imposed on
him, especially if the seller adopts a take it or leave it attitude. 'The long term
strategy open to the buyer is to develop another source of supply. However, this
depends on the availability of technology and requisite volume of business. Till then
he will have to be content with the monopolists, or share the experience with other
buyers.
Price is the major consideration during most negotiations. The buyer cannot
afford to force the seller to always reduce his price below his profitable limits. He
must not forget that the seller also exists in business, so that he may obtain a
reasonable return on his investment. If the buyer persists in price reduction, then
the solutions that are possible are detrimental to his interests. He will have to search
for a new vendor, or will be forced to accept inferior goods. In both cases he will be
the loser. Just as the buyer cannot afford to arbitrarily reduce the prices, the seller
also cannot quote at his will. Even a monopoly supplier who quotes unreasonably
high prices, runs the risk of inviting competitors, as the buyers will always develop
new sources, which can deliver material at better rates in the long run or from
buyers' cartels as a short-term remedy, in order to ration the requirements among
the consumers.
Price negotiations will have various dimensions, other than the intrinsic cost
consideration, factor such as rates of trade discounts. quantity discounts, taxes,
freight, insurance rates, assured supply, etc. to be finalised during the negotiations.
In the case of works contracts, the supply of long lead-time items and international
currency fluctuating price variation clauses will have to be added. Besides price, the
buyer has to negotiate discounts, specifications, quality,' quantity, delivery, legal
terms, payment terms, dispatch terms: insurance and contracts. The negotiations
will normally be long drawn out in the case of capital equipment buying decisions.
The buyer will have to consider after sales service, availability of spares, supply of
spares, guarantee, and buy-back clauses. Negotiating for these characteristics
requires both technical and commercial knowledge. In the case of imported items,
the negotiator will have to contend with other factors, like exchange regulations,
currency fluctuations, legal-terms, international contracts, marine insurance and all
dealing with foreign national or their agents. There can even be language problems
in these negotiations and there have been instances where the foreigner feigns
ignorance of common language in order to get away with as little commitments as
possible. Such notions will have to consider both the technical and careful enough
not to lose track of one, while trying to clinch an issue with regard to the other.
Human nature plays a leading role in affecting the progress of a negotiation. If a
negotiator is made to fee that the opposite party is just letting him have his say, then

132

he would become the most difficult person to negotiate with; Therefore, it is

important that negotiator should not hurt the feelings of the vendors representative.
This factor is very relevant, when a large under taking negotiates with its small
suppliers.
The location and time of meeting is also very important. The day just after a
holiday is a bad choice, because the other person may have to clear a back log. So
also is the day prior to a holiday. The negotiator must make a clear analysis of his
requirements, his stocks, his other sources, estimates of the cost of alternatives and
comparison of the cost of the product with the quoted price, market conditions etc.,
based on purchase intelligence. Some times negotiations are held between teams
and the role of each member should be made very clear. This is done especially in
the cases of purchase of high technology capital equipment
Once the negotiation starts, the buyer takes the offensive, outlines his position
provides supporting points and appeals to reason and encourages the supplier to
change his point of view. With the presentation of each point, the buyer attempts to
convince the supplier that his position is sound. The supplier will attempt to
convince the buyer of the validity of his position, the risk he is taking at the price
quoted. As the negotiation progresses the points of difference should be summarized
and agreement reached to move to another issue. The settlement of a subsequent
issue may automatically settle an issue on which a settlement could not be reached.
However, it is important that all aspects of each issue are discussed and resolved, so
that renegotiation is not all necessary at a later date on out standing points, unless
it is desired for strategic reasons, to postpone the decision making process. Neither
side should endeavor to shorten the negotiation to effect a compromise, which is not
economical. The purpose of negotiation is not to reach an agreement for agreements
sake, but rather to maximise the benefits to both parties Negotiation is inherently a
reasoning logical process, it cannot be divorced from, economic aspects and the
bargaining strength of

both sides. Ultimately, the final position may rest on the

bargaining strength of each party on various parameters.

10.3 PURCHASE BUDGET
Once the right price and the quantity is determined, the next is to initiate the
process of purchase budget. A budget is a co-coordinated financial forecast of the
income and expenditure of an organization and the purpose of the budget is to plan
and control the activities of various departments in order to achieve the corporate
goal. Purchase budget is a plan showing how much of the various resources will be
spent on buying. It is well known that purchase department accounts for a bulk of
cash out flows. For a purchase budget: the sales forecast is the starting point, and
aspects such as the product mix, the seasonal fluctuations in manufacture, packing

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sizes, schedules of production and bill of material are obtained. We will have to work
backward from the sales targets, break them into assemblies, sub-assemblies and so
on, after allowing for rejections at all stages. Besides giving the timing of purchases
and estimated cost of raw materials. this will give us the material requirements that,
will have to be procured from outside the organization.
The purchase executive must then formulate his purchase plan, taking into
account the procurement lead time. From this he must compute the funds required
and monthly cash out flows. The quantity specifications and the time schedule of
the requirements are available from the material plan. The purchase division will
have to give the price data and a multiplication and summation exercise will give the
funds needs for procurement action. The computer can be useful for the
multiplication of price by the quantity and will have access to latest price by holding,
the supplier data file. The purchase budget covers capital items, tools, raw
materials, production material, spares and miscellaneous items. It is also possible
to' have it class-wise, department wise and work centre wise, brought in for
compiling the budget. Periodic reviews and regular feed back enable the purchase
executive to identify the variances and take an appropriate remedial measure in
consultation with the user department, on factors such as genuine price increase,
increased quantity of consumption, higher in process rejection etc.
Management uses the purchase budget for the purpose of educating the
performance and exercising the function of control, which envisages an improvement
of performance by knowing how exactly we have performed in the past. The objective
of any purchasing division is to expend only the right price for the purchased
quantities. In other words, we have to optimize the utilization of the available
resources by procuring as much as possible. The responsibility for budget
preparation operation, supervision, must be formally defined for this purpose. In
any organisation unless the operations are monitored and controlled, they can cause
havoc. This is more important in the case of purchasing, as it is the main expender
of the organizations finance, and budgetary control comes in very handy in such
situations. Based on budgets, costing exercises and the price forecasts, we can
estimate fairly accurately; the upper limits of expenditure under broad categories of
materials, such as raw materials, consumables and spares. We can have separate
limits for each of the A category items and group limits for categories. So long as
the purchasing division is keeping the consumables supplied and functioning within
the budgetary constraints, the operations are well under control. No sooner is there
a clam our for materials, or the budget is exceeded, then remedial action is called
for, as to whether' the price has increased or consumption is more. Price reduction,

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or performing within the budget, while at the same time meeting the consumers'
requirement goes to the credit of the purchasing and operating divisions. Naturally,
this should preclude situations where there is a general price decrease. Similarly
adopting conservative budgeting strategies to be on the safe side, should be
discouraged. One obvious advantage of budgetary control is that, we can do away
with the system of sanctioning by the competent authority. This will reduce the leadtime required for converting an indent into a 'purchase order and will increase the
discretionary powers of the purchasing executive, thereby improving the over all
efficiency of the operating system.
10.4 BILL MARKET SYSTEM
The discussion on the purchase budget will not be complete without reference
to, the bill market scheme periodically announced by the Reserve Bank of India. The
scheme encourages increasing use of bills of exchange as an instrument of credit.
From the point of view of the short-term borrower, the advantage would be that a
clean bill of exchange can be discounted at rates lower than those charged by banks
on cash credits or overdrafts. The authorities said that the scheme will not only
impose financial discipline on the purchaser but also help the suppliers and
producers to plan their financial commitment's realistically. Depending upon the
health of the Indian economy several changes in scope of the bill on purchases from
the suppliers, he should then request them to draw the bill of exchange for the
period of credit received by the buyer on such extended period of credit upto 120
days. If on the other hand, the buyer does not receive credit, the suppliers may be
asked to draw trade bills, the period of usance corresponding to the period required
for conversion of stocks into finished goods. The format in which the bills of
exchange should be drawn for rediscount in the Reserve Bank of India under the bill
marketing scheme, is shown below.

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To
(Name' and address of buyer)

No: .......................

....................... .......................

Place: .......................

....................... .......................

Date: .......................

....................... .......................
At .......... . days after date sight (inclusive of days of grace) pay to us or to our
order at .......................the sum of rupees inclusive of interest at .............
Signature of the seller,

Note:- This bill of exchange has been drawn in connection with the sales
of. ..............(specify the description of goods sold) .......... covered by (Number and
date of document) like railway receipt, lorry receipt, invoice no. etc.
We accept this ................ date of 1974 to revise the bill on maturity.
Signature of the buyer.
10.5 INSURANCE
All business

involves risk and the object of insurance is to safe guard the

business from a risk, which may affect its solvency. Any organisation is concerned
with insurable risks at different stages mainly raw material transit, from supplier to
the stores and also the transport of finished goods from warehouse to retail out let.
The buyer is involved in the decision process of what property to insure, what value
to be insured for and what risks to be covered. Hence, he Should have a thorough
knowledge of the various types of policies, cost of purchasing insurance, the
conditions and warranties affecting the settlement of claims if an insured event
occurs, etc. The purchase managers' association with insurance begins from the
time he places an order with the supplier, till the materials reach in the hands of the
ultimate user. He has to analyse the insurance needs, so that the possibility of
catastrophe and losses to his organisation are avoided. The buyer has to are that the
claims against the insurance are lodged at the appropriate time in such away, that
compensation from insurers' is received in full with minimum delay.
10.5.1 Marine Insurance
Marine cargo insurance deals with the insurance of goods in transit. It is a
valued policy, as it covers the invoice value of the cargo, amount of import duty in
the case of imports and the reasonable amount of profits and the incidental. The
sum insured stated in the policy is binding on the insurer and it is normal to
insurer overseas consignment for 110 per cent of cost plus insurance plus, freight
value however greater values can be insured with the insurer to take care of duty
and profit. The policy can over the invoice value of cargo Import duty and reasonable

136

profit. The risk covered may relate to overseas Import shipment, inland transit, war
and strikes from port to port. Commercial risks, like loss of market production
stoppages, etc are not included in this.
The conduct of marine business is governed by the Marine Insurance Act. 1963
Unlike other policies, marine policies are insured for one particular voyage transit,
Land journey incidental to sea journey, both before and after, is treated as part of
the given transit. There are three sets of clauses known as A, B and C, as the new
institute cargo clauses in the case of imports/exports. Clause C provides cover
against risks of fire or explosions, stranding/ sinking, overturning, derailment,
collision, discharge of cargo at port of distress, Jettisoning, salvage charges, and
general agency sacrifices. Clause B provides cover against risks of all events covered
under clause B provides cover against risks of all events covered under clause C plus
lightning, earthquake, washing over board and total loss of package in loading and
unloading. Clause A provides against all risks of loss or damage except risks
specifically excluded. This would mean that unless it is specifically excluded, it is
covered by this clause. The insurance of duty and profit is available only to the
holders, of replacement license. An open insurance scheme is available, whereby a
total sum is assured for a particular period, and as the dispatches are made the
value is debited. As and when the total dispatches equal the sum assured a new
contract is made.
The exclusion common to all the three sets of clauses are as follows. (a) Willful
misconduct of the assured, (b) Ordinary leakage/loss of weight/wear and tear (c)
Insufficiency or unsuitability of packing, (d) inherent vice or nature of commodity, (e)
delay even caused by insured risk, (f) Insolvency of financial default of operators of
owner/ mangers/ charters/ operators of vessels,

(g) deliberate/ damage/

distribution by harmful actor malicious and (I) war and strike risks. The insurance
cover ceases as soon as the goods are delivered to the consignee at the destination
named in the policy. The cover ceases if the goods are stored at a warehouse, which
the insured elects to use for storage other than in the ordinary course of transit. The
cover is operative only during the ordinary course of transit. Where there is a change
of voyage or termination of voyage before the goods' reach the final destination, the
cover is operative provided prompt notice is given to the insurer and additional
premium paid. Subrogation means one's right to claim the third party who had
caused the loss. Once the claim against is settled by the insurer, the latter acquires
all the rights and remedies of the insured to legally proceed against the carriers who
are responsible for the loss of damage to goods in transit to recover the losses. All
the three sets of clauses provide warehouse to warehouse cover. There is however, a
limit of 60 days after discharge at the final port for the inland journey to be

137

completed. This is the maximum period. If due to circumstances beyond the control
of the insured, extension is required, the insurers have to be approached and
additional cost paid for such extensions naturally granted for a period of 30 days at
one time.
10.5.2 Inland Transit Insurance
Two types of police are, in case of goods transported in the country. In case of
goods transported in the country.

In case of internal transit, rail road and air

transport of materials are covered.

The policy B covers fire, breakage of bridge,

collision, overturning and derailment. While policy A covers all risks. The cover is
available from warehouse to warehouse with the limitation of 7 days at the carriers
godown at the destination.

The duration can be extended upto a maximum of 8

weeks by payment of additional premium. If the goods still are not cleared, only fire
and burglary can be insured, by means of specific policies, periods of storage at the
destination should be clearly specified during which the risk will be covered.

The

term of the cover should be as wide as an all risk policy or as restricted as road risk
or rail risk policy. The all risk policy provides for compensation in the event of any
accidental damage to the cargo except those covered by delay inherent or the nature
of the subject matter insured. War risk on land cannot be covered by the insurance
companies. Riot and strike cover is an exclusion under the standard policy, which
should be included specifically by payment of additional premium. The insurance
commences with the loading of the material into the vehicle, extends during the
transit including transshipment, prior to reaching' the destination and cases seven
days after the arrival of the vehicle at the destination.
The extent of cover must be determined by asking the following questions. (a)
should the insurance be done restricted to road risk or rail risk basis or on wider
terms. (b) should the insurance be left to the supplier stipulating that the supplier
should replace the damaged goods. (c) if it is to be self-insurance, what are the risk
accumulation points. (d) what is the maximum possible loss arising out of an
accident. (e) if insurance is arranged, what is the period of storage at the destination
for which cover has to be extended. (f) while railways and lorry transport companies
are liable for compensating the consigner for negligent handling of goods, the time
and effort enquired to recover from them is substantial and their reliability like riot
damages is doubtful.
10.5.3 Stores Insurance
During storage, goods are usually insured against fire, explosion riot, Strike,
flood, earthquake, pilferage etc., standard fire policies cover the risks of fire, water
damage, fire brigade damage, damage during removal, lightening, explosion of gas or
boiler used. The fire policy excludes perils due to earthquake, war, riot, malicious

138

damages and losses due to theft during fire, spontaneous combustion burning by
order of public authority short circuiting or overheating of electric machines. The
articles excluded in the fire insurance policy are items held on trust, bullion, work
part exceeding rupees one thousand, manuscripts, plans, drawings, securities,
stamps, paper, money, cheques, books of accounts, and explosives. Some of these
require payment of additional premium. Fire policies are not valued policies; so, for
insurance of stocks, with fluctuating value a declaration policy can be obtained,
provided value of the stock is atleast Rs. 20 lakhs. A fidelity guarantee policy for the
key personnel controlling the stores, often turns out to be a wise investment since
the cost for such insurance is relatively low; monthly declaration of stock values
have to be made and the actual premium is charged on the basis of average of these
declaration, with the provision that the refund premium would not exceed 35% of
the deposit made. The benefit of escalation clause for stock is usually about 15% to
take care of inflation. The basis of rating depends upon the type of construction,
occupation, commodity, warrantees, use of fire extinguishing appliances etc.
It has been found in practice that the loss of production or consequential loss
following a fire is generally more substantial than the material damage. It is possible
to insure this loss of profits by taking out a policy for gross profits, calculated for the
previous year. But this policy is issued only if material damage policy has been
taken. The period of indemnity should be the period required to get back into the
normal production after the fire. There are reinstatement value policies, that are
applicable to builders, plant and machinery. Claims are settled for the cost of
building or replacement and hence the sum insured must be related to these costs.
The payment is based on the actual reinstatement.
10.5.4 Contractors All Risk Insurance
This policy is meant for insurance of contracts, where a major portion of the
risk, i.e., over 50% relates to civil engineering works, like erection of buildings, road
or railway construction, waterworks, bridge construction, sewage works, drainage
scheme etc. The insured is protected against accidents resulting in physical loss or
damage of the work in progress and constructional plant and equipment. This policy
cover is available against the risk of: (a) accident/damage/loss/damage caused by
the use of faulty material or workmanship. (b) burglary theft/ malicious damage; (c)
fire/lightning/explosion/storm,(d) earthquake/ flood/ inundation/ landslide;

(e)

Riot and strike; (f) loss of damage to constructional plant/equipment/machinery

occurring during loading, unloading, storage on site, (g) Third party personal injury
and property damage, risk up to the limit of indemnity, irrespective of anyone
accident as may be selected by the insured. The cold storage policy grants cover
against the deterioration or putre fraction of the contents of the cold storage, caused

139

by (a) rise of fall in temperature, resulting from a breakdown of the refrigeration

plant and equipment at the premises, or damage to such plant by an accidental
extraneous cause and (b) action of the refrigerant fumes escaping from the plant and
equipment from any cause. The boiler and pressure plant insurance is an annual
contract and provide insurance protection to steam generating boilers and pressure
vessels which are commissioned. This covers damages of surrounding property of
the insured.
10.5.5 Miscellaneous Insurance
Motor insurance is classified as private car/commercial vehicles/motor
cycles/specialised vehicle insurance. The three common policies are ACT, third party
cover and comprehensive. ACT recovers body injury or the death of the third person
and is essential for obtaining license for the vehicle. The third, party cover includes
damages of the property of the third party. The comprehensive policy covers the
damage to the vehicles and the legal dues to an employed driver. Other passengers
are not covered by this insurance. Discounts in premium are offered for fleets and
automobile association members, no claim bonus is a specialty of motor insurance.
Burglary insurance is available for business premises and is relevant to purchase
function Loss of cash in transit, cash in safe, and declared'

materials can be

covered by this policy. Only forcible violent entry while breaking open the door is
covered by this policy. A fidelity guarantee policy can be taken to cover pilferages by
employees. Obviously, robust commonsense will be the guiding factor in deciding the
burglary insurance. For example, heavy casting which cannot be pilfered need not be
insured. Engineering insurance is available for machinery action and testing,
machinery breakdown, boiler explosion and loss of profits. Specialized risks in
manufacturing industries are covered under the scheme.
The purchase executive has to consider the premium, while considering the
landed cost of any imported item. Usually, the market value or value for which any
asset/property can be bought or sold in its existing condition is considered for
determining the premium. A simple and practical method of arriving at his value
would be to determine the replacement cost as new and reduce it by depreciation for
age, use, maintenance, wear and tear etc. This is the value for which property
should be insured. The computation of the cost of the risks involved is based on
statistical and actuarial principles. The average total insurance cost, including
transit and stores Insurance in industry is about 3 per cent of the average value of
the stocks, while its range has been 1 to 8 per cent. It is desirable to insure all
transit material with Indian, insurance companies. This allows faster claim
settlement and conserves foreign exchange. The premium rate for warehousing is

140

dependent on the nature of the storage and it is possible to economies the premium.
if hazardous material is segregated from non hazardous items.
10.6 REVISION POINT
Negotiation in purchasing
Purchase Budget
Insurance
10.7 INTEXT QUESTIONS
1. Explain clearly the various parameters considered for creative purchasing.
2. (a) What is negotiation? What are the important 4 factors that influence
negotiation?
(b) How does human behaviour playa decisive role in negotiation?
3. Explain the use of purchase budget.
4. Describe briefly the following insurance system:
(a) Marine insurance.
(b) Stores insurance.
(c) Inland transit insurance
(d) Contractors risk insurance.
10.8 SUMMARY
In this lesson, the concept of negotiation and how it influence the purchasing
function and purchase budget, and insurance were discussed in detail.
10.9 TERMINAL EXERCISE
1. Explain the negotiating strategy and tactics. What is negotiable
instruments? Discuss.
2. What is negotiable instruments? Discuss.
3. Explain the method of preparing a purchase budget.
10.10 SUGGESTED READING/ REFERENCE BOOK/ SET BOOK
1. Donald

W.Dobler

and

David

N.

Burt,

Purchasing

and

supply

Management , Text and Cases, Tata Mc-Graw Hill, 2002, 6 ed, pp- 357.
th

2. P. Gopala Krishnan, Purchasing and Materials management Tata M.C

Graw Hill, 2000.
10.11 KEY WORDS:
Negotiation, Purchase Budget, Bill Market system, Marine Insurance, Inland
Transit insurance, stores Insurance, Contractors Insurance.

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142
LESSON -11

MAKE OR BUY DECISIONS

OBJECTIVES
To understand the Break-Even analysis
To know that how it is applied in Make or Buy decisions.
CONTENT
11.0 Introduction
11.1 Break even Analysis
11.2 Break even Analysis for make or Buy Decision
11.3 Influencing factors
11.4 Role of PERT and CPM in make or Buy decisions
11.5 Illustrative problems
11.6 Revision Point
11.7 Intext Questions
11.8 Summary
11.9 Terminal Exercises
11.10 Suggested Redding/ reference Books/set books
11.11 Key words
11.0 INTRODUCTION
Companies producing goods from assembled parts, usually earn more profit on
components they make "in-house" than on components they buy from outside
suppliers. Nevertheless, if they tried to produce all their own needed components;
they would probably lose money. This is because they would lack the diversified
skills and facilities needed to do an effective job.
Some items, such as supplies and low valued components that are not within
the main line of expertise of the firm, are obvious candidates for purchase. For
example a paint manufacturer would procure its office supplies and computer
controlled processing equipment from outside vendors. However, when the
components are a critical or significant element of the finished product, producers
sometimes integrate back to the supply. Thus, Ford Motor Company produces some
of its own steel, even though steel making is not its, primary line of business.
Make or buy decisions made on a day to day basis relate largely to the use of
existing capacity. They may, require the joint evaluation of the purchasing,
operations, engineering, accounting, and other departments of the firm because

143

numerous considerations come into play. One approach is to first establish the
economic feasibility and then follow with a consideration of more value based "less
economic" factors. The use of "Break-Even Analysis" come handy in solving make-orbuy decisions.
11.1 BREAK EVEN ANALYSIS
Break even analysis implies that at some point in the operations of an industry,
the total revenue from the sale of manufactured products equals the total cost of
measuring them. The point, in terms of the quantity of products sold or in terms of
currency at which the revenues and the costs agree exactly is termed as BREAK
EVEN POINT.

The break-even point is therefore, the volume of output at which neither

a profit is made nor a loss is incurred.

The break-even analysis can be carried out algebrically or graphically.

Break-Even' Analysis is based upon the very fundamental model of economic

theory which states that profits arise from the excess of total revenues (TR) over total
costs (TC). The total costs are composed of both fixed costs (FC) and total variable
costs (TVC).
Therefore, Profit = TR -TC
= TR -(FC + TVC)
The fixed costs are those costs that tend to remain relatively constant
regardless of the volume of production. Supervision, taxes, office salaries,
depreciation and rents are of a more fixed or semi variable nature. These costs are
essentially constant over a given range of output but admittedly do change over the
long run as plant expansions are made, taxes change and the like.
The variable costs are those which tend to vary directly with the volume of
production. The direct labour, direct material plus some other items such as factory
supplies are variable costs as they change typically with the volume of production.
A break even chart is a convenient means of graphically describing the
relationship between the costs and revenues for different volumes of output Fig. 11.1
depicts this relationship over a range of volume where total revenue increases
linearly with-each unit sold, and total, cost reflects both an unavoidable fixed costs
plus a per unit variable costs. The Break-even point (BEP) is that ere the fixed and
variable covered, but no profit exists. Thus at BEP, the total revenues equal the total
costs (TR = TC). Recognising that revenues reflect the price, P, charged per item
times the volume, V, sold.

144

Hence P(V) = FC + VC(V).

Therefore VBEP =

FC
P-VC

Break-even analysis is simple and easy to visualize, and it condenses decision

information with a form that is readily understandable by almost anyone. Also, it is
concerned with a vital aspect of the free enterprise of organizations, profitability.
However, it is a technique asked wholly upon economic factors.

FIG. 11.1.1 BREAK EVEN ANALYSIS

Problem: 1. A Producer of electronic Calculators, has the production
information as shown below. What are break-even point?
Price Trend

Fixed Cost

1992

Rs. 100 .

Rs. 12,00,000

1993

Rs. 200

1994

Rs. 250

VBEP =

FC =

Rs. 12,00,000 =

Variable cost/unit
Rs. 30

Rs. 12,00,000

145

P-VC

250 30

220

= 5454.5 or 5455 units.

11.2 BREAK-EVEN ANALYSIS FOR MAKE OR BUY DECISIONS
Economically, any item is a candidate for in house production if the firm has
sufficient capacity and if the component value is sufficient to cover all the variable
costs that go into it and as well as make some contribution to fixed costs. The
variable cost of production is usually less than the purchase cost because its
purchase price includes a profit for the supplier (and other members of the
marketing channels). Fixed costs of production include plant and equipment
investment plus and overhead charges.

146

Fig. 11.2.1 Make versus buy decisions

Fig 11.2.1 depicts the make versus buy decision terms of a break- even or in
different point of analysis low volumes of production tend to favour buying, Whereas,
high volumes favour making. This is because the cost to buy involves little or no
fixed component even though the slope of the total-cost line (that is the purchase
price per unit) is steeper than for the cost-to-make situation. After sufficient volume
is produced to cover the fixed cost of making then it is profitable, to produce the
product in-house.

147

Uncertainties of supply, demand, or product 'quality complicate the make

versus buy decision. However, if historical or market information is available, it may
sometimes be converted into a probabilistic form which can be used to reach better
decision.
11.3 INFLUENCING FACTORS
The decision to purchase the

capital investment or to sub-contract its

manufacture is more complicated than a decision, to buy a regularly consumed item.

The choice depends upon a large number of contributing factors, such as process
secrets, technology, cost, volume, profitability, seasonal, cydical effects, high
investments, longhead quality considerations and policy guidelines, while such
decisions are taken at the top management level. The buyer plays a advisory role by
providing relevant, information needed for this decision process. However, the buyer
should know the logic behind these decisions, make-buy decisions should be
reviewed by every company periodically.
The make or buy criterion is influenced by the market, technical, economic,
human and other factors and hence they should be evaluated. The following are
some of the influencing factors in this context, which need to be analysed in depth:
a) Competitive threat based on supply, demand and price
b) Substitutive products-quality and availability
c) Economic forecasts, raw material availability, electricity supply and water
situation
d) Chief technology
e) machine capabilities
f)

productivity

g) capacity utilization
h) Plant efficiency and engineering features
i)

Compatibility with existing system

j)

maintenance decision

k) replacement decision
l)

physical life-span

m) economic life-span
n) tax life
o) purchase costs
p) capital costs

148

q) installation costs
r) breakdown or shortage costs
s) depreciation policy as straight line or sum digit or double declining
t)

operating revenue/gross net

u) capital gains
v) time value of money
w) social benefit
x) internal rate of return
y) decision making structure and decision alternatives based on scientific
analysis of appropriate data
11.4 ROLE OF PERT AND CPM IN MAKE/BUY DECISIONS
It is the time and cost estimates, which play a vital role in the successful
implementation of any project. Since these estimates are, in the majority of cases,
judgmental values, care should be taken to involve a number of concerned technical
experts. Not only should the person entrusted With the job be involved in the
estimation process, but also his boss and his peers. More such estimation should be
done after a number of sittings so that factors not considered in one sitting may be
considered in another. These estimates are the very heart of "management by
network analysis". PERT/CPM, thus help in the estimations of the time and hence
the cost of manufacturing a product aid consequently the intricacies arising in the
make versus buy decisions are solved.
11.5 ILLUSTRATIVE PROBLEMS
1) A manufacturer of motorcycles buy spark plus at Rs. 40 each. In case he
makes it himself the fixed and variable costs would be Rs. 10,000 and Rs. 30 per
plug respectively. Should the manufacturer make or buy the spark plug?
Fixed Cost

Rs. 10,000

Variable cost

Rs. 30 per price.

Assuming BEP as Q
Variable costs for manufacturing Rs. 30 x Q.

Breakeven point BEP =

Fixed Cost
Price-Variable Cost'

149

10,000
40.30

10,000 1000 Peces.

10

Ans:
(i) If the requirement is less than 1000 pieces - BUY.
(ii) If the requirement is more than 1000 pieces - MAKE.
2) Deepak and Co. has been buying a particular part from a private firm at a
price of Rs. 80 per part. The part is a cast iron machined item. Deepak and Co. has
so far been purchasing this item though they have both foundry and machine shop.
Since the capacity of the above said shops are increased now, the decision to make
or buy has to be taken. The cost estimation reveals the following:

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Foundry

Machine Shop

Rs.

Rs.

Material cost

25-00

Direct Labour

10-00

15-00

Overhead

12-00

20-00

Total

47.00

35.00

Assuming no rejections and 50% overhead is variable advise the company

whether it should make the part or buy stating the reasons.
Fixed Cost = 20,00 + 12.00 = Rs. 32.00 (overheads)
Variable Cost = material + labour + 50% overhead.
= Rs. 25.00 + Rs. (10+15.00) + 50% (Rs. 32.00)
= Rs. 25.00 + Rs. 25.00 + Rs. 16.00 = Rs. 66.00
Fixed Cost
Break Even Point =
Price-variable Cost

Rs.32.00
80.00-66.00

Rs.32.00
14

4
2
14 pieces

Approximate 3 pieces.
ANS:
(1) If the requirement is less than 3 pieces -BUY.
(11) If the requirement is more than 3 pieces MAKE
11.6 REVISION POINTS
Break even analysis, Influencing a factor for Make or Buy Decision.
11.7 INTEXT QUESTIONS
1. The Evergreen tractor company has extra capacity that can produce gears
that the company has been buying for Rs. 400 each. If Evergreen makes the gears, it
will incur materials cost of Rs. 120 per unit, labour costs Rs. 60 per unit and
variable overhead cost Rs. 40 per unit. The annual fixed cost associated with the
unused capacity is Rs. 3,20,000. Demand over the next year is estimated at 4,000
units.
a) would it be profitable for the company to make the gears?

151

b) Suppose the capacity could be used by another department for the

production of some sprats equipment that would cover its fixed and variable costs
and contribute Rs. 1,20,000 to profit. What would be more advantageous, gear
production or sports equipment production.
2. A telephone equipment Co. Manager must decide whether to make or buy a
relay and a switch. Capacity is available and no other uses of the capacity are
apparent.
Relay

Switch

30,000

18,000

Material cost/unit

4.00

Rs. 100

Direct Labour hr.

400

220

Overhead (variable) labour hr

Rs. 500

Rs. 500

Purchase price/unit

Rs.20

Rs.9

Quantity required (unit/year)

If Make:

If Buy:

The direct labour cost is Rs. 360 per hour, and the variable position of overhead
is Rs. 480 per labour hour. The fixed overhead of the available capacity is estimated
at Rs. 1,04,000 per year. Suggest a suitable solution.
3. Northwest products company has received an order for 800 portable heating
cells from a military agency. The heaters have a special casing that must be molded
to such close tolerances that some of the them don't fit and must be reworked, The
percentages of defectives, along with the probabilities of occurrence are(as shown:

% Defective

Probability

P(D)

0.60

0.20

0.10

0.05

0.03

0.02

152

The casing cost Rs. 2400 to make and Rs, 2000 to purchase, A buyer in the
purchasing department has located a potential supplier of Rs, 2450 per casing.
Determine whether the company should purchase the casings or produce them,
a) What is the break-even point in the proportion of defectives such that the
cost of the making the casings would be equal to the cost of buying them?
b) What proportion of defectives can be expected if the firm produces its own
casings?
c) On the basis of this data. should North West make or buy the casings?
4. What general procedure is to be followed in analyzing a make versus buy
decision'?
5. How is break-even analysis adopted to analyse a make versus buy decision.
11.8 SUMMARY
Concept of Break even analysis and use of this bream even analysis in make or
Buy Decision were discussed in detail, With examples. The criterias that influence
the make or buy Decision are also reviewed.
11.9 TERMINAL EXERCISE
1. Briefly explain the concept of Break-even analysis
2. List the factors that influence the make / buy Decisions.
3. Explain the role of PERT and CPM in make /buy Decisions
11.10 SUGGESTED READING/ REFERENCE BOOKS/ SET BOOKS
1.

S.C. Sharma, Materials management and materials Handing, Khanna

Publishers, 2000.

2.

Donald. W.

Dobler and David N. Burt, Purchasing and supply

management, text and cases, TATA Mc-Graw Hill, 2002.

11.11 KEY WORDS
Break-even analysis, make or buy decision, PERT CPM.

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LESSON 12

VALUE ANALYSIS AND COST REDUCTION

OBJECTIVES
To know the value analysis concept
To understand the Techniques for value analysis
To know the application of value analysis.
CONTENT
12.0 Introduction
12.1 Value Analysis
12.2 Historic Background
12.3 Concept of value
12.4 Items for value Analysis
12.5 Organisation for value Analysis
12.6 Value Analysis application
12.7 Techniques for value analysis
12.8 Brain storming: A & Z way
12.9 Steps for value Analysis
12.10 Matrix method
12.11 Road blocks to value analysis
12.12 Revision Point
12.13 Intext Questions
12.14 Summary
12.15 Terminal Exercises
12.16 Suggested Redding/ reference Books/set books
12.17 Key words
12.0 INTRODUCTION
The material manager is always in search of cost reduction tools. Value analysis
is synonymous with cost reduction and is a powerful practical cost reduction
technique available to the purchase executive. Since it attacks the basic design the
product, value analysis is more effective than other cost control techniques. It is
concerned with ascertaining whether the materials purchased is of good value for
the money, for the required purpose.

154

12.1 VALUE ANALYSIS

Value analysis is an organised creative approach aimed

at identifying

unnecessary costs and eliminating the same from the system without affecting the
functional utility / guarantee/ safety performance. The essence of value analysis is
to identify the function of the product, to examine alternative ways by which the
function can be accomplished and finally choosing that, which involves the least
cost. Value analysis correlates the cost of purchasing a product or service with its
end use. It attempts to examine critically the make-up of every item, which I
contributes towards the cost of the product and whether this cost contributes to the
function appropriately. It is an approach of providing the required function of the
product at the desired time and place at the lowest cost. This approach is concerned
with the right quality, design, specifications, standards, methods of manufacture,
etc. and involves the substitution of material or component at a lesser price or better
quality.
Several, other techniques closely resembling value analysis are also used in the
industry with different names, and these are mentioned in the following. The
application of the value analysis ideas during design and engineering stage of
product before its manufacture, is known as value engineering. Some of the related
techniques

using the

same logic

are

listed below:

PROFIT-Product return

opportunities by function investigation techniques; FIRST -functional ideal system

techniques; FAST -functional analysis system techniques; FACTS - Functional
analysis of components of total system: VM/VI-Value management and value
improvement. But value analysis is the generic name for all the above techniques
and the differences, if any, are negligible.
12.2 HISTORIC BACKGROUND
The concept of value analysis is as old as the human race and is practiced by
all shrewd purchase executives; the housewife often changes her menu and buys the
low priced seasonal vegetables, thereby satisfying the demand at a reduced cost. On
the industrial scene, immediately after World War II, the cost of production was
going up in General Electric, as in most other companies, due to inflation. For
different civilian consumer products, a desperate situation arose, Lawrence D. Miles
was forced to turn to basics and asked the appliers to provide with some machine,
labour or material, which will provide the desired function.
It was found that many war-time substitutes and methods were performing at
least as well as the original in many situation and at less cost. He established a
research facility in the central purchase department to study the new approach. He
refined and developed this cost reduction technique and called it Value Analysis.

155

Leaders like Robert McNamara used this tool in Department of Defense in the USA
and saved a reported $ 14 billion in rive years. As a result, the Defense Department
wrote an incentive clause making value engineering an integral part of government
contracts on projects above a particular value. The Society of American Value
Engineers -SAVE -was formed in 1959 to give the new methodology continuing
vitality and stimulation. The Indian Value Engineering Society founded 1978,
conducts annual conferences and brings out a quarterly journal Invest, wherein
successful Indian experiences have been shared.
12.3 CONCEPT OF VALUE
The English dictionary has several meanings of the word "value" such as worth,
a fair equivalent, intrinsic worth, relative worth, that which renders something
useful, etc. In the field of purchasing value can be defined as the lowest cost for
reliably performing an essential function and should be considered as the ratio of
worth to-cost. The determination of value requires a combination of the following
considerations:
a. Functional or use value which helps in accomplishing a task: this may be
divided into primary, secondary and tertiary.
b. Esteem value -associated with pride of possession and sentiment.
c. Exchange value -exchange value is the barter value expressed as the sum of
use and esteem value.
d. Cost value -depends upon the commercial value of the cost of production.
e. Scrap value -the money that can be recovered when the item is no longer
needed.
The concept of value is dynamic and it changes with time. An item which has
functional value today will have esteem value after some time and finally as time
passes, the item will have only scrap value.
12.4. ITEMS FOR VALUE ANALYSIS
The product life-cycle concept comes in handily for identifying the product for
value analysis. It is well known that any product like the human race, goes through
the do of the life-cycle, namely-concept development, growth, maturity and decay.
The return on investment also varies from one type of product to another. When the
product stabilizes or reaches the stage of maturity, the competitors enter the market
with an improved version of the product and this will force the organization to effect
modifications in the product for survival. These efforts for cost reduction start right
from the design stage and is continued in the production system through process
modification, tool changes, materials substitution etc. Thus the product with

156

decreasing return on investment, particularly in the maturity stage is considered

ideal for value analysis. In addition, products which suffer from maximum over
design can also be chosen for value analysis. Non-critical items with high annual
consumption value or A category items-based on cost criticality analysis, form the
starting point for value analysis.
Many organization have reduced packaging cost by adopting value analysis
methods on packing materials. But, usually firms identify the product for value
analysis by ABC analysis, which ranks the components in relation to the annual
turnover, production or revenue generated. This ensures that any increase in value
relative to costs would yield maximum possible benefits.
12.5 ORGANIZATION FOR VALUE ANALYSIS
A common question arises as to who should carry out value analysis in a
company.

Ideally,

value

analysis

is

basically,

team

effect

and

requires

interdisciplinary approach. Interdisciplinary teams of four of five individuals are

selected from all key departments such as marketing, design, purchasing, cost
accounting, research, quality, packaging, safety, maintenance, and manufacturing,.
The methodology of value analysis is exposed to the members by an expert in a
workshop for a period of three or four days. Each team, later, selects and works on a
specific project and finally prepares a report. The value engineering study also may
require the aid and advice of specialists in various areas as consultants.
In case of large industries, a separate department headed by a senior executive
is formed to devote their time for value analysis studies. These studies involve people
at two levels. The first level consist of senior managers to decide broad policies, such
as accepting proposals, procedures, budgets and accepting team recommendations.
The second level consists of operative executives to carry out value analysis studies.
The people working in value engineering department should have self-confidence,
patience, loyalty, curiosity, creativity and good human relations. It is necessary that
the members of the team should interact freely and creatively with one another for
the specific purpose of cost reduction. Some organisations feel, the inclusion of
representatives of consumers and suppliers in the team would add a further
dimension in value improvement.
12.6 VALUE ANALYSIS APPLICATIONS
Several organisations in public, private, industrial service, large and small
sectors have used value analysis and are making sizeable savings every year. It
brings the much needed technique of plain common sense into the operations, by
bringing out on a voluntary basis, the best talent in people. It uses a confidence
building and creative process, that results in the generation of valuable ideas by

157

tapping the creative human power. It makes employees cost conscious and promotes
team work. Value analysis studies emphasize on total system concept and the
studies should be carried out keeping the interests of producers, consumers,
employees, traders and the society. Many areas of application in different sectors
and industries have been reported in a large number of articles in different stages
and some are mentioned below:
The value analysis team in one steel plant in India found that many of the rigid
material and process specifications in some of the intermediate stage were not
required, for the tasks for which the steel products are ultimately expected to
perform. This has allowed the organization to reduce some of the required
processing of various steel items to offset the physical over design. The electrical
engineering industry has substituted the indigenously able aluminium instead of
imported copper, a major breakthrough resulting in substantial savings.
The DGS&D -a central buying organization catering to for the needs of defiance,
railways and P&T buys above Rs. 3000 corers per year, has through value analysis
saved substantially on just one supplier of inspection lamps. In one engineering
firm, value analysis was applied at the; design stage of the machines and it was
found that a spring loaded stripper arm can do the same function by remaining
stationary. This resulted in considerable reduction in maintenance cost. Value
analysis has been practiced by many firms as a policy for import substitution. In the
packaging of consumer goods like tooth paste, instant coffee, soap, cigarettes,
biscuits, etc., value analysis techniques have been profitably used to bring about
economy in packing. Thus value analysis helps to maximise the conservation of
scarce material resources in the country and helps to achieve cost reduction.
12.7 TECHNIQUES FOR VALUE ANALYSIS
The sequential steps involved in carrying out a value analysis include the
following: (1) product selection (2) information gathering (3) definition of function of
the product (4) identification of function (5) speculation of alternatives (6) evaluation
of alternatives (7) reporting

about recommendations and (8) implementation and

follow up. Darsiri means to 'consider' in Sanskrit and this also follows similar steps.
Here Darsiri method stands for data collection, analysis, record ideas, speculate,
Investigate, recommend and implement. Other techniques include MISS-modify,
improve, subdivide, substitute and EXCHANGE Eliminate, keep, change. The given
specifications are challenged in the meeting, if necessary by assigning rupee value
for the tolerance. Simplification, diversification and standardization can also
contribute to the cost reduction and must, be used In conjunction with value
analysis. The team should be familiar with the material sciences and the research
that has taken place in the context of the chosen items.

158

In the value engineering approach, the definition of the value on the function
should be limited only to two words, a verb and a noun. The two-worded definition
must suggest the function of the product of the item considered for value analysis.
For example the function of a "cigarette lighter" can be defined as to "provide
Ignition". After the definition, the functions are classified as primary and secondary
functions. For any product or part, there can be only one primary function and
there can be any number of secondary functions. The primary function of a shirt is
to cover the body, while the secondary function can be to appear elegant.
Sometimes the functions are also classified based on different disciplines, such
as structural function, electrical function, mechanical function, etc. However,
generally the utility is usually classified as primary and secondary in value analysis.
After defining the functions for the main assembly, sub-assemblies, parts and
components, a group of the functions are selected by the team for speculation of
alternatives. Either the product as a whole, or a few of the parts are selected for
speculation of alternatives. Speculation of alternatives' emphasizes creativity.
Creativity means looking at problems from unconventional angles. There are three
stages in creativity, viz. imitation, innovation and invention. Creativity emphasises
the principles of blast, create and refine the ideas.
12.8 BRAIN STORMING: A to Z WAYS
Brain storming sessions help in creativity and speculation of alternatives." The
philosophy of brain storming sessions is not to judge the ideas as they come as this
inhibits the people in coming out with creative ideas. Here the emphasis is on
creation of as many ideas as possible. The brain storming groups normally consist of
five to seven people with different backgrounds drawn from different departments of
the organization. They meet in a group to speculate the alternatives. The alternatives
suggested by different members of the group are listed in this step for evaluation in
the subsequent step.
The following illustrative questions aid in creative thinking and in the
speculation of alternatives and finding answers to some questions in the committee
to help to reduce the cost:
a) What is the item and can we do without the item?
b) Why is it this shape? How does it contribute to the value?
c) If it is flat can it be round (vice versa)?
d) Can two components be made into one (vice versa)'?
e) Why does it need to be so thick? Does it need all the features?

159

f) Why does it need to be so thin?

g) (If we make) can we buy It cheaper (vice versa)?
h) What new processes can we use? Can we use more of a less expensive
material?
i) Is the cost reasonable in terms of its contribution to the end product'?
j) Is the quantity purchased most economical on the ultimate cost?
k) Does the item need all the features?
l) Is the item made on proper tooling?
m) Is any other organization buying less and if so from whom?
n) Is it necessary to have such a finish?
o) Is a material available which will be eliminating finishing?
p) Is anyone buying for less cost?
q) Have all basic processes been considered?
r) What are the competitors doing?
s) Can we get ideas from suppliers/consumers on cost reduction?
t) What are the alternatives possible?
u) Is this item standard as regards specification, size, shape, type etc.?
v) If the item is imported, can it be indigenously made?
w) Does the analysis of the reasonable cost of material production and profits,
roughly equal to the price quoted, or is exorbitant according to the analysis?
x) Is it possible to put a rupee sign on all tolerances and would you use your
own money in this way?
y) Is the cost proportional to the utility?
z) How do you increase the worth to you and decrease the price of the item?
12.9. STEPS FOR VALUE ANALYSIS
The first and crucial question in value analysis is what is the function of the
product. process or service? The next question is, how to enhance the quality or
value with lowest cost? In this process, the following eight phases or sequential steps
are considered:
a. Information phase -In this phase all relevant facts/ data about a
particular troublesome product/part/process are gathered, organized and
analyzed.

160

b. Functional phase- Here, a few items of poorest value (they cost far more
than they should) are identified, and the functions that must be
performed by the product are inspected, analysed and classified.
c. Creative phase -A probing, for reaching collection of solutions, probable
and improbable, is gathered in an effort to generate ideas to perform the
functions identified for the poor value items.
d. Judicial analysis phase -The ideas generated in the creative phase are
now evaluated in a practical, pragmatic and analytical mode. Several
ideas are selected and ranked in order of importance.
e. Development phase -The best creative and practical ideas are now
refined by the team and brought into shape. The cost factor is added here
and applied to reality. This is a consolidation of what the team thinks.
f.

Presentation -The proposed changes are put in final form to be presented

to the management decision makers. This proposal describes two or three
ideas for performing the function of the original, basic and very expensive
item with a workable alternative of better value.

g. Implementation and follow-up-phase -After ideas have been accepted by

the management the changes are implemented, monitored and followed
through proper periodical reviews, while developing an idea is important,
selling it to top management is equally important. It has been noted that a
sizeable percentage of the proposals does not see the light of day. Only
about 50 per cent of the valuable ideas generated in the team workshop
are accepted for practical implementation.
h. The master phase -In terms of salesmanship and communications, take
one new idea from the list of ideas that have been initially turned down by
management, and with additional sophisticated fine-tuning analysis and
description, and present it better in such a way that management can
understand and implement.
12.10. MATRIX METHOD
In the matrix method, the most suitable alternative is chosen with the help of
all objective numerical evaluation by simultaneous comparison of suppliers with
factors. All the alternative factors for different suppliers, are given marks by a team
of evaluation in various scales and each scale is given a weightages. The weighted
average of the marks obtained under various scales then gives an objective appraisal
of the alternatives. The system requires the following basic steps (a) Identify the
emphasis factors for the product/item; these are the marks given to the item under

161

various performance/quality categories, and indicate how efficiently the alternatives

are graded against each other in the various functions. Obviously, the number of
sets of emphasis factors is equal to the number of functions. (b) Emphasis
coefficients: each function is given a weightage according to its usefulness and this
is called the emphasis coefficient and is determined by the group after a lot of
discussion. (c) The sets of emphasis factors are then multiplied by the respective
emphasis coefficients and this product is summed for all the functions for an
alternative. The alternative with the highest score is then chosen as the product to
be purchased.
Let us suppose that we have four samples of four suppliers A,B,C and D of an
item and that we have to rate them by value analysing them in respect of the
following five attributes which the using departments consider the most important
in determining the overall utility or value of a sample: (a) price (b) quality (c) yield
(d)reliability of the suppler (e) lead time of supply. The first thing to do is to compare
these five factors or attributes between themselves, in pairs, and give relative
weightages to the various factors, For instance, comparing price and quality, if
quality is considered more important than price by the evaluating committee, more
weightage say 1 is given to quality and less -say 0 to price. Price is then compared
with each of the remaining factors and the relative weightages are recorded in the
form of a table or matrix. Similarly, each factor is compared in turn with each of the
others and the relative weightages are recorded. In this case, the number of
comparisons made in pairs, will be (5 x 4)/2 = 10. (In general, if there are n
attributes, the number of comparisons will be n(n-1)/2. Weightages given to the
different attributes are added up for each attribute and divided by the total number
of comparisons made to give the "attribute weightage coefficient" (AWC) for each
attribute.
The next step is to compare the samples, in pairs, with respect to each of the
attributes, giving the superior sample a weightage of 1 and the other 0. As before,
the weightages of each samples, in respect of the attribute: under consideration are
recorded in a table and added up and divided by the number of comparisons, which
will in this, case be (4 x 3)/2=6, as there are only 4 samples. This gives us the
"sample weightage coefficient" (SWC) in respect of this particular factor or attribute.
This generates as many matrices as there are attributes, in this case 5.
In the final step the two types of weightages coefficients are combined by
multiplying the attribute weightage coefficient for each attribute by the sample
weightage coefficient for each sample. These are then added up to give the total
weightage coefficient for each sample with respect to all the factors taken together,

162

i.e. its acceptability. The total weightage coefficients, or the acceptability of the
samples can then be ranked for a final decision.
This various attributes are listed horizontally in the table and their average
weightage coefficient entered under each. The samples are listed vertically at the left
and their sample weightage coefficient with respect to each attribute entered under
the appropriate average weightage coefficient. The weightage of each of the samples
in relation each of the attributes is obtained by multiplying the average weightage
coefficient by the corresponding sample weightage coefficient and entered against
each sample in the different attribute columns. These weightages are then totaled
for the final ranking of the samples. On the basis of the total weightage or overall
acceptability, the ranking is made.
The decision matrix can be usefully employed in many situations, where an
unbiased and objective decision is required among a large number of suppliers and
factors. Such a decision is forced on one by the very nature of the method. In
addition to the selection of samples of an item, the decisions matrix can be employed
by some firms in selecting a candidate for promotion at senior levels where, from a
number of candidates having more or less identical claims, only one can be
promoted to the higher post in the light of a few well-chosen attributed for the post.
In each of the situations mentioned, the evaluating committee must be carefully
chosen and must include all top or senior personnel: who how intimately the
samples/candidates/ problems/objectives suppliers and are affected by the
decision. Even though this method is complex, involving numerical figures, it
enables us compare several suppliers for a large number of performance factors
simultaneously; to identify the least cost item.
12.11 ROAD BLOCKS TO VALUE ANALYSIS
Like any other cost reduction technique, value analysts also has its limitations.
The common limitations to using value analysis techniques and excuses given for its
non-implementation are as follows:
a) lack of motivation
b) resistance to change
c) inertia
d) lack of knowledge
e) lack of patience
f) it would not work in India
g) we are too small
h) we are too big

163

i) we have tried it before

j) it is too radical a change
k) if it is so good, let our competitors try it first
j) difficult to get the team meeting for achieving a consensus.
However, these inhibitions are encountered only in the initial stages in any
organization. In view of the inherent potential of cost reduction, there is a growing
awareness in many Indian organizations about this-important approach. But value
analysis should not be considered as a panacea for all the ills of an organization, or
a substitute for the existing technical competence. It should be considered as an aid
for cost reduction in the organization. Results achieved in one department should be
given adequate publicity so that more people are interested in value analysis.
12.12 REVISION POINTS
Value Analysis
Item for value Analysis
Techniques for value Analysis
Steps for value Analysis
12.13 INTEXT QUESTIONS
1. Write in detail the functions and of value analysis.
2. Enumerate the-various steps involved in the-implementation of value analysis
in industries.
3. Value analysis is a remedial process while value engineering is a preventive
process discuss.
4. What is value Analysis? Cite few cases of the use of value analysis in cost
reduction.
12.14 SUMMARY
Value analysis is synonymous with cost reduction in the management field. The
historic background, concept of value, items to be value analysed, organization for
value analysis, value analysis applications in materials field, techniques for value
analysis, brain storming, steps for value analysis, matrix method and road blocks to
implementation are available in this chapter.
12.15 TERMINAL EXERCISE
1. List the items for value Analysis.
2. Discuss the concept of value.

164

3. List the application of value analysis.

4. Discuss matrix method.
5. List the limitations of value analysis.
12.6 SUGGESTED READING/ REFERENCE BOOKS/ SET BOOKS.
1.S.C. Sharma, Materials Management and Materials Handling, Khanna
publishers, 2000.
2.A.K. Datta, Materials Management, Procedures Text and Cases. PrenticeHall of India Ptv. Ltd. 2004.
3.P.Gopalakrishnan, Purchasing and Materials Management, Tata Mc-Graw
Hill, 2000.
4.Donald W. Dobler David N. Burt, Purchasing and Supply Management. Text
and Cases, Tata Mc-Graw Hill. 2002.
12.17 KEY WORDS
Value analysis, Functional value, Esteem value, exchange value, cost value,
scrap value, Matrix method.

165
LESSON -13

INTERNATIONAL BUYING
OBJECTIVES
To know the import policy
To have a clear view about the procedures involved in importing the
materials
To understand the various problem in imports
CONTENT
13.0 Introduction
13.1 Import policy
13.2 Classification of Importers
13.3 Objectives of control
13.4 Fees and validity of License
13.5 Preliminary formalities
13.6 Source Selection
13.7 License procedures
13.8 Letter of credit
13.9 Documentation
13.10 Bill of lading
13.11 Customs clearance
13.12 Problems in Imports
13.13 Revision Point
13.14 Intext Questions
13.15 Summary
13.16 Terminal Exercises
13.17 Suggested Redding/ reference Books/set books
13.18 Key words
13.0 INTRODUCTION
Self-sufficiency in today's inter-dependent countries of the world is a far cry.
One has no alternative but to depend upon other countries in some form or the
other, for his own or his society's needs. For a growing economy like ours, achieving
self- sufficiency should be the long-term goal. In this process, importing or

166

purchasing the material from outside the country is an essential economic function.
Even an industrially advanced nation like the United States, which, is endowed with
most of the natural resources, imports materials. This follows from Riccardo's
Princip1e of comparative advantage which states that it would be beneficial for an
economy to concentrate on production of items, in which it specialises, export these
items and import its requirement of other items, in order to arrive at altruistic
solutions. But international trade is not guided merely by simple rules, as every
country wants to protect its interest and controls the international trade emanating
from its shore through protective legislative measures. India is forced to import due
to lack of certain natural resources, like crude oil and due to lack of high technology.
13.1 IMPORT POLICY
To facilitate the easy flow of goods, the government announces its annual
import policy, usually in the beginning of the new financial year, i.e. on first of April,
The Import Trade Control (ITC) Policy, popularly known as the Red Book, is issued in
two volumes. These policies are periodically updated by amendments depending
upon socio-economic and political factors. Volume 1 deals with the policy of the
government with regard to user's import of materials and Volume 2 deals with the
government policy with regard to registered exporters. It is an established practice,
that the Government of India publ1shes handbooks of rules and procedures
simultaneously along with the Red Book.
The Government of India reviews the import policy considering various
aspects,such as trade balances, raw material positions, crude production, shortages
on agricultural front, etc. The concerned ministries, DGTD and other administrative
ministries and consulted, recently, the import policy has been liberalized, as
shortage of raw materials has led to under-utilization of capacity. In some cases,
automatic licenses will be issued to cut down the procedural delays, Import policies
as such are not static and changes in policies and procedures are very important to
industries, which depend upon imports for their production. The review of the policy
is a combined approach to see that import is allowed to the extent required, to
enable the indigenous industries to have access to their requirements of raw
materials at the most competitive prices -i.e. at the international price, but at the
same time to avoid unnecessary imports of items, which would directly affect the
indigenous production. Even though a three-year policy was announced for the
period ending 31 March 1988, licensing period continues to be one year and the
government resumes the right to amend the policy at any time. For case of
referencing,

it

was

proposed

to

issue

six-

monthly

compilation

amendments/orders/public notice issued during the preceding six months.

of

all

167

Import of spare parts, the procedures for which have been released, is usually
on a repeat basis, i.e. for same value as in earlier years. In the case of non-priority
industries, a consolidated license for spare parts and raw material is issued. Small
industries can have a special status when they apply through their respective
sponsoring authority. The application for import of capital goods must go through
the sponsoring authorities. There is a special capital goods committee, which clears
these applications on the basis of various factors, such as availability from
indigenous sources, essentiality, of import availability of foreign exchange, etc. For
emergency requirements of spare parts, the procedures are simplified and there are
special forms.
The policy is more liberal towards registered exporters. Industries that export a
certain minimum percentage of their production will be given preferential treatment
in the allocation of foreign exchange. They have several duty agreement, like refund
or exemption from payment from central excise "duties, and customs/excise duty
drawback on raw material used for the exported items. Ini addition, they get refund
of local duties and exemptions in freight, income tax, sales tax, etc., under certain
conditions they can even transfer the licenses and nominate beneficiaries.
Actual users who require additional raw materials, components, consumables
and spares may submit their applications for supplementary licenses after giving
adequate reasons for the additional requirements. They are required to maintain
separate accounts of consumption of materials imported against supplementing
licenses. New units, who have made firm arrangements for land, premises, power,
plant, machinery, etc. should apply for their import requirements through the
respective sponsoring authorities and the value is initially up to Rs. five lakhs.
13.2 CLASSIFICATION OF IMPORTERS
The importers are broadly categorized as: a) actual users (industrial), (b) actual
users (non-industrial) (c) registered exporters (d) registered importers, i.e. those who
import under the import policy for registered equipments, and (e) others. Actual user
means a persons or any company who applied for/secured a license for the import of
any item or an allotment of any imported item required for his own use and not for
business or trade in it. Thus in the case of industrial undertaking, the item
concerned should be used for the manufacturing processes or operations conducted
within its authorized premises (or) made available to jobbing into 'or other units
outside for intermediate processing, only as a part of production effort). In the nonindustrial category such as hospital, research and development, commercial
establishments and individuals, the concerned item shall be utilised for his own use
for the purpose for which the item was sought for import. The actual users are
further classified as priority and non-priority industries, scheduled units registered

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with DGTD and small-scale industries. Registered exporter means a person holding
a valid registration certificate issued by an export promotion council.
Every importer/exporter, whether an individual or firm or company importing
or exporting goods, will have to get importers code number from the licencing
authority concerned, under whose jurisdiction the importer falls and without this
code number, the customs authorities will not permit. The policy also defines
exporters, trading houses, capital goods and component, Spares is defined as a
part of sub-assembly for substitution of worn out parts, whereas accessory/
attachment means an assembly that contributes to the effectiveness of a price of
equipment. Separate licences are issued for instrument test equipments and
samples.
The requirements of actual users in the matter of raw materials, consumables,
spares and components will be met by open general licences, list number 8 of
Appendix gives a list of items to be allowed under open general licence. At present
import control covers practically articles and are included in schedule of import
control order 1955. Import of gold, silver, currency notes are controlled by the
Reserve Bank of India under the Foreign Exchange Regulation Act.
13.3 OBJECTIVES OF CONTROL
The foreign exchange resources available to our country are not unlimited and
the government has to optimally utilise the funds available so that all sectors of our
economy benefit. The import control was first introduced as a war time measure in
the early period of the Second World War. The primary objective is to conserve the
foreign exchange resources of the country. As we know, India imports goods worth
about Rs. 30,000 crores, whereas it exports only about Rs. 20,000 crores worth
creating the years in spite of the efforts to reduce the imports and boost the exports
resulting always in adverse balance of payment position. While our nation has to
import these items from other countries, it will be equally fruitless to undertake
import substitution of all items at any cost. It is noted that crude oil, food, fuel,
fertilizer, capital equipments and spares and industrial raw material from the bulk of
the imports in the country.
After the Second World War, the emergency provisions ordinance was
promulgated to continue import control provisions, and this was replaced by the
Import and Export Control Act. 1947. Thereafter, gradually the act has been
extended for an indefinite period. Several notifications and amendments have been
reproduced in appendices 1A, 1 B, 1C of the Handbook of Import Export Procedures,
1985-1988 and subsequent publications.

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The main objectives of the import and export control are to provide easy access
to imports, essential for production and exports, at the same time safeguarding the
reasonable interests of the domestic industries, thereby to discourage, excessive
imports to items that are manufactured in the country and also to encourage export
of items which are not of strategic importance. Sensitive in nature or mass
consumption, etc. It is neither liberalized nor restrictive, but a balance between the
need for import and export production.
13.4 FEES AND VALIDITY OF LICENCE
Every application has to be accompanied with a fee of Rs. 50, if value of goods
specified does not exceed Rs.50,000 and Re. 1 per additional 1000, subject to a
maximum of Rs. 10,000. The last date for filing applications are (a) 31 October for
automatic licences; (b) 28 February for filing for supplementary licences; (c) 31
December for actual user for non-permissible spares; (d) 28 February for all
applications including capital goods; and (e) for emergency spare any time within the
licensing period. The year represents the financial year of Government of India i.e.
from 1 April to 31 March.
The validity period will be six months for emergency spares for capital goods 24
months and for others. 12 months. Licences may be general currency area licences
or specific licences issued under special credits, like World Bank, Asian Bank,
Special Drawing Rights and from different countries. Aid India Consortium or rupee
currency area licences valid for countries with which rupee trade agreements. There
can also be replenishment licences and capital goods licences. Procurement is
limited if the credit is tied to a country.
The licencing authority scrutinizes the application to ascertain the following
requirements before issuing the-licences; (a) foreign exchange, its requirements.
Quantity and availability; (b) monetary ceiling, (c) stock in hand and expected arrival
on date of application against the licences already issued, (d) the indigenous
sources, availability of materials, the country for which import licences are issued,
(e) imports in the past by-the applicant (f) consumption in the past by the applicant,
(g) estimated and actual during the preceding period, (h) shortfall in production
schedule and estimate and (i) policy of the government with respect to the item for
which respect to the item for which the licence is required.
13.5 PRELIMINARY OF FORMALITIES
the first act of an intending importer is to make sure that the material or its
equivalent is not available indigenously. The publications of DGTD, namely (a) A
handbook of indigenous manufacturers for chemical and miscellaneous stores, Gives
a list of indigenous sources. The case of plant and equipment are advertised in the

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Indian trade journal. If the indigenous manufacturers are not in a position to quote,
the intending importer should get such a declaration from them. Once it has been
established theat there are no suitable indigenous sources. The buyer should
approach his sponsoring authority. The sponsoring authority for large-scale
industries is the directorate general of technical development, some of the other
sponsoring authorities are the state directors of industries, commissioner for small
scale industries and trade associations like the handloom board, Tea board, Etc. The
sponsoring authorities play only a recommendatory

role and recommends the

quantities to the licencing authorities. The licencing authority works under the
ministry of commerce and is under the chief controller of imports and exports,
Which has branches in important places in the country. Companies can get import
entitlements on the exports even if they be indirect.
13.6 SOURCES SELECTION: A TO Z FACTORS
The source selection process is similar to the indigenous source identification.
As many foreign companies, Have their representative in India, The buyer can also
get useful information by contacting Ministry of Trade, foreign consultants, foreign
trade missions, foreign embassies, overseas agents, foreign publications, through a
process of global tenders, foreign directories, etc. Usually a foreign consulate has a
commercial attache, who is well versed with the list of suppliers in his country. The
quotations have to be evaluated and the supplier to be selected afterwards. The
matters on which negotiations take place are a) price, b) validity of price c)
guarantees and warrantees d) currency payment, e) currency fluctuations, f) mode of
payment g) contract terms, h) CIF-price including cost, insurance and freight i) C&F
cost and freight alone with buyer arranging for insurance j) FOB -free on board
k) FAS-free alongside steamer or port of export l) ex-works-buyer arranges the
movement from seller's factory (m) arbitration/adjudication n) packaging o) delivery
schedules p) transportation q) credit facilities r) service after sales s) replacement of
rejected goods t) commitment to contractual objections u) delivery schedules v)
reputation of the supplier w) meeting emergency commitments x) financial
soundness of parties y) technological advancement including high-tech z) long
lasting commitment on supply of spares.
It is advisable to compare the price on the basis of landed cost. The cost of
packing and forwarding to the port of despatch, the loading and port duties, cost of
freight and insurance, clearing and forwarding at port. Of receipt, and the cost of
transportation to the point of' consumption must be added to the ex-factory price to
get landed cost.
Once these have been agreed tothe buyer should apply for import licence.

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13.7 LICENCE PROCEDURE

The application for licence should be made in the prescribed forms for the
particular category of items as given in the handbook of rules, they should be
properly filled and signed by the authorised person. Usually the application must be
accompanied by an income- I verification certificate. Care should be taken so that no
error is committed in the classification of the item. Generally one application for
each commodity in one licensing period is allowed the licences should be registered
in a port and normally the imports would be allowed only through these ports. The
application should be made to the respective licensing authority under whose
jurisdiction the importer falls.
Normally the entitlement for raw materials is based on past consumption and
past licences. However, under clauses of export performance or priority industries,
these amounts can be increased. The export efforts, consumption data should
normally be certified by a charactered accountant. It should be noted that if a
previous licence has not been fully used for a value grater than or equal to CIF value
of the present application, then the present application will not be accepted. The
supplier may give a credit facility to the importer, or against documents through the
imports bank. But the system of a letter of credit or an assurance to the bank to the
supplier, that a sum of money will be paid to him by the bank when the relevant
shipping documents are submitted is the most popular form of international buying.
In case a licence is lost or misplaced, a duplicate copy of the same will be issued by
the appropriate authority. A letter of credit is an arrangement, whereby the
obligation to pay an exporter is undertaken by a bank. The bank's credit is available
to an importer who is not known outside and who other wise would not be trusted
with goods by a trader in another country. If a credit is received from a bank, the
credit standing of the importer is of little consequence. What become important to
the exporter is the credit standing of the bank issuing the letter of credit.
13.8 LETTER OF CREDIT
A letter of credit is an arrangement, whereby the obligation to pay an exporter is
undertaken by a bank.

The banks credit is available to an importer who is not

known outside, and who other wise would not be trusted with goods by a trader in
another country.

If a credit is received from a bank, the credit standing of the

importer is of little consequence.

What become important to the exporter is the

credit standing of the bank issuing the letter credit.

The features of letter of credit are as follows: a) The importer requests a bank in
his country to issue a letter of credit in favour of the exporters. b) The name of the
bank issuing the letter of credit is stated on the top of the instrument. The exporter

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receiving the letter should see whether the bank is acceptable or not. c) The
instrument mentions the name and full address of the beneficiary i.e. the seller in
whose favour it is issued. d) The amount for which the credit is issued is clearly
stated. e) Since banks are not willing to honor drafts for smaller or larger amount,
some flexibility is introduced by resorting to the word-about. F) The name of the
person, for whose account the credit is opened, is mentioned in the letter of credit. g)
The credit standing of the importer is of little consequence to the seller, if he is
satisfied with the issuing bank. h) The tenure of draft or drafts to be drawn under it
must be clearly stated in it. i) The letter of credit lists the documents to be attached
in the draft drawn under it. The documents clearly indicate, the discharge of
contractual obligation by the exporter. Any discrepancy may result in refusal by the
advising bank to honour the draft. J) The letter of credit has an expiry date
indicating its validity. k) If the time given is not enough, the exporter may
communicate with the issuing bank or the importer to get the date changed. l) The
type of credit revocable, irrevocable, confirmed, unconfirmed, revolving - is stated on
the instrument m) The letter of credit mentions any other conditions that may be
demanded by the importer and iliat may have been settled between the importer and
the exporter.
13.9 DOCUMENTATION
The items that are imported must be cleared from port and customs before
these can be used. These agencies have an established procedure and it is advisable
to use a clearing agent unless the organization has so many transactions to warrant
the establishment of a separate clearance cell. The nature of documents involved in
import of goods are discussed below. To clear the goods from customs, a bill of entry
should be filled with them. This should be accompanied by a) bill of lading, b) signed
commerial invoice, c) packing list, d) specification/test certificate, e) country of
origin certificate, f) insurance certificate, g) indent and acceptance, h) catalogue or
write up, i) valid import licence, j) markings of packing, k) commercial invoice from
seller to buyer indicating conditions of sale and description of goods, rates of
exchange, 1) export and import permit numbers.
After scrutiny of the documents, the customs appraiser will assess the
consignment and fix the duty to be paid. On payment of the duty, the consignment
will be released. After this formality, the Port dues have to be cleared before the
goods can be removed by the importer. When materials are received in bulk,
importers have the option to store them in a bonded warehouse and release the
quantity required on payment of appropriate amount of duty. The import licence
should be valid and there should be a consonance between the description in the
licence and the description of goods. Fortunately, the new customs tariff is based on

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the Brussels tariff nomenclature and it is easier for importers to use similar
nomenclature, both with suppliers and authorities.
13.10 BILL OF LADING
The bill of lading is the most important document which accompanies bills of
exchange drawn under letters of credit. This is signed by the master of the ship and
indicates that the goods have been despatched by the supplier and gives the
importer title to the goods. This is an undertaking by the carrier of having received
from the consignor, the goods under description from the given place of origin to be
delivered to the order of the consignor at the port of destination.
Details such as freight to be paid, number of packages, condition of packages,
contents, Shipping marks, etc., are also included in the bill. It is usually made out
in sets of four, the fourth copy being retained by the carrier. The carrier protects
himself by entering in what stage of packing he has received the goods and whether
they are suitable for normal handling abroad the vessel. Insurance claims are
invalid, when the packing is bad. The carrier has the claim of the goods upto his
freight charges and need release them only if they are paid. Hence, endorsement on
freight is a key factor. Though the bill of lading transfers the title yet the transferee
obtains it subject to equities i.e. if there were any fraud he will not obtain any title.
Thus bill of lading is, a) receipt of goods delivered to carrier for transportation, b)
contract between the shipper and the carrier for transportation of goods and c)
document of title of goods giving the holder title to the goods mentioned. The bill of
lading can be transferred by endorsement to another person, as a quasi-negotiable
instrument subject to equities.
A bill of lading which indicates that the goods are in apparent good condition
without any qualification, is known as a clean bill of lading. It does not have a
superimposed clause, expressly declaring a defective condition of item. If the bill
bears some remark relating to a defect in packing, such as tom, broken, damped
condition etc. it is known as a foul bill of lading which is not an acceptable
document.
13.11 CUSTOMS CLEARANCE
Both national and individual interest require that the goods imported are
cleared expeditiously, so that they can be put to productive use as soon as possible.
The time delay increase the cost of goods by locking up the capital and demurrages.
Further, the ports get clogged and free movement is prevented. The following are
useful tips for early clearance of goods from customs:

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a) The importer can file his documents much earlier to the arrival of the vessel
and complete the documentation part of it in the customs house, even before
the arrival of the vessel.
b) On arrival of vessel, he can straightaway proceed to take delivery of the goods
after examination.
c) When the importer does not have the full information relating to imported
goods, he can request for provisional assessment of the goods on execution of
an appropriate bond.
d) Even when goods have to be tested prior to release, the importer can request
for release of goods on execution of a suitable bond. In some cases he can ask
for part delivery of the goods, even without execution of bond.
e) When the importer does not have the licence with him for submission to the
customs officer, he can request for clearance of the goods on a bond after
furnishing a Photostat copy of the licence, to satisfy the customs officer that
he has in fact a valid licence with him to cover the goods and that he is
unable to produce it because of certain circumstances.
f)

When the importer is prevented from clearing his goods due to some
extraordinary circumstances, like lock out and strike, he can deposit the
goods in a warehouse without actually going through the warehousing
procedure. This will ensure that the goods do not incur demurrage.

g)

When an importer imports goods solely for export production, he can take
recourse to the facility of manufactured in bond, so that he may avoid
payment of duty.

h) A complete machinery imported in a number of consignments can be

assessed under machinery contract procedure, as a complete machine
subject to compliance with certain formalities.
i)

When goods are imported for the setting up of a plant, or a specified project
for substantial expansion of an existing plant by following project import
regulations, goods can be assessed at confessional rates. This will facilitate
assessment of raw materials, semi-finished goods, and spare parts within
limits at the same confessional rates applicable to the machinery.

j)

When customs duties are levied because of application of wrong rates of duty,
or because of misclassification, the importer may me a claim with the
assistant collector of customs within six months from the payment of duty.

k) To speed up matters, direct communication with the exporter is resorted to in

case of discrepancies

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l)

In case of shortages, the exchange control copy of the import licence will be
automatically treated as valid for replacement of the consignment.

13.12 A TO Z PROBLEMS IN IMPORTS

Importing materials, machineries and components pose several problems to
purchasers. The nation's policy being one of protecting foreign exchange, the
procedures for clearance of imports are naturally rigorous. It takes more than six
months to get the clearance from the authorities and depends on categories like
spares, capital equipment, component, raw materials etc., and the type of industry.
The imported quantity is about one year's requirements and the renewal of the
licence is based on the previous year's consumption. Hence the companies play safe
and carry more of imported components. Thus, the policy of conserving scarce
foreign exchange has resulted in locking up of money in the form of increased
inventory holdings.
The contract with a foreign supplier for the purchase of material usually
involves a clear understanding of the quality, price and other contractual
obligations. In many cases, language may pose a problem. Further difficulties are:
(a) comparisons, b) licences, c) customs tariff, d)shipping documentation, e)
financial implications, f) legal term, g) interpretation of languages, h) source
development, i) source, selection, j) inspection, k) rejection of imported items
resulting in stock out, l) long lead-time, m) handling, n) transportation, o) clearance,
p) liaison with customs, q) customs declaring spares as components with more levy,
r) fluctuating currency, s) complicated documents, t) different types of contracts,
legal systems, u) maritime frauds v) insurance claims settlements w) racketeers in
imports x) holding back a portion of payment till arrival of plant, y) approval of
performance guarantee and z) purchaser can protect with a manufacturer's
guarantee certificate or from an independent inspection agency regarding credibility
of the supplier. Early liaison with customs and excise authorities or through clearing
agents can obviate much difficulty at the time of contracting and also at the time of
arrival. On the financial side foreign exchange division of commercial banks can
offer useful advice.
13.13 REVISION POINTS
Import Policy
Validity of Licence
Licence Procedure
Letter of Credit
Bill of Lading

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Customs clearance
13.14 INTEXT QUESTIONS
1. How are the importer classified?
2. Discuss a) Letter of credit and b) Bill of lading.
3. What are the various problems encountered in imports?
4. Give the stepwise procedure for obtaining an import licence.
5. Give the stepwise procedure for importing raw materials for your
organization.
13.15 SUMMARY
The import

policy relevant to international purchase is discussed in this

chapter the objectives of control, source selection formalities, licensing procedure,

letter of credit, documentation, bill of lading, customs clearance and problems in
imports are clearly identified in tile process of international buying.
13.16 TERMINAL EXERCISE
1. Explain the important reasons for importation of equipment.
2. When are the letters of credit required
3. Write short notes on Import policy.
4. Briefly explain import of capital items.
13.17 SUGGESTED READING/ REERENCE BOOK/ SET BOOKS
1. S.C. Sharma, Materials Management and Materials Handling, Khanna
publishers, 2000.
2. P.Gopalakrishnan, Purchasing and Materials Management, Tata Mc-Graw
Hill, 2000.
13.18 KEY WORDS
Letter of Credit, Documentation, Bill of lading, Customs clearance.

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LESSON-14

LEGAL ASPECTS OF PURCHASING

OBJECTIVES

To Know the various laws that have a direct impact on the purchasing
executives

And also to know the laws that have an indirect impact on the marketing
operations of the purchasing executives.
CONTENT
14.0 Introduction
14.1 Law of agency
14.2 Power of attorney
14.3 Sale of goods Act
14.4 Transit Damages
14.5 Inspection and Acceptance
14.6 Law of carriage of goods
14.7 Transfer of title
14.8 Negotiable Instruments
14.9 Arbitration
14.10 Revision points
14.11 Intext Questions
14.12 Summary
14.13 Terminal Exercises
14.14 Suggested Redding/ reference Books/set books
14.15 Key words
14.0 INTRODUCTION
My word is my bond is the slogan in the Liverpool stock exchange. But, being
the main expender of the company's finances, the purchasing executive can ill afford
to overlook the legal implications of his actions. The purchase document is legal
document that binds the company to buy from the seller. Hence the purchase
executive must understand the relationship existing between himself and the
company with which he is connected, on the one hand and the consequences of his
actions to the market on behalf of the company on the order. A lack of knowledge of

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the law can lead to costly blunders. While contracting the supply of good and
services.
The laws that have a direct impact on the purchasing executive are the Law of
Agency, the Law of Contract and the Law of Sale of Goods. The laws pertaining to
Negotiable Instruments, Insurance, Arbitration, Sales Tax, Customs, Central Excise,
Insolvency, Companies Act, MRTP Act, Trade Marks, and Patents have an indirect
impact on the market operations of the purchasing executives. Therefore, it is
imperative, for the purchasing executive to have at least a working knowledge of
these laws. In fact, a lack of knowledge of the existing laws can never be given as an
excuse for an illegal act of omission or commission. Not only must this purchase
executive know his own rights, but also those of his suppliers.
14.1 LAW OF AGENCY
The concept of agency is important for corporations. The board of directors
designates certain individuals In the company to have power of attorney. The
purchasing executive and the company he serves lead a symbiotic existence. Just as
the company expects an unequivocal loyalty from him, it reciprocates by supporting
his actions. Even though this inter-relation is much more than what is required by
the Law of Agency, yet it is worthwhile for both parties to have a clear understanding
of the legalities of their situations. The purchase contracts are negotiated and signed
by the purchase executive on behalf of the company. Thus, the executive is an agent,
whose actions are binding on the company who are his principals.
The Law of Agency elaborates the relationships that exists between the
principal and the agent and the authority of the agent to act for his principals. The
principal or the company enters into contracts with outsiders through the agent.
This contract of an agency by which the executives act on behalf and as the agent of
the company, can be made either verbally or in writing, and such a written contract
is called the power of attorney . The rules of agency is based on 'Qui fact per actum
facit per se, which means that he who does through another does it by himself. This
is subject to the conditions set forth in the rules of agency.
14.2 POWER OF ATTORNEY
The duties of an agency include the following:
a. duty to execute the mandate given by the principal;
b. duty to follow instructions or accepted customs;
c. duty of reasonable case and skill expected of a man of average prudence;
d. duty to avoid conflict of interest with principal;
e. duty to remit money wherever earned by him to the principal and

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f. duty not to sub-delegate without principal's authorization.

No consideration is necessary to create an agency. The fact that the principal
has agreed to be represented by the agent is sufficient determinant to the principal
to the contract of agency. A contract of agency is deemed to exist-between a principal
and his agent, if intention to act on behalf of the company is implied; The legal
requirement for this implication is for the principal to conduct himself towards the
agent, or the outside, in such a manner as if he had conceded the agency, or to the
appointment of the agent. The purchasing agent will be liable for any loss which his
firm may sustain, if he has acted outside the scope of authority given to him.
14.3 SALE OF GOODS ACT
The offer to buy or sell goods will become effective only when it is accepted by
the offeree. Instead of mere acceptance, the offeree makes new proposal, then it is
counter offered and has to be accepted by the first party. The conditions of sales
enumerated by a vendor on leceivtng a purchase order is therefore, a counter offer.
Sale differs from hire purchase in title of goods, entitlement, payment, sales tax and
legal aspects. The sales is usually done by description/sample.
A very important factor that has to be considered the period of validity of an
offer and an acceptance. It is a normal practice to confirm telephone order through a
formal purchase order. But, it should be noted that an offer cannot be revoked once
the acceptance is set in its motion of communication to the officer. Similarly, the
offeree cannot revoke his acceptance, once the acceptance has reached the offerer.
In this contest, the rate contracts are only standing offers for a stipulated period and
there is no guarantee of the quantity. In contrast, running contracts stipulate the
quantities also within a certain plus and minus range. The buyer should also be
familiar with the concepts of turnover tax, entry tax, purchase tax, etc., which are
being introduced in some states and should be familiar with documentation and
permits.
14.4 TRANSIT DAMAGES
The Indian Sale of Goods Act stipulates the various legal problems connected
with the sale of goods and the rights and remedies that are available to the buyer.
The problems which normally arise; are payment tends, delay in the supplies and
the acceptance or rejection of supplied materials.
According to Indian Sale of Goods Act, stipulations regarding time of payment
are not an essential portion of contract, since- delay in payment does not deem any,
contract to be without any consideration. But if the delivery of the goods is in
installments with a corresponding payment, or the payment is a hire-purchase
installment, then the payment schedule must be adhered to by the buyer. However,

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it, should be noted that more than legal remedies, good buyer-seller relationships
will help solve these payment problems in an altruistic basis. Unless a different
intention appears from the tends of contract, stipulations of payment are not
deemed to be the essence of contract of sale.
It should be noted that the sale of goods act accommodates only a reasonable
time' for the supply of goods. This is based on the normal conditions that are
prevailing in the market, the knowledge between the two parties. Hence if the
purchaser wants to guard himself, he must stipulate the delivery periods, while
entering into the contract. In such case, the buyer can reject the goods supplied
beyond the schedule.
A major problem which risks both the buyer and the seller is that. who is
responsible for any damage to the material during transit? Usually transport
companies undertake goods only on their clients' risk and this leads to the need for
a transit insurance. But obtaining the claims, whether from the transport company
or from the insurer, is a tedious process and hence both the buyer and the seller
would like to avoid such a burden. Here, it should be noted, that the risk of loss
generally follows the FOB point specified in the contract. i.e. the risk follows the title
to the goods, and the title holder at the time of the damage, has the burden of the
claims.
14.5 INSPECTION AND ACCEPTANCE
It is a normal practice for the buyer to inspect the goods before acceptance, so
that he can assure himself of its quality and quantity and whether it is according to
the specifications. Such an inspection must be made within a reasonable time of
receiving the goods. But the difficulty arises mainly in industrial goods, where all
the defects may not be evident on inspection, but may come into focus on use.
Problems may also arise when inspection is carried on at suppliers works and one
can always commit the error of passing defects. Hence, the buyer has to be
extremely careful in these cases. Usually, it is advisable to purchase on the basis of
samples. The advantages to tile buyer is that, he always has the sample as a
standard for comparison. But most of the goods are purchased or sold by
description. In these cases, the purchaser must be unambiguous about his
specifications by furnishing drawings and tolerances, or referring to standards, or by
prescribing tests that the item has to pass. Stage-wise inspection as well as third
party inspection are also in vogue and in such cases the third party is responsible if
defective items are passed by them in inspection.
Legally, once the buyer irrevocably accepts the goods, he cannot thereafter
reject it. But he has remedies if the goods are later found defective and he can claim

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damages from the seller. The buyer has the choice between accepting the entire
quantity, or accepting part or rejecting the entire quantity of goods, if they fail to
meet the specifications and quite expectedly he needs to pay only for the accepted
quantity at the contracted rate. In addition to this, he has the right to damages
even if he accepts the entire quantity. It should however be noted that the buyer
must take sufficient care of goods rejected, if they are in his custody. He should not
leave them in the open as they deteriorate in quality and should follow the
reasonable instructions of the seller with regard to their return. In all these cases.
the passing of the title from the seller to the buyer is very important.
14.6

LAW OF CARRIAGE OF GOODS

The Carries Act1865 defines a common carrier as any individual firm or

company -other than the government - who or which transport goods over hand or
inland water-ways without discrimination between different consignors. Thus any
person who offers for hire, as a regular business for money, to carry from one place
to another of goods of any person who choose to employ him for the purpose, is
called a common carrier. In ordinary circumstances, a common carrier cannot
refuse to carry goods for anyone if (a) the person asking him to do so is prepared to
pay the established charges; (b) the goods

are of a category, which the common

carrier has declared to carry and (c) the place of destination is within the area in
which he operates. A common carrier takes upon himself the responsibility of safe
delivery of goods, if they are stolen within his custody or destroyed by fire or handed
over to a wrong person. He can refuse to deliver the goods until his charges are paid
and has a right to recover damages due to the goods being dangerous in nature.
A person or company who carries the goods for selected parties and not for all
clientele is a private carrier. The private carrier does not make a general offer but
restricts his clientele to particular parties with whom he negotiates special terms
and is governed by the law relating to bailment. Good is are divided into dangerous
goods, like explosive / acid / poison, as well as scheduled and non-scheduled goods.
The scheduled goods include, inter-alia, gold, silver, ornaments precious stones,
Clocks, time piece, hundies, bank notes, maps, writings, paintings, photograph,
work of art, sculptures, glass, china silk, shawls, opium, ivory, coral, sandalwood,
musical instruments and scientific gadgets. A carrier is not liable for loss or damage
of scheduled goods over Rs.100 if at the time of booking their description and value
are not given.
14.7 TRANSFER OF TITLE
The following are the details relating to transfer of title:
a. In the case of specific goods in a deliverable state property in them passes
at the time when the contract is made.

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b. In the case of specific goods to which something has to be done by the

seller to put them in a deliverable state, property passes only when such a
thing is done and notice thereof is given to the buyer.
c. In the case of ascertained goods by description, property passes when
goods of that description in a deliverable state are unconditionally
appropriated by the seller or the buyer with the consent of the other
party.
d. Delivery to carrier for purpose of transmission without the seller reserving
the right of disposal amount to appropriate.
e. In the case of goods delivered on approval, Property passes when the
buyer signifies his approval of acceptance or keeps it after the expiry of
the time.
14.8 NEGONABLE INSTRUMENTS
Negotiable means transferable and instrument means a written document
which a right is created by means of some persons. A negotiable instrument means
a written document which entitles the bearer to a certain sum of money on a
particular date. In our country, this means a promissory note, bill of exchange, or
cheque payable. Transfer of Property means that the new holder gets a right to
possess the instrument to recover the amount mentioned in the instrument on due
date. A bill of exchange as an instrument in writing, containing an, unconditional
order, signed by a maker, directs a certain person to pay a certain sum of money to
the bearer of the instrument. The maker is the drawer and the receiver is the
drawee. The drawee signifies his acceptance by signing on the bill. In this context
hypothecation is implied as a charge not amounting to a pledge, which is merely on
equivatable charge without actual possession.
In this context, the claim for compensation for loss of goods should be preferred
within six months from the date of booking of goods. The Indian Railways get about
Rs.6 lakhs as claims and settle an annual claim of about Rs. 25 crores. A
substantial amount of claims occur in respect of traffic handled, imports over which
the railways do not have any control and hence these are rejected.
14.9 ARBITRATION
Arbitration is a useful method of settling disputes between two parties. It is
much quicker than going to a court of judicature. Hence it is normal practice to
include a clause on arbitration in the contract. It should be noted that if such a
clause has been agreed upon. Litigational proceedings can begin only after the
arbitration efforts have failed. The awards of the arbitrator are much binding on the
parties as the awards of the court. Usually the International Chamber of Commerce
is recognized as the arbitrator in a large number of cases.

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14.10 REVISION POINTS

Power of Attorney
Sale of goods Act
Law of Carriage of goods
Negotiable Instrument
14.11 INTEXT QUESTIONS
1. Describe in detail
a. Law of agency b. Power of attorney c. Law of carriage of goods
2. What is a negotiable instrument? Give examples.
3. What is mean by Sale of goods act? Explain.
4. Explain law of carriage of goods in detail.
5. Explain various legal aspects related to purchase transaction.
14.12 SUMMARY
Every purchase transaction legally binds the organization. Legal concept like
law of agency, sale of goods act, transit damage, law of carriage of goods act,
Transfer of title, Arbitration, have been discussed at length.
14.13 TERMINAL EXERCISE
1. Write a short notes on Sale of goods act .
2. Briefly Explain Transit damages
3. Define Inspection and Acceptance.
4. Explain Arbitration briefly.
14.14 SUGGESTED READING/ REERENCE BOOK/ SET BOOKS
1. P.Gopalakrishnan, Purchasing and Materials Management, Tata Mc-Graw
Hill, 2000.
14.15 KEY WORDS
Law of agency, Attorney, law of carriage of goods Arbitration.

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LESSON 15

PURCHASE ETHICS AND PERFORMANCE APPRAISAL

OBJECTIVES
To know the concept of ethics
To understand the ethics in buying
To know the various problems in ethics
To know the need of evaluation of materials function and process of
evaluation.
CONTENT
15.0 Introduction
15.1 Business ethics
15.2 Ethics in Buying
15.3 Code of ethics
15.4 Problems in ethics
15.5 Evaluation of material function
15.6 Various indices of performance appraisal
15.7 Revision points
15.8 Intext Questions
15.9 Summary
15.10 Terminal Exercises
15.11 Suggested Redding/ reference Books/set books
15.12 Key words
15.0 INTRODUCTION
One of the hotly discussed topics in today's materialistic word is a Greek word
'ethics', and that too in the context of industrial buying. Hitherto the economics of
business and profits of enterprises were the main determinants in the business
world. The emphasis to at lesser degree was on professional aspects and not on the
ethos and socio-economic setting 'in which the buyer should and ought to function.
The relevance of national and international compulsions, which recognise the
importance of socio-economic ethical conditions and of social benefits along with
commercial profits, is being felt more and more by the buyer of today. In the
relentless pursuit of accumulation of wealth, one hopes that Oliver Goldsmith's
words, III fares the land, to hastening ills a prey, where wealth accumulates and men
decay, does not come true. It is, however, a fact that despite several developments,

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the ancient warning of the 'coveat emptor' or buyer beware still operates. The words
of George Herbert, 'the buyer needs a hundred eyes, the seller not one, are relevant
today. Absolute power in any sphere-social, political, economic, religious, industrial
corrupts absolutely, forcing unethical decisions.
In the context of ethics, Mahatma Gandhi mentioned the seven ills of the
society which should be avoided: (a) politics without principle (b) wealth without
work (c) pleasure without conscience (d) knowledge without character (e) science
without humanity (f) commerce without morality, and (g) worship without sacrifice.
These statements are particularly true in the context of purchasing, which is the
largest spending department in the organisation and hence, is bound to be wisdom
of temptations and allurements and compromises in the form of wine, women,
wealth, arts, commission, kickbacks, donations, Winding up charges,

bribery,

fraud, gifts, hospitality, complementarities and, entertainment. How should we avoid

these temptations is a difficult equation to answer. But ethics is the first and
foremost engine to shape the moral character to its best. Have we given a decent
burial to Gandhian ethics in public life?
15.1 BUSINESS ETHICS
Ethics represent the eternal and prevalent moral standards, personal values,
corporate code of conduct and are generally part of the cultural tradition of a
country. According to John Huxley, major steps in the human phase of evolution are
achieved by breakthrough to new dominant patterns of mental organisation of
knowledge

ideas,

ideological

beliefs,

instead

of

physiological

or

biological

organisation. Hence this influence the socio-economic environment, while the socioeconomic ethos itself is determined by the interaction of culture ethics and psychosocial factors. Ethical values are inseparable from the pursuits of ordered human
society and dharma is the value that bind people together to form an integrated
organisation the society. The essence of our socio-economic ethics should be a
pervasive social awareness contributing towards efficiency and humanizing our
outlooks and actions.
The conduct of an individual citizen or a corporate citizen involves the destiny
of one or more individuals or corporate bodies in the society and affects others. It is
like the state taking taxes from the people only to ensure their own prosperity in
return; just as the sun takes up the moisture only to give back in thousand-fold
measure. One should devote oneself to perform with a spirit of dedication; the
pursuit of excellence through efficiency in work is held out as the highest form of
yoga and improves the quality of life. In this context, ethics can be defined as a
self-generated system of moral standards in the realm of business, to which a
substantial majority of executives give voluntary assent; genuine differences of

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opinions and dissidence should not be stifled as indiscipline. The concepts such as
Work is workshop, action is thy duty -fruit is not thy concern, trust begets trust
and other ideals should be practised institutions and nor discarded as theoretical
slogans.
15.2 ETHICS IN BUYING
Ethics is a philosophy of life and based on the principle, "do unto others as you
would like others do unto you". Ethics is the discipline which points out the
obligations between persons or group of persons, based on a written code of civilised
conduct. If there is such a thing, as a profession, as distinct from a vocation, it must
consist of the ideals in which they maintain character, which they bring to the
performance of their duties and the austerity of self imposed ethical standards. It is
the most important element among others, which is related to the simplest principle
of the purchasing profession, as it is the primemover and motivating force for
shaping moral character. Ethics try to set standards in absolute terms, as ethical
behaviour gets a man respect, social recognition, moral strength and internal
satisfaction. The personal characteristics of the buyer will largely determine what
other people think of him. The personal ethics are derived from well-set moral
standards and must be on a higher plane than business ethics, if there is to be
improvement and must be pulled but not pushed up. The buyer has not only to
build his reputation, but must appreciation that the reputation of his organisation
depends on his thought, action and deeds.
It is well-known that a buyer can purchase everything, but he cannot buy
reputation or honesty or integrity, which have to be built by professional ethics,
moral character, wisdom, reliability etc. The concept-that all methods are fair in war,
low and buying, must be avoided in the field of purchasing. The ethics and integrity
of the purchasing personnel must be such that their suppliers always trust them:
Since their decisions affect the company's business, their conduct must be above
reproach. The qualification of a good buyer should be a confidence in his own
judgement in fair dealings. Relating to source development, source selection,
adherence to purchase order, placing, disputes, quantity to be ordered, negotiated
price, inspection, documentation, etc. Hence the buyer-seller relationship should be
correct, cordial, fair and long-lasting. However, the concept of morality, fair dealings,
trust and other ethical values is confined only to youngsters, probationers.
temporary staff, etc. and change with experience in service for a long period in
consonance with the central values of the organisation.
15.3 CODE OF ETHICS
The ethical code of the international federation of purchase and materials
management states that members shall not use their authority or office for personal

187

gain and shall seek to uphold and enhance the standard of purchasing by a)
maintaining an unimpeachable standard of integrity in all their business
relationships both inside an outside the organisation in which they are employed b)
complying with the letter and spirit of the laws of the country in which they work.
Loyalty to the company, justice to those with whom he deals and faith in his
profession are the basic codes of purchasing professionals. In this context, the code
of a professional organisation, the Indian Institute of Materials Management, is given
below a) to consider first the total interest of one's organisation in all transactions
without impairing the responsibility and dignity to one's office b) to buy without
prejudice. seeking to obtain the maximum ultimate value for each rupee of
expenditure; c) to subscribe and work for honesty and truth in buying and selling, to
denounce all forms and manifestations of commercial bribery and to eschew antisocial practices; d) to accord to prompt and courteous reception, so far as conditions
will permit, to all who call up on legitimate business mission; and e) to respect one's
obligations and those of one's organisation consistent with good business practice.
It will be admitted that these codes are worthless if it is not backed up by
deeds, preferably supported by policy statements. It is expected that the buyer
should never forget that he is the symbol of all ethical standards and at all costs, in
all circumstances, he would never deviate from the ethical standards to fall prey to
temptations and allurements.
15.4 PROBLEMS IN ETHICS
It is well known that purchasing executives negotiate contracts worth millions
of rupees and hence are exposed to temptations which few other executives in other
functional areas have to encounter. The foundations of transactions are based on
honesty, equity, fairplay, integrity, etc. between the two parties of the game and
hence must enjoy the support and confidence of their companies and the
relationship between the two parties is one of trusteeship. If there is a lack of trust,
or the actions of the purchase executive is suspect, the company cannot be expected
to prosper. If the chief concern of a purchase executives is pf getting, rich quickly,
then the relationship will weaken and crumble. Dishonesty, corruption, cuts,
kickbacks, commissons, etc. in the area of purchasing are merely a reflection of the
prevalent creed in the organisation, industry, society, public life, as well as in the
socio-political environment in the national and international areas.
It is noted that in many organisations, all purchasing decisions are influenced
by the user department which indicates the sources of supply. The" marketing
department sometimes exerts its own pressures on the plea of reciprocal buying. Top
management dictates to purchasing, particularly when large contracts and capital

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equipments are involved, it is a common sight to see double standards practiced in

that, marketing department is forced to give gifts to the consumers, while vendors
are prohibited to give present to the buyers. The comments such as 'no smoke
without fire' 'man who takes honey is bound suck his fingers' are often heard in the
corridors of large organisations. The attitude of people to bribery and their actual
behaviour in critical situations are diametrically opposite.
In this context, we recall the speech of the Indian Prime Minister Shri Rajiv
Gandhi, who said in the Congress convention in Bombay dul1ng December 1985,
corruption is regarded as the hallmark of leadership. Flagrant contradictions
between what they say and what we do become the way of life in our party' When it
comes to the crunch, the behaviour of people even in the highest political and
executive policy making levels, is contemptible' in the latter of personal honesty and
integrity, which is obvious when one goes through the report of inquiry commissions
at the highest level. One can easily come across corruption and kickbacks, in
defence scandals, at political level, executive policy making level, implementing and
operating levels, etc., the government turning a Nelson's eye to the dubious tactics of
businessmen.
Scandals like Bofors, Recruit, Watergate, wiretap, getting cuts, agreement
violations are well-known. In such environment, the industria1 buyer will also be
affected by this process and it is impossible to expect the purchasing executives to
be a saint, who has renounced all worldly attachments and pleasures. Trust is
difficult to measure not only in politics but also between the buyer and the seller. It
is not created by romantic or sentimental gesture, but the ethical value system. rests
on trust. Alcoholism, nepotism, power brokers, influencing peddlers, etc. turn the
corridors of power into characteristic, opportunistic and sycophantic. While the
standards

of

integrity

have

fallen,

with

honour

and

patriotism

becoming

unfashionable in most countries today with supreme indifference to ethical values. A

business gift means big business and the palm that works has to be greased.
15.5 EVALUATION OF MATERIALS FUNCTION
One of the truly unsung heros in Indian business today is the man charged
with the awesome responsibility of goods and services for his company. In India, the
annual value of goods and services purchased by the manufacturing industry
constitutes over 60 per cent of the gross value of the output. If only one percent of
this expenditure could be reduced, then the gross profits of manufacturing industry
would be increased by about six percent. Hence success of an organisation depends
to a great extent upon the performance of the materials function, which must be
measured regularly and so that necessary corrective steps can be taken whenever
needed. Such a system will enable the chief executive to industry the weak spots for

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weeding out from the system and recognise successful ones to reward them
adequately. For this purpose, the materials function has to be judged by the success
it achieves in the field of productive wealth brought through its contributions to the
corporate profits. If the organization succeeds, the materials management is
understood to have carried out his job effectively. On the contrary, if it fails, the first,
blame will come to purchasing as purchasing represents a result oriented activity of
the firm.
15.5.1 Background Conditions
Before proceeding to discuss the process of evaluation, it is desirable to identity
the background conditions in which the purchasing function operates in a
developing economy like India. While all the management functions like production,
marketing etc. as well as many oilier professions in the world are evaluated on the
basis of their achievements, materials is one of the few professions which is judged
essentially by failures or non- delivery resulting in stock-outs.
In a controlled, scarce and developing economy like India, the purchase
managers feel that it is difficult to practice scientific management principles. The
lead-time particularly in public sectors and that too for imported items, is invariably
large. In a few firms, including semi processed goods, scrap, obsolete items,
furnished goods, stores and material planning, which demands different types of
competence. The job description for managing the materials function includes such
diverse aspects as commercial, technical, financial, legal and public relations. In
view of such problems, goals are difficult to set for the materials function and
deviations are impractical to measure, as ideal conditions do not exist in actual
practice, However, it will be appreciated that evaluation of materials function is a
continuous process, in order to attain the corporate excellence. To operate
effectively, the executive must become a coordinator, representing corporate
interests, respecting other functions, responsibilities and opinions and using a
unified approach to outside vendors.
A materials executive, a) who Is completely familiar with his company's product
line, is up-to-date on and market developments, b) who has acquired knowledge,
experience and expertise in modem techniques of materials management; c) who can
justify his decisions in placing orders on sound and ethical grounds; d) who
appreciates the long-term advantages of good will and sound relationships with
suppliers; e) who deals with his staff with understanding and humility f) who is loyal
to his company without surrendering his own principles of correct conduct, honesty
and integrity; is the ideal man for the job. If the profession of materials is to gain in
value and importance, materials executives must raise themselves to the highest
levels of technical competence and managerial leadership, to be able to take their

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rightful place in the organisational hierarchy. In this process, training purchase

managers becomes a crucial factor.
15.5.2 Managerial Styles
A key factor that is relevant to the evaluation of materials function is the
managerial style or organizational culture of the company. The various managerial
styles adopted in the companies include-management by rules, management by
procedures, management by crisis, management by exception, management by
objectives, management by committees, management by dictatorship/ autocracy,
management by participation, management by results, management by consensus,
management by contacts/liaison, etc. The styles of management is relevant in the
context of evaluating purchase function, because the buyer is taken to task for
stock-outs, without being praised for meeting daily requirements or savings effected
in buying. To meet the varied attacks from user finance, itself on its performance by
adopting function will have to introspect itself on its performance by adopting SWOTStrength, Weakness, Opportunity and Threat-as well as MBO-Management By
Objectives Principles
Through SWOT analysis, the materials function can take stock of its own
strengths and weakness in the face of external opportunities and threats. The
course of action is to increase the strengths and reduce the weaknesses, so that the
opportunities can be capitalized and the threats subdued. For example, an effective
forecasting ability can be used to overcome the threat of fluctuating prices.
Management by objective approach is helpful for planning, organizing, directing,
controlling,

monitoring, measuring and appraising the performance of the

personnel. In this approach, the objective of materials is extracted with the

organizational goals. The key result areas in purchasing are identified and action
plans are drawn to achieve some, which are reviewed at the year end. The emphasis
is on results. rather than on activities by identifying the resources, responsibilities
and accountability. It must be emphasised that the industry is not a machine, it is a
complex form of human association and a true understanding of industry is to
understand the thoughts of those engaged in it by proper scientific methods of
evaluation.
15.5.3 Who Evaluates
The evaluation of materials management function can either be done by
external agencies or internally. Within the organization the top management, usually
at the year end and periodically during the year evaluates the purchase function.
The user departments evaluate in terms of the number and duration of failure of
supply. In a few organisations a committee frequently reviews the performance of the
purchase function against the set objectives.

191

It is also known that the suppliers, who are evaluated by the purchase
department, in turn, evaluates the buyer and his company, in terms 'of quality
consciousness, seriousness of adherence- to delivery schedule, his decision-making
capacity in the organisation and the adherence to, bill payment date. The other
external agencies interested in the efficiency of the procurement division are the
shareholders, banks with regard to credit-worthiness and bill discounting, excise,
customs, vigilance, railways, lorries, carriers, professional associations, industry
association, etc., particularly with regard to the ethical standards, adopted in
purchasing. In a few cases, consultants are brought in to evaluate the performance
of the purchase division and compare it with that of similar organisations.
15.5.4 Reporting
The evaluation of the materials function is usually done by the top
management on the basis of periodic reports emanating from the materials wing.
More facts reflect what has happened, whereas the reports would give the summary
of the working of the purchasing function. The report should be written in a simple
language. Clearly and briefly, Reporting is a communication which helps in setting
things right and goes a long way in efficient functioning of the department. Besides
establishing an effective communication, reporting is the means for collection and
dissemination of data. This process is a two-way traffic, weekly reports containing
the value of purchases, stock status, stock- outs, etc. usually meant for the middle
-level executives, are common in many organisations. Monthly and annual
summaries of the report with special emphasis on long-term aspects, such as effects
of cost reduction achieved, source development, vendor rating, value analysis, are
found to be useful documents for the management.
In order to take suitable remedial corrective measures and to improve materials
activities in the organisation. The reports should be submitted at the appropriate
time-viz. Monthly reports in the first week of the following month and an annual
report in the first month of the following year. Wherever necessary, diagrams, charts,
graphs, tables and comparative statements with adequate explanatory notes should
be made in the reports. The frequency and content of the reports depend upon the
level to which it is intended. Quarterly and annual reports with specific
recommendations on future are intended for top-management, while the monthly
reports with detailed information may be sent to all in the purchase and user
department. The reports should be accurate, up-to-date, brief, clear and to the
point. The report should be serve the materials policy in an organization, namely,
Continuity of supply of uniform quality of inputs, with the lowest cost of ultimate
product. For this purpose, the reports should be presented such that they are easily
read and understood. The report must include enough supporting diagrams, data

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'and charts to explain the variations from the budgeted figures. The reports should
cater to the managements needs, an analysis of the business conditions,
environment

price

movements

material

requirements,

estimates

of

cash

requirements, changes in lead-time, comparison of actual performance with budgets,

etc. Obviously, the reports should be more frequent, containing detailed and
quantitative data to the operating levels, whereas the results should be summarized
with suitable recommendations for the policy-making level.
15.5.5 Process of Evaluation
The mechanical process of evaluation can be done by comparing one
'organisation with a similar organization in the same year, or the same organisation
over a period of two or three years, for some key performance characteristics. The
evaluations can be done by external management users, stores, materials, planning,
marketing, finance, costing and audit are some departments concerned with the
evaluation of the performance of the purchase function. Occasionally, evaluation
committees are also used to judge the performance of purchasing.
The steps involved in the process are-setting acceptable standards for key
characteristics reflecting the corporate objectives, and checking the performance
against the standards. If any deviations occur, then the causes are analysed with a
view to improve the overall purchasing performance. Thus, the process in all the
cases is to formulate norms for each of the key characteristics, and compare the
actual performance with the norms. In this context, the concept of MBOmanagement by objectives or the participative style of management, with the
purchase executives setting their own targets after identifying the key result areas in
a participative fashion, is also being utilised in a few companies.
15.5.6 A To Z Parameters of Evaluation
In any organization, the materials function will be judged by the success it
achieves in the field of productive wealth brought into the organisation by its
contribution. A large number of criteria can be developed to evaluate the purchasing
function in an organisation. These criteria depend on factors such as the company
objectives, corporate culture, function of purchasing activity, evaluation process,
attitude of other departments, etc. The criteria could be divided as subjective and
objective. To develop the parameters, many companies follow the questionnaire
approach on purchase activity, by using the words-what, why, how, when, where,
who, etc. Specifically, the questions are raised on the organisational goals, goals of
purchasing, supplier, financial position, supply position, lead-time, price, quantity,
inventory procedures etc.

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The subjective characteristics cannot be measured accurately, and it is difficult

to set norms for these. The subjective characteristics include morale of purchasing
staff, user satisfaction, buyer-seller relations, purchase managers, knowledge of the
processes and products, training, manpower development, updating systems,
planning for growth, increasing productivity, contributing to high-tech, development
of new procedures, attitude to modem scientific technique of purchasing, exception
reporting, ancillary development, influencing motivation, fixation of responsibilities.
and effective control of staff, skills and systems.
The

performance

measurement

should

cover,

among

other

things,

quantitative measure of stock-outs, the purchasing cost a percentage value of

materials, acquisition cost per order, lead time application of cost reduction
methods, source development, and a measure of the extent of savings on discounts.
In other words we have to find out through the evaluation system how effective the
purchasing division has been in buying the light quality of economical quantity, at
the right time from the right source, paying the right price. For this purpose, a
judicious combination of subjective and objective criteria is helpful.
15.6 VARIOUS INDICES OF PERFORMANCE APPRAISAL
While self evaluation and the satisfaction of one's own conscience is the best
form of evaluation, organizations refer to evaluate the materials function by means
of ratios and indices. The most important parameter is the savings effected by the
materials department. Comparison of the indices/ratios of one company with those
of a similar organisation in the same year or with the previous performance
generally result in improving of purchase efficiency.
a. Average value of each purchase order.
b. Total expenses of purchase department.
c. Cost of purchasing as % value of purchase orders.
d. Savings due to purchasing.
e. Value of indigenous materials to total materials cost.
f. Vendor rating quality index:

Numer of lots rejected

Number of lots accepted

Each lot of material received from the supplier is subjected to rigorous quality
control exercises and based companies quality control level (), the lots are either
accepted or rejected. The quality index of vendor rating the ratio of the rejected lots
to accepted lots of supplied material.
g. Vendor rating price index:

Lowest Price bid

Price bid by vendor

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Quotations would be invited from all the short listed vendors and the ratio of
the lowest price of all the prices quoted to the price quoted by the particular vendor
is the vendor rating price index. This ratio will always be equal to or less than 1.00.
h. Vendor rating delivery :
i. Forecast price Index :

Delivery on Schedule
Total no.of deliveries

Forecast prie of item

Actual price of the item

j. Quantity discounts index:

k. Price Variance Index:

Standard Price - Actual price

Standard price

l. Planning efficiency index:

m. Lead-time index :

Discounts availed
Total value of purchase

Value of rush orders

Total value of purchase

Average lead - time this year

Average lead - last year

n. Order efficiency index :

Price paid by the firm

Market price

o. Negotiation efficiency :
p. Value analysis index:
q: Cash discount index :

Number of small value orders

Total number of orders

Savings accrued by value analysis

Total material
Cash discount availed
Total purcahse value

15.7 REVISION POINTS

Ethics in Buying
Code of ethics
Problems in ethics
Evaluation of Materials function
Indices of performance appraisal
15.8 INTEXT QUESTIONS
1. What are the various purchase ethics?
2. What are the various indices of performance appraisal?
15.9 SUMMARY
The need for purchase ethics and evaluation material function on an objective
basis is always felt in many organizations. Business ethics, ethics in buying, code of

195

ethics problems in ethics and evaluation of materials function and performance

indicators are presented in this chapter.
15.10 TERMINAL EXERCISE
1. Write a short notes of Ethics.
2. Explain ethics in Buying.
3. What is code Ethics.
4. List the parameters of evaluation.
15.11 SUGGESTED READING/ REERENCE BOOK/ SET BOOKS
1. P.Gopalakrishnan, Purchasing and Materials Management, Tata McGraw Hill, 2000.
15.12 KEY WORDS
Ethics, code of ethics, performance appraisal.

K. RAGHUKANDAN
Reader in Production Engg.
Annamalai University

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ANNAMALAI UNIVERSITY

DMM-9
1-15

DIRECTORATE OF DISTANCE EDUCATION

POST GRADUATE DIPLOMA IN MATERIALS

MANAGEMENT

COURSE :1
PURCHASING MANAGEMENT
LESSON 1-15

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