PURCHASING MANAGEMENT NOTES OF

Topics

Introduction

Purchase structure & organization

Quality assurance

Sourcing

Supplier and market behavior

Purchase and contract management

Support tool for purchasing decision making

Negotiation

Ethics and integrity in purchasing

Emerging issues and trends

Management functions

There are many different activities that mangers perform into a few conceptual categories
that are now called as management function. There are six management functions, they
are.
1. Planning
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6. Controlling

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Planning

In this function it establishes goals and objectives to pursue during a future period. The
planning function spans all levels of management. Top managers are involved in strategic
planning that sets board, long-range goals for an organization. These goals become the
basis for short-range, annual operational planning; during which top and middle
managers determine specific departmental objectives that will help the organization
makes progress toward the broader, long-range goals.

Organizing

In this function it typically follows planning and reflects how the organization tries to
accomplish its goals and objectives. In relation to the structure of a company, organizing
involves the assignment of tasks, the grouping of tasks into departments and the
allocation of resources to departments. Organizing also involves establishing the flow of
authority and communication between position and levels within the organization. Top
manager performs these activities. Likewise, middle manager and supervisors organize
the tasks to create positions within their departments. Job analysis and job design
activities are organizing function.

Coordinating

In this function coordinating refers to management activities related to achieving an

efficient use of resources to attain the organization's goals and objectives.

Staffing

In this function staffing refers to the fundamental cycle of human resources activities,
determining human resource needs, and recruiting, selecting, hiring, training, and
developing staff members.

Directing

In this function directing is also referred to as leading, it involves influencing division,

departments, and individual staff members to accomplish the organization's goals and
objectives.

Controlling
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In this function manager performing the controlling management function translate
organizational goals and objectives into performance standards for divisions, department
and individual position. Controlling also involves assessing actual performance against
standards to determine whether the organization is on target to reach its goals and taking
corrective actions as necessary. Managers practicing the evaluative component of
controlling assess how well the organization has achieved its objectives.

Staffing is the process of acquiring, deploying, and retaining a workforce of sufficient

quantity and quality to create positive impacts on the organization’s effectiveness.

FOUNDATIONS OF PLANNING
Planning is one of the four functions of management. Planning involves defining the
organization’s goals, establishing an overall strategy for achieving these goals, and
developing plans for organizational work activities
. The term planning refers to formal planning.
Purposes of Planning
Planning serves a number of significant purposes.
1. Planning gives direction to managers and non-managers of an organization.
2. Planning reduces uncertainty.
3. Planning minimizes waste and uncertainty.
4. Planning establishes goals or standards used in controlling. Planning and Performance
Although organizations that use formal planning do not always outperform those that do
not plan, most studies show positive relationships between planning and performance.
Effective planning and implementation play a greater part in high performance than does
the amount of planning done.
Studies have shown that when formal planning has not led to higher performance, the
external -environment is often the reason.

The Role of Goals and Plans in Planning

Planning is often called the primary management function because it establishes the basis
for all other functions. Planning involves two important elements: goals and plans.
Goals (often called objectives) are desired outcomes for individuals, groups, or entire
organizations.

Types of goals
a. Financial goals versus strategic goals Financial goals related to the financial
performance of the organization while strategic goals are related to other areas of an
organizations performance.

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b. Stated goals versus real goals Stated goals are official statements of what an
organization says and what it wants its various stakeholders to believe its goals are.
Real goals are those that an organization actually pursues, as defined by the actions of its
members.
Types of Plans
Plans can be described by their breadth, time frame, specificity, and frequency of use
On the basis of Breadth plans can be Strategic or operational plans. Strategic plans
(long-term plans) are plans that apply to the entire organization, establish the
organization’s overall goals, and seek to position the organization in terms of its
environment.
Operational plans (short-term plans) are plans that specify the details of how the
overall goals are to be achieved.
On the basis of Time frame plans can be Short-term or long-term plans. Short-term
plans are plans that cover one year or less.
Long-term plans are plans with a time frame beyond three years.
On the basis of Specificity plans can be Specific or directional plans
.
Specific plans are plans that are clearly defined and leave no room for interpretation.
Directional plans are flexible plans that set out general guidelines
.
On the basis of Frequency of use plans can be Single-use or standing plans
A single-use plan is a one-time plan specifically designed to meet the needs of a unique
situation.
Standing plans are ongoing plans that provide guidance for activities performed
repeatedly.
Approaches to Establishing Goals
Goals can be established through the process of traditional goal setting or through MBO
(Management by objectives)
Traditional goal setting is an approach to setting goals in which goals are set at the top
level of the organization and then broken into sub-goals for each level of the
organization.
This traditional approach requires that goals must be made more specific as they flow
down to lower levels in the organization.
Management by objectives (MBO) is a process of setting mutually agreed-upon goals
and using those goals to evaluate employee performance. Studies of actual MBO
programs confirm that MBO can increase employee performance and organizational
productivity.
The following steps are involved in a typical MBO program: The organizations overall
objectives and strategies are formulated. Major objectives are allocated among divisional
and departmental units. Unit managers collaboratively set specific objectives for their
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units with their managers. Specific objectives are collaboratively set with all department
members
Action plans, defining how objectives are to be achieved, are specified and agreed upon
by managers and employee. The action plans are implemented Progress toward objectives
is periodically reviewed, and feedback is provided Successful achievement of objectives
is reinforced by performance based rewards. Whether an organization uses a more
traditional approach to establishing objectives, uses some form of MBO, or has its own
approach, managers must define objectives before they can effectively and efficiently
complete other planning activities.
Characteristics of Well-Designed Goals
1 Written in terms of outcomes
2. Measurable and quantifiable
3. Clear as to a time frame
4. challenging, but attainable
5. Written down
6. Communicated to all organizational members
Five Steps in Goals Setting
1. Review the organization’s mission (the purpose of the organization).
2. Evaluate available resources.
3. Determine the goals individually or with input from others
4. Write down the goals and communicate them to all who need to know.
5. Review results and whether goals are being met. Make changes as needed.
Developing Plans
The process of developing plans is influenced by three contingency factors and by the
particular planning approach used by the organization. Three Contingency Factors in
Planning are
Manager’s level in the organization:
Operational planning usually dominates the planning activities of lower-level managers.
As managers move up through the levels of the organization, their planning becomes
more strategy oriented.

Quality Control and Operations Management

The concept of quality control has received a great deal of attention over the past twenty
years. Many people recognize phrases such as "do it right the first time, "zero defects",
"Total Quality Management", etc. Very broadly, quality includes specifying a
performance standard (often by benchmarking, or comparing to a well-accepted
standard), monitoring and measuring results, comparing the results to the standard and
then making adjusts as necessary. Recently, the concept of quality management has
expanded to include organization-wide programs, such as Total Quality Management,
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ISO9000, Balanced Scorecard, etc. Operations management includes the overall activities
involved in developing, producing and distributing products and services.

OBJECTIVES OF PURCHASING FUNCTIONS

The general objectives of purchasing function is that it should obtain; -

The right material, In the right quantity, For delivery at the right time, and right place,
from the right source, with the right service at the right price. N/B the seven RIGHTS

IMPORTANCE OF SUPPLY FUNCTION

-Participate in new products development.

-Responsible for selecting appropriate sources of supply

-Develop and nurture supplies partnership and strategic alliances.

-Help in managing (minimizing) cost.

-Issue long-term agreements with carefully selected suppliers and in organization ’s

strategic planning process.

Supply management is expected to focus on;

1. Quality

Expected to play a leading role in ensuring quality of purchased materials and

services i.e.- inventory should be universally defects free.

2. Cost

The purchasing and supply management functions must focus on strategic cost
management i.e.- the process of reducing the total cost of acquiring, moving,
holding, converting and supporting products containing purchased materials and
services throughout the supply chain.

3. Time

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 The purchasing and supply management functions play active roles in reducing
the time required to bring new products to market.

4. Technology

It ensures that the firm’s supply base provides appropriate technology in a timely
manner and ensures that technology which affects the firm’s core competences is
carefully controlled when dealing with outside suppliers.

5. Continuity of supply

Monitor supply trends; develop appropriate supplies alliance in order to reduce the work
of supply disruptions.

6. Business environment. Supply management must address the identification of

threats, and opportunities in the firm’s supply environment. (PESTLE)

THE PURCHASING FUNCTION INCLUDES THE FOLLOWING

RESPONSIBILITIES:

1. Making purchases for all departments in accordance with applicable laws and
regulations.

2. Establishing and enforcing a system for approving and accounting for purchases;

3. Maintaining appropriate records on price quotations of supplies most frequently

purchased;

4. Maintaining other supplemental data to assist in making purchases at the most

economical prices possible;

5. Maintaining NC E-Procurement compliance and making purchases through the E-

Procurement Service to the extent appropriate to maximize savings and efficiency in the
purchasing function;

6. Establishing a practical degree of standardization of equipment, supplies and materials

with sufficient flexibility to meet unique needs of schools and departments;

7. Operating a central inventory warehouse;

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8. Supervising the receiving of all materials, including establishing procedures to ensure
received goods are properly inspected, counted and documented;

9. Maintaining lists of potential bidders for various types of materials, equipment and
supplies;

10. Providing information regarding bidding opportunities to vendors;

11. Providing information and service to schools and departments that wish to make
purchases; and

12. Maintaining current information on all applicable laws, regulations, board policies
and administrative procedures.

STRUCTURE TYPES

Organizational structures typically use one of two approaches:

 A centralized structure gives most of the authority and decision-making power to

the team at the top.
 A decentralized structure distributes authority and decision-making power at
lower levels, which might include departments, groups, or business units.

A company can be organized in a number of ways. It might be built around divisions,

functions, geography, or with a matrix approach:

 A divisional structure is organized around divisions or business units that are self-
contained entities with their own functional departments such as human resources,
marketing, and so on.
 A functional structure is based on job functions often labeled as departments –
finance, purchasing, etc.
 A geographical structure is often used when a company has multiple locations.
Each location operates independently.
 With a matrix structure, the company is organized around teams assembled for
specific tasks. Team members usually report to more than one person – the team
leader, and the supervisor for the team member’s functional area.

Organizational structure is required so that employees know who is supervising their

work and can help with problem-solving and other issues. That structure also helps them
understand growth potential in their jobs. In addition, an expanding business can
minimize growing pains when it has an organizational structure or hierarchy in place to
build on during growth periods.

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ORGANIZATIONAL STRUCTURE, DEFINITION AND MEANING

The organizational structure of, for example, a company is a system used to define its
hierarchy. Each employee’s position is identified, including their function and who they
report to within the firm. It is the way in which a company or organization is organized,
including the types of relationships that exist between the directors, managers and
employees.

The organizational structure, which may refer to the hierarchy of not just a business, but
also any entity such as a charity, government department, agency or education
establishment, is developed to establish how an entity operates and helps the organization
in achieving its goals and objectives.

The organizational structure outlines how activities including task allocation, supervision
and coordination are directed towards its individual aims. It is also a ‘viewing glass’ or
perspective through which employees may see their organization and its environment.

In this type of structure, the organization is divided into different functional work
activities – departments. A level of top managers usually oversees the work carried out
by employees in each functional area.

Organizational structure helps firm meet goals

Put simply, it refers to how an organization arranges its staff and jobs so that its work can
be performed and its objectives and goals met.

There are many different ways in which a company or organization may be structured,
depending on why it exists and what its objectives are.

This type of organization divides the functional areas into divisions – each one with its
own resources in order to operate independently. Divisions may be defined according to
products/services, geographical area or any other measurement.

In any medium- or large-sized businesses, employees’ job descriptions are typically

defined by what they do, their immediate supervisors (who they report to), and who
reports to them if they are managers or directors.

ORGANIZATIONAL CHART ILLUSTRATES THE STRUCTURE

How these different positions are inter-related is often illustrated graphically in an

organizational chart. The features of any organizational structure depend on many factors
including: – how big it is – how many people work in it – its revenue – where it is
located (could be in several locations) – what it sells and how many different markets it is
active in.

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 Employees are placed according to their function and the product. With this structure
you get the best of both the worlds of divisional and functional structures. The business
uses teams to complete tasks. Teams are formed according to the functions of each
member plus the product he or she is involved in.

TYPES OF ORGANIZATIONAL STRUCTURES

There are many kinds: vertical & tall with many tiers, or flat with just a couple of levels
separating top from bottom. Below are the four most common:

Functional: also known as a bureaucratic organizational structure. It divides the

company based on specialty, with a marketing department customer service department,
sales department, HR department, etc.

In a functional structure, each employee is dedicated to a single function. These clearly-

defined job descriptions and expectations reduce confusion. One drawback with this type
is that it makes it harder to facilitate inter-departmental communications.

Divisional: this type of organization structures leadership according to different projects

or products. For example, while International Consolidated Airlines Group, S.A. (IAG) is
the company, there are four different airlines underneath – British Airways, Iberia,
Vueling and IAG Cargo. Each one operates as an individual company, but they are
ultimately under IAG.

Matrix: in this kind of organization the workers have several different bosses and
reporting lines. They report to, for example, a divisional manager, and also have project
managers for certain project.

A matrix organization is more likely to experience confusion and complications,

especially when staff members have to carry out conflicting tasks.

Flat hierarchy: more common in new startups and smaller companies. These types of
businesses have a bit of vertical hierarchy but also flat structures, i.e. they may be more
hierarchical and then have ad-hoc teams for flat structures, or vice-versa.

Flat hierarchy structures are very dynamic in nature and are typically constantly evolving
and changing.

According to the Cambridge Dictionary, organizational structure is:

“The way in which a large company or organization is organized, for example, the types
of relationships that exist between managers and employees.”

2. Functional structure

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Employees within the functional divisions of an organization tend to perform a
specialized set of tasks, for instance the engineering department would be staffed only
with software engineers. This leads to operational efficiencies within that group.
However it could also lead to a lack of communication between the functional groups
within an organization, making the organization slow and inflexible.

As a whole, a functional organization is best suited as a producer of standardized goods

and services at large volume and low cost. Coordination and specialization of tasks are
centralized in a functional structure, which makes producing a limited amount of
products or services efficient and predictable.

3. Divisional structure

Also called a "product structure", the divisional structure groups each organizational
function into a division. Each division within a divisional structure contains all the
necessary resources and functions within it. Divisions can be categorized from different
points of view. One might make distinctions on a geographical basis each division may
have its own sales, engineering and marketing departments.

4. Matrix structure

The matrix structure groups employees both function and product. This structure can
combine the best of both separate structures. A matrix organization frequently uses teams
of employees to accomplish work, in order to take advantage of the strengths, as well as
make up for the weaknesses, of functional and decentralized forms. An example would
be a company that produces two products, "product a" and "product b". Using the matrix
structure, this company would organize functions within the company as follows:
"product a" sales department, "product a" customer service department, "product a"
accounting, "product b" sales department, "product b" customer service department,
"product b" accounting department. Matrix structure is amongst the purest of
organizational structures, a simple lattice emulating order and regularity demonstrated in
nature.

a) Organizational circle: moving back to flat

The flat structure is common in small companies (entrepreneurial start-ups, university

spin offs). As companies grow they tend to become more complex and hierarchical,
which leads to an expanded structure, with more levels and departments.

5. Team

One of the newest organizational structures developed in the 20th century is team. In
small businesses, the team structure can define the entire organization. Teams can be both
horizontal and vertical. While an organization is constituted as a set of people who

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synergize individual competencies to achieve newer dimensions, the quality of
organizational structure revolves around the competencies of teams in totality

6. Network

Another modern structure is network. While business giants risk becoming too clumsy to
proact (such as), act and react efficiently, the new network organizations contract out any
business function that can be done better or more cheaply. In essence, managers in
network structures spend most of their time coordinating and controlling external
relations, usually by electronic means.

7. Virtual

Virtual organization is defined as being closely coupled upstream with its suppliers and
downstream with its customers such that where one begins and the other ends means little
to those who manage the business processes within the entire organization. A special
form of boundary less organization is virtual. Hedberg, Dahlgren, Hansson, and Olve
(1999) consider the virtual organization as not physically existing as such, but enabled by
software to exist. The virtual organization exists within a network of alliances, using the
Internet. This means while the core of the organization can be small but still the company
can operate globally and be a market leader in its niche

KENYA (KEBS)

The Kenya Bureau of Standards (KEBS) was established by an Act of Parliament - the
Standards Act, Chapter 496 of the Laws of Kenya. It started its operations in July 1974.
The aims and objectives of the Bureau include preparation of standards relating to
products, measurements, materials, processes, etc., and their promotion at national,
regional and international levels; certification of industrial products; assistance in the
production of quality goods; improvement of measurement accuracy and circulation of
information relating to standards.

KEBS' organizational structure comprises the following:

- Standards Development and International Trade Division
- Quality Assurance Division
- Testing and Metrology Services Division, and
- Finance and Administration Division.
The National Standards Council is the policy making body which has power to supervise
and control the administration and financial management of the Bureau. The Managing
Director of the Bureau is the Chief Executive, whose responsibilities are the day-to-day
running and administration of the Bureau within the broad guidelines formulated by the
Council.

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Benefits of standards
Kenyan Standards set out the specifications and design procedures to ensure goods and
services consistently perform in the way they are intended. They make a sustained
contribution to generating national wealth, improving our quality of life, increasing
employment, improving safety and health and using our national resources more
efficiently.
Imagine a world without Standards
A reminder as to how much difference standardization makes is the example of overseas
traveler who has to carry a suitcase full of adaptors from country to country. These plugs
were all specified in the days before international standardization was widely recognized
and they are a daily reminder of the universal value of Standards. Similarly, the example
of a person trying unsuccessfully to connect a computer to a phone system in a country
other than the one in which it was bought.

Standards protect Kenyan

Kenyans at home, at play and at work are made safer by Standards. Traffic lights,
footpaths, power points, seatbelts and child restraints, air quality, smoke and fire alarms
are all underpinned by Kenyan Standards. Standards give businesses and consumers
confidence that the goods and services they are developing or using are safe, reliable and
will do the job they were intended for. Standards help consumers make everyday choices
between one product and another. They protect Kenyan tradesmen - builders, electricians,
plumbers - and their customers. Government public health, safety and environment
policies are often measured against Kenyan Standard yardsticks.

Standards support Kenyan innovation

Standards provide a platform on which to build new and exciting ideas. As our world
changes, new Standards are introduced to reflect the latest technologies, innovations and
community needs - redundant Standards are discarded. New closed circuit television
Standards, infrastructure protection Standards and luggage safety advice will protect all
Kenyans and are a direct response to community concerns around security issues. New
risk management Standards have improved business practice while information and
communications technology Standards have helped spread ‘cutting edge’ practices across
emerging industries.

Standards boost Kenyan production and productivity

Kenyan manufacturing, materials handling, mechanical systems and components.
Standards save businesses time and money. Standards cut production costs. They drive
economies of scale, the use of common parts and specifications, help cut energy bills and
foster new technologies. The Government uses Kenyan and international record-keeping
Standards to handle and move information around its vast networks. Small businesses
become more efficient and grow by using Standards, guidelines and handbooks
developed by industry experts.

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Standards make Kenyan businesses more competitive
Products that comply with Kenyan Standards have a competitive edge over products that
don’t - consumers know the difference. Businesses know products made to Kenyan
Standards have more credibility - whether it’s a bike helmet, baby napkins or complaints
handling system. Kenyan exporters using international Standards have a head start when
they move into overseas markets. International aerospace, food and medical equipment
markets all have strict Standards that can dictate success or failure.

Standards link Kenya to the rest of the world

Standards ensure products manufactured in one country can be sold and used in another.
A nut made in Nairobi fits a bolt made in London, 35 mm film made in Kenya will fit 35
mm cameras made in Japan. Standards reduce technical barriers to international trade,
increase the size of potential markets and position Kenyan firms to compete in the world
economy. Containers, electrical equipment, data packaging, PIN management - just a few
of the Kenyan Standards that link local businesses directly with international markets.

Standards complement Kenyan regulation and make markets work better.

Around a third of all Kenyan Standards form some part of Territory, State or Kenyan law.
They are at the heart of the Kenyan Code and the Trade Practices Act. They help
governments craft laws to protect the community. Standards help make laws and
regulations consistent across Kenya. By using a Standard, a Kenyan consumer law
becomes consistent with a Tanzanian fair trading regulation. Standards offer an
alternative to regulation, with less red tape and business costs, while still providing
security for families and small business consumers.
Working on Kenyan Standards rewards participants
Being a part of a Kenyan Standards development team has its own rewards - increased
knowledge, stronger business networks and competitive advantages.

Quality Assurance Tools & Techniques

 Cost-Benefit Analysis.
 Cost of Quality (COQ)
 Control Charts.
 Benchmarking.
 Design of Experiments (DOE)
 Statistical Sampling.
 Flow Charting.
 Quality Management Methodologies (i.e. Six Sigma, CMMI, etc)
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QUALITY ASSURANCE

Quality is an important factor when it comes to any product or service. With the high
market competition, quality has become the market differentiator for almost all products
and services.

Therefore, all manufacturers and service providers out there constantly look for
enhancing their product or the service quality.

In order to maintain or enhance the quality of the offerings, manufacturers use two
techniques, quality control and quality assurance. These two practices make sure that the
end product or the service meets the quality requirements and standards defined for the
product or the service.

There are many methods followed by organizations to achieve and maintain required
level of quality. Some organizations believe in the concepts of Total Quality
Management (TQM) and some others believe in internal and external standards.

The standards usually define the processes and procedures for organizational activities
and assist to maintain the quality in every aspect of organizational functioning.

When it comes to standards for quality, there are many. ISO (International Standards
Organization) is one of the prominent bodies for defining quality standards for different
industries.

Therefore, many organizations try to adhere to the quality requirements of ISO. In

addition to that, there are many other standards that are specific to various industries.

Since standards have become a symbol for products and service quality, the customers
are now keen on buying their product or the service from a certified manufacturer or a
service provider.

Therefore, complying with standards such as ISO has become a necessity when it comes
to attracting the customers.

Quality Control

Many people get confused between quality control (QC) and quality assurance (QA).
Let's take a look at quality control function in high-level.

As we have already discussed, organizations can define their own internal quality
standards, processes and procedures; the organization will develop these over time and
then relevant stakeholders will be required to adhere by them.

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The process of making sure that the stakeholders are adhered to the defined standards and
procedures is called quality control. In quality control, a verification process takes place.

Certain activities and products are verified against a defined set of rules or standards.

Every organization that practices QC needs to have a Quality Manual. The quality
manual outlines the quality focus and the objectives in the organization.

The quality manual gives the quality guidance to different departments and functions.
Therefore, everyone in the organization needs to be aware of his or her responsibilities
mentioned in the quality manual.

QUALITY ASSURANCE

Quality Assurance is a broad practice used for assuring the quality of products or
services. There are many differences between quality control and quality assurance.

In quality assurance, a constant effort is made to enhance the quality practices in the
organization.

Therefore, continuous improvements are expected in quality functions in the company.

For this, there is a dedicated quality assurance team commissioned.

Sometimes, in larger organizations, a 'Process' team is also allocated for enhancing the
processes and procedures in addition to the quality assurance team.

Quality assurance team of the organization has many responsibilities. First and foremost
responsibility is to define a process for achieving and improving quality.

Some organizations come up with their own process and others adopt a standard
processes such as ISO or Kebs.

Quality assurance function of an organization uses a number of tools for enhancing the
quality practices. These tools vary from simple techniques to sophisticated software
systems.

The quality assurance professionals also should go through formal industrial trainings
and get them certified. This is especially applicable for quality assurance functions in
software development houses.

Since quality is a relative term, there is plenty of opportunity to enhance the quality of
products and services.

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The quality assurance teams of organizations constantly work to enhance the existing
quality of products and services by optimizing the existing production processes and
introducing new processes.

Conclusion

Quality control is a product-oriented process. When it comes to quality assurance, it is a

process-oriented practice.

When quality control makes sure the end product meets the quality requirements, quality
assurance makes sure that the process of manufacturing the product does adhere to
standards.

Therefore, quality assurance can be identified as a proactive process, while quality

control can be noted as a reactive process.

Quality Assurance

Quality assurance methods document what functions a product or system must fulfill, and
what characteristics it must possess. They specify the required resources and ensure that
these resources are available. For production, they specify the characteristics of incoming
material and supplies, the qualifications of the people carrying out the work, and the tests
required to verify actual versus specified qualities. For other systems, quality assurance
methods specify performance levels and output parameters. In this way, they result in
output of a specified quality.

Lean

Companies apply lean principles to increase efficiency. They do this by continuously

monitoring processes to reduce waste and unnecessary effort. This is especially important
for small businesses, whose resources are limited. Lean principles identify and eliminate
process steps that don't add value, repeated mistakes that take time to fix, and movement
of people and materials without a productive purpose. They streamline a process by
reducing waiting times, and emphasize on-time delivery. Companies implement these
principles by assigning specific responsibilities for performance of particular tasks and
the desired results to clearly identified individuals. These individuals are responsible for
performance, but companies also give them leeway in deciding how to achieve the
desired results.

Six Sigma

Six sigma principles focus on reducing defects. The term refers to a statistical value for
almost zero defects. Measuring such defects is a key part of the system. A defect is an
output that doesn't correspond to user expectations. Companies design processes simple
enough to allow the production of low-defect outputs. Simple processes in production are

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especially valuable for small business because it frees up personnel for other business
functions. An overview of the principles gives the five functions of define, measure,
analyze, improve and control. Companies apply these functions to simplify their
processes and determine how successful they have been in achieving zero defects in their
output.

Performance

The key to a company's performance lies in the achievement of targets that match the
overall goals. Quality assurance methods deliver output that satisfies quality goals, but
they don't address efficiency. Application of the lean principles lets companies maintain
the level of quality they need while becoming more efficient. Six sigma principles
complement quality assurance and lean principles by introducing statistical measurement
into the operations. Companies that embrace quality assurance together with lean six
sigma principles can reduce costs, improve performance and produce higher quality
output.

Benchmarking

Benchmarking is comparing one's business processes and performance metrics to

industry bests and best practices from other companies. Dimensions typically measured
are quality, time and cost. In the process of best practice benchmarking, management
identifies the best firms in their industry, or in another industry where similar processes
exist, and compares the results and processes of those studied (the "targets") to one's own
results and processes. In this way, they learn how well the targets perform and, more
importantly, the business processes that explain why these firms are successful.

Benchmarking is used to measure performance using a specific indicator (cost per unit of
measure, productivity per unit of measure, cycle time of x per unit of measure or defects
per unit of measure) resulting in a metric of performance that is then compared to others.

Benchmarking may be a one-off event, but is often treated as a continuous process in

which organizations continually seek to improve their practices.

Quality circle

A quality circle or quality control circle is a group of workers who do the same or
similar work, who meet regularly to identify, analyze and solve work-related problems.
Normally small in size, the group is usually led by a supervisor or manager and presents
its solutions to management; where possible, workers implement the solutions themselves
in order to improve the performance of the organization and motivate employees. Quality
circles were at their most popular during the 1980s, but continue to exist in the form of
Kaizen groups and similar worker participation schemes.

Standardization'
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Standardization is a framework of agreements to which all relevant parties in an industry
or organization must adhere to ensure that all processes associated with the creation of a
good or performance of a service are performed within set guidelines. This ensures that
the end product has consistent quality and that any conclusions made are comparable
with all other equivalent items in the same class.

Standardization is achieved by setting generally accepted guidelines in regards to how a

product or service is created or supported, as well as to how a business is operated or how
certain required processes are governed. The goal of standardization is to enforce a level
of consistency or uniformity to certain practices or operations within the selected
environment.

Computer-aided design (CAD) is the use of computer systems (or workstations) to aid
in the creation, modification, analysis, or optimization of a design. CAD software is used
to increase the productivity of the designer, improve the quality of design, improve
communications through documentation, and to create a database for manufacturing.
CAD output is often in the form of electronic files for print, machining, or other
manufacturing operations. The term CADD (for Computer Aided Design and Drafting) is
also used.

Its use in designing electronic systems is known as electronic design automation, or

EDA. In mechanical design it is known as mechanical design automation (MDA) or
computer-aided drafting (CAD), which includes the process of creating a technical
drawing with the use of computer software.

A cross-functional team is a group of people with different functional expertise

working toward a common goal. It may include people from finance, marketing,
operations, and human resources departments. Typically, it includes employees
from all levels of an organization.

Cost–benefit analysis

Cost–benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a

systematic approach to estimating the strengths and weaknesses of alternatives (for
example in transactions, activities, and functional business requirements); it is used to
determine options that provide the best approach to achieve benefits while preserving
savings.

CBA has two main purposes:

1. To determine if an investment/decision is sound (justification/feasibility) –

verifying whether its benefits outweigh the costs, and by how much;

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 2. To provide a basis for comparing projects – which involves comparing the total
expected cost of each option against its total expected benefits.

In CBA, benefits and costs are expressed in monetary terms, and are adjusted for the
time value of money, so that all flows of benefits and flows of project costs over time
(which tend to occur at different points in time) are expressed on a common basis in
terms of their net present value.

Flowcharting

Flowcharting is a tool for analyzing processes. It allows you to break any process down
into individual events or activities and to display these in shorthand form showing the
logical relationships between them. Constructing flowcharts promotes better
understanding of processes, and better understanding of processes is a pre-requisite for
improvement.

These lines represent the flow of activity in the process being described; hence the name
of the technique.

Flowcharting, as a tool for clarifying situations and thus improving knowledge and
understanding, is particularly useful when used by a group or team. This is because by
drawing a flowchart together, the team,

 develops a common understanding of the situation

 contributes a larger pool of knowledge than an individual can (assuming team
members are well chosen for their knowledge and experience)
 can agree a common approach to solving problems, resolving ambiguities and
making improvements

Team leaders will find that drawing a flowchart progressively on a whiteboard or

flipchart, as team members contribute their information, opinions and ideas, will not only
identify problems and areas of confusion, but will automatically build consensus and
commitment by focusing the team’s attention on a single shared view of their task. Be
warned, however, that while flowcharting looks easy to do, it takes practice to use
effectively. It forces users to identify process steps so that they are clear and logical,
which is of course its principal purpose.

IMPORTANCE OR BENEFITS OF QUALITY CONTROL

1. Encourages quality consciousness:

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The most important advantage derived by introducing quality control is that it develops
and encourages quality consciousness among the workers in the factory which is greatly
helpful in achieving desired level of quality in the product.

2. Satisfaction of consumers:

Consumers are greatly benefited as they get better quality products on account of quality
control. It gives them satisfaction.

3. Reduction in production cost:

By undertaking effective inspection and control over production processes and

operations, production costs are considerably reduced. Quality control further checks the
production of inferior products and wastages thereby bringing down the cost of
production considerably.

4. Most effective utilization of resources:

Quality control ensures maximum utilization of available resources thereby minimizing

wastage and inefficiency of every kind.

5. Reduction in inspection costs:

Quality control brings about economies in inspection and considerably reduces cost of
inspection.

6. Increased goodwill:

By producing better quality products and satisfying customer’s needs, quality control
raises the goodwill of the concern in the minds of people. A reputed concern can easily
raise finances from the market.

7. Higher morale of employees:

An effective system of quality control is greatly helpful in increasing the morale of

employees, and they feel that they are working in the concern producing better and higher
quality products.

8. Improved employer-employee relations:

Quality control develops to better industrial atmosphere by increasing morale of

employees which ensures cordial employer-employee relations leading to better
understanding and closeness between them.

9. Improved techniques and methods of production:

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By supplying technical and engineering data for the product and manufacturing
processes, improved methods and designs of production are ensured by quality control.

10. Effective advertisement:

Organizations producing quality products have effective advertisement. They win the
public confidence by supplying those better quality products.

11. Facilitates price fixation:

By introducing quality control measures, uniform products of same quality are produced.
This greatly facilitates the problem of price fixation. One price of standard products
becomes prevalent in the market.

12. Increased sales:

Quality control ensures production of quality products which is immensely helpful in

attracting more customers for the product thereby increasing sales. It is greatly helpful in
maintaining existing demand and creating new demand for the product. It has been
rightly pointed out that quality control is a powerful instrument with the help of which
markets both at home and abroad can be expanded.

SOURCING

In business, the term word sourcing refers to a number of procurement practices, aimed
at finding, evaluating and engaging suppliers of goods and services:

 Outsourcing, the process of contracting a business function to someone else

 In sourcing, a process of contracting a business function to someone else to be
completed in-house
 Global sourcing, a procurement strategy aimed at exploiting global efficiencies in
production
 Strategic sourcing, a component of supply chain management, for improving and
re-evaluating purchasing activities
 Trade good sourcing, a process of finding the right suppliers who have gone
through the unique Trade good "Business done right" verification process by
Intertek, the global leading quality and safety company.
 Sourcing (personnel), the practice of recruiting talent using strategic search
techniques

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THE PROCUREMENT PROCESS

Identify Opportunities

Opportunities are usually triggered by a business requirement for a product or service.

Material requirements might include:

 Equipment
 Components
 Raw materials
 Completely finished products

Service requirements might include:

 Computer programmers
 Hazardous waste handlers
 Transportation carriers
 Maintenance service providers

Users (also called internal customers) identify a need for material or service
requirements, and communicate this need to purchasing.

Analyze the Situation

Situation analysis can include “Purchase Requisitions” or “Statements of Work.”

Purchase Requisitions should contain:

 Description of required material or service

 Quantity and date required
 Estimated unit cost
 Operating account to be charged
 Date of requisition (this starts the tracking cycle)
 Date required
 Authorized signature

Statements of Work (SOW) for services specify the work that is to be completed, when it
is needed, and what type of service provider is required.
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  Marketing may want to purchase an advertising campaign.
 R&D may need a clinical trial.
 Human resources may need to print a brochure.

Undertake Strategic Analysis

Procurement must work with the suppliers and its internal customers to analyze the
process to understand where opportunities exist to eliminate waste and increase value
delivery.

SUPPLIER DEVELOPMENT

Supplier development is defined by the Chartered Institute of Procurement & Supply as

“the process of working with certain suppliers on a one-to-one basis to improve their
performance and expand capabilities for the benefit of the buying organization.” Supplier
development can come in many different forms, from informal initiatives to a formally
structured program. There are numerous examples, use cases, and best practices that
show a broad spectrum of supplier development initiatives to fit any size organization or
supplier diversity program.

In reality, most supplier diversity programs already have some form of supplier
development activities occurring within their procurement organizations. As supplier
diversity and procurement professionals interact with diverse suppliers, they are often
teaching, guiding, and offering mentoring and development as well as other resources to
help foster growth. The idea of supplier development is to help diverse suppliers become
more sustainable in service to corporations and the marketplace as a whole.

Why Invest in a Supplier Development

The supplier diversity industry offers many success stories of why investing in supplier
development is essential for supplier diversity programs. Through focusing on supplier
development, organizations are able to generate many mutually beneficial opportunities,
including:

 Expanding the competitive landscape (pricing, service levels, and offerings)

between the organization’s existing and potential vendors
 Promoting innovation and “out-of-the-box” thought leadership through the
entrance of new products, services, and solutions in the business
 Growing the sources and channels from which to procure products and services
 Creating a collaborative environment between suppliers that may see themselves
as competitors, when in fact their solutions may be complementary, allowing
them to team up on business opportunities on which they could not normally bid

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  Showcasing the organization’s commitment to the economic growth of the
communities in which they operate
 Driving job creation
 Building the capacity of diverse businesses to not only serve the organization
more effectively but also increasing their sustainability in the entire marketplace
 Increasing the organization’s customer satisfaction, whether it be B2B or B2C
 Integrating supplier diversity into the strategic sourcing process, which will drive
corporate-supplier-diversity goal achievement
 Increasing visibility and awareness of executive management to key diverse
suppliers
 Fostering engagement of management executives across all parts of the
organization, not just Procurement

Supplier development affords corporations an opportunity to bring together teams of

suppliers to work in harmony for the benefit of the company, improving the bottom line
in the long run. Additionally, these approaches can showcase the organization’s
commitment to the economic growth of local communities, while building the capacity of
diverse businesses to serve the organization more effectively.

Supplier Development is segmented into five functions:

 Strategic Planning and Risk Definition
 Engagement, Collaboration and Project Management

 Quality Systems, Process and Controls

 Training and Facilitation
 Continuous Improvement and Surveillance

Supplier Development

"What is the purpose of a supplier development program?" At a minimum, a supplier

development program should be aimed at achieving the following:
 Lower supply chain total cost
 Increased profitability for all supply chain participants

 Increased product quality

 Near-perfect on-time-delivery at each point in the supply chain

Thus, a supplier development program must be aimed at improving suppliers

performance, not browbeating them into charging less or simply auditing and rewarding
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them. Instead, supplier development is all about providing suppliers with what they need
to be successful in the supply chain. Two of the most important functions of a supplier
development program are:

 Providing information about products, expected sales growth, etc. Poor

communication is one of the biggest wastes with a lean supply chain. Lack of
information translates into additional costs (usually in the form of just-in-case
inventory). Suppliers need to become extensions of their customers.
 Training in the application of lean and quality tools. Asking suppliers to drop their
price without giving them the know-how to lower their costs through lean
implementation is not sustainable long-term. In other words, this will drive
suppliers out of business, which goes against the purpose of supplier
development.

The benefits of a good supplier development program include:

 Sourcing cycle time reduced.

 Time-to-market reduced.
 Inventory costs lowered.
 Improved quality, reliability, and manufacturability of new designs
 Increased responsiveness to customer needs and market dynamics

 Improved collaboration and knowledge sharing.

Supplier evaluation

In-depth evaluation is required for major purchases. It is used for non-routine supply
items of higher value. It begins with a list of potential suppliers. Existing suppliers with
good track records should not be ruled out.

Supplier assessment criteria

1. Equipment and facilities

 Up-to-date?
 Ability to expand in the future?

2. Processes

 Ramp-up capabilities?
 Process cycle times?
 Reliable quality control program?
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  General housekeeping?
 Working conditions?
 Status of back orders?

3. Management Capabilities

 Project management skills?

 Stable, harmonious team?
 How do they view your company as a customer?
 Long-range strategic vision?
 Leadership?

4. Information Systems

 Up to date?
 Training requirements?

Supplier evaluation criteria

1. Planning and control systems

Planning and control systems include those systems that release, schedule, and control the
flow of work in an organization. As we shall see in later courses, the sophistication of
such systems can have a major impact on supply chain performance. Among the
questions the buying firm should ask:

 Does the supplier have well-developed systems for planning material, personnel,
and capacity needs? If not, why not?
 Does the supplier track key performance measures, such as throughput time,
quality levels, and costs? Are these measures compared to performance objectives
or standards?
 How easy is it for customers to interact with the supplier’s planning and control
systems?

2. Environmental regulation compliance

The 1990s brought about a renewed awareness of the impact that industry has on the
environment. The Clean Air Act of 1990 imposes large fines on producers of ozone-
depleting substances and foul-smelling gases, and governments have introduced laws
regarding recycling content in industrial materials. As a result, a supplier’s ability to
comply with environmental regulations is becoming an important criterion for supply
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chain alliances. This includes, but is not limited to, the proper disposal of hazardous
waste.

3. Minimum typical evaluations to consider

 Price
 Quality
 Service
 Delivery

SOURCING AND PROCUREMENT SERVICES

Sourcing and Procurement Services provides assistance with purchasing goods and
services. This includes training and assistance with all purchasing functions in the
financial system.

Buying Goods & Services

Buying goods and services include the ordering, receiving, and payment for all goods and
services used to support the mission of an organization. Sourcing and Procurement
oversees the various methods used to order goods and services

Before You Buy

Before you buy there are guidelines established that must be followed when buying
products and services.

Buying Methods

There are three methods for purchasing goods and services.

They are:

 The Marketplace (web-based, self-service, e-commerce tool) no spending limits

 The PCard (issued to the individual employee to make small purchases).
 A purchase requisition (processed and ordered by the Purchasing Department,
received and approved for payment by the department)

After you buy

After making a purchase the Sourcing and Procurement Services also can help you with
you’re after purchase needs and questions. This includes:
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  Change orders
 Tracking Market Place orders
 You did not receive your order
 Tracking your requisition
 Viewing your Requisition Status
 Merchandise received damaged

Sourcing involves all decisions related to procuring goods from suppliers.

Product sourcing involves the selection of a supplier for goods as well as the agreements
on specifications of the product and its delivery. It also can involve the sourcing of
services used in producing and marketing a product. The best sourcing methods depend
on the context, as each have their own advantages and disadvantages. Thus, sourcing
methods often change over time as a firm evolves.

In-House Sourcing

In-firm sourcing can involve extensive coordination of production processes as well as

adequate facilities and equipment. Purchasing such facilities and hiring qualified staff
may require significant funding and time, a potential disadvantage. However, in-house
sourcing gives firms a high level of control over the supply process and may ultimately
cut costs because firms aren't paying others to do the work. Controlling more aspects of
the supply chain is called value chain integration. Producing goods in-house also allows
firms to retain knowledge if manufacturing their products relies on technologies
developed in-house. In such cases, firms typically must still use direct material sourcing,
which is the procurement of the materials used to create the product.

Outsourcing

Purchasing goods or completed products from suppliers can be a major advantage if

manufacturing of the firm's products is highly complex. With outsourcing, firms may
simplify their operations. Challenges of outsourcing include knowing whether materials
were produced sustainably and in compliance with any applicable regulations and
standards. Firms can quickly gain negative publicity if their offshore suppliers violate
human rights, for example.

Customization

Project managers often work closely with suppliers to customize goods rather than
purchasing predesigned goods. Customers purchasing the products may have the
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opportunity to customize the products in highly specific ways. Customer satisfaction is a
major advantage of this strategy. The project manager must work closely with the
company manufacturing the goods. One major disadvantage is that if the manufacturing
firm halts operations or prices rise, the project manager may have great difficulty finding
a firm to fill that role.

Competitive Sourcing

In competitive sourcing, a project manager focuses on using financial leverage to drive

the best deal with a supplier. Price becomes a focal point, and the companies don't
necessarily expect to have a long-term relationship. This can help the project manager to
gain the best deal, but it may limit innovation and collaboration in product design.

Collaborative Sourcing

Conversely, collaborative sourcing aims to cultivate long-term, mutually beneficial

relationships with suppliers. The firms work together to create innovative products. This
helps a product manager to differentiate the firm's products from those of competitors and
to establish a reliable supply source. The product manager may pay more for the goods,
but the positive relationship between the firms often leads to a greater quality of products,
potentially improving return.

Evaluation Techniques for Potential Suppliers

Technique Description
Supplier Surveys ask a number of questions of the supplier, including referrals,
surveys references, P&L history, defect rate, and quality management system.
Financial Financial analysis can often prevent the expense of further study. This
condition analysis includes key financial metrics and ratios that assess the financial
analysis stability of the supplier. Credit ratings can also help determine whether
the supplier can meet the demands.
Third-party Trained third-party organizations are often hired to evaluate and audit
evaluators suppliers or even processes like handling of hazardous waste.
Evaluation Face-to-face discussion can help clarify specifications and determine
conference whether a supplier can meet the demands of a complex purchase.
Facility visits Many suppliers look good on paper, but visiting a site can help determine
whether there are inefficiencies. These visits usually include a cross
functional team with both strategic and tactical participants from the
buying firm. Weighted scorecards are often used during evaluation.
Quality The quality department and top management help to shape the quality
capability capabilities of a firm. Understanding the supplier quality philosophy and
30
Technique Description
analysis past quality performance can help determine whether the supplier is in
alignment with the buying company.

PURCHASE & CONTRACT MANAGEMENT

Contract management or contract administration is the management of contracts made

with customers, vendors, partners, or employees. The personnel involved in Contract
Administration required to negotiate, support and manage effective contracts are
expensive to train and retain. Contract management includes negotiating the terms and
conditions in contracts and ensuring compliance with the terms and conditions, as well as
documenting and agreeing on any changes or amendments that may arise during its
implementation or execution. It can be summarized as the process of systematically and
efficiently managing contract creation, execution, and analysis for the purpose of
maximizing financial and operational performance and minimizing risk.

Common commercial contracts include employment letters, sales invoices, purchase

orders, and utility contracts. Complex contracts are often necessary for construction
projects, goods or services that are highly regulated, goods or services with detailed
technical specifications, intellectual property (IP) agreements, and international trade.

CONTRACTS

A contract is a written or oral legally-binding agreement between the parties identified in

the agreement to fulfill the terms and conditions outlined in the agreement. A prerequisite
requirement for the enforcement of a contract, amongst other things, is the condition that
the parties to the contract accept the terms of the claimed contract.

Contracts can be of many types, e.g. sales contracts (including leases), purchasing
contracts, partnership agreements, trade agreements, and intellectual property
agreements.

• A sales contract is a contract between a company (the seller) and a customer

where the company agrees to sell products and/or services and the customer in return is
obligated to pay for the product/services bought.

• A purchasing contract is a contract between a company (the buyer) and a supplier

who is promising to sell products and/or services within agreed terms and conditions. The
company (buyer) in return is obligated to acknowledge the goods / or service and pay for
liability created.

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• A partnership agreement may be a contract which formally establishes the terms
of a partnership between two legal entities such that they regard each other as 'partners' in
a commercial arrangement.

Stages in Contract Placement

(STEP 1) Requirements Analysis (STEP 2) Evaluation Plan (STEP 3) Invitation to

Tender (STEP 4) Evaluation of Proposals

Change management

There may be occasions where what is agreed in a contract needs to be changed later on.
A number of bases may be used to support a subsequent change, so that the whole
contract remains enforceable under the new arrangement.

A change may be based on:

• A mutual agreement of both parties to vary the contract, outside the framework of
the existing contract. This would be an independent basis for changing the contract.

• A unilateral decision to vary the contract, contemplated and allowed for by the
existing contract. This would normally have notice periods for fairness and often the right
of the other, especially in consumer contracts, to cease the contractual relationship. Be
careful that any one-way imposition of change is contractually justified, otherwise it may
be interpreted as a repudiation of the original contract, enabling the other party to
terminate the contract and seek damages.

• A bilateral decision to vary the contracting, within the variation or change control
process outlined in the existing contract. These are often called change control
provisions.

Phases of Contract Management

Contract Management can be divided into five phases namely:

- Initial Phase

- Bid Phase

- Development Phase

- Manage Phase

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- Maintenance Phase

Contract management

Administrative activities associated with handling of contracts, such as;

(1) invitation to bid, (2) bid evaluation, (3) award of contract, (4) contract
implementation, (5) measurement of work completed, and (6) computation of payments.

It also includes monitoring contract relationship, addressing related problems,

incorporating necessary changes or modifications in the contract, ensuring both parties
meet or exceed each other's expectations, and actively interacting with the contractor to
achieve the contract's objective(s).

Procurement is the acquisition of goods, services or works from an outside external

source. It is favourable that the goods, services or works are appropriate and that they are
procured at the best possible cost to meet the needs of the purchaser in terms of quality
and quantity, time, and location .

Procurement steps

Procurement life cycle in modern businesses usually consists of seven steps:

• Identification of need: This is an internal step for a company that involves

understanding of the company needs by establishing a short term strategy ( three to five
years) followed by defining the technical direction and requirements.

• Supplier Identification: Once the company has answered important questions like:
Make-buy, multiple vs. single suppliers, then it needs to identify who can provide the
required product/service.

• Supplier Communication: When one or more suitable suppliers have been

identified, requests for quotation, requests for proposals, requests for information or
requests for tender may be advertised, or direct contact may be made with the suppliers.
References for product/service quality are consulted, and any requirements for follow-up
services including installation, maintenance, and warranty are investigated. Samples of
the P/S being considered may be examined, or trials undertaken.

• Negotiation: Negotiations are undertaken, and price, availability, and

customization possibilities are established. Delivery schedules are negotiated, and a
contract to acquire the P/S is completed.

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• Supplier Liaison: During this phase, the company evaluates the performance of
the P/S and any accompanying service support, as they are consumed. Supplier scorecard
is a popular tool for this purpose .When the P/S has been consumed or disposed of, the
contract expires, or the product or service is to be re-ordered, company experience with
the P/S is reviewed. If the P/S is to be re-ordered, the company determines whether to
consider other suppliers or to continue with the same supplier.

• Logistics Management: Supplier preparation, expediting, shipment, delivery, and

payment for the P/S are completed, based on contract terms. Installation and training may
also be included.

• Additional Step - Tender Notification: Some institutions choose to use a

notification service in order to raise the competition for the chosen opportunity. These
systems can either be direct from their e-tendering software, or as a re-packaged
notification from an external notification company.

Public procurement

Public procurement generally is an important sector of the economy.

Green public procurement

In Green public procurement (GPP), contracting authorities and entities take

environmental issues into account when tendering for goods or services. The goal is to
reduce the impact of the procurement on human health and the environment.

Procurement frauds

Procurement fraud can be defined as dishonestly obtaining an advantage, avoiding an

obligation or causing a loss to public property or various means during procurement
process by public servants, contractors or any other person involved in the procurement.
An example is the kickback, whereby a dishonest agent of the supplier pays a dishonest
agent of the purchaser to select the supplier's bid, often at an inflated price. Other frauds
in procurement include:

• Collusion among bidders to reduce competition.

• Providing bidders with advance "inside" information.

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• Submission of false or inflated invoices for services and products that are not
delivered or work that is never done. "Shadow vendors", shell companies that are set up
and used for billing, may be used in such schemes.

• Intentional substitution of substandard materials without the customer's

agreement.

• Use of "sole source" contracts without proper justification.

• Use of prequalification standards in specifications to unnecessarily exclude

otherwise qualified contractors.

• Dividing requirements to qualify for small-purchase procedures to avoid scrutiny

for contract review procedures of larger purchases.

FOUR ESSENTIAL ELEMENTS OF A CONTRACT

An agreement must contain four essential elements to be regarded as a contract. If any

one of them is missing, the agreement will not be legally binding.

1. Offer

There must be a definite, clearly stated offer to do something. For example: A quotation
by sub-contractor to the main contractor and an offer to lease.

An offer does not include ball park estimates, requests for proposals, expressions of
interest, or letters of intent.

An offer will lapse:

- When the time for acceptance expires;

- If the offer is withdrawn before it is accepted; or

35
 - After a reasonable time in the circumstances (generally the greater the value of the
contract, the longer the life of the offer).

Invitation to treat

An invitation to treat is a mere declaration of willingness to enter into negotiations; it is

not an offer, and cannot be accepted so as to form a binding contract. An agreement is not
created if there is an acceptance of the invitation to treat.

An invitation to treat is part of the preliminaries of negotiation, whereas an offer is

legally binding once accepted, subject to compliance with the terms of the offer. For
example: Invitations to treat are advertisements, price lists, circulars and catalogues.

2. Acceptance

Only what is offered can be accepted. This means that the offer must be accepted exactly
as offered without conditions. If any new terms are suggested this is regarded as a counter
offer which can be accepted or rejected.

There can be many offers and counter offers before there is an agreement. It is not
important who makes the final offer, it is the acceptance of that offer that brings the
negotiations to an end by establishing the terms and conditions of the contract.

Acceptance can be given verbally, in writing, or inferred by action which clearly

indicates acceptance (performance of the contract). In any case, the acceptance must
conform with the method prescribed by the offerer for it to be effective.

3. Intention of legal consequences

36
A contract requires that the parties intend to enter into a legally binding agreement. That
is, the parties entering into the contract must intend to create legal relations and must
understand that the agreement can be enforced by law.

The intention to create legal relations is presumed, so the contract doesn't have to
expressly state that you understand and intend legal consequences to follow.

If the parties to a contract decide not to be legally bound, this must be clearly stated in the
contract for it not to be legally enforceable.

4. Consideration

In order for a contract to be binding it must be supported by valuable consideration. That

is to say, one party promises to do something in return for a promise from the other party
to provide a benefit of value (the consideration)

Consideration is what each party gives to the other as the agreed price for the other's
promises. Usually the consideration is the payment of money but it need not be; it can be
anything of value including the promise not to do something, or to refrain from
exercising some right.

The payment doesn't need to be a fair payment. The courts will not intervene where one
party has made a hard bargain unless fraud, duress or unconscionable conduct is
involved.

SUBCONTRACTING

The practice of assigning part of the obligations and tasks under a contract to another
party is known as a subcontractor. Subcontracting is especially prevalent in areas where
complex projects are the norm, such as construction and information technology.
Subcontractors are hired by the project's general contractor, who continues to have
overall responsibility for project completion and execution within its stipulated
parameters and deadlines.

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'Subcontracting'

Subcontracting is very useful in situations where the range of required capabilities for a
project is too diverse to be possessed by a single general contractor. In such cases,
subcontracting parts of the project that do not form the general contractor's core
competencies may assist in keeping costs under control and mitigate overall project risk.
Advantages and disadvantages of subcontracting work (outsourcing

Advantages and disadvantages of subcontracting work

As you evaluate your choices and decisions in outsourcing different components of your
operations, you will need to consider the advantages of outsourcing. When done for the
right reasons, outsourcing will actually help your company grow and save money. There
are other advantages of outsourcing that go beyond money.

Advantages of outsourcing

1. Focus On Core Activities. In rapid growth periods, the back-office operations of a

company will expand also. This expansion may start to consume resources (human and
financial) at the expense of the core activities that have made your company successful.
Outsourcing those activities will allow refocusing on those business activities that are
important without sacrificing quality or service in the back- office.

2. Cost And Efficiency Savings Back-office functions that are complicated in nature, but
the size of your company is preventing you from performing it at a consistent and
reasonable cost, is another advantage of outsourcing.3. Reduced Overhead costs of
performing a particular back-office function are extremely high. Consider outsourcing
those functions which can be moved easily.

3. Operational Control Operations whose costs are running out of control must be
considered for outsourcing. Departments that may have evolved over time into
uncontrolled and poorly managed areas are prime motivators for outsourcing. In addition,
an outsourcing company can bring better management skills to your company than what
would otherwise be available.5. Staffing Flexibility Outsourcing will allow operations
that have seasonal or cyclical demands to bring in additional resources when you need
them and release them when you’re done.

4. Continuity & Risk Management Periods of high employee turnover will add
uncertainty and inconsistency to the operations. Outsourcing will provided a level of
continuity to the company while reducing the risk that a substandard level of operation
would bring to the company.

5. Develop Internal Staff. A large project needs to be undertaken that requires skills that
your staff does not possess. On-site outsourcing of the project will bring people with the

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skills you need into your company. Your people can work alongside of them to acquire
the new skill set.

DISADVANTAGES

1. Loss of Managerial Control. Whether you sign a contract to have another company
perform the function of an entire department or single task, you are turning the
management and control of that function over to another company. True, you will have a
contract, but the managerial control will belong to another company. Your outsourcing
company will not be driven by the same standards and mission that drives your company.
They will be driven to make a profit from the services that they are providing to you and
other businesses like yours.

2. Hidden Costs. You will sign a contract with the outsourcing company that will cover
the details of the service that they will be providing. Anything not covered in the contract
will be the basis for you to pay additional charges. Additionally, you will experience
legal fees to retain a lawyer to review the contacts you will sign. Remember, this is the
outsourcing company’s business. They have done this before and they are the ones that
write the contract. Therefore, you will be at a disadvantage when negotiations start.

3. Threat to Security and Confidentiality. The life-blood of any business is the

information that keeps it running. If you have payroll, medical records or any other
confidential information that will be transmitted to the outsourcing company, there is a
risk that the confidentiality may be compromised. If the outsourced function involves
sharing proprietary company data or knowledge (e.g. product drawings, formulas, etc.),
this must be taken into account. Evaluate the outsourcing company carefully to make sure
your data is protected and the contract has a penalty clause if an incident occurs.

4. Quality Problems. The outsourcing company will be motivated by profit. Since the
contract will fix the price, the only way for them to increase profit will be to decrease
expenses. As long as they meet the conditions of the contract, you will pay. In addition,
you will lose the ability to rapidly respond to changes in the business environment. The
contract will be very specific and you will pay extra for changes.5. Tied to the Financial
Well-Being of Another Company Since you will be turning over part of the operations of
your business to another company, you will now be tied to the financial well-being of that
company. It wouldn’t be the first time that an outsourcing company could go bankrupt
and leave you holding-the-bag.

5. Bad Publicity. The word "outsourcing" brings to mind different things to different
people. If you live in a community that has an outsourcing company and they employ
your friends and neighbors, outsourcing is good. If your friends and neighbors lost their
jobs because they were shipped across the state, across the country or across the world,
outsourcing will bring bad publicity. If you outsource part of your operations, morale
may suffer in the remaining work force.

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THE CONTRACT

A contract is a legally binding agreement between two or more parties. Usually, one party
is known as a buyer and another as a seller. The contract is the key to the buyer and seller
relationship. It provides the framework for how they will deal with each other.

Procurement contracts can be broadly divided into three categories:

1. Fixed-Price Contract

2. Cost Reimbursable Contract, and

3. Time and Materials

Please note that there is no hard-and-fast rule which governs the type of contract selected
for any particular situation. As a project manager, it will be your job to select a contract
type to satisfy your needs.

Fixed-Price Contract

A Fixed-Price Contract is also known as a lump-sum contract. This type of contract is

used when there is no uncertainty in the scope of work. Once the contract is signed, the
seller is contractually bound to complete the task within the agreed amount of money
and/or time. Due to the nature of the contract, the seller bears the majority of the risk, as
he must provide for the completion of the work as stipulated in the contract

A Fixed-Price Contract can be further divided into three categories:

1. Firm Fixed-Price Contract (FFP)

2. Fixed Price Incentive Fee Contract (FPIF)

3. Fixed Price with Economic Price Adjustment Contracts (FP-EPA)

The main advantage of Fixed-Price Contract is that both parties know the scope of the
work, and the total cost of the task before the work is started.

Generally, outsourcing and turnkey procurement contracts are signed under a fixed-price
contract on a deliverables basis.

This type of contract is very useful if the scope of work is defined accurately. Fixed-price
contracts are good for controlling the cost.

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However, changes in scope must be carefully observed. The cost of any change in scope
is very steep in fixed-price contract. I have seen that the contractors get the contract by
bidding the lowest price, and then try to generate extra revenue on any opportunity for
change requests, such as added scope.

I have also seen contractors fighting with the project manager regarding the scope.
Although they agreed initially, later they argue on small issues to raise the change request
to earn some extra money.

For this reason, you have to be very careful with this type of contract, make sure that the
scope is as detailed as well-defined and detailed as possible.

Firm Fixed-Price Contract (FFP)

This is the simplest type of procurement contract. In this type of contract, the fee is fixed.
The seller has to complete the job within an agreed amount of money and time. Any cost
increase due to bad performance of the seller will be the responsibility of the seller, who
is contractually bound to complete the job within the agreed amount.

A Firm Fixed-Price Contract is mostly used in government or semi-government contracts

where the scope of work is specified with every possible detail.

This type of contract is easy to float on the market, receive bids, and evaluate the bids
primarily on a cost basis.

Since the risk is borne by the seller, the cost tends to be higher. Another drawback of a
Firm Fixed-Price Contract is possible disputes between the buyer and the seller if the
scope is not clear. Moreover, any deviation from the original scope can cost you a lot.

Example: The seller has to complete the job for 100,000 USD within 18 months.

Fixed-Price Incentive Fee Contract (FPIF)

In this type of contract, although the price is fixed, the seller is given an additional
incentive based on his performance. This incentive lowers the risk borne by the seller.

The incentive can be tied to any project metrics such as cost, time, or technical
performance.

Example: 10,000 USD will be paid to contractor as an incentive if he completes the work
before two months.

Fixed-Price with Economic Price Adjustment Contracts (FP-EPA)

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If the contract is multi-year long, a Fixed-Price with Economic Price Adjustment
Contract is used. Here you include a special provision in a clause which protects the
seller from inflation.

Example: About 3% of the cost of the project will be increased after a certain time
duration based on the Consumer Price Index.

Purchase Order (PO)

This type of contract is used to buy commodities.

Example: Buy 10,000 bolts at the cost of 1.00 USD.

Cost Reimbursable Contract

This contract is also known as a Cost Disbursable Contract. In this type of contract, the
seller is reimbursed for completed work plus a fee representing his profit. Sometimes this
fee will be paid if the seller meets or exceeds the selected project objectives; for example,
completing the task before time or completing the task with less cost, etc.

A Cost Reimbursable Contract is used when there is uncertainty in the scope, or the risk
is higher. In this contract, since the buyer pays for all cost, he bears the risk.

Scope Creep is an inherent drawback of a Cost Reimbursement Contract, especially when

the requirements are unclear. The seller will always try to elevate the cost because it will
be tied to some sort of fee or reimbursement.

This difficulty can be minimized with proper management of the contract and capping the
seller’s profit; e.g. 10% of the total cost.

Cost Reimbursable Contracts can be further divided into four categories:

1. Cost Plus Fixed Fee Contract (CPFF)

2. Cost Plus Incentive Fee Contract (CPIF)

3. Cost Plus Award Fee (CPAF)

4. Cost Plus Percentage of Cost (CPPC)

A Cost Reimbursable Contract provides you with better cost control when you don’t have
a well-defined scope.

Cost plus Fixed Fee Contract (CPFF)

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In this type of contract, the seller is paid for all incurred costs plus a fixed fee (which will
not change), regardless of his performance. Here, the buyer bears the risk.

This type of contract is used in projects where risk is high, and no one is interested in
bidding. Therefore, this type of contract is selected to keep the seller safe from risks.

Example: Total cost plus 25,000 USD as a fee.

Cost plus Incentive Fee Contract (CPIF)

In a Cost plus Incentive Fee Contract, the seller will be reimbursed for all costs plus an
incentive fee based upon achieving certain performance objectives mentioned in the
contract. This incentive will be calculated using an agreed on predetermined formula.

Here the risk also lies with the buyer; however, this risk is lower than the Cost Plus Fixed
Fee where the buyer has to pay a fixed fee along with the cost incurred.

In a Cost Plus Incentive Fee Contract, the incentive is a motivating factor for the seller. If
the seller is able to complete the work with less cost or before time, he may get some
incentive.

Most of the time the incentive is a percentage of the savings, which is shared by the buyer
and the seller.

Example: If the project is completed with under budget, 25% of remaining fund will be
given to the seller.

Cost plus Award Fee (CPAF)

Here, the seller is paid for all his legitimate costs plus some award fee. This award fee
will be based on achieving satisfaction according to certain performance objectives
described in the contract.

The evaluation of performance is a subjective matter, and you cannot appeal it.

Note: There is a difference between the incentive fee and the award fee. An incentive fee
is calculated based on a formula defined in the contract, and is an objective evaluation.
An award fee is dependent on the satisfaction of the client and is evaluated subjectively.
Award fee is not subjected to an appeal.

Example: If the seller completes the task meeting or exceeding all quality standards,
based on his performance he may be given an award of up to 10,000 USD.

Cost plus Percentage of Cost (CPPC)

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Here the seller is paid for all costs incurred plus a percentage of these costs. This type of
contract is not preferred buy the buyer because the seller might artificially increase the
cost to earn a higher profit.

Example: Total cost plus 15% of cost as a fee to contractor.

Time and Materials Contract

This is a hybrid contract of Fixed-Price and Cost Reimbursable Contracts. Here the risk is
distributed to both parties.

A Time and Materials type of contract is generally used when the deliverable is “labor
hours.” In this type of contract, the project manager or the organization will provide the
required qualification or experience to the contractor who is responsible for providing the
staff.

This type of contract is used to hire some experts or any outside support.

Here the buyer can specify the hourly rate for the labor with a “not-to-exceed” limit.

Example: Technician will be paid 20 USD per hour.

Summary

Selecting the contract type is a very important decision for a project manager. It
determines your relationship with the seller and mitigates risk.

You should always select a contract which provides the optimum value for your time and
money, and protects your project from any risks. If the scope of work is well defined and
fixed, you should go for the Fixed-Price Contract. However, if the project scope is not
fixed and is exploratory, you should choose the Cost Reimbursable Contract.

TYPE OF CONTRACTS

Learning objectives

1. Identify factors that determine which type of contract to select.

2. Describe the types of fixed cost contracts.

3. Describe the types of cost reimbursable contracts.

44
4. Understand progress payments and how to reduce problems in changing the
contractors’ scope of work.

An agreement between the organization and an outside provider of a service or materials

is a contract. To limit misunderstandings and make them more legally binding, contracts
are usually written documents that describe the obligations of both parties and are signed
by those with authority to represent the interests of the parties.

Because legal agreements often create risk for the parent organization, procurement
activities are often guided by the policies and procedures of the parent organization. After
the project management team develops an understanding of what portions of the project
work will be outsourced and defines the type of relationships that are needed to support
the project execution plan, the procurement team begins to develop the contracting plan.
On smaller, less complex projects, the contract development and execution is typically
managed through the parent company or by a part-time person assigned to the project. On
larger, more complex projects, the procurement team can consist of work teams within
the procurement function with special expertise in contracting. The contract plan defines
the relationship between the project and the subcontractors (supplier, vendor, or partner)
and also defines a process for making changes in the agreement to accommodate changes
that will occur on the project. This change management process is similar to the change
management process used with the project agreement with the project client.

The contracting plan of the project supports the procurement approach of the project. The
following are some factors to consider when selecting the type of contract:

• The uncertainty of the scope of work needed

• The party assuming the risk of unexpected cost increases

• The importance of meeting the scheduled milestone dates

• The need for predictable project costs

There are several types of contracting approaches and each supports different project
environments and project approaches. The legal contracts that support the procurement
plan consist of two general types of contract: the fixed-price and the cost-reimbursable
contracts, with variations on each main type.

Fixed-Price Contracts

The fixed-price contract is a legal agreement between the project organization and an
entity (person or company) to provide goods or services to the project at an agreed-on
price. The contract usually details the quality of the goods or services, the timing needed
to support the project, and the price for delivering goods or services. There are several
variations of the fixed price contract. For commodities and goods and services where the

45
scope of work is very clear and not likely to change, the fixed price contract offers a
predictable cost. The responsibility for managing the work to meet the needs of the
project is focused on the contractor. The project team tracks the quality and schedule
progress to assure the contractors will meet the project needs. The risks associated with
fixed price contracts are the costs associated with project change. If a change occurs on
the project that requires a change order from the contractor, the price of the change is
typically very high. Even when the price for changes is included in the original contract,
changes on a fixed-price contract will create higher total project costs than other forms of
contracts because the majority of the cost risk is transferred to the contractor, and most
contractors will add a contingency to the contract to cover their additional risk.

Fixed-price contracts require the availability of at least two or more suppliers that have
the qualifications and performance histories that assure the needs of the project can be
met. The other requirement is a scope of work that is most likely not going to change.
Developing a clear scope of work based on good information, creating a list of highly
qualified bidders, and developing a clear contract that reflects that scope of work are
critical aspects of a good fixed-priced contract.

If the service provider is responsible for incorporating all costs, including profit, into the
agreed-on price, it is a fixed-total-cost contract. The contractor assumes the risks for
unexpected increases in labor and materials that are needed to provide the service or
materials and in the materials and timeliness needed.

The fixed-price contract with price adjustment is used for unusually long projects that
span years. The most common use of this type of contract is the inflation-adjusted price.
In some countries, the value of its local currency can vary greatly in a few months, which
affects the cost of local materials and labor. In periods of high inflation, the client
assumes risk of higher costs due to inflation, and the contract price is adjusted based on
an inflation index. The volatility of certain commodities can also be accounted for in a
price adjustment contract. For example, if the price of oil significantly affects the costs of
the project, the client can accept the oil price volatility risk and include a provision in the
contract that would allow the contract price adjustment based on a change in the price of
oil.

The fixed-price with incentive fee is a contract type that provides an incentive for
performing on the project above the established baseline in the contract. The contract
might include an incentive for completing the work on an important milestone for the
project. Often contracts have a penalty clause if the work is not performed according to
the contract. For example, if the new software is not completed in time to support the
implementation of the training, the contract might penalize the software company a daily
amount of money for every day the software is late. This type of penalty is often used
when the software is critical to the project and the delay will cost the project significant
money.

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If the service or materials can be measured in standard units, but the amount needed is
not known accurately, the price per unit can be fixed—a fixed unit price contract. The
project team assumes the responsibility of estimating the number of units used. If the
estimate is not accurate, the contract does not need to be changed, but the project will
exceed the budgeted cost.

Table of Fixed Price Contracts and Characteristics

Cost-Reimbursable Contracts

In a cost-reimbursable contract, the organization agrees to pay the contractor for the cost
of performing the service or providing the goods. Cost-reimbursable contracts are also
known as cost-plus contracts. Cost-reimbursable contracts are most often used when the
scope of work or the costs for performing the work are not well known. The project uses
a -reimbursable contract to pay the contractor for allowable expenses related to
performing the work. Since the cost of the project is reimbursable, the contractor has
much less risk associated with cost increases. When the costs of the work are not well
known, a cost-reimbursable contract reduces the amount of money the bidders place in
the bid to account for the risk associated with potential increases in costs. The contractor
is also less motivated to find ways to reduce the cost of the project unless there are
incentives for supporting the accomplishment of project goals.

Cost-reimbursable contracts require good documentation of the costs that occurred on the
project to assure that the contractor gets paid for all the work performed and to assure that
the organization is not paying for something that was not completed. The contractor is
also paid an additional amount above the costs. There are several ways to compensate the
contractor.

• A cost-reimbursable contract with a fixed fee provides the contractor with a fee,
or profit amount that is determined at the beginning of the contract and does not change.

• A cost-reimbursable contract with a percentage fee pays the contractor for costs
plus a percentage of the costs, such as 5% of total allowable costs. The contractor is
reimbursed for allowable costs and is paid a fee.

• A cost-reimbursable contract with an incentive fee is used to encourage

performance in areas critical to the project. Often the contract attempts to motivate
contractors to save or reduce project costs. The use of the cost reimbursable contract with
an incentive fee is one way to motivate cost reduction behaviors.

• A cost-reimbursable contract with award fee reimburses the contractor for all
allowable costs plus a fee that is based on performance criteria. The fee is typically based
on goals or objectives that are more subjective. An amount of money is set aside for the

47
contractor to earn through excellent performance, and the decision on how much to pay
the contractor is left to the judgment of the project team. The amount is sufficient to
motivate excellent performance.

On small activities that have a high uncertainty, the contractor might charge an hourly
rate for labor, plus the cost of materials, plus a percentage of the total costs. This type of
contract is called time and materials (T&M). Time is usually contracted on an hourly rate
basis and the contractor usually submits time sheets and receipts for items purchased on
the project. The project reimburses the contractor for the time spent based on an agreed-
on rate and the actual cost of the materials. The fee is typically a percentage of the total
cost.

Time and materials contracts are used on projects for work that is smaller in scope and
has uncertainty or risk and the project, rather than the contractor, assumes the risk. Since
the contractor will most likely include contingency in the price of other types of contracts
to cover the high risk, T&M contracts provide lower total cost to the project.

Table of Contract Types and Characteristics

To minimize the risk to the project, the contract typically includes a not-to-exceed
amount, which means the contract can only charge up to the agreed amount. The T&M
contract allows the project to make adjustments as more information is available. The
final cost of the work is not known until sufficient information is available to complete a
more accurate estimate.

PROGRESS PAYMENTS AND CHANGE MANAGEMENT

Vendors and suppliers usually require payments during the life of the contract. On
contracts that last several months, the contractor will incur significant cost and will want
the project to pay for these costs as early as possible. Rather than wait until the end of the
contract, a schedule of payments is typically developed as part of the contract and is
connected to the completion of a defined amount of work or project milestones. These
payments made before the end of the project and based on the progress of the work are
called progress payments. For example, the contract might develop a payment schedule
that pays for the development of the curriculum, and payment is made when the
curriculum is completed and accepted. There is a defined amount of work to be
accomplished, a time frame for accomplishing that work, and a quality standard the work
must achieve before the contractor is paid for the work.

KEY TAKEAWAYS

• Contract selection is based on uncertainty of scope, assignment of risk, need for

predictable costs, and the importance of meeting milestone dates.

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• Total fixed cost is a single price where the scope is well defined. A fixed price
with incentive contract offers a reward for finishing early or under budget or a penalty for
being late. A fixed price with adjustment allows for increases in cost of materials or
changes in currency values. A fixed unit price contract sets a price per unit, but the exact
number of units is not known.

• In a cost reimbursable contract, the project pays for costs. A cost plus fixed fee
contract assures the contractor of a known fee. A cost plus percentage fee calculates the
fee as a percentage of the costs. A cost plus incentive fee sets goals for the contractor to
achieve that would result in a bonus. A cost plus award fee is similar, but the goals are
more subjective. Time and materials contracts pay for costs plus an hourly rate for the
contractor’s time.

• Payments to vendors and suppliers are required during the course of the project. A
change management system needs to be in place when dealing with vendors and
suppliers.

The bidding process

If you are subsequently invited to bid, you will be sent all the documents.

Tenderers should carefully read the advert, tender documents and instructions for
tendering and pay close attention to:

• when and where to return a bid (time, date and correct building)

• using unmarked packaging, excluding company logo and so on

• Returning the bid in an appropriate format. Don't change the order of the
documentation, or submit alternative responses

• providing all information required

• signing and dating documentation where instructed

• not adding items to qualify the bid and no alternative bids.

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SUPPORT TOOLS FOR PURCGASING DECISION MAKING

FORECASTING TECHNIQUES

Forecasting is the process of making predictions of the future based on past and present
data and most commonly by analysis of trends. A commonplace example might be
estimation of some variable of interest at some specified future date. Prediction is a
similar, but more general term. Both might refer to formal statistical methods employing
time series, cross-sectional or longitudinal data, or alternatively to less formal judgmental
methods.

Risk and uncertainty are central to forecasting and prediction; it is generally considered
good practice to indicate the degree of uncertainty attaching to forecasts. In any case, the
data must be up to date in order for the forecast to be as accurate as possible.

CATEGORIES OF FORECASTING METHODS

Qualitative vs. quantitative methods

Qualitative forecasting techniques are subjective, based on the opinion and judgment of
consumers, experts; they are appropriate when past data are not available. They are
usually applied to intermediate- or long-range decisions. Examples of qualitative
forecasting methods are] informed opinion and judgment, the Delphi method, market
research, and historical life-cycle analogy.

Quantitative forecasting models are used to forecast future data as a function of past data.
They are appropriate to use when past numerical data is available and when it is
reasonable to assume that some of the patterns in the data are expected to continue into
the future. These methods are usually applied to short- or intermediate-range decisions.
Examples of quantitative forecasting methods are last period demand, simple and
weighted N-Period moving averages, simple exponential smoothing, Poisson process
model based forecasting and multiplicative seasonal indexes.

Time series methods

Time series methods use historical data as the basis of estimating future outcomes.

• Moving average, Weighted moving average, Kalman filtering, Exponential

smoothing, Autoregressive moving average (ARMA)

• Autoregressive integrated moving average (ARIMA)

Causal / econometric forecasting methods

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Some forecasting methods try to identify the underlying factors that might influence the
variable that is being forecast. Forecasting models often take account of regular seasonal
variations.

Several informal methods used in causal forecasting do not employ strict algorithms], but
instead use the judgment of the forecaster. Some forecasts take account of past
relationships between variables: if one variable has, for example, been approximately
linearly related to another for a long period of time, it may be appropriate to extrapolate
such a relationship into the future, without necessarily understanding the reasons for the
relationship.

Causal methods include:

• Regression analysis includes a large group of methods for predicting future values
of a variable using information about other variables. These methods include both
parametric (linear or non-linear) and non-parametric techniques.

• Autoregressive moving average with exogenous inputs (ARMAX)

Quantitative forecasting models are often judged against each other by comparing their
in-sample or out-of-sample mean square error, although some researchers have advised
against this.

Judgmental methods

Judgmental forecasting methods incorporate intuitive judgement, opinions and subjective

probability estimates. Judgmental forecasting is used in cases where there is lack of
historical data or during completely new and unique market conditions.

Judgmental methods include:

• Composite forecasts, Cooke's method, Delphi method, Forecast by analogy

• Scenario building, Statistical surveys, Technology forecasting

• Some socioeconomic forecasters often try to include a humanist factor. They

claim that humans, through deliberate action, can have a profound influence on the
future. They argue that it should be regarded a real possibility within our current
socioeconomic system that its future may be influenced by, to a varying degree,
individuals and small groups of individuals.

Forecasting accuracy

The forecast error (also known as a residual) is the difference between the actual value
and the forecast value for the corresponding period.

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where E is the forecast error at period t, Y is the actual value at period t, and F is the
forecast for period t.

A good forecasting method will yield residuals that are uncorrelated and have zero mean.
If there are correlations between residual values, then there is information left in the
residuals which should be used in computing forecasts. If the residuals have a mean other
than zero, then the forecasts are biased.

Training and test sets

It is important to evaluate forecast accuracy using genuine forecasts. That is, it is invalid
to look at how well a model fits the historical data; the accuracy of forecasts can only be
determined by considering how well a model performs on new data that were not used
when fitting the model. When choosing models, it is common to use a portion of the
available data for fitting, and use the rest of the data for testing the model, as was done in
the above examples.

Cross Validation

A more sophisticated version of training/test set.

for cross sectional data, cross-validation works as follows:

1. Select observation i for the test set, and use the remaining observations in the
training set. Compute the error on the test observation.

2. Repeat the above step for i = 1,2,..., N where N is the total number of
observations.

3. Compute the forecast accuracy measures based on the errors obtained.

This is a much more efficient use of the available data, as you only omit one observation
at each step

for time series data, the training set can only include observations prior to the test set.
therefore no future observations can be used in constructing the forecast. Suppose k
observations are needed to produce a reliable forecast then the process works as:

1. Select the observation k + i for test set, and use the observations at times 1, 2, ...,
k+i-1 to estimate the forecasting model. Compute the error on the forecast for k+i.

2. Repeat the above step for i = 1,2,...,T-k where T is the total number of
observations.

3. Compute the forecast accuracy over all errors

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This procedure is sometimes known as a "rolling forecasting origin" because the "origin"
(k+i -1) at which the forecast is based rolls forward in time

Limitations of Errors

The two most popular measures of accuracy that incorporate the forecast error are the
Mean Absolute Error (MAE) and the Root Mean Squared Error (RMSE). Thus these
measures are considered to be scale-dependent, that is, they are on the same scale as the
original data. Consequently, these cannot be used to compare models of differing scales.

Seasonality

Seasonality is a characteristic of a time series in which the data experiences regular and
predictable changes which recur every calendar year. Any predictable change or pattern
in a time series that recurs or repeats over a one-year period can be said to be seasonal. It
is common in many situations – such as grocery store or even in a Medical Examiner’s
office- that the demand depends on the day of the week. In such situations, the
forecasting procedure calculates the seasonal index of the “season” – seven seasons, one
for each day – which is the ratio of the average demand of that season (which is
calculated by Moving Average or Exponential Smoothing using historical data
corresponding only to that season) to the average demand across all seasons. An index
higher than 1 indicates that demand is higher than average; an index less than 1 indicates
that the demand is less than the average.

Cyclic behaviour

The cyclic behaviour of data takes place when there are regular fluctuations in the data
which usually last for an interval of at least two years, and when the length of the current
cycle cannot be predetermined. Cyclic behavior is not to be confused with seasonal
behavior. Seasonal fluctuations follow a consistent pattern each year so the period is
always known. As an example, during the Christmas period, inventories of stores tend to
increase in order to prepare for Christmas shoppers. As an example of cyclic behaviour,
the population of a particular natural ecosystem will exhibit cyclic behaviour when the
population increases as its natural food source decreases, and once the population is low,
the food source will recover and the population will start to increase again. Cyclic data
cannot be accounted for using ordinary seasonal adjustment since it is not of fixed period.

Applications

Forecasting can be described as predicting what the future will look like, whereas
planning predicts what the future should look like. There is no single right forecasting
method to use. Selection of a method should be based on your objectives and your
conditions (data etc.). A good place to find a method, is by visiting a selection tree. An
example of a selection tree can be found here. Forecasting has application in many
situations:

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• Supply chain management - Forecasting can be used in supply chain management
to ensure that the right product is at the right place at the right time. Accurate forecasting
will help retailers reduce excess inventory and thus increase profit margin. Studies have
shown that extrapolations are the least accurate, while company earnings forecasts are the
most reliable.[ Accurate forecasting will also help them meet consumer demand.

Limitations pose barriers beyond which forecasting methods cannot reliably predict.
There are many events and values that cannot be forecast reliably. Events such as the roll
of a die or the results of the lottery cannot be forecast because they are random events
and there is no significant relationship in the data. When the factors that lead to what is
being forecast are not known or well understood such as in stock and foreign exchange
markets forecasts are often inaccurate or wrong as there is not enough data about
everything that affects these markets for the forecasts to be reliable, in addition the
outcomes of the forecasts of these markets change the behavior of those involved in the
market further reducing forecast accuracy.

FOUR PRIMARY FORECASTING TECHNIQUES

Primary forecasting techniques help organizations plan for the future. Some are based on
subjective criteria and often amount to little more than wild guesses or wishful thinking.
Others are based on measurable, historical quantitative data and are given more credence
by outside parties, such as analysts and potential investors. While no forecasting tool can
predict the future with complete certainty, they remain essential in estimating an
organization's forward prospects.

Delphi Technique

The experts are kept apart and unaware of each other. The results of the first
questionnaire are compiled, and a second questionnaire based on the results of the first is
presented to the experts, who are asked to reevaluate their responses to the first
questionnaire. This questioning, compilation and requisitioning continues until the
researchers have a narrow range of opinions.

Scenario Writing

In Scenario Writing, the forecaster generates different outcomes based on different

starting criteria. The decision-maker then decides on the most likely outcome from the
numerous scenarios presented. Scenario writing typically yields best, worst and middle
options.

Subjective Approach

Subjective forecasting allows forecasters to predict outcomes based on their subjective

thoughts and feelings. Subjective forecasting uses brainstorming sessions to generate
ideas and to solve problems casually, free from criticism and peer pressure. They are

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often used when time constraints prohibit objective forecasts. Subjective forecasts are
subject to biases and should be viewed skeptically by decision-makers.

Time-Series Forecasting

Time-series forecasting is a quantitative forecasting technique. It measures data gathered

over time to identify trends. The data may be taken over any interval: hourly; daily;
weekly; monthly; yearly; or longer. Trend, cyclical, seasonal and irregular components
make up the time series. The trend component refers to the data's gradual shifting over
time. It is often shown as an upward- or downward-sloping line to represent increasing or
decreasing trends, respectively. Cyclical components lie above or below the trend line
and repeat for a year or longer. The business cycle illustrates a cyclical component.
Seasonal components are similar to cyclical in their repetitive nature, but they occur in
one-year periods. The annual increase in gas prices during the summer driving season and
the corresponding decrease during the winter months is an example of a seasonal event.
Irregular components happen randomly and cannot be predicted.

FORECASTING METHODS AND ANALYTICAL TOOLS

The OECD’s forecasts combine expert judgement with a variety of existing and new
information relevant to current and prospective developments. These include revised
policy settings, recent statistical outturns and conjectural indicators, combined with
analyses based on specific economic and statistical models and analytical techniques.

Assessing the current situation

An important starting point in the forecasting process is the re-assessment of the

economic climate in individual countries and the world economy as a whole. Here, a
combination of model-based analyses and statistical indicator models play an important
role in "setting the scene" at the start of each projection round.

These results are mechanical and therefore intended to be no more than a guide to the
informed judgments of country and topic experts on the underlying “forces acting”.

Key variables and relationships

In making the overall assessment of current and future economic performance in

individual countries, a number of key variables and relationships are examined, broadly
along the following lines:

• Domestic expenditures. Projections of private consumption and saving rates

typically take into account real disposable income, household wealth, changes in the rate
of inflation, monetary and financial conditions, and leading indicators of consumer
confidence and retail sales. Business fixed investment is mainly assessed in relation to
non-financial (sales, output and capacity utilisation) and financial (cash flow, monetary

55
conditions and interest rates) variables. Business sentiment and survey information is also
taken into account. Projections for residential construction typically take account of
demographic trends, housing stocks, real income and financial conditions, but also draw
on cyclical indicators for the construction sector. Projections of stockbuilding are usually
made with reference to relevant stock-output and stock-sales ratios in relation to normal
trends.

• Employment, wages and prices. Employment and other labour market trends are
generally assessed on the basis of actual and projected activity. Important additional
considerations relate to productivity trends, capacity constraints and costs.
Unemployment rate projections are derived from employment and labour supply
projections, with the latter assessed on the basis of demographic trends and participation
rate assumptions. Wage and earnings assessments take into account a number of key
factors, such as the pattern of current wage settlements data as a leading indicator.
Unemployment, labour market conditions, productivity and the terms of trade also
influence the overall projection for real wages and real compensation per employee. The
assessment of domestic prices and inflation trends depends on unit costs, the strength of
demand reflected by output gaps and foreign prices.

• Output gaps. The output gap is measured as the difference between actual and
estimated potential GDP, in volume terms and in per cent of potential GDP. Output gaps
are difficult to estimate and subject to substantial margins of error given that potential
output and structural unemployment rates are generally unobservable variables. OECD
work in this area generally follows a production function approach, taking into account
the capital stock, changes in labour supply, factor productivities and underlying "non-
accelerating inflation rates of unemployment" (NAIRU) .

• Foreign trade and balance of payments. In making the forecasts, particular

attention is paid to consistency at domestic and world levels, and to ensure that key
accounting identities and relationships are observed, notably with respect to international
trade and the balance of payments. For international trade volumes and prices, the
process is assisted by use of the OECD’s international trade model. Within this
framework, projections for aggregated import volumes of goods and services typically
take account of domestic activity (weighted expenditures) and relative price
competitiveness, giving additional weight however to current and past trend
developments in import penetration. Aggregate goods and services export volume
projections are generally linked to developments in export weighted markets,
competitiveness positions and trend export performance. Projections for export prices
take account of domestic labour costs and import prices, as well as competitors' export
prices, while import prices are derived as weighted averages of foreign and domestic
prices.

Fiscal analysis

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In assessing the fiscal situation of Member countries, the OECD uses a wide range of
indicators over a period of several years, since looking at one concept for a single year
could give a distorted picture, given changes in economic conditions and special one-off
factors.

More specifically, the cyclically-adjusted budget balance represents what government

revenues and expenditure would be if output were at its potential level. In evaluating the
stance of fiscal policy it is also useful to correct the cyclically adjusted balance for
interest payments on government debt since these payments do not represent
discretionary spending items. Thus, the primary cyclically-adjusted budget balance is
derived by adding back net interest payments to the cyclically-adjusted balance. Changes
in the primary cyclically-adjusted balance can then be used as a rough indicator for
changes in discretionary fiscal policies.

THE BASICS OF BUSINESS FORECASTING

It is not unusual to hear a company's management speak about forecasts: "Our sales did
not meet the forecasted numbers," or "we feel confident in the forecasted economic
growth and expect to exceed our targets." In the end, all financial forecasts, whether
about the specifics of a business, like sales growth, or predictions about the economy as a
whole, are informed guesses. In this article, we'll look at some of the methods behind
financial forecasts, as well as the actual process and some of the risks that crop up when
we seek to predict the future.

Financial Forecasting Methods

There are a number of different methods by which a business forecast can be made. All
the methods fall into one of two overarching approaches: qualitative and quantitative.

Qualitative Models

Qualitative models have generally been successful with short-term predictions, where the
scope of the forecast is limited. Qualitative forecasts can be thought of as expert-driven,
in that they depend on market mavens or the market as a whole to weigh in with an
informed consensus.

Qualitative models can be useful in predicting the short-term success of companies,

products and services, but meets limitations due to its reliance on opinion over
measurable data. Qualitative models include:

• Market Research Polling a large number of people on a specific product or service

to predict how many people will buy or use it once launched.

• Delphi Method: Asking field experts for general opinions and then compiling
them into a forecast.

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• Quantitative Models

Quantitative models discount the expert factor and try to take the human element out of
the analysis. These approaches are concerned solely with data and avoid the fickleness of
the people underlying the numbers. They also try to predict where variables like sales,
gross domestic product, housing prices and so on, will be in the long-term, measured in
months or years. Quantitative models include:

• The Indicator Approach: The indicator approach depends on the relationship

between certain indicators, for example GDP and unemployment rates, remaining
relatively unchanged over time. By following the relationships and then following
indicators that are leading, you can estimate the performance of the lagging indicators, by
using the leading indicator data.

• Econometric Modeling: This is a more mathematically rigorous version of the

indicator approach. Instead of assuming that relationships stay the same, econometric
modeling tests the internal consistency of data sets over time and the significance or
strength of the relationship between data sets. Econometric modeling is sometimes used
to create custom indicators that can be used for a more accurate indicator approach.
However, the econometric models are more often used in academic fields to evaluate
economic policies. (For a basic explanation on applying econometric models, read
Regression Basics For Business Analysis.)

• Time Series Methods: This refers to a collection of different methodologies that

use past data to predict future events. The difference between the time series
methodologies is usually in fine details, like giving more recent data more weight or
discounting certain outlier points. By tracking what happened in the past, the forecaster
hopes to be able to give a better than average prediction about the future. This is the most
common type of business forecasting, because it is cheap and really no better or worse
than other methods.

How Forecasting Work

1. A problem or data point is chosen. This can be something like "will people buy a high-
end coffee maker?" or "what will our sales be in March next year?"

2. Theoretical variables and an ideal data set are chosen. This is where the forecaster
identifies the relevant variables that need to be considered and decides how to collect the
data.

3. Assumption time. To cut down the time and data needed to make a forecast, the
forecaster makes some explicit assumptions to simplify the process.

4. A model is chosen. The forecaster picks the model that fits the data set, selected
variables and assumptions.

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5. Analysis. Using the model, the data is analyzed and a forecast made from the analysis.

6. Verification. The forecaster compares the forecast to what actually happens to tweak
the process, identify problems or in the rare case of an absolutely accurate forecast, pat
himself on the back.

Problem with Forecasting

Business forecasting is very useful for businesses, as it allows them to plan production,
financing and so on. However, there are three problems with relying on forecasts:

1. The data is always going to be old. Historical data is all we have to go on and there is
no guarantee that the conditions in the past will persist into the future.

2. It is impossible to factor in unique or unexpected events, or externalities. Assumptions

are dangerous, such as the assumptions that banks were properly screening borrows prior
to the subprime meltdown, and black swan events have become more common as our
dependence on forecasts has grown.

3. Forecasts can't integrate their own impact. By having forecasts, accurate or inaccurate,
the actions of businesses are influenced by a factor that can't be included as a variable.
This is a conceptual knot. In a worst case scenario, management becomes a slave to
historical data and trends rather than worrying about what the business is doing now.

The Bottom Line

Forecasting can be a dangerous art, because the forecasts become a focus for companies
and governments, mentally limiting their range of actions, by presenting the short to
long-term future as already being determined. Moreover, forecasts can easily breakdown
due to random elements that can't be incorporated into a model, or they can be just plain
wrong from the beginning. The negatives aside, business forecasting isn't going
anywhere. Used properly, forecasting allows businesses to plan ahead of their needs,
raising their chances of keeping healthy through all markets. That's one function of
business forecasting that all investors can appreciate.

INVESTMENT APPRAISAL

Investment appraisal is a collection of techniques used to identify the attractiveness of an

investment.

General

The purpose of investment appraisal is to assess the viability of project, programme or

portfolio decisions and the value they generate. In the context of a business case, the

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primary objective of investment appraisal is to place a value on benefits so that the costs
are justified.

There are many factors that can form part of an appraisal. These include:

• financial – this is the most commonly assessed factor;

• legal – the value of an investment may be in it enabling an organisation to meet

current or future legislation;

• environmental – the impact of the work on the environment is increasingly a

factor when considering an investment;

• social – for charitable organizations, return on investment could be measured in

terms of ‘quality of life’ or even ‘lives saved’;

• operational – benefits may be expressed in terms of ‘increased customer

satisfaction’, ‘higher staff morale’ or ‘competitive advantage’;

• risk – all organizations are subject to business and operational risk. An investment
decision may be justified because it reduces risk.

A financial appraisal is the most easily quantifiable approach but it can only be applied to
benefits that produce financial returns.

The simplest financial appraisal technique is the payback method. The payback period is
the time it takes for net cash inflow to equal the cash investment. This is a relatively
crude assessment and is often used simply as an initial screening process.

A better way of comparing alternative investments is the accounting rate of return (ARR)
which expresses the ‘profit’ as a percentage of the costs. However, this has the
disadvantage of not taking into account the timing of income and expenditure. This
makes a significant difference on all but the shortest and most capital-intensive of
projects.

In most cases, discounted cash flow techniques such as net present value (NPV) or
internal rate of return (IRR) are appropriate to evaluate the value of benefits and
alternative ways of delivering them. NPV calculates the present value of cash flows
associated with an investment; the higher the NPV the better. This calculation uses a
discount rate to show how the value of money decreases with time. The discount rate that
gives an investment a NPV value of zero is called the IRR. NPV and IRR can be
compared for a number of options.

Appraisal of capital-intensive projects and programmes should take into account the
whole-life costs across the complete product life cycle as there may be significant

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termination costs. In the case of the public sector, where income is usually zero, it is
common practice to identify the option with the lowest whole-life cost as the option that
offers the best value for money.

The appraisal on less tangible and non-financial factors is more subjective. In some cases,
a financial value may be calculated by applying a series of assumptions. For example,
work that improved staff morale may lead to lower staff turnover and reduce recruitment
costs. A financial appraisal of this benefit would have to include assumptions about the
numerical impact of increased morale on staff turnover and the estimated costs of
recruitment.

Where benefits cannot be quantified then scoring methods may be used to compare the
subjective value of benefits.

Project

Stand-alone projects will use investment appraisal to compare alternative approaches to

achieving the required benefits. Wherever possible, the project should use techniques that
are the organisational, programme or portfolio standard approach.

Where a project is part of a programme, the initial investment appraisal may be

performed by the programme management team. That does not exempt the project
management team from being familiar with the content of the appraisal or the techniques
used to perform it. It will still be responsible for keeping the business case up to date and
this will involve repeating the investment calculations to account for changing
circumstances.

Where a project is undertaken by a contracting organisation, the financial appraisal is

relatively straightforward as it will simply be a comparison of costs with the fee paid by
the client, probably using a discounted cash flow technique.

Programme

Programmes are usually defined to bring about organisational change. This inevitably
gives rise to a higher proportion of intangible and non-financial benefits being included
in the business case. Commercial programmes must be careful not to be overly dependent
on non-financial benefits, as anything can be justified through subjective views of value.

The programme management team must set out standards for the appraisal of the
component projects and their associated benefits. Consistent and compatible techniques
must be used across the programme so that individual project business cases can be
aggregated and summarised in the overall programme business case.

Portfolio

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In the definition phase of a portfolio there may be many ideas and suggestions for
projects and programmes to meet the strategic objectives. The portfolio management
team must establish a system for capturing and screening these ideas.

This is where broad-brush techniques such as payback may be used. A criterion may be
set that requires payback within the financial planning cycle. Any projects or
programmes that do not provide payback in that period are discarded. As the higher-
potential ideas are captured, they will be subject to more detailed, analytical techniques.

The prioritisation and balancing phases of the portfolio will rely heavily on how
investment appraisal has built the business cases of the component projects and
programmes. It is essential that the portfolio management team establishes standard
methods and consistent approaches across the portfolio to ensure reliable decision-
making. The team should also provide specialist advice and guidance on the use of
appraisal techniques to all project and programme teams.

The portfolio management team must also ensure that investment appraisals consider
potential investments in the context of the existing and planned projects and programmes.
For example, to identify opportunities for reuse of components and avoid double
counting of benefits.

COSTING TECHNIQUES DEFINITION

Costing techniques are methods for ascertaining cost-for-cost control and decision-
making purposes. They can be applied to make-or-buy decisions, negotiation, price
appraisal and assessing purchasing performance (Lysons & Farrington

METHODS AND TECHNIQUES OF COSTING

Methods of Costing:

Methods to be used for the ascertainment of cost of production differ from industry to
industry. It primarily depends on the manufacturing process and also on the methods of
measuring the departmental output and finished products.

Basically, there are two methods of costing (as per CIMA Terminology) viz.:

(i) Specific Order Costing (or Job/Terminal Costing) and

(ii) Operation Costing (or Process or Period Costing.)

Specific Order Costing is the category of basic costing methods applicable where the
work consists of separate jobs, batches or contracts each of which is authorised by a

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specific order or contract. Job costing, batch costing and contract costing are included in
this category.

Operation Costing is the category of basic costing methods applicable where standardized
goods or services result from a sequence of repetitive and more or less continuous
operations or process to which costs are charged before being averaged over units
produced during the period.

All these methods are discussed briefly as under:

1. Job Costing:

Under this method, costs are collected and accumulated for each job, work order or
project separately. Each job can be separately identified; so it becomes essential to
analyse the cost according to each job. A job card is prepared for each job for cost
accumulation. This method is applicable to printers, machine tool manufacturers,
foundries and general engineering workshops.

2. Contract Costing:

When the job is big and spread over long periods of time, the method of contract costing
is used. A separate account is kept for each individual contract. This method is used by
builders, civil engineering contractors, constructional and mechanical engineering firms
etc.

3. Batch Costing:

This is an extension of job costing. A batch may represent a number of small orders
passed through the factory in batch. Each hatch is treated as a unit of cost and separately
costed. The cost per unit is determined by dividing the cost of the batch by the number of
units produced in a batch. This method is mainly applied in biscuits manufacture,
garments manufacture and spare parts and components manufacture.

4. Process Costing:

This is suitable for industries where production is continuous, manufacturing is carried on

by distinct and well defined processes, the finished products of one process becomes the
raw material of the subsequent process, different products with or without by¬products
are produced simultaneously at the same process and products produced during a
particular process are exactly identical.

As finished products are obtained at the end of each process, it will be necessary to
ascertain not only the cost of each process but also cost per unit at each process. A
separate account is opened for each process to which all expenditure incurred thereon is
charged.

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The cost per unit is obtained by averaging the expenditure incurred on the process during
a certain period. Hence, this is known as average costing. As the products are
manufactured in a continuous process, this is also known as continuous costing.

5. One Operation (Unit or Output) Costing:

This is suitable for industries where manufacture is continuous and units are identical.
This method is applied in industries like mines, quarries, oil drilling, breweries, cement
works, brick works etc. In all these industries there is natural or standard unit of cost. For
example, a barrel of beer in breweries, a tonne of coal in collieries, one thousand of
bricks in brickworks etc.

The object of this method is to ascertain the cost per unit of output and the cost of each
item of such cost. Here cost accounts take the form of cost sheets prepared for a definite
period. The cost per unit is determined by dividing the total expenditure incurred during a
given period by the number of units produced during that period.

6. Service (or Operating) Costing:

This is suitable for industries which render services as distinct from those which
manufacture goods. This is applied in transport undertakings, power supply companies,
municipal services, hospitals, hotels etc. This method is used to ascertain the cost of
services rendered.

There is usually a compound unit in such undertakings, e.g., tone, kilometer (transport
undertaking), kilowatt-hour (power supply) and patient day (hospitals).

7. Farm Costing:

It helps in calculation of total cost and per unit cost of various activities covered under
farming. Farming activities cover agriculture, horticulture, animal husbandry (i.e., rearing
of live-stocks), poultry farming, fish culture (i.e., rearing of fish), dairy, sericulture (i.e.
silkworm breeding), nurseries for growing and selling of seedlings and plants and rearing
of fruits and flowers.

Farm costing helps to improve the farming practices to reduce cost of production, to
ascertain the profit on each line of farming activity which ensures better control by
management and to obtain loans from banks and other financial institutions as they give
loans on the basis of proper cost accounting records.

8. (Multiple) Operation Costing:

Multiple operation method of manufacture consists of a number of distinct operations. It

refers to conversion cost i.e., cost of converting the raw materials into finished goods.
This method takes into consideration the rejections in each operation for calculating input

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units and cost. The different operations in machine screw are—stamps, knurl, thread and
trim. The cost per unit is determined with reference to final output.

9. Multiple Costing:

It represents the application of more than one method of costing in respect of the same
product. This is suitable for industries where a number of component parts are separately
produced and subsequently assembled into a final product. In such industries each
component differs from the others as to price, material used and process of manufacture
undergone. So it will be necessary to ascertain the cost of each component.

For this purpose, process costing may be applied. To ascertain the cost of the final
product batch costing may be applied. This method is used in factories manufacturing
cycles, automobiles, engines, radios, typewriters, aero planes and other complex
products. This method has been dropped from the latest CIMA Terminology.

Types or Techniques of Costing:

Following are the main types or techniques of costing for ascertaining costs:

1. Uniform Costing:

It is the use of same costing principles and/or practices by several undertakings for
common control or comparison of costs.

2. Marginal Costing:

It is the ascertainment of marginal cost by differentiating between fixed and variable cost.
It is used to ascertain the effect of changes in volume or type of output on profit.

3. Standard Costing:

A comparison is made of the actual cost with a pre-arranged standard cost and the cost of
any deviation (called variances) is analyzed by causes. This permits management to
investigate the reasons for these variances and to take suitable corrective action.

4. Historical Costing:

It is ascertainment of costs after they have been incurred. It aims at ascertaining costs
actually incurred on work done in the past. It has a limited utility, though comparisons of
costs over different periods may yield good results.

5. Direct Costing:

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It is the practice of charging all direct costs, variable and some fixed costs relating to
operations, processes or products leaving all other costs to be written off against profits in
which they arise.

6. Absorption Costing:

It is the practice of charging all costs, both variable and fixed to operations, processes or
products. This differs from marginal costing where fixed costs are excluded.

Any of the methods of costing like unit or output costing, service costing, process costing
etc. can be used under any techniques of costing.

MODELING AND SIMULATION

Modeling and simulation (M&S) refers to using models – physical, mathematical, or

otherwise logical representation of a system, entity, phenomenon, or process – as a basis
for simulations – methods for implementing a model (either statically or) over time – to
develop data as a basis for managerial or technical decision making.[1][2] M&S supports
analysis, experimentation, and training. As such, M&S can facilitate understanding a
system's behavior without actually testing the system in the real world. For instance, to
determine which type of spoiler would improve traction the most while designing a race
car, a computer simulation of the car could be used to estimate the effect of different
spoiler shapes on the coefficient of friction in a turn. Useful insights about different
decisions in the design could be gleaned without actually building the car. In addition,
simulation can support experimentation that occurs totally in software, or in human-in-
the-loop environments where simulation represents systems or generates data needed to
meet experiment objectives. Furthermore, simulation can be used to train persons using a
virtual environment that would otherwise be difficult or expensive to produce.

Interest in simulations

Technically, simulation is well accepted. The 2006 National Science Foundation (NSF)
Report on "Simulation-based Engineering Science"[3] showed the potential of using
simulation technology and methods to revolutionize the engineering science. Among the
reasons for the steadily increasing interest in simulation applications are the following:

1. Using simulations is generally cheaper, safer and sometimes more ethical than
conducting real-world experiments. For example, supercomputers are sometimes used to
simulate the detonation of nuclear devices and their effects in order to support better
preparedness in the event of a nuclear explosion. Similar efforts are conducted to
simulate hurricanes and other natural catastrophes.

2. Simulations can often be even more realistic than traditional experiments, as they
allow the free configuration of environment parameters found in the operational
application field of the final product. Examples are supporting deep water operation of

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the US Navy or the simulating the surface of neighbored planets in preparation of NASA
missions.

3. Simulations can often be conducted faster than real time. This allows using them
for efficient if-then-else analyses of different alternatives, in particular when the
necessary data to initialize the simulation can easily be obtained from operational data.
This use of simulation adds decision support simulation systems to the tool box of
traditional decision support systems.

4. Simulations allow setting up a coherent synthetic environment that allows for

integration of simulated systems in the early analysis phase via mixed virtual systems
with first prototypical components to a virtual test environment for the final system. If
managed correctly, the environment can be migrated from the development and test
domain to the training and education domain in follow-on life cycle phases for the
systems (including the option to train and optimize a virtual twin of the real system under
realistic constraints even before first components are being built).

Simulation in science

Modeling and simulation is important in research. Representing the real systems either
via physical reproductions at smaller scale, or via mathematical models that allow
representing the dynamics of the system via simulation, allows exploring system behavior
in an articulated way which is often either not possible, or too risky in the real world.

As an emerging discipline

"The emerging discipline of M&S is based on developments in diverse computer science

areas as well as influenced by developments in Systems Theory, Systems Engineering,
Software Engineering, Artificial Intelligence, and more. This foundation is as diverse as
that of engineering management and brings elements of art, engineering, and science
together in a complex and unique way that requires domain experts to enable appropriate
decisions when it comes to application or development of M&S technology in the context
of this paper. The diversity and application-oriented nature of this new discipline
sometimes results in the challenge, that the supported application domains themselves
already have vocabularies in place that are not necessarily aligned between disjunctive
domains. A comprehensive and concise representation of concepts, terms, and activities
is needed that make up a professional Body of Knowledge for the M&S discipline. Due
to the broad variety of contributors, this process is still ongoing.

M&S Science contributes to the Theory of M&S, defining the academic foundations of
the discipline.

• M&S Engineering is rooted in Theory but looks for applicable solution patterns.
The focus is general methods that can be applied in various problem domains.

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• M&S Applications solve real world problems by focusing on solutions using
M&S. Often, the solution results from applying a method, but many solutions are very
problem domain specific and are derived from problem domain expertise and not from
any general M&S theory or method.

Models can be composed of different units (models at finer granularity) linked to achieve
a specific goal; for this reason they can be also called modeling solutions.

APPLICATION DOMAINS

There are many categorizations possible, but the following taxonomy has been very
successfully used in the defense domain, and is currently applied to medical simulation
and transportation simulation as well.

• Analyses Support is conducted in support of planning and experimentation. Very

often, the search for an optimal solution that shall be implemented is driving these efforts.
What-if analyses of alternatives fall into this category as well. This style of work is often
accomplished by simulysts - those having skills in both simulation and as analysts. This
blending of simulation and analyst is well noted in Kleijnen.

• Systems Engineering Support is applied for the procurement, development, and

testing of systems. This support can start in early phases and include topics like
executable system architectures, and it can support testing by providing a virtual
environment in which tests are conducted. This style of work is often accomplished by
engineers and architects.

• Training and Education Support provides simulators, virtual training

environments, and serious games to train and educate people. This style of work is often
accomplished by trainers working in concert with computer scientists.

Individual concepts

Although the terms "modeling" and "simulation" are often used as synonyms within
disciplines applying M&S exclusively as a tool, within the discipline of M&S both are
treated as individual and equally important concepts. Modeling is understood as the
purposeful abstraction of reality, resulting in the formal specification of a
conceptualization and underlying assumptions and constraints. M&S is in particular
interested in models that are used to support the implementation of an executable version
on a computer. The execution of a model over time is understood as the simulation.
While modeling targets the conceptualization, simulation challenges mainly focus on
implementation, in other words, modeling resides on the abstraction level, whereas
simulation resides on the implementation level. MODIFY BY KENBRAYO

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