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DEPARTMENT OF BUSINESS AND SOCIAL STUDIES

COURSE CODE: BBM3112

COURSE TITLE: GENERATION OF REQUIREMENTS

Instructional Material for BBM- Distance Learning

COURSE CODE: BBM3112

COURSE TITLE: GENERATION OF REQUIREMENTS

Contact hours: 42

Pre-requisites: BBM 214: Introduction to Purchasing and Supply Management

Purpose: Equip students with purchasing principles and techniques

Expected Learning Outcomes of the Course:

By the end of the course unit the learners should be able to:-

i) List and explain purchase descriptions and specifications

ii) Discuss the role f purchasing in new product development
iii) Describe outsourcing and make or buy decisions ad implications
iv) Describe the development of a buying plan

Course Content:

Purchase descriptions and specifications-approaches to balanced specifications; types of specifications;

importance of specifications; Role of purchasing in new product development- early supplier and
purchasing involvement in design, development and production; Standardization and simplification-
implications; industrial and international standards; metric conversion; usefulness of catalogs;
Outsourcing and make or buy decisions- strategic and tactical decisions and core competencies; factors
influencing make or buy decisions; Developing and managing a buying plan-reactive and proactive
purchasing

Course Assessment

Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total - 100%

Recommended Text Books:

i) Arjan Van Weele (2004), Purchasing And Supply Chain Management, PVT publishers, New Delhi
ii) Benton W C (2007), Purchasing & Supply Management, Routledge, London

Text Books for further Reading:

i) Michael Quayle (2005), Purchasing And Supply Chain Management: Strategies And Realities,
Routledge, London
TABLE OF CONTENT
 CHAPTER ONE: THE PURCHASE DESCRIPTIONS
Learning Objectives

By the end of this chapter the learner should be able to:

a) Identify the components of purchase descriptions

b) Describe the purchase descriptions flow
c) Explain methods of communicating material needs
d) Describe how to develop good purchasing descriptions
e) Discuss various approaches to specifications
f) Describe the general process of developing specifications

1.1 Introduction
Determining what materials and services to purchase is the first and one of the most
crucial steps in the procurement process. Responsibility for this determination varies with
the requirement. In many cases, the using department is responsible. For example, Plant
Engineering is responsible for
developing equipment requirements. Plant Operations develops requirements for
operating supplies such as drill bits, lubricating oils, and related items. Administrative
Services initiates requirements for office supplies, equipment, and services.
The responsibility for determining which component materials to specify for newly
designed products is a complex issue, complicated by the frequently conflicting interests,
orientations, and biases of the many departments that have an interest in the end item or
service. For example, Engineering may desire design excellence. Marketing may demand
nonstandard and unique features. Operations prefers long production runs utilizing
existing equipment, requiring few operators, and using high-quality, easy-to-work
materials. Purchasing prefers to buy readily available materials from several dependable
sources at reasonable prices.

Historically, Purchasing contributions to the organization's success have been seen as

being in two basic areas:
  ensuring the timely availability of required supplies and services and
 Obtaining them at economic prices.
However, these contributions are greatly expanded when purchasing is included at the
beginning of the design process. For instance, as material requirements are developed,
purchasing
should ensure that only essential needs are incorporated in the requirement. The
description of the
requirement (usually a specification) should not contain features that unduly limit
competition among qualified suppliers. Further, purchasing can help the designer to be
sensitive to the relative availability and cost of the alternative materials that may satisfy
product requirements. Timely availability of required materials and services usually is
enhanced by the availability of two or more qualified sources or carefully structured
strategic alliances.

1.2 Purchase requisitions/statement of work

The most common method of informing purchasing of material needs is through a

purchase requisition. Users may also transmit their needs by phone, by word of mouth or
through a computer generated method.

Although there are a variety of purchase requisition formats, every requisition should contain the
following;

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
Although varieties of formats exist, at a minimum a purchase requisition should include
a detailed description of the material or service, the quantity, date required ,estimated
cost and authorization. This form of communication for a specific need is called a
requisition. A requisition is an electronic or paper form that provides some critical
information about the need. A typical requisition will provide a description of the
product (e.g a valve) the material and color (brass, red valve), the quantity required (20
red brass valves), the intended purpose (20 red brass valves to be used in a maintenance
project for equipment XYZ) and the required date for delivery (three weeks).
Sometimes a service is required. For instance, marketing may want to purchase an
advertising campaign R & D may need a clinical trial or human resources may need to
print a brochure. In this case, the user will complete a statement of work (SOW) that
specifies the work that is to be completed, when it is need and what type of service
provider is required.

A standard purchase requisition or SOW is used most often for routine, noncomplex
items that are increasingly being transmitted through online requisitioning systems
linking users with purchasing. An online requisition system is an internal system
designed primarily to save time through efficient communication and tracking of
material requests. Users should use these systems only if they require purchasing
involvement. It is possible that users have access to other systems that will allow them to
purchase an item directly from a supplier such as corporate procurement card. In that
ease requisitions forwarded to purchasing are unnecessary.

There are wide differences across organizations in the quality and use of electronic
purchase requisition systems. A system that simply requires users to submit to
purchasing what they require for electronic transmission is similar to electronic mail. This
type of system provides little added value except to speed the request to purchasing.
Conversely, one system was so complex that users were afraid to use it.

This type of system provides little added value except to speed the request to purchase.
They bypassed online requisitioning and relied instead on the phone or intracompany
mail.

Exhibit 1.2.1 provides further details regarding how a purchase requisition is approved,
converted into a purchase order, and ultimately prepared for delivery and payment.
Although the user may suggest a supplier, purchasing has final selection authority.

Exhibit 1.2.1: Purchase Requisition Flow

Create
requisition

Approve
requisition

Generate PO
from Requisition PO

Vendor
Submit PO Product
to vendor

Order
Invoice
Received

Payment Refund

Acknowledge Match
receipt Invoive
with PO

Accounts
payable
settle invoice

For routine, off the shelf items, the requisition may contain all the information that
purchasing requires. However, for technically complex or nonstandard items, Purchasing
may require additional information or specifications with the requisition. Examples of
such specifications include the grade of material method of manufacture and detailed
measurements and tolerance. Purchasing may send an acknowledgment of the receipt of
the purchase requisition to the requestor. This acknowledgment often takes the form of a
confirming order requisition. The acknowledgement may be a separate form notifying the
user that purchasing has received and is processing the requisition, or it may he a copy of
the original requisition. The confirmation verifies the accuracy of the user’s material
request.

1.3 Methods of communicating material needs

There are various ways of communicating material needs, namely
1.3.1 Travelling purchase Requisitions/Bar Code
Materials needs are also communicated through a travelling purchase requisition – a
form consisting of a printed card or a bar code with information about whom the item is
purchased from. This method is used primarily for very small companies that have not
automated their purchasing or inventory management process. Information on the card
or the database entry associated with the bar code can include the following;
 Description of item
 List of approved suppliers
 Prices paid to suppliers
 Reorder points
 Record of usage
A travelling requisition can be helpful because it can conserve time when reordering
routine materials and supplies. When stock levels reach a specific reorder point an
employee notifies purchasing by forwarding the traveling requisition maintained with
the inventory or by electronically scanning the bar code into the ordering system. The
employee notes the current stock level and desired delivery date. To eliminate the need to
research information, the travelling requisition includes information required for the item
on the card (or in the data base) that otherwise would require research by a buyer. For
example the travelling requisition can include a list of approved suppliers, prices, a
history of usage and ordering and lead time information. Historical ordering information
is noted directly on the record over a period of time. As inventory systems are used less
frequently. With an automated system, clerks simply enter the order requirement and the
system generates a purchase requisition or automatically places an order.

1.3.2 Forecast and Customer Order

Customer orders can trigger a need for material requirements, particularly when changes
to existing products require new components. Customer order can also signal the need to
obtain existing materials. As companies increasingly customize products to meet the
needs of individual customers, purchasing must be ready to support new material
requirements. Market forecast can also signal the need for material. An increasing
product forecast, for example, may signal the need for additional or new material. If a
supplier is already selected to provide that material, then an automated ordering system
such as material requirements planning (MRP) systems may forward the material request
to suppliers automatically.

1.3.3 Reorder Point System

A reorder point system is a widely used way to identify purchase needs. Such a system
uses information regarded order quantity and demand forecast unique to each item or
part number maintained in inventory. Each item in a reorder point system, which is
usually computerized, has a predetermined order point and order quantity. When
inventory is depleted to a given level the system notifies the materials control department
(or the buyer, in some organizations) to issue a request to a supplier for inventory
replenishment. This signal might be a blinking light on a screen, a message sent to the
materials control departments e-mail address, or a computer report. Most recorder point
systems are automated using predetermined ordering parameters (such as an economic
order quantity, which considers inventory holding and order.

Most reorder point systems are automated using predetermined ordering parameters
(such as an economic order quantity, which consider inventory holding and ordering
costs). Electronic systems (such as material requirements planning systems) can instantly
calculate reorder point parameters. Most systems can also calculate the cost tradeoffs
between inventory holding costs, ordering cost and forecast demand requirements.
Reorder point systems are used for production and nonproduction items.

An automated reorder point system efficiently identifies purchase requirements. This

type of system can routinely provide visibility to current inventory levels and
requirement of thousands of parts number. The reorder point system is the most common
method for transmitting routine material order requests today, particularly for companies
that maintain spare part distribution centers.

1.3.4 Stock Checks

Stock checks (or cycle counts) involve the physical checking of inventory to verify that
system records (also called the record on hand, or ROH) match actual on hand inventory
levels also called the physical on-hand (POH) levels. If the physical inventory for an item
is below the system amount, an adjustment to that part record can trigger a reorder
request for additional inventory. Why might physical inventory be less than what the
computerized system indicates should be on hand? Placing material in an incorrect
location, damage that is not properly recorded, theft and short shipments from the
supplier that receiving did not notice all can contribute to the POH being less than the
ROH for example, at one major hardware retailer, missiong inventory on the shelf may be
located in another area of the store, or may simply be missing because f a problem with
the incorrect item being entered into the system.

Smaller firms that rely on standard, easy-to-obtain items often use stock checks to
determine material ordering requirements. In this environment, the stock check consists
of physically visiting a part location to determine if there is enough inventories to satisfy
user requirements. No purchase reorder is necessary if there is enough inventories to
satisfy user requirements. No purchase reorder is necessary if there are enough
inventories to cover expected requirements.

1.3.5 Cross-functional New-Product Development Teams

When users contact purchasing with a specific need, we say that purchasing is operating
in a reactive manner. When purchasing works directly with internal customers to
anticipate future requirements, such as during new product development purchasing is
being proactive. What does it mean to anticipate a requirement? If purchasing is part of
new product development teams, then the opportunity exists to see product designs at
early stages of the process. Purchasing can begin to identify potential suppliers for
expected requirements rather than reacting to an engineering requirements at a later date
anticipating requirements can contribute to faster products development cycle times and
better supplier evaluation and selection. As firms continue to be forced to reduce the time
required to develop new products cross-functional interactions will increasingly be the
means through which organizations identify, and hopefully anticipate, materials
requirements in the purchasing process cycle.

However the need is clarified, the point here is that a requisition document is completed
by requisitioner. A requisitioner is someone who is authorized by purchasing to complete
the needs clarification process. In some cases, the person who expresses the need can also
be the requisitioner. This occurs in case where the supplier has already been qualified,
and the individual who has the need can go to a supplier’s online catalogue, order the
product or service directly and pay for the item using a company purchasing credit card.
In such cases, the item is typically low cost, and it is not worth the expense and trouble
completing an entire requisition.

1.4 Developing the Right Purchase Description

Within the requisitioning, it is important to include a description of what is to be sourced.

Why? If the time is not spent to describe the product or service purchasing will have no
idea of what to go out and purchase! How purchasing accomplishes this will defer
dramatically from one situation to the next.
There are two main problems common in the area of purchase descriptions:
  Requiring activities frequently fail to consider the cost implications of alternative
proaches to describing their requirements.
 Purchasing departments often fail to conduct systematic procurement research and
analysis on alternate materials when appropriate.
The word requirement means "need," not product or service type, which is a solution to a
need. All purchasing starts with need determination, and this process eventually is
translated into products or services, which then direct us to potential suppliers and the
cost of the solution. Under appropriate circumstances, need determination may include
carefully screened suppliers. Jumping to a product skips the essential first step of
identifying alternatives and can result in automatic supplier selection,locked-in high
costs, mistakes causing very expensive change orders, and users doing the buying-all
potentially uneconomical actions. For example, if the need is to join two pieces of material
together, we can weld, bolt, glue, screw, or use other methods to fasten, that is, the need is
to "fasten together" and the requirement determination process is which method, then
which product, then which supplier.
This kind of thinking also forces the investigation of new methods and helps prevent the
continued use of obsolete products/procedures.

1.5 Classifying an Inventory Catalog

An inventory catalog should be coded according to several classifications, easily done
today with computer data systems. A few classic classifications are:

1. Buying-Using Experience. Is the product/service a new buy, modified rebuy (same

product type, slightly different need), or straight rebuy? This will determine the amount
of effort needed to determine the requirement. Most of the straight rebuys are via systems
contracts, electronic data interchange (EDI), and such; they should be "automated" with
requirements changed as the need dictates.
2. Value-Volume Relationships. This is the familiar ABC inventory analysis, which usually
starts with a finding that A items account for 80% of the dollars spent but represent just
20% of the physical volume, B items represent 15% of the dollars spent for 30% of the
physical volume, and C items represent 5% of the dollars for 50% of the physical volume.
This traditional analysis targets candidates for special study. Critical items that can shut
the operation down also qualify as A items. Requirements for A items are obviously the
top priority, for they are the real cost drivers.

3. Type of Product or Service. Capital goods, especially production machine tools, call for a
vastly different requirement determination than most raw materials or maintenance,
repair, and operating (MRO) supplies.
Coding your inventory catalog according to the above classifications have the following
advantages:
 facilitate rapid computer
 printouts to give direction to purchasing research assignments.
 It helps the purchasing department focus activities to achieve the highest payoff.
 It also helps to explore the questions of simplification and standardization to avoid
too many unnecessary requirements and/or slight variations adding little or
nothing to value.
 Serving a medium of communication by enabling staff to tell which items are carried in
the inventory, whether interchangeable items are carried in the inventory for missing
items . etc
 Acting as an inventory control tool through reduction of duplicate records for identified
parts.

1.6 The Importance of the Purchase Description

Once the buyer has known the need, he or she can now write the purchase description
that forms the heart of any procurement. the process of describing purchase is known as
specification. Specification can be defined as a statement of needs. It defines what the
purchaser wants to buy and, consequently, what the supplier is required to provide.
Specifications can be simple or complex depending on the need.
The success of the purchasing activity relies on the specification being a true and accurate
statement of the buyer’s requirements.
Apart from being a means of identifying the goods or services required, a specification
will form part of any future contract that might result from offers received.
The specification forms part of an “Invitation to Offer” document. Other elements in the
invitation document include the “Conditions of Offer”, the “Conditions of
Arrangement/Supply/Contract” and “Form of Offer” and response schedules.
Good specifications should:

• state the requirement clearly, concisely and logically in functional and performance
terms unless specific technical requirements are needed;
• for goods, state what the item will be used for;
• contain enough information for offerors to decide and cost the goods or services they
will offer and at what level of quality;
• permit offered goods or services to be evaluated against defined criteria by
examination, trial, test or documentation;
• state the criteria for acceptance of goods or services by examination, trial, test or
documentation;
• provide equal opportunity for all potential suppliers to offer goods or services which
satisfies the needs of the user, including goods or services incorporating alternative
solutions;
• form the fundamental basis of the contract between buyer and seller;
• not over-specify requirements; and
• not contain features that directly or indirectly discriminate against any suppliers

Whether a purchase order or contract will be performed to the satisfaction of the buyer
frequently is determined at the time the purchase description is selected or written. In no
other form of communication is there a greater need for clarity and precision of
expression. The extent of this precision has a major bearing on the successful completion
of the procurement.
Purchase descriptions serve a number of purposes. Some of these are used to do the
following:
* Communicate to the buyer in the purchasing department what to buy
* Communicate to prospective suppliers what is required.
* Serve as the heart of the resulting purchase order.
* Establish the standard against which inspections, tests, and quality checks are made.
The purchase description can greatly influence the amount of competition. The amount of
competition has a major impact on the purchase price. The type of purchase description
also may affect the "depth" of competition: This depth of competition may have an even
more pronounced effect on the purchase price.

1.7 Approaches to Describe What to Purchase (specifications)

a) Brand or Trade Name

The use of a brand name is the simplest way to describe what to purchase. A brand name
is used by a manufacturer to distinguish a product and to aid in its promotion. Brand
names ensure that the goodwill developed in satisfied customers is credited to the
product. Such goodwill requires that the manufacturer provide consistent quality. Using
a brand name description implies a reliance on the integrity and the reputation of the
manufacturer. When purchasing by brand name, the purchaser has every right to expect
that follow-on purchases of the brand name will possess the same quality as the original.
Normally the expression "or equal" should be used immediately following a brand name
to facilitate competition. When using an "or equal" after a brand name, it is desirable to
set forth those salient physical, functional, or other characteristics of the referenced
product that are essential to the purchaser's needs. The term or equal means that any
proposed item should be able to perform the function to the same level of satisfaction as
does the specified brand.
Although the use of brand names simplifies the procurement process, it tends to be
expensive. Even when competition is introduced through the use of the "or equal"
provision, higher prices tend to result than when several of the alternative descriptions of
the item are employed. Brand-name products generally are sold at higher prices than
unbranded products of similar quality. There are several advantages and disadvantages
in specifying brand names.
Advantages
* Describing the desired item is simple for the requiring department.
* Purchasing by brand name is relatively simple.
* Brand-name products tend to be more readily available than unbranded items.
* The use of a brand-name purchase description may be the most efficient method of
obtaining a desired level of quality or skill when this level of quality cannot be defined
easily.
* The branded item may be advertised so widely and successfully as to aid in promotion
of the product in which it will be incorporated.
* Inspection of brand-name items is relatively simple.
* Testing of an item may be impractical. The purchaser may avoid such testing by relying
on the brand-name manufacturer's quality standards and test reports.
* The purchaser is assured that the manufacturer will stand behind his or her brand-name
product.

Disadvantages
* Brand-name products usually cost more.
* Using brand-name products may mean that the purchaser is not taking advantage of
improvements introduced by competitors of the brand-name manufacturer.
* The use of the "or equal" provision may mean that items are purchased from a variety of
manufacturers. Since each manufacturer exercises its own quality control, the quality
variation probably will be larger than if the item were purchased from one source only or
purchased by detailed specification. When commonality of items from purchase to
purchase is essential, the use of "or equal" is not desirable.
 b) Samples
The need to develop a purchase description sometimes is avoided through the use of
samples.
Prospective suppliers are invited to match or duplicate the buyer's sample. Such an
approach may be appropriate when special, non repetitive items are to be purchased and
quality requirements are not a significant factor.
Advantage
* Use of samples is a very simple method of communicating what is required.
* It is almost mandatory when purchasing materials requiring a specific color, feel, finish,
or look, such as painted printed surfaces, fabric, style, film, packaging, signs, letterhead
stationary, and the like.
Disadvantages
* Detailed tests and inspections may be required to determine that the furnished item
meets the sample.
* The inspection on a requirement such as color may be very subjective.
* No definite standards are established either for record-keeping purposes or as the basis
of future purchases.
* If the sample is exactly reproduced, all performance warranty responsibilities shift to
the buyer as the supplier has performed as per the instructions from the buyer.

c) Standard Specifications
Recurring needs for a consistent level of quality have led industry and government to
develop standard specifications for many items. Standard specifications include
commercial standards, country specifications, and international specifications. Such
standard specifications contain descriptions of the quality of materials and the quality of
workmanship to be used in manufacturing the item. Testing procedures are included to
ensure that those quality standards are met.
Advantages
* The use of standard specifications greatly facilitates communications. The requirer,
purchaser, and supplier all know what is needed.
* The cost of developing a design specification is avoided.
* The use of standard specifications results in wider competition and lower prices.
* The use of standard specifications facilitates the firm's standardization program,
resulting in savings in purchase price, inspection, materials handling, and inventory
carrying costs.
* Standardized items tend to be more readily available.
* Designs developed by professional societies are often state of the art and thoroughly
tested.

Disadvantages
* Standard specifications may be dated. Accordingly, the buyer may not be taking
advantage of the latest technology.
* The specification may call for inputs or processes that are difficult or expensive to
achieve.
* Testing costs might be higher than with brand-name products, as there is less
performance history.
* As with samples, responsibility for the suitability of the purchased item rests with the
purchaser.
Normally, the supplier who produces under a specification cited in a purchase order is
not responsible for ensuring that the item will satisfy the customer's need. (With a
performance specification, this responsibility is shifted to the supplier.)
* The use of standard specifications results in the purchase of standardized items. The
incorporation of such standardized items in the purchaser's end product may conflict
with marketing's desire to sell a unique product.
 d) Design Specifications
Design specifications* spell out in detail the materials to be used, their sizes, shapes, and
tolerances, exact physical and chemical characteristics, and how the item is to be
fabricated. They provide a completely defined item capable of manufacture by a
competent manufacturer. They also describe test procedures to be used to verify that all
stated requirements have been met. The specification must meet the requirements of
many departments in the firm: Engineering's concern for technical adequacy, Marketing's
concern with consumer acceptance, Manufacturing's concern for ease of production, and
Purchasing's concern for availability and economy. As would be expected, design
specifications often use commercial standards and other standard specifications.

Since design specifications frequently are the basis of competitive bidding, they must
communicate what is needed without need for further clarification. Thus, critical
dimensions must be spelled out in detail, and all necessary quality requirements must be
fully described. Concomitantly the specification must avoid imposing unnecessary
conditions that would disqualify an otherwise acceptable product because it fails to meet
a nonessential condition. The design specification must convey a complete and accurate
understanding of what is required. The same word or expression is subject to different
interpretations by different people. The supplier will interpret the specification to its own
advantage.

A specification essentially is the means of transferring knowledge between minds. Each

mind will test the words of a specification against its own experience. If the design
specification is ambiguous, the ambiguity will be construed against. Blueprints and
engineering drawings are included under the heading of design specifications. Blueprints
and drawings should include a statement of function.
When design specifications control performance under a purchase order or a contract,
there is a presumption that the specifications are adequate for the purposes intended and
that, if followed, the desired outcome will be obtained. There is an implied warranty that
the specifications are adequate. Thus, the supplier who produces under the customer's
specification is not responsible for the suitability or acceptability of the resulting product.
However, if the supplier knows (or perhaps from experience should know) that the
desired product cannot be obtained, it cannot make a useless thing and expect to be paid
for it. If the supplier knows (or should have known) that the specification is defective, it is
obligated to notify the customer of the defect. The supplier discharges this obligation by
making the defect known to the customer.
As might be expected, design specifications must be reviewed periodically and updated.
Unfortunately, the use of design specifications tends to complicate purchase order
administration (follow-up and expediting) and may increase costs, delay delivery result
in delivery of obsolete items, and sharply increase inventory carrying costs. The use of
design specifications may create a costly storage and distribution system for items that
are not generally commercially available.

There are several advantages and disadvantages in using design specifications.

Advantages
* The purchasing organization avoids having to purchase on a sole-source basis.
savings can be enjoyed by avoiding sole-source situations.
* The purchasing organization avoids paying premium prices on branded goods.
* Design specifications facilitate the corporate standardization program, and many
savings are enjoyed through such a program.
* They can solve the problem of "no supplier can design it," if true.

Disadvantages
* Design specifications are expensive to develop. Both time and human resources are
required.
* The purchaser is responsible for the adequacy of the specification and the buying firm
may use obsolete technology.
* The use of design specifications may deny the purchaser the latest advances in both
technical
development and manufacturing processes.
* Using a design specification for material that is very similar to an item covered by a
commercial standard may result in higher unit prices. Further, the item covered by the
design specification will tend to be less readily available.
* The use of design specifications restricts competition to one approach or concept. As we
have seen, competition of concepts resulting from use of a performance specification may
lead to significant financial and time savings.
* Purchase through the use of design specifications tends to complicate the purchase
order administration function. Late delivery of unique items is much more common than
it is for standard ones.
* The purchaser usually assumes the inventory responsibility for such unique items.

e) Performance Specifications

Performance specifications generally describe a product by its capacity, function, or

operation instead of by its physical, chemical, or quality characteristics. The supplier need
only demonstrate acceptable performance to achieve acceptance of the product.

A performance specification provides a description of the intended use of an item

(whether component, plant, or equipment). A performance specification may include a
statement of the qualitative nature of the item required. When necessary, it may set forth
those minimum essential characteristics and standards to which such item must conform
to satisfy its intended use. Performance specifications describe in words what the item is
to do instead of describing the item in terms of its physical and chemical properties.

Although a performance specification is much shorter and easier to develop than a design
specification, caution must be exercised in its development. Once again, engineering,
marketing, manufacturing, and purchasing requirements must be considered.

The following general principles apply to the development of performance specifications:

* The performance specification must not be so narrow that it stifles creativity.
* While unnecessarily restrictive performance specifications are undesirable, the
performance specification must be sufficiently specific to obtain desired objectives. If it is
written too broadly, potential suppliers may choose not to respond because of the
uncertainty and risk involved, their inability to relate work requirements to their talents
and capabilities, or difficulties in estimating costs.
* The performance specification serves as the nucleus of the purchase order or contract.
The resulting performance is a direct function of the quality, clarity, and completeness of
the specification.
* The element of risk to the supplier inherent in producing under the performance
specification should affect the type of pricing on the resulting purchase order (e.g., firm
fixed price, fixed-price incentive).

As with other approaches to defining and communicating the requirement, the use of
performance specifications has inherent advantages and disadvantages.

Advantages
* Performance specifications are relatively easy to prepare.
* Their use tends to avail the purchaser of the latest technology.
* Using performance specifications ensures that the purchaser obtains the specified
(desired) level of quality.
* When several already designed, developed, and produced items can meet the
performance specification, the depth of competition is enhanced and purchase costs are
reduced.
* Performance specifications allow a greater degree of innovation by suppliers. Under
performance specifications, the supplier assumes the responsibility of providing a
product suitable to the purchaser's need.
Disadvantages
* Marginal suppliers look for loopholes in specifications. Care and effort must be taken to
screen potential suppliers to ensure that only reputable ones are asked to submit
proposals. The use of performance specifications is restricted by purchasing's ability to
select capable and ethical suppliers-the kind who do not look for loopholes.
* Competition tends to be reduced when the performance specification requires potential
suppliers to perform considerable engineering in preparation for submitting a bid or
proposal. Reduced competition may result in higher prices.

1.8 The general process of developing the specifications

Step 1: Planning and analysis

The foundation of a good specification is in the planning and analyses which are
undertaken before writing begins. Key people who can help such as purchasing staff,
technical officers, project officers and managers and end users need to be involved.
Planning and analysis will provide a better understanding of the requirement(s) and may
reveal alternative solutions.
Planning and analysis are particularly important when developing complex
requirements. These may take some time to define, perhaps even years in the case of
major equipment. The accuracy and detail of the definition is likely to improve as
information is gathered and assimilated.
Define the requirement(s) and then approach industry to see what is available to meet the
department’s/agency’s needs. If industry is approached too early in the development
process, there is the risk of deciding the solution to the problem before the requirement(s)
is fully defined.

In some cases potential solutions may be discovered and explored which may allow
refinement of needs. Think in terms of the performance required or the functions to be
performed. In other cases, however, solutions may not be readily available or there could
be the danger in stating a solution up front that may restrict offers of alternative
solutions. In this situation, a full explanation of the issue or problem is needed.
Breaking down the requirement(s) in terms of function and performance will better
define the need. Defining the requirement(s) in terms of the lowest level functions or sub
components should also help to discover conflicts and inconsistencies within the
requirement(s). Alternative solutions, too, may be revealed in the process.
Value analysis could be used to highlight and explore possible solutions. It is a complex
cost analysis technique that requires expertise for its successful use. In simple terms, value
analysis looks for the optimum way of using materials, designs, equipment etc. to meet a
(functional) requirement while providing savings over the life of the equipment or at the
initial purchase stage. The technique is particularly useful in identifying potential,
innovative solutions.

Step 2: Consultations and information gathering

Developing specifications requires consultation and can be perceived as an evolutionary

process involving close and continuous liaison between the end-user, technical officers,
project officers/managers, purchasing officers and the specification writer.
Valuable information and advice relating to the requirement can be obtained by
discussing it with purchasing officers, technical officers and other users of similar goods
or services within the department/agency. Purchasing officers should be involved from
the start of the process (that is, the information gathering and design stages).
Other sources of information include:
• Other departments or agencies (including Federal and Local Governments);
• Industry - either industry associations or particular companies (ensure that industry
does not assume pre-offer negotiations);
• Educational institutions, for example, universities and TAFE Institutes;
•Country standards;
• Industrial Supplies Office Ltd (ISO Queensland) which can assist in identifying and
evaluating appropriate local industry capabilities; and
• other users of the goods or services.
These organizations may help to refine the requirement and also suggest potential
solutions.

Step 3: Writing specifications

• Use simple, clear language without jargon (to minimize misinterpretation).

• Define terms, symbols and acronyms (include a “Glossary of Terms”).
• Be concise.
• Do not explain the same requirement in more than one section.
• Define each aspect of the requirement in one or two paragraphs where possible.
• Adopt a user-friendly format.
• Number the sections and paragraphs.
• Seek feedback from someone unfamiliar with the requirement.
• Discuss the draft and refine it.
There are no fixed rules on formats and structures because each specification reflects a
different requirement or need. A specification should list the functional, performance and
technical characteristics separately.
Refine the structure before writing by discussing with colleagues and purchasing officers.
Include tables, sketches, diagrams, or statistical matter if these help to make the
specification clearer. Be careful that these types of information do not limit the options for
offerors to provide alternative solutions.

Step 4: Vetting specifications and obtaining approval

After writing the specification, ask a colleague who is unfamiliar with the requirement to
critique it from a potential supplier’s view.

Try to identify improvements by considering:

• readability,
• simplicity of meaning,
• clarity, and
• logic.
Seek approval from the appropriate financial or purchasing delegates in the
department/agency after vetting the specification but before issuing it.

Step 5: Issuing the specifications

The specification should be included as part of the “Invitation to Offer” document. The
“Invitation to Offer” should target suppliers that are capable of meeting the specification
by direct approach (after market analysis) or through advertising in newspapers,
websites and industry magazines, etc.

Step 6: managing amendments to the specifications

Should a need arise to amend the specification during the “Invitation to Offer” process,
the amendment should be authorized by the project manager. The amended specification
should be noted in the project files and all offerors or potential offerors must be given a
reasonable opportunity to offer to the new specification.

Step 7: Revising and storing the specifications

The specification should be reviewed at the end of the purchasing activity to ensure that
it effectively defined the goods or services that were actually bought. If areas for
improvement are identified, revise the specification with the benefit of hindsight.
When the review of the specification has been completed and if it relates to goods or
services that are likely to be purchased frequently, keep it on file. Before each purchase,
review the specification to ensure that it reflects your department’s/agency’s needs at
that time. Alternatively, institute a program to review specifications on a regular basis.
1.9 Selecting the Right Approach to Describing Requirements
Although the decision on what type of purchase description to use may appear to be
simple, many factors complicate the issue. For small, non critical procurements, brand
names or samples frequently best describe requirements. The use of a brand name as a
purchase description is appropriate to:
 Obtain the desired level of quality or skill when these are not described easily,
 Gain the benefits of wide advertising of the brand-name item that would aid in
promotion of the purchaser's end product,
 Accommodate users who have a bias or prejudice (whether founded or
unfounded) in favor of the brand. Such prejudices can be virtually impossible to
overcome.
When brand names or samples are inappropriate for describing requirements, some type
of specification is employed. When selecting or developing the specification,
consideration must be given to the importance of competition and the desirability of
avoiding unnecessarily restrictive criteria.

Once a need has been identified and functionally described, and when the size of the
contemplated purchase warrants, procurement research and analysis should be
conducted to investigate the availability of commercial products able to meet the
company's need. Normally, these commercial products are described by one of the
standard specifications. This research and analysis also should provide information to aid
in selecting a procurement strategy appropriate to the situation.
Procurement research and analysis involves obtaining the following information as
appropriate:
* The availability of products suitable to meet the need (with or without modification)
* The terms, conditions, and prices under which such products are sold
* Any applicable trade provisions or restrictions or controlling laws
* The performance characteristics and quality of available products, including quality
control and test procedures followed by the manufacturers
* Information on the satisfaction of other users having similar needs
* Any costs or problems associated with integrating the item with those currently used
* Industry production practices, such as continuous, periodic, or batch production
* The distribution and support capabilities of potential suppliers
If a suitable commercial product is unavailable at a reasonable price, a determination
should be made on whether to use a design or a performance specification.

Summary
Once the need or required function is determined, the purchase description forms the
heart of the procurement. The organization's satisfaction with the purchased item
frequently is determined at the time the purchase description is selected or developed.
Purchase descriptions communicate to the buyer what to purchase, communicate to
prospective suppliers what is required, serve as the principal element of the resulting
purchase order or contract, and establish standards for inspection.
Five types of purchase descriptions have been described: brand or trade names, samples,
standard specifications, design specifications, and performance specifications. Each has
inherent advantages and disadvantages; no one approach is right or best in all
circumstances.
 Review Questions

i) Define the following terms:

a) Purchase descriptions
b) Purchase requisitions or statements of work
ii) Describe the purchase descriptions flow
iii) Discuss various methods used in communicating material needs
iv) explain how good purchasing descriptions are developed
what are the various approaches to specifications
v) Describe the general process of developing specifications

Suggested Further Readings

Arjan Van Weele (2004), Purchasing and Supply Chain Management, PVT publishers, New Delhi

Benton W C (2007), Purchasing and Supply Management, Routledge, London

 CHAPTER TWO
STANDARDIZATIONS AND SIMPLIFICATIONS OF MATERIALS AND
COMPONENTS
Learning Objectives

By the end of this chapter the learner should be able to:

a) Define the following terms:

 Standards
 Simplifications
b) Explain various types of standards classifications
c) Identify items to be standardized
d) Discuss the importance of standardizations and simplifications
e) Explain the methods of standardization
f) Discuss how simplifications are achieved

2.1 Introduction
A standard is defined as a model or general agreement or a rule established by authority,
consensus, or custom, created and used by various level of interest.

Standardization is the orderly and systematic formulation, adoption, application and

review of industrial standard which lead to simplification or variety reduction.

This implies reducing unnecessary varieties and standardizing to the most economical
sizes, grades, shapes, colour or types of parts. The word “standard” is multivalued as it
may means physical standard prototype of mass or a technical document. Industrial
standard s is the generally accepted statement of the requirement.

Standardization eliminates the rule thumb method as the width of the thumb varies
widely from one individual to another.

Simplification is the process of reducing the variety of items. It reduces the number of
types and sizes of item s to a minimum; consistent with the needs of an organization.
Simplification in company operators is an essential process of standardization.
Standardization is the process of formulating and applying rules for a beneficial and
orderly approach to specific activity. It is based on consolidated efforts of science,
technology and experience, reflecting in: (a) units of measurement

(b) Terminology

(c) Products

(d) Process

(e) Safety of persons.

The term "standard" or "technical standard" includes:

 Common and repeated use of rules, conditions, guidelines or characteristics for

products or related processes and production methods, and related management
systems practices.
 The definition of terms; classification of components; delineation of procedures;
specification of dimensions, materials, performance, designs, or operations;
measurement of quality and quantity in describing materials, processes,
products, systems, services, or practices; test methods and sampling procedures;
or descriptions of fit and measurements of size or strength.

2.2 TYPES OF STANDARDS

Standards may be classified in numerous ways. Standards can be differentiated based on

purpose.

 A basic standard has a broad ranging effect in a particular field, such as a standard for
metal which affects a range of products from cars down to screws.
 Terminology standards (or standardized nomenclature) define words permitting
representatives of an industry or parties to a transaction to use a common, clearly
understood language.
 Test and measurement standards define the methods to be used to assess the
performance or other characteristics of a product or process.
  Product standards establish qualities or requirements for a product (or related group of
products) to assure that it will serve its purpose effectively.
 Process standards specify requirements to be met by a process, such as an assembly line
operation, in order to function effectively.
 Service standards, such as for repairing a car, establish requirements to be met in order
to achieve the designated purpose effectively.
 Interface standards, such as the point of connection between a telephone and a computer
terminal, are concerned with the compatibility of products.
 Standards on data to be provided contain lists of characteristics for which values or other
data are to be stated for specifying the product, process or service.
 International Standards have been developed through a process that is open to
participation by representatives of all interested countries, transparent, consensus-based,
and subject to due process. The existence of non-harmonized standards for similar
products, processes, and services in different countries or regions can create barriers to
trade. Therefore, export-minded countries and industries have recognized the need for
internationally accepted standards to help rationalize the international trading process.

Standards may also be classified by the intended user group. Some examples include:

 Company standards are meant for use by a single industrial organization and usually are
developed internally.
 International standards are developed and promulgated by international governmental
and non-governmental organizations, such as the North Atlantic Treaty Organization
(NATO) or the International Organization for Standardization (ISO).
 Harmonized standards can be either an attempt by a country to make its standard
compatible with an international, regional or other standard or it can be an agreement by
two or more nations on the content and application of a standard, the latter of which
tends to be mandatory.
 Industry standards are developed and promulgated by an industry for materials and
products related to that industry.
 Government standards are developed and promulgated by Federal, State, and local
agencies to address needs or applications peculiar to their missions and functions.

Another distinction among standards is the manner in which they specify requirements.
  Performance standards describe how a product is supposed to function. A performance
standard for water pipe might set requirements for the pressure per square inch that a
pipe must withstand, along with a test method to determine if a specimen meets the
requirement.
 Design standards define characteristics or how the product is to be built. The
specification that a pipe be made of a given gage of copper would characterize a design
standard.

Government agencies are encouraged to write technical regulations and standards in terms of
performance, rather than design characteristics.

Still another classification scheme distinguishes between voluntary standards, which by themselves
impose no obligations regarding use, and mandatory standards. A mandatory standard is generally
published as part of a code, rule or regulation by a regulatory government body and imposes an
obligation on specified parties to conform to it. However, the distinction between these two
categories may be lost when voluntary consensus standards are referenced in government
regulations, effectively making them mandatory" standards.

It is clear, then, that standards cover a broad range of types and serve a wide variety of purposes.

Where appropriate purchasing should work with design, engineering, and operation to
seek opportunities to standardize materials, components and supplies to increase the
usage of standardize items. For example, a car manufacture could design different
models of automobiles to use the same starter mechanism, thus increasing its usage and
reducing the need for multiple items storage space. While allowing for large quantity
price documents. This will also reduce the number of small value purchases for less
frequently used items.
PROCEDURE OF STANDARDIZATION

The task force, responsible for standardization must follow procedure to get the items
standardized. They should get all relevant facts from the concerned executive. They
should develop standards which are easy to understand and to implement. There should
be a constant reviewing, updating and monitoring committee so that best benefits accrue
to the company. The process of standardization can be conceived on a three dimensional
plane. To include factors such as levels, aspect, subject and there interrelation .the level
includes individual, departments, company, industry, nation, international, and universe.
While the aspects may include forms, ethics, code of conducts procedures, contracts,
inspection, testing sampling, agreements or reporting, notes etc. The third dimension,
namely the subjects, encompasses industry, education, agriculture, communication,
transport, mining, trade, commerce, energy, family planning, construction and
administration.

The standardization process may take the form of a document containing a set of
conditions to be fulfilled, a fundamental unit or physical constant or an object for physical
comparison. The apex body of standards in Kenya is the Kenya bureau of standards
(KeBS).

At international level, international standard organization is based in Geneva.

Items to be standardized

The warehouse and inventory manager should involve executives from design,
maintenance, inspections, operations and costing department in order to ensure that the
recommended standards are implemented. This team should update its knowledge on
the latest available technological development to effectively implement the process of
standardization. If the standard is approved as a company standard, the standard
department should make necessary reproduction and distribute copies as mandatory to
all concerned.

We have the kilogram as standard of weight, meters as the standard of length. Keeping to
the right as the standard of the road, motors are made only in certain ratings, bulbs only
in specific voltages, etc. Procedures, formats, reporting system, sampling inspections
plans, letter heads, operating manual, standard costing method, etc. are the examples one
comes across in the field of standardization. It is advantageous to tackle non critical high
value, easily available item for standardization, as otherwise there will be opposition
from design department. MRO-maintenance, repair and operation items like fasteners,
hardware items, maintenance, etc. are a good starting point to impose standardization.

2.3 METHOD OF STANDARDIZATION

When ever published standards are available from outside sources the same can be
applied. The frequency distribution of demand for each type and size of an item in terms
of quantity of materials purchased/used /or products sold, would be an excellent
starting point for standardization and variety reduction in an organization. For instance,
consider the example where the diameters in millimeters of pipes are 5.0, 5.1, 5.2, 5.3, 5.4
and the past pattern shows that only two sizes 5.1 and 5.4 are often used. Then the orders
for the remaining three dimensions can be gradually discontinued if these items are not
critical from performance and safety angles.

The preferred number series-a series of standard sizes is suitable steps used in the bulbs
and currency-developed by Renaud and known as R-5, R-10, R-29, R-40 etc is another
way of stating the standardization process.

2.4 Simplification
Simplifications refers to reduction of the number of the company, supplier, or standard
materials used in the product or process during product design. For example, an engine
starter manufacture could design all of its starter model to use a single type of housing or
solenoid. Thus, simplification can further reduce the number of small value purchases
while reducing storage space requirements, as well as allowing for quantity purchase
discounts. Simplification can achieved as follows;

i) Accumulating Small Order to Create a Large Order

Number small orders can be accumulated and mixed into a large order, especially if the
material request is not urgent. Otherwise, purchasing can simply increase the order
quantity if the ordering cost exceed the inventory holding cost. Larger orders also reduce
the purchase price and unit transportation cost.

ii) Using a fixed order interval for specific categories of materials/supplies

Another effective way to control small orders is to group materials and supplies into
categories and then set fixed order intervals for each category. Order intervals can be set
as biweekly or monthly depending on usage. Instead of requesting individual materials
or supplies, users request the appropriate quantity of each item in the category on a
single requisition to be purchased from a supplier. This increases the dollar value and
decreases the number of small orders.
2.5 Benefit of standardization

The warehousing and inventory manager must have an unambiguous nomenclature for
identifying the terms, in order to serve the customer promptly.

a) In this process, standardization which reduces the variety plays a vital role by reducing
the number of varieties of the same item held in the warehouse.

b) More than any other executive, the stores in charge comes into direct contact with a
variety of materials. He can gain knowledge on the uses of materials in the store and can
contribute significantly to achieve standardization.

c) Standardization enables one to concentrate on large quantity of fewer items.

d) It is possible to place economic order quantity or orders of staggered deliveries with

bulk discount.

e) Economic lot size at manufacturing will not be a problem as items can as items can be
manufactured with the same set up timings for standard items.

f) Since the inventory is likely to be less, the working capital commitment of the
organization will also be less.

g) The items can be easily identified by all persons in stores as the bin location can also be
standardized.

h) Standardization reduce the time involve in negotiation process with the suppliers as
communication is better with prompt delivery schedule.

i) The procurement lead time gets reduce as everyone knows the item clearly.

j) The buyer-seller relations can be improved as all dimensions including price analysis.
Specifications lead time etc, are standardized without scope for disputes.

K) Standardization promotes healthy competition amongst vendor as standard items can

be bought by several companies.

l) Standardization minimizes obsolescence.

m) It is possible to have rate running contracts for standardized items.

n) Standardization reduces design time by concentrating on fewer parts.

O) It minimizes draft time through respective of standard drawings.

p) It expands the engineers list of known and power items.

q) It reduces specification writing by repetitive use of standard specifications.

r) Interchangeability of parts is assured through standardization.

s) Lower cost of production through continuous manufacturing run with less material
handling problems and increased capacity utilization is achieved by standardization.

t) The workers at all levels and departments become more efficient by repeated handling
of items and it is possible to utilize less skilled workers for standard operations.

u) Standardization enables reduced inspections and quality control burden.

V) Since methods are standardized, it ensures safety to all.

w) Standardization directly reduces the variety and improves the information system of
the warehouse manager.

x) Standardization enables reduced number of maintenance tools and improves

maintenance practices.

y) Standardization aims at maximum variety of finished product with minimum

categories of assemblies, sub assemblies and components.

z) In general, standardization result in simple operations, minimum paper work, improve

inter departmental coordination, ease of computer application and pinpoints areas
involving inefficiency. In short, standardization is a means to faster and better
understood communication, with fewer mistakes and hence smoother life.

2.6 Roadblock to standardization

Standardizations should not lead to monotony and prohibit innovations. For instance, it
is not possible to introduce standardizations of end products in job shops, but
assemblies/parts constituting a final product may be standardized. Similarly, it is
possible to standardize items like shoes in terms of seven, or eight sizes. Standardizations
must not lead to rigidity in design or restrict technical development. Standardizations is
also based on previous practices.

In summery, the following points should be borne in mind;

i) Identify the relevance of standardizations in warehousing and inventory

management
 ii) Discuss the benefit of standardization to different departments in the
organizations
iii) Explain how you will identify the items of standardizations
iv) Describe the procedures for standardizations
v) Enumerate the pitfalls of standardization
vi) Elucidate the applications of the concept of frequency distributions to
standardizations
vii)Clarify the concepts of preferred number series in relations to standardization
viii) Specify the interrelationship between standardizations ,simplifications and
specifications
ix) Explain the role of Kenya bureau of standards in development of standards
x) Examine the scope of standardizations in job shop, office and administrations.

Review Questions

i) Define the following terms:

a) standards
b) simplifications
ii) discuss various types of standard classifications
iii) discuss the importance of standardizations and simplifications
iv) explain how simplifications are achieved

Suggested Further Readings

i) Arjan Van Weele (2004), Purchasing and Supply Chain Management, PVT publishers,
New Delhi

ii) Benton W C (2007), Purchasing and Supply Management, Routledge, London

iii) Gopalakrishnan P(1994) Handbook of Material Management, Prentice Hall, India

 CHAPTER THREE: OUTSOURCING AND MAKE OR BUY DECISIONS
Learning Objectives

By the end of this chapter the learner should be able to:

i) Explain the basic issues in make or buy decisions

ii) Discuss why firms outsource
iii) Differentiate between turnkey and partial outsourcing
iv) Explain the motives of outsourcing under:
 Focus on core competence.
 Focus on cost efficiency/effectiveness and
 Focus on service
v) Explain factors found by McQuiston to be core to a successful outsourcing
relationship
vi) Describe the outsourcing process
vii) Describe the four phase strategic outsourcing model
viii) Describe the factors considered in deciding where to buy

3.1 Introduction
Many chief executives consider the make-or-buy decision to be among the most critical and most
difficult confronting their organizations. Not only are billions of dollars needlessly wasted if the
wrong decision is made, but scarce management resources frequently are stretched past the
breaking point.
Outsourcing is a term being used in relation to services such as accounting, maintenance,
security, promotion, stocking, and the like. The basic issues are the same concerning the
question of doing it yourself or contracting with an independent outside the buying firm.
The strategic issue requires the firm to identify its core competencies-the things
that differentiate it and make it viable. If an item or service at or near the heart of the
firm's core competencies is to be outsourced, it should only be supplied by a carefully
selected supplier under a tightly woven strategic alliance.
Top management has the ultimate responsibility for make-or-buy decisions. In most
cases, this responsibility can be satisfied through operating procedures that develop and
pool all relevant information surrounding a make-or-buy issue. Purchasing is a source of
much of this information.
Also, Purchasing frequently should identify candidates for a make-or-buy analysis.

Five major problems are common in the make-or-buy area namely:

1. Make-or-buy decisions are made at too low a level in the organization.
2. Not all factors are considered when conducting a make-or-buy analysis.
3. Decisions are not reviewed on a periodic basis. Circumstances change!
4. The estimates underlying the cost of making are less objective and accurate than the
purchase facts.
5. Members of the buying company assume they know more than the supplier about the
material or service.

3.2 Make or buy issues

a) The Strategic issues
"What kind of an organization do we want to be?" This issue is the first, and perhaps
most critical, to be addressed. Pride or purely emotional reasoning plays a major part in
many decisions. Pride in Self-sufficiency can become a dominant factor that can lead to
many problems. While self-sufficiency in some areas is desirable or even necessary, it is
impossible for even a large firm to become entirely self-sufficient.

These decisions influence the firms manufacturing operation shape and capacity by
determining;

- What product to make

- What investments to make in plant and equipment
- The framework for short term tactical and component decisions.
- Development of new products.

II) Tactical make or buy decisions

This deal with the issue of temporary imbalance in manufacturing capacity e.g. changes in
demand may make it possible to make everything in house.

III) Component make or buy decisions

Made at the design stage, these decisions have to do with whether a particular component should
be made in – house or is bought.

b) Costs

Two keys prerequisites are essential to a thorough and sound analysis of the cost
considerations of a make-or-buy decision.
 Cost must be segregated between fixed costs and variable or incremental ones.
Such cost figures must include all relevant costs, both direct and indirect, near
term and anticipated changes. Realistic estimates of in-house production costs
must include expected rejection rates and spoilage. These estimates also should
consider the likely effects of learning resulting from long production runs.
 Accurate and realistic data must be available on the investment required to make
or to buy an item. Frequently, the working capital required in the manufacture of
an item can equal and even exceed the investment required for facilities and
equipment. It is essential to consider both the facilities and the working capital
components of an investment.

Cost factor in make or buy decisions often require the application of marginal costing and break –
even analysis

i) Marginal costing
this is a principle whereby valuable costs are charged to cost units and the fixed costs
attributable to the relevant period written off in full against the contributions for that period
contribution = purchase price – vc per them
 Example;

D.T. Dobic requires 10,000 shock absorbers for the assembly of Nissan pick ups in Kenya. The
company could make this shock absorbers ltd which sells its shocks at ksh 1560. Only 30% of
the fixed costs are recoverable if the component is bought. The following are the costs that
D.T. Doble would incur should it decide to make the shocks.

Ksh
Materials 900
Labour 400
V. overhead 100
Fixed overheads 200

Should D.T Dobic buy or make the shocks?

Make Buy Difference

Valuable costs 1400 1560 160
(900x400x100)
Volume (10000) 14,000,000 15,600,000 1,600,000
Fixed (30 % of 200 x 600,000 600,000 -
10,000)
14,600,000 16,200,000 1,600,000

v.c = variable cost

In consequences buying instead of making profits would reduce by ksh 1,000,000. (15c – 146). It is
therefore advisable to make the shocks. This decision is made in light of the fact that fied costs of
ksh 600,000 would likely continue since the capacity would be unused the fixed overheads would
not be absorbed into production.
Question;

If the buying price was reduced from 1560 to 1450 should the firm make the shocks or buy them

Make Buy Difference

Valuable costs Ksh 1400 1450 50
Volume 10,000 14,000,000 14,500,000 500,000
Fixed costs 600,000 600,000 -
14,600,000 15,100,000 500,000

D .J Dobic should buy the shocks since by Buying the firm will reduce the Costs attributable to the
shocks by 100,000 thereby earning the firm a profit of the same amount (a shilling saved is a
shilling earned) i.e. if the firm was to make the final costs of the shock will be 14,600,000/= which
it could buy them @ 14,500,000/=.

ii) Break – even analysis

This is the determination of the level of activity in units to value at which total revenues equal
total costs.

B .E .P is given by f = BEP

P–V

Where; F = fixed costs, p= purchase price, v = valuable cost per unit.

TR

Tc

VC

P FC

B.E.P (units) = total fixed costs

Selling price – variable costs per unit

B.E.P (sh) = fixed costs

Contribution ration (CR)

Fixed costs

P/v

CR = sales – variable costs

Sales

= 1 – valuable costs

Sales

CR = P/V

Profit volume ratio

Using the D.T Dobic example;

600, 000 = 600,000 = 3750 shocks

1560 – 1400 160

This means that;

- if only 3750 shock are required then one are will be indifferent on whether to make or buy
- if more than 3750 shocks are required as is the case then it is wise to make
- If less than 3750 shocks are required then buying is a better alternative.
- Why is this so?

ii) opportunity cost

This is the potential benefit that is foregone because one course of action has been chosen over
another. I.e. if the production facilities used in making the item had been applied to some
alternative purpose.

Using the D.T Dobic example, if instead of producing the shocks the facilities could be used to
make suspension springs with a contribution of ksh 175 each.

Should D.T Dobic make the shocks or buy.

Making Buying but production Buying less

Capacity not used Opportunity cost
Ksh 14,000,000 15,600,000/= 15,600,000
- 1,750,000
13,850,000

D.T Dobic should in this case buy the shocks why?

3750 Units 3000 units 4000 units
Make 5250000 4,200,000 5600000
Buy 5,850,000 4,680,000 6,240,000
600,000 480,000 640,000
- 600,000 600,000 600,000
0 - 120,000 + 40,000

 example II – break when analysis

What would be the decision points if the price of the shocks were reduced from 1560 to
1450/=

Using Break even analysis

f = 600,000 = 600,000

p–V 1450 – 1400 50

They would need to produce 12,000 units to break even since the firm needs 10,000 shocks then
they would rather buy.

 Example II – opportunity cost

Valuable D.T Dobic makes or buy the shocks

(i) The contribution of the suspension springs reduce of from 175/= to 160/= - 156
00000 – 160 000000
- same cost structure this indifference
(ii)The price of the shocks reduced from 1560/= to 1450/= with the contribution of the
suspension springs at

(a) 175/= (a) 14500,000 (b) 14500,000

(b) 160/= - 1750000 1600000

12,750,000 12,900,000
(a) They should buy the shocks

(b) They should buy the shocks.

If D.T Dobic buys the shocks and uses the facilities to make suspension springs the cost
structure for both activities will be 13,850,000/= against a cost structure of 14,000,000 were the
firm to make the shocks instead. Thus in buying the shocks DT Dobic will have made/ earned
ksh 150,000 (14,000,000 – 13,850,000)

(iv) Learning curves / skill acquisition / experience curve

This a graphical representation of the rate at which skills or knowledge is acquired is a period
of time. The basis of learning curves is that “skill to do come by doing. I.e. A task is performed
more quickly with each subsequence replication until a point is reached where no further
improvement is possible and performance levels out.

The learning curve theorem states that each time the number of production units is doubled,
the cumulative average lab our hrs per unit’s previous cumulative average.

The learning curve equation is y = a x6

Where y = cumulative average time per unit

X = number of units produced so far

A = time taken to produce the first item

B = log (learning rate)

Log (2)

E.g. if the learning rate to produce shock absorbers is 80% and it requests 1 day to produce
one shock absorber, then to produce 2 shocks is 1.6 days with a cumulative average of

B = log ( 0.8) = - 0.09691 = (-) 0.09691

Log (2) 0.301 0.301

b = - 0.322

y = axb

= a x -0.322

= a X 0.322

For 2 shocks

½* 0.322 = 0.8 days per item/shock

= 1.6 days for 2 shocks

For 5 shocks

Y = ½ *0.322 = 0.5956 days per shock

= 2.98 days for 5 shocks

For 7 shocks

Y 1/7 0.322 = 0.534 days per shock

= 3.74 days for 7 shocks

For 10 shocks

Y = 1/10 0.322 = 0.476 days per shock

= 4.76 days for 10 shocks

For 12 shocks

Y = 1/12 0.322 = 0.499 days per shock

= 5.39 days for 12 shocks

0.8 days and for 8 shock is 4.10 days with a cumulative average of 0.51 days per shock etc

The graph is then plotted using cumulative average time against units produced.
 When components are bought from specialist manufacturers there may be little opportunity
for learning. When items are new the costs of making and buying may have to be adjusted for
the learning factors.

Other considerations in make or buy decisions

Infavour of making

I) Cost considerations

The major elements of the cost considerations are:

- Materials and labour costs

- Follow on costs stemming from quality related problem
- Incremental inventory carry on costs
- Incremental factory overhead costs
- Incremental management costs
- Incremental purchase costs
- Incremental costs of capital
ii) Desire to integrate plant operations

iii) Reproductive use of excess plant capacity to help absorb fixed costs

iv) Need to exert direct control over production and /or quality.

v) Design secrecy required

vi) Unreliable suppliers

i) Desire to maintain a stable work force (in periods of low sales )

ii) Potential lead time reduction
iii) Exchange rate risk
iv) Greater purchasing power with bulk purchase of materials.

C) Quality
When there is a significant difference in quality between items produced internally and
items purchased or when a specified quality cannot be purchased, then management
must consider these quality considerations in the make-or-buy decision. One argument
for making over buying is the so-called impossibility of finding a supplier capable or
willing to manufacture the item to the desired specifications. But further investigation
should be conducted before this argument can be accepted.
Why are these specifications so much more rigid than those of the rest of the industry?
The Manufacturer should reexamine the specifications and make every effort to secure
the cooperation of potential suppliers to ensure that the quality specifications are realistic
and that no satisfactory product is available. Frequently, suppliers can suggest
alternatives that are just as dependable if they know the intended purpose of the item.
On the other hand, the firm may desire a level of quality below that commercially
available. Suppliers may be selling only a quality far above that which would fully satisfy
the need in question and may, at the same time, have so satisfactory a volume at the
higher level as to have no interest in a lower quality product. If this is the case, the user
may be justified in manufacturing the item.
Frequently, it is claimed that in-house production may better satisfy manufacturing's
quality requirements. The user of an item usually better understands the operational
intricacies involved in the item's use. With a make decision, a better degree of
coordination will probably exist between those responsible for producing the item and
those responsible for assembling it. Communications between the two groups are
facilitated compared with the situation in which the item is furnished by an outside
supplier. If the firm has a weak purchasing department, such assumptions may be true.
But with a professional purchasing operation, the flow of information and coordination
between purchaser and supplier should result in no more problems than between two
production activities of the same firm.
Since quality must be controlled in either the purchased or manufactured items, a
competent quality assurance staff and a TQM (total quality management) program must
be employed. The purchase order may state that the purchaser's quality assurance
inspectors have access to the supplier's manufacturing, inspection, and shipping
departments. Thus, the purchaser can maintain significant control and still not incur the
additional cost resulting from manufacturing the item.
 c)Quantity
One of the most frequent reasons for making over buying is that a requirement may be
too small to interest suppliers. Small volume requirements of unique, nonstandard items
may be difficult to purchase. The firm may feel that it is forced to make such items;
however, it may be economically imprudent to do so. The costs of planning, tooling,
setup, and purchase of required raw materials may be exorbitant. It may be far more cost
effective to purchase the required item in larger quantities or to identify a suitable
substitute.
If a large quantity of an item is required on a repetitive basis, then the analysis described
in the Cost section should be made. The company should have a high degree of
confidence that its requirements for the item will continue to the point that it receives a
satisfactory ROI before deciding to make such an item.
Frequently a firm will follow a conscious policy of making an item at a level of
production sufficient to meet its minimum requirements and purchase additional items
as required. This policy builds a degree of stability into the firm's production activities
and provides accurate comparative cost data. Such a policy should be adopted only after
investigating the willingness and ability of suppliers to fill such fluctuating demand.

d) Service
Service often is defined simply as reliable delivery. In a broader sense, it includes a wide
variety of intangible factors that lead to greater satisfaction on the part of the purchasing
firm. This consideration must be judged fairly and the purchasing firm must not be given
undue credit with respect to service simply for emotional reasons. Merely because the
item is produced in-house is not proof that service will be superior to that of a supplier.
Assurance of supply is a primary service consideration. When the lack of an item causes
serious problems, such as total production stoppage, and totally reliable suppliers are not
available, the decision to make rather than buy may be justified.
When a purchaser is faced with a monopolistic environment, the service accompanying
the product is generally somewhat poorer than in a highly competitive market. Such a
situation may induce the would-be purchaser to make the product. If an item is used as a
subcomponent on a product the purchaser is selling and is causing the entire product to
be unreliable, the resulting loss of goodwill and sales may be significant enough to justify
a make decision, even though the cost analysis does not support such a decision.

e)Specialized Knowledge
Frequently, a supplier possesses specialized knowledge, abilities, and production know-
how that would be very expensive to duplicate. Suppliers may have a large R&D budget
leading to improved and/or less expensive products.
The protection of innovation achieved by the supplier is a critical aspect of trust, that is,
the buyer must not under any condition give this innovation to a supplier's competitor or
use the technology were it to make the item.

f) Design or Production Process Secrecy

Occasionally, a firm decides to manufacture a certain part because additional industrial
security can be provided, especially when the item is a key part for which a patent would
not provide adequate protection. This justification must be used with caution, however,
as the firm can provide very little protection against design infringement after sale. In
short, if a patent will not protect a certain part, then in-house manufacturing may not
either. Frequently, a firm may have developed a unique or proprietary production
process. Such circumstances may support a decision to make over buying.

g) Urgent Requirements
The firm usually can purchase a small quantity much more readily than were it to
produce the item. If the requirement is urgent, such as to preclude stopping an assembly
line, the payment of a higher price to buy the item is justified.

h) Labor Problems
The production of any new item may require labor skills that the company does not
possess. The hiring, cross-training, and upgrading of personnel may be a troublesome
and complex process, especially if a union is involved. The company may be entering a
field in which it has no experience and no adequately trained personnel. Labor problems
are easily shifted to someone else, namely, the supplier, through a decision to buy.
The presence of unions within the company also may be a significant factor. Unions often
have clauses in their contract prohibiting the purchasing of items that can be
manufactured within the plant. The history of labor problems in the supplier's company
also may influence the make-or-buy decision.

i) Plant Capacity
Obviously the more significant the item in question is relative to the company's size, the
greater the probability that the item will be purchased rather than produced in house.
When the item would require a significant investment, the smaller company has no
rational decision other than to buy.
Generally the more mature company will try to integrate items currently purchased into
its production more often than will a new company. The new company understandably
concentrates on increasing output and has very little excess capital or plant capacity to
divert to production of components. Quite the opposite is true for the more mature
company. Such a firm tends to have extra facilities, capital, and personnel and, therefore,
is in a better position to increase profit by producing what was formerly purchased.
Excess plant capacity and the likely duration of the excess capacity should always be
considered in the make or buy decision as should additional expenses such as tooling,
setup, and training.

j) Capital Equipment
Manufacturers sometimes find it necessary to make a needed item, simply because a
suitable supplier does not exist. This is most frequently the case with highly specialized
manufacturing equipment.
 k) Use of Idle Resources
A make decision can prove profitable to a firm even when suitable supplies are available.
In periods of1 recession or business slumps, a firm is faced with the problem of idle plant
equipment, labor, and management. By making a product that it may have been buying,
a firm can put its idle machinery to work, retain skilled employees, and spread its
overhead costs over a larger volume of production.
Perhaps the biggest benefits obtained from a make decision during a slump are in the
area of labor relations. Employee morale can be maintained and layoff penalty costs can
be avoided by timely use of the make decision. Even in times of recession, most firms find
it desirable to retain highly skilled production personnel. These personnel can be kept at
work and a stable workforce maintained by a decision to make. The long-run benefits
from good labor relations are obvious.

Great caution must be taken when basing a make decision primarily on temporary idle
resources.
Make decisions tend to be permanent. A decision to make temporarily an item under
such circumstances should be reviewed when demand increases.

3.3 Make and Buy

Some firms make and buy critical nonstandard items to ensure that a reliable second
source is available in case of difficulty with the supplier. Such a policy also provides data
that are useful in reviewing internal production and management efficiency.

Making the Decision

Make-or-buy decisions can have a critical effect on the economic health of a firm, even on
its survival.
Frequently, these decisions are made at too low a level in the organization. On many
occasions, no conscious decision appears to have been made. Things just happen! The
decision to make is often weaker than the decision to buy because buy costs are known
whereas make costs are estimates. Obviously, the amount of time and effort and the level
 of managerial attention appropriate are functions of the amount of money involved and
the criticality of the item to the firm's well-being. Normally several departments should
be interested and involved in make-or-buy decisions: Production, Purchasing,
Engineering, Finance, and Marketing.

Any of the following situations should precipitate a make-or-buy analysis:

* New product development and modification. Every major component should be reviewed.

* Unsatisfactory supplier performance. If purchasing is unable to develop reliable sources for

an item, the item should be reviewed and analyzed to ensure that the specified quantity
level is essential and to ensure that suitable substitutes are not available. If the item, as
specified, passes these reviews, it becomes a candidate for in-house sourcing.

* Changes in sales. Sales demand that exceeds capacity calls for a make-orbuy review of
those items produced in house that contribute the lowest ROI. Declines in sales and
production should prompt a review of candidates for in-house production.

* Periodic review of previous decisions. Changing costs and other considerations can convert
a good make-or-buy decision into a bad one very quickly. Major make-or-buy decisions
should be reviewed as a component of the firm's annual planning process.

Decision process for make or buy

Is the component Have we design Have we Are we

core business capability manufacturing competitive
capability

YES NO YES NO YES NO YES NO

MAKE MAKE MAKE BUY MAKE BUY MAKE BUY

US BUY US BUY US BUY

3.4 OUTSOURCING

This is the strategic use of resources to perform activities traditionally handled by international
staff and their resources. An alternative definition is the buying in of components, sub –
assemblers finished products and service from outside suppliers rather than supplying them
internally. It is strategy by which an org outstand.

The term “outsourcing” probably refers to buying materials or components from

suppliers instead of making then in-house. It also refers to buying materials or
components that were previously made in-house. In recent years, the trend has been
moving toward outsourcing combined with the creation of supply chain relationships,
although traditionally firms preferred the make option by using backward and forward
vertical integration. Backward vertical integration refers to acquiring upstream
suppliers, whereas forward vertical integration refers to acquiring downstream
customers. For example, an end-product manufacturer acquiring a supplier’s operations
that supplied component parts is an example of backward integration. Acquiring a
distributor or other outbound logistic providers would be an example of forward
integration.
Whether to make or buy materials or components is a strategic decision that can impact
an organization’s competitive position. It is obvious that most organizations buy their
MRO and office suppliers rather than make the items themselves. Similarly, seafood
restaurants usually buy their fresh seafood from fish market. However, the decision on
whether to make or buy technically advanced engineering parts tat impact the firm’s
competitive position is a complicated one.
Traditionally, cost has been the major driver when making sourcing decisions. However,
organizations today focus more on the strategic impact of the sourcing decision on the
firm’s competitive advantage.
Generally, organizations outsourcing noncore activities while focusing on core
competencies. Finally, the make-or-buy decision is not an exclusive either-or option.
Firms can always choose to make some components or services in-house and buy the rest
from suppliers.
3.5 Reasons for buying or Outsourcing
Organizations buy or outsource materials, components, and/or services from suppliers
for many reasons.
1. Cost advantage: For many firms, cost is an important reason for buying or
outsourcing, especially for supplies and components that are nonvital to the
organization’s operations and competitive advantage. This is usually true for
standardized or generic supplies and materials for which suppliers may have the
advantage of economies of scale because they supply the same items to multiple
users. In most outsourcing cases, the quantity needed is to small that it does not justify
the investment in capital equipment to make the item. Some foreign suppliers may
also offer cost advantage because of lower labour and/or materials costs.
2. Insufficient capacity: A firm may be running at or near capacity, making it unable to
produce the components in-house. This can happen when demand grows faster than
anticipated or when expansion strategies fail to meet demand. The firm buys parts or
components to free up capacity in the short term to focus on vital operations. Firms
may even subcontract vital components and/or operations under very strict terms
and conditions in order to meet demand. When managed properly, subcontracting,
instead of buying, is a more effective means to expand short –term capacity because
the buying firm can exert better control over the manufacturing process and other
requirements of the component parts or end products.
3. Lack of expertise: The firm may not have the necessary technology and expertise to
manufacture the item. Maintaining long term technological and economical viability
for noncore activities may be affecting the firm’s ability to focus on core competencies.
Suppliers may hold the patent to the process or product in question, thus precluding
the make option, or the firm may not be able to meet environmental and safety
standards to manufacture the item.
4. Quality: Purchased components may be superior in quality because suppliers have
better technology, process, skilled labor and the advantage of economies of scale.
Suppliers may be investing more in research and development. Suppliers’ superior
 quality may help firms stay on top of product and process technology, especially in
high-technology industries with rapid innovation and short product life cycles.

An organization also makes its own materials, components, service and/or equipment in-
house for many reasons. Let us briefly review these reasons;
1. Protect proprietary technology: A major reason for the make option is to protect
proprietary technology. A firm may have developed an equipment, product, or
process that needs to be protected for the sake of competitive advantage. Firms may
choose not to reveal the technology by asking suppliers to make it, even if it is patent.
An advantage of not revealing the technology is to be able to surprise competitors and
bring new products to market ahead of competition, allowing the firm to charge a
price premium.
2. No competent supplier: If the component does not exist, or suppliers do not have the
technology or capability to produce it, the firm may have no choice but to make an
item in-house, at least for the short term. The firm may use suppliers development
strategies to work with a new or existing supplier to produce the component in the
future as a long-term strategy.
3. Better quality control: If the firm is capable, the make option allows for the most
direct control over the design, manufacturing process, labour and other inputs to
ensure that high quality components are built. The firm may be so experienced and
efficient in manufacturing the component that suppliers are unable to meet its exact
specifications and requirements. On the other hand, suppliers may have better
technology and processes to produce better quality components. Thus, the sourcing
option ensuring a higher quality level is a debatable question and must be
investigated thoroughly.
4. Use existing idle capacity: A short term solution for a firm with excess idle capacity is
to use the excess capacity to make some of its components. This strategy is valuable
for firms that produces seasonal products. It avoids laying off skilled workers and,
when business picks up, the capacity is readily available to meet the demand.
5. Control of lead-time, transpiration, and warehousing cost: The make option provides
easier control of lead time and logistical costs since management controls all phases of
the design, manufacturing and delivery process. Although raw materials may have to
be transported, finished goods can be produced near the point of use, for instance, to
minimize holding cost.

Outsourcing can be described as the transfer of activities, that were previously conducted
in-house, to a third party. Ellram and Billington (2001) see outsourcing primarily as the
transfer of the production of goods or service that had been performed internally to an
external party.
Outsourcing means that the company divests itself of the resources to fill a particular
activity to another company to focus more effectively on its own competence.
The difference with subcontracting is the divestment of assets, infrastructure, people and
competencies.
3.6 Types of outsourcing
There are two different types of outsourcing namely :
 turnkey integral and
 Partial outsourcing.
Turnkey outsourcing applies when the responsibility for the execution of the entire
function (or activities) lies with the external supplier. This includes not only the execution
of the activities but also the coordination of these activities. Partial outsourcing refers to
the case in which only a part of an integrated function is outsourced.

The advantages and disadvantages of Turnkey and partial outsourcing

Advantages Disadvantages
Turnkey Buyer has minimal responsibility The buyer has limited influence
outsourcing for outsource processes. on the determination of the price
and little insight into cost
structure of provider.
 Buyer doesn’t need to have The buyer has limited influence
experience with similar projects. on the staff, technology and
materials used an their quality.
The project generally goes Large dependence of buyer on
smoothly for the buyer. provider resulting in high
commercial, technical and
performance risks.
Partial The buyer has more influence on The buyer is required to have
outsourcing prices, rates and costs. knowledge of the separate parts
of the outsourced
functions/activities.
The buyer has more influence on The buyer is required to have the
the staff, technology and organizational capacities to
materials used and their quality. coordinate and integrate the
outsourced functions/activities.
Specific advantages can result in Communication and
cost reductions. coordination problems between
parties involved can be a cause of
delay and disappointment.
Optimal usage of knowledge, Continuous follow-up and
equipment and experience of monitoring of the supplier
third party relationship is necessary
Increased flexibility: fluctuations Risks of communication and
in the workload can more easily organizational problems during
be absorbed. the transfer of activities to a third
party.
Outsourcing leads to easier and Risk of leakage of confidential
more focused primary processes information
in the organization.
 Input through an independent Depending on balance of power
party’s point of view which between parties; inability to
reduces the risks of introvert execute contractual performance
short-sightedness in the incentives and penalties.
organization
Risk of losing essential strategic
knowledge.

3.6 Strategic phase

During the strategic phase three essential questions have to be answered:
 The question relates to the objective of the firm with regard to its intent to
outsource a certain activity.
 what activities are considered for outsourcing.
 what qualifications a supplier should be able to meet in order to qualify as a
potential future partner for providing the activity concerned must be answered.
The decision to outsource should support and enable the company’s overall
strategy. The motives that are cited most are:
1. Focus on core competence.
2. Focus on cost efficiency/effectiveness and
3. Focus on service
This motives and that strategy of the outsourcing company should be aligned. These
three motives and the outsourced activities should contribute to this strategy.
The second question relates to what should be outsourced. Two important approaches
are used to answer this question;
 The transaction cost approach and
 The core competence approach.
The transaction cost approach is based on the idea of finding a governance structure
aimed at arriving at the lowest cost possible for each transaction that is made.
Transaction cost is defined as the costs that are associated with an exchange between two
parties. The assumptions of the transaction costs approach is that an exchange with an
external party is based upon a contract. The (potential) costs associated with establishing,
Monitoring and enforcing the contract, as well as the costs associated with managing the
relationship with the external party, are all considered to be part of the transaction costs
as well as the costs associated with the transaction itself. Therefore all of these costs
should be taken into account when deciding between make or buy options.
The level of the transaction costs depends upon three important factors. These factors are:
 frequency of the transaction,
 the level of the transaction specific investments and
 the external and internal uncertainty.
The frequency of the transaction is an important factor because the more frequently
exchanges occur between partners, the higher the total costs that are involved. The level
of the transaction-specific investments also determines the level of transaction costs,
because transaction-specific investments are investments that are more or less unique to a
specific buyer-supplier relationship.
Examples are investments in specific supplier tooling (such as molds and dies) by a large
automotive manufacturer and the change costs involved when choosing a new
accountant (internal staff need to get accustomed to the new accountant, the new
accountant needs to be thoroughly briefed to get acquainted with the company etc.).
These examples show that investments are made in assets as well as in human capital.
Obviously the higher these investments are, the higher the transaction cost will be. The
last factor that determines the transaction costs is the external and internal uncertainty.
Uncertainty is a normal parameter in the decision-making process. It can be defined as
the inability to predict contingencies that may occur. The higher these uncertainties, the
more slack a supplier wants to have in presenting his proposal and rates, and the more
difficult it will be to make a fixed price or lump sum contract that deals with all
uncertainties beforehand.
 The outsourcing process
Strategic phase Transition phase Operational
phase
Competence Assessment Contract Project execution Managing Contract
analysis and approval negotiation and transfer relationship termination
The
Outsourcing
Process

Therefore, the higher the level of uncertainty, the higher the transaction costs will be.
The other approach on which an outsourcing decision can be based is the core
competence approach. This theory is based, among others, on the work of Quinn and
Hilmer (1994). The core competence approach is based on the assumption that, inorder to
create a sustainable competitive advantage, a company should concentrate its resources
on a set of core competencies where it can achieve definable pre-eminence and provide a
unique value for customers … (hence it should) strategically outsource all other activities’
(Quinn and Hilmer, 1994 p43). The important question to be answered here is what are
the firm’s core competence. Characteristics of core competence are;
 Skills or knowledge sets, not products or functions
 Flexible, long term platforms that are capable of adaptation
 Limited in number; generally two or three
 Unique sources of leverage in the value chain
 Areas where the company can dominate
 Elements important to the customer in the long run
 Embedded in the organization’s system
The competencies that satisfy these requirements are the core competencies and provide
the firm with its long-term competitive advantage. These competencies must be closely
protected and are not to be outsourced. All other activities should be procured from the
markets if these markets are totally reliable and efficient.
Long and Vickers-Koch (1992) distinguish five categories of a firm’s activities, instead of
two categories, core or non-core, (Quinn and Hilmer 1994). These five categories are;
 Cutting edge activities. The activities that determine the competitiveness of the
organization from a long term perspective.
 Core activities. The activities that create the foundation and main process for the
organization and its possible competitive advantages.
 Support activities. Those activities that are directly connected to the core competences.
 Separate activities. The activities that are part of the main process, but easily separated
from that process and not related to the core competences.
 Peripheral activities. The activities that do not concern the main process.
Anorld (2000) also makes a further distinction in a firms activities. He distinguishes
between:
 Company core activities. Activities that are directly to the core activities.
 Close-core activities. The activities that are directly related to the core activities.
 Core distinct activities. The supporting activities.
 Disposable activities. Activities with general availability.
Both studies imply that the outsourcing decision framework based upon the work of
Quinn and Hilmer (1994) needs adjustment. Anold (2000) has developed a general model
for whom the function should be outsourced. After the decision to outsource has it is
essential that the right supplier is chosen. A suppler has to be selected who has the
necessary technical and managerial capabilities to deliver the expected and required level
of performance. Also the supplier should be able to understand and be committed to
these requirements.

The supplier selection process is key to the success of the buyer-supplier relationship.
Companies that make extensive use of supplier selection and monitoring practices in
supplier partnership seem to be more successful than the companies. An adequate
supplier selection model is crucial for the success of the outsourcing decision.
Momme and Hvolby (2002) present a four-phase model (figure below). This model gives
guidance on how to identify, evaluate and select outsourcing candidates and therefore is
an appropriate tool to use in the strategic phase . it also gives a brief guidance for the
transition (phase 2 and 3) and the operational phase (phase 4), but needs to be elaborated
for that purpose.
Four phase strategic outsourcing model
Identification and
assessment

Phase 1
 Market search Market
 Preliminary Benchmark
assessment
 Potential
supplier list

Phase 4 Phase 2
 Supplier report card  Detailed audit
 Post contract review Customer  Confidentiality

Audit and
management

approval
Performance

 Continuous focus agreement

improvement  Approved
 Supplier validation supplier list

Phase 3
 Contract
Continuous negotiation
improvement  Order issue
opportunities  Kickoff meeting
 Execution

Project
execution

After the strategic phase in which the outsourced activities and supplier have been
identified, the transmission phase starts. The transition consist of the contract negotiation
and the project execution and transfer. The most important issue in the contract
negotiation in an outsourcing agreement is often the start of a long term relationship, so
not only the contractual issues should be dealt with but the people issues and the
importance of a sound and cooperative relationship should be covered as well.
The contract is the legal basis for the relationship and is therefore the key document in
the outsourcing process. It allows both organization to maximize the rewards of the
relationship, while minimizing the risk. This makes the outsourcing contact key success
factor for the establishment of a strategic outsourcing relationship.
The contract and the type of contract should reflect the business plan (the goal of the
cooperation) the two parties have and should be seasonable for both parties.
There are different types of contracts. The type chosen depends on the characteristics and
the scope of the contract and the functions or activities that are outsourced.

After the transition phase has successfully ended, the operational phase of the
outsourcing process starts. This operational phase consists of two processes namely:
 Managing the relationship and
 contract termination.
Managing the buyer-supplier relationship management is one of the, if not the critical
stage in the outsourcing relationship. Achieving the goals of the outsourcing relationship
is impossible without close cooperation. When the relationship is not properly managed
the conditions for close cooperation will not be present and the outcome of the
outsourcing relationship will be far from optimal.

The true value of outsourcing comes after the relationship has had time to develop and
additional synergies have emerged. Creating a sustaining, long relationship with a
supplier is exciting: it’s where the win-win is really beginning to show.

Many researchers have written on the characteristics of a successful buyer-supplier

relationship. The top five include
 the factors trust,
 flexibility,
 team approach,
 shared objectives and
 open communication.

The factors found by McQuiston to be core to a successful outsourcing relationship are

presented in the table below.
Core values Supporting factors
Shared goals and objectives Developing a personal relationship
Mutual dependence Having professional respect
Open line for communication Investment of effort by top
Concerned for the other’s profitability management
Mutual commitment to customer Commitment to continuous
satisfaction improvement
Trust

Suggested Further Readings

Sudhi Seshadri (2005) Sourcing Strategy: Principles, Policy and Designs, PVT publishers, New Delhi

Elizabeth Anne Sparrow (2007), Guide To Global Sourcing, Prentice Hall, Chicago

Larry Paquette (2004), Sourcing Solution, Routledge, London

 CHAPTER FOUR
THE PURCHASING AND NEW PRODUCT DEVELOPMENT
Learning Objectives
By the end of this chapter the learner should be able to:
I. Describe the process of new product development
II. State the role of purchasing in new product development
III. Explain the conflicts that are likely to arise between engineering and other
functions within the organization
IV. Discuss the design of new product stage and the degree of its complexities

4.1 Introduction
Many companies attempt to track down new technologies and product through
systematic market research. The results of this research are usually translated by the
marketing department into several new products idea which are then discussed with
research and development and the engineering department. These discussions are often
the starting point for projects aimed at improving current products or the developments
of new ones.

4.2 The process of new product development

Depending on the nature of the product and the type of company the development
process, starting with conceptualization and ending with introduction to the market will
pass through several stages

 Products development. In this phase the idea supplied by the marketing

department are translated into a few concrete, but still relatively abstract.
Functional design. Such designs describe the functions that the product to be
developed will have to fulfill for the user. From these functional designs, the most
promising design is selected to be elaborated further.
  Product design. In this phase the functional design is worked out in detail –
proposals are made about the materials to be used. The physical properties that
the product must satisfy. E t c. Often several products designs are produced which
meet the functional design and these can be presented to potential clients at an
early stage. In order to get the first reaction and impressions concept testing. This
information enables the engineers to focus on the most promising design.
Subsequently the product design is elaborated in the form of prototype can also be
presented to potential buyers and users.
 Production planning. The manufacturability of the product has already been
considered during the product design stage the production requirements are taken
into account. After the prototype has been approved. Preparation for production
can be started. If it concerns a technically complex products this phase may take a
lot of time and it may be necessary to purchase new production equipment. The
capacity requirements of this new equipment will have to be determined based on.
Among other things, Market exploration and sale forecasts. Production planning
frequently ends with a number of production series
 Start of the production. Products from the pre production series are subjected to
through examination: based on the result of this examination the product design or
the setting of the machines might be adopted so as to limit future production and
quality problems to a minimum. One of the problems that might occur in this
phase is changing the specifications. Every change is documented in a change –
order send by the engineering department to the purchasing department in order
to discuss this with the supplier. This phase means a lot of work for the purchaser
involved in the project.

Every change in the specification has to be approved by the supplier, the consequences
for the total costs have to be analyzed, the change product needs to be tested again, etc.
This is one of the reason why it takes so long for a new product to become available for
customers. Only when the problem have been taken care of, can actual production
commence.
It goes without saying it is possible to refine this sequence of steps, depending on the
nature of the product and the type of company. As the development process advances,
the specifications become more rigid and it becomes more difficult to introduce changes.
The consequence for purchasing is that its latitude decreases and the cost of technical
changes introduces at a later stage in the process become higher.
Once a suitable material or construction has been found, tested and approved, the
willingness to consider any alternatives (in the form of a different material, component or
a substitute product from another supplier) will be limited at a later stage. Any
alternative will have to be tested and approved again, which implies not only a lot of
work but also risks. This desire to reduce technical risk may result in specific components
being channeled in the direction of one particular supplier because of positive
experiences with this supplier in the past.
The buyer is put in a difficult situation since it is awkward to negotiate with such
suppliers. Based on his job perceptions, a buyer will always attempt to have more than
one supplier to fall back on. For the buyer to go out into the market, the product
preferably must be described in terms of functional specifications rather than in terms of
supplier or brand specifications. There exists therefore, a kind of natural conflicts in the
way the engineers and buyers operate which can only be solved by cross functional
development teams.

4.3 communications between buyers and first tier suppliers

Large manufacturers communicate with their first tier suppliers in product development
as follows:
 Purchasing engineering. This is a specialist function to provide the liaison between
the engineering department and the purchasing department. Purchasing engineers
are members of the design teams, where they will evaluate designs against
purchasing-specific criteria. It is their task to bring in specific supply market
knowledge and new supplier at an early stage of design.
  Early supplier involvement (ESI) suppliers who have proved in the past to be
‘best-in-class’ are invited to participate in the company’s development projects at
an early stage. In this way they are able to criticize future designs, suggest
alternative materials, come up with ideas for more efficient manufacturing, etc as a
stage where engineering changes can be made without severe cost consequences.
 Residential engineering. A next step is to co-locate engineers from the suppler on a
more or less permanent basis within the organization in order to work on design
or.
4.4 benefits of early supplier involvement
In accessing the benefits of early supplier involvement, companies need to differentiate
between short-term and long-term benefits (Van Echtelt, 2004).
Short-term benefits may result from improved product quality, reduction of product cost,
reduction of development time and reduction of development cost. These benefits result
from the supplier’s in-depth knowledge of components and technologies, which enables
them to match component designs better with their manufacturing capabilities.
Long-term benefits may consist of more efficient and effective collaboration in future new
product development projects, the alignment of future technology strategies, a better
access to the technology resources of the supplier and the contribution of suppliers to
product differentiation.
Involving buyers in development processes at an early stage can result in contribution of
new knowledge and better understanding of:
 Construction
 Suitable materials
 Suppliers
 Supplier knowledge
Involving the supplier in new product development can also result in considerable
savings.
The following shows the degree of design complexities with each of product design stage.
 Review Questions
a) Describe the process of new product development
b) State the role of purchasing in new product development
c) Explain the conflicts that are likely to arise between engineering and other
functions within the organization
V. Discuss the design of new product stage and the degree of its complexities

Suggested Further Readings

i) Sudhi Seshadri (2005) Sourcing Strategy: Principles, Policy and Designs, PVT
publishers, New Delhi

ii) Elizabeth Anne Sparrow (2007), Guide To Global Sourcing, Prentice Hall, Chicago

iii) Larry Paquette (2004), Sourcing Solution, Routledge, London

iv) Handfield, R., Ragatz, G., Petersen, K., Monczka, R. (1999). Involving suppliers in
new product development. California Management Review.
v) Lakemond, N. Echtelt, F, and Wynstra, F. (Fall, 2001). A configuration typology
for involving purchasing specialists in product development. The Journal of Supply
Chain Management.
 CHAPTER FIVE: THE PROCUREMENT PLAN
Learning Objectives
By the end of this chapter the learner should be able to:
a) Define procurement plan
b) Explain the importance of procurement plan
c) Explain the process of establishing an effective strategic purchasing plan
d) Explain the factors that affects material planning
e) Describe the guidelines for materials planning
f)Describe the techniques of drawing up materials budgets

5.1 Introduction
One of the most important aspects of inventory control is to have the items in stock at
the moment they are needed. This includes going into the market to buy the goods
early enough to ensure delivery at the proper time. Thus, buying requires advance
planning to determine inventory needs for each time period and then making the
commitments without procrastination.

For retailers, planning ahead is very crucial. Since they offer new items for sale
months before the actual calendar date for the beginning of the new season, it is
imperative that buying plans be formulated early enough to allow for intelligent
buying without any last minute panic purchases. The main reason for this early
offering for sale of new items is that the retailer regards the calendar date for the
beginning of the new season as the merchandise date for the end of the old season.

For example, many retailers view March 21 as the end of the spring season, June 21 as the
end of summer and December 21 as the end of winter.

Part of your purchasing plan must include accounting for the depletion of the inventory.
Before a decision can be made as to the level of inventory to order, you must determine
how long the inventory you have in stock will last. For instance, a retail firm must
formulate a plan to ensure the sale of the greatest number of units. Likewise, a
manufacturing business must formulate a plan to ensure enough inventory is on hand for
production of a finished product.

In summary, the purchasing plan details:

 When commitments should be placed; ! When the first delivery should be

received;
 When the inventory should be peaked;
 When reorders should no longer be placed; and
 When the item should no longer be in stock.

Well planned purchases affect the price, delivery and availability of products for sale.

5.2 What is a Procurement Plan?

A Procurement Plan defines the products and services that you will obtain from external
suppliers. A good Procurement Plan will go one step further by describing the process
you will go through to appoint those suppliers contractually. Whether you are embarking
on a project procurement or organizational procurement planning exercise, the steps will
be the same. First, define the items you need to procure. Next, define the process for
acquiring those items. And finally, schedule the timeframes for delivery.

Procurement Plan helps the organization to procure products and services from external
suppliers. It provides firms with a complete project procurement plan template, to help
them to quickly and easily create a Procurement Plan for the business.

By planning procurement carefully, the firm can buy the right products for itself at the
right price.

5.3 Importance of procurement plan

The Procurement Plan helps to:

 Define your procurement requirements
 Identify all of the items you need to procure
 Create a sound financial justification for procuring them
 List all of the tasks involved in procuring your products
 Schedule those tasks by allocating timeframes and resources
 Create a robust project procurement process for your business
Procurement Planning is critical if you want to get the most out of your supplier
relationships. By using this Procurement Plan template, you can quickly and easily define
your procurement requirements, the method of procurement and the timeframes for
delivery.

5.4 Strategic purchasing plan

Manufacturers that plan, manage, and control their materials management and
purchasing functions can significantly improve cash flow, profits, and customer
satisfaction. A strategic purchasing plan can achieve these results. Establishing an
effective strategic purchasing plan requires a manufacturer to undertake a five-step
process of developing goals for improvement and monitoring its progress

I. Business Performance Measurement

The first step in developing a strategic purchasing plan is to establish and evaluate the
company’s materials management performance measurements and identify areas of
potential improvement; for example, inventory turns and payable days as they relate to
measurements of cash flow.
For every purchased product or service there is an opportunity for improvement in areas
such as price, quality, service, delivery, consignment, and supplier-value added. Profit
improvement goals should be established to reflect what is possible and not what is easily
attained. Most organizations can expect to achieve a 20 to 60 percent improvement for
each performance measurement, depending on the particular goal, the creativity utilized,
and the company’s commitment. It is important that current performance levels and goals
for improvement are communicated to employees. In addition, suppliers should be
advised of goals that affect them.
A good way to communicate these goals is to design a business performance
measurement matrix

II. Organizational Strengths

Once the manufacturer has identified the areas it wants to improve, it must assess its
organizational strengths to determine which assets will be needed to achieve those goals.
Assets useful in strategic purchasing include material requirements planning software
(MRP), business forecasting/budgeting methods, floor plans that promote timely
communications, business teams, and cycle time compression.
One of the most important strengths a company has is its personnel. Every organization
has employees who not only understand the need for improvement but can also convert
goals into reality. Employees that can accept responsibility for project leadership and
completion should be recruited to serve on cross-functional business teams that will pave
the way for the rest of the company.
To get all employees involved in the improvement process, a manufacturer should
implement a closed-loop management system that provides feedback to employees,
encourages the setting of goals, and emphasizes the measurement of progress as it is
made. This system can organize, train, and mobilize all employees with a focus on
improvement.
Above all, the crucial element for success in any strategic purchasing plan is
management’s commitment to the process. A philosophical commitment is not enough-
management must be ready to fully participate in the strategic purchasing plan. All
employees will be asked to change the way they view the business and to develop a
discipline of continuous improvement, and unless management actively participates and
demonstrates its commitment, that change will not occur.
III. Supplier Integration
Suppliers are the single greatest underutilized business resource. Most manufacturers fail
to see suppliers as an extension of their organization and don’t share information with
them. A company’s suppliers share in its success and can be willing and valuable
participants in the strategic purchasing plan.
Suppliers are experts in their particular businesses and have knowledge and expertise
that can be valuable to the company seeking improvement. The manufacturer should
inform current suppliers of the company’s strategic purchasing plan, including the
magnitude of improvement that is expected, and seek their input. It’s also a good idea to
contact suppliers that might want to increase their level of business with the company
and give them the opportunity to participate.

Suppliers can contribute to a manufacturer’s success in several ways:

• Assist in the forecasting of high dollar and long lead time purchases.
Results:
• supplier may commit to stocking materials
• improved on-time delivery
• reduced setup charges
• reduced transportation costs (e.g., emergency delivery)
• Identify areas of excessive specifications and other areas of high costs and provide input
on lead time reduction.
• Aid in new product introduction.
• More accurate introduction lead times, estimated costs, and design/costs/specification
relationships
• Reduced time-to-market cycle

IV. Strategy for Improvement

After investing considerable time and effort into identifying goals and assessing its
organizational strengths, a manufacturer must devise an implementation strategy that will
foster the success of the strategic purchasing plan so that its efforts will not be wasted. A
good method of ensuring success is to begin the improvement process with the “low
hanging fruit”-that is, choose a goal that is sure to be attained as the first step in the plan.
When that goal is attained, it will gain momentum for the plan and inspire confidence
among employees. It will also discredit any “doubting Thomases.”

V. Measure the Results

To ensure success, a method of measuring progress toward goals must be established.
Measurement is important because it creates discipline and a routine of improvement. It
identifies those teams and employees who may require help and provides an opportunity
to recognize and reward achievement. To support the momentum and enthusiasm
necessary for success, incremental progress should be conveyed to employees.
A successful strategic purchasing plan is the result of a business that understands the
magnitude of change required, has the conviction to commit to the change process, and
utilizes the tools and concepts of organized and controlled change management. As a
result, the manufacturer will become financially stronger and more responsive to the
marketplace, resulting in a larger market share.

5.5 MATERIALS PLANNING

Production planning is an area for top management decisions through which production
plans, programmes and targets are spelled out. Production planning process starts well
before the completion date so that sufficiently long time is given to the management to
enable it to consider “alternative courses of action and authorize major commitments for
materials, manpower, and plant facilities.”

Materials planning are a part of production planning. In fact for an effective inventory
control, production plans should be converted into materials plans. This enables the
management in clearly defining the quantity and schedule of the equipments. In the
integrated materials arrangement, production and materials planning get a pride of place.
Inventories consume a larger part of working capital. For best possible utilization of
available capital resources, a material, planning is resorted to. It enables the management
to anticipate the future materials demands. Such anticipation helps in managing the
materials in a manner in which it enables the organization to accomplish the given
objectives. Infact, materials planning provides a mechanism for inventory control.

Materials planning defined

“Materials planning” is the scientific way of determining the requirements of raw

materials, components, spares and other items that go into meeting production needs
within the economic investment policies.” As the definition goes, materials planning are a
function and are a system which evolves methodology to plan the requirements of
materials in a scientific manner. It is positively related with production which follows
market conditions and sales forecasts. Further it cannot ignore the economy and the
investment policy of the organization. These two factors also go side by side.

Factors affecting Material Planning

The following are the two factors which affect materials planning substantially:

1. The external Factors, and

2. The Internal Factors.

In economic terminology, external factors may be termed as macro factors which may be
enumerated as under:

1. National Economy
2. Price Trends.
3. Monetary and Fiscal Policy of the Government:
(a) Credit Regulations,
(b) Direct and Indirect Taxes,
(c) foreign Exchange regulations,
(d) Import Policy, and
(e) International Market, etc.
 4. Business Cycles, and
5. Other factors which usually fall under factors not within the reach of the
organization, that is, uncontrollable factors.

The internal factors, affecting materials planning may be termed as micro factors or
incorporate factors, are as listed below.

1. Corporate objectives and plans;

2. Technology available;
3. Market demand
4. Lead time and rejection rates
5. Working capital available
6. Nature of the inventory required and help;
7. Plant capacity and its utilization
8. Inventory levels;
9. Seasonal variations and market supply position;
10. Information and data available;
11. Delegation of power;
12. Communication system
13. Warehousing facilities available; and
14. Overall materials policy

5.6 Purchasing and Materials planning

Main job of purchasing personnel is to get materials when needed and pay for them as
little as possible considering quality, quantity and other requirements and prices trends.
It is the efficiency of the purchasing personnel which makes the real difference on the
profit by the industrial unit as well as a commercial unit. Specific technical knowledge
cost analysis; value analysis and good judgment go a long way in making a purchasing
efficient.
But conservative thinking that purchasing function is an order – placing activity still
holds good. The modern thinking is yet to penetrate and wipe off the outside
manufacture and hence we have to view it from materials planning point of view. This
takes for granted a closer tie between purchasing and other functions. A close liacon
between other departments of the organization on the one hand materials department is
a prerequisite for an effective materials planning. For smooth and an interrupted
operation of the organization, it is necessary that every – one in the organization should
be actively involved in the attainment of the objectives of the organization. It is this
involvement which is important for any effective material planning since all the
departments of the organization are somehow or other related to what is required and
procured for the efficient running of the whole organization.

Here, we are faced with an awesome question: “in view of the wide diversity of
responsibility( of the purchasing personnel)…., is it possible to formulate any unified
procedure o the basis of which we may determine what is considered to be the escape of
the purchasing for materials planning?”

Certainly it is possible. What is required is that we should follow well recognized

principles of sound purchasing procedures, which are listed below.

1. The ascertainment of the need,

2. an accurate statement of the character and the quantity of goods desired,
3. The transmission of requisition,
4. Negotiation for possible sources of supply,
5. Analysis of the proposed purchase, selection of Vendors and placing of the
supply order,
6. the follow up of the order,
7. The checking got the invoice,
8. The receipt and inspection of goods delivered, and
9. Completion of the records.
For any effective materials planning, it is necessary that purchasing functions should be
well – organized and the department should follow well – recognized principles.
Materials planning should be such which may enable the materials manager to cope with
the demand for materials and as when it comes to him. Materials are basic to profitability.
Raw materials, purchased materials and other supplies are cost centre of the demand for
materials planning is done in close co- operation and consultation with the purchasing
department is we- equipped with the economies of purchasing. Hence, materials
planning may carry meaning and prove result – yielding if purchasing department of the
organization is actively associated at all the stages and at all the levels.

5.7 TECHINIQUES OF MATERIALS PLANNING

The under mentioned two techniques are usually used for materials planning:

1. Bill of Materials Technique, and

2. Past consumption Analysis Technique.

Bill of Materials Technique

A bill of materials indicates the name, part, and usage of each component and the sub-
assembly in which it is to be used. Each product has a bill of materials since each of the
products has its own equipments dependent on its design and according to the
engineering designs and the components consisting of standard parts need for particular
product to be manufacture. If a chair is to be prepared it can be split into (i) legs (ii) arms,
(iii) seat, (iv) back rest. Each of the parts of the chair will have separate specifications and
naturally each may have its own manufacturing design. According to the specifications
and design, the bill of materials will be drawn on such composite information for the
product – the chair in this case. In a bill of materials for a product, the components
required may be procured according to the specifications.

When any of the units of the organization receives a work order or production
programme is finalized, the concerned foreman prepares a list of all the materials
required for the execution of the order or manufacturing of the product as per production
programme. The list of materials so prepared is known as a bill of Materials which
includes all the details as regards to quality, quantity, code number, and other necessary
specifications, etc.

Once the production programme is finalized, each product is exploded (split) into its
basic requirements with the help of it’s of materials. The number required per item is
multiplied by the number to be produced in order to arrive at the total requirement. The
total requirements are further adjusted for various losses. Rejections should also be
provided for. Every care should make for them. Provisions for stock and lead time
consumption should be made. Taking all these provisions into consideration the bill for
materials should be drawn for each component and then through multiplication process
total requirement should be obtained.

The bill of materials – known as BOM – is the simplest technique of materials planning
.BOM with required lead -time and necessary contingency provisions is drawn which
eventually turns into indents for procurement. it also acts as a guide to delivery and
inventory requirement. BOM, therefore, helps in keeping watch over the delivery of
matching equipments, spare part, and components and also over materials directly going
into production. It enables the evaluation of the progress of the project undertaken and
ensures the flow of need materials. Such an avoidance of capital blockage saves and
diverts the working capital and reduces the inventory carrying cost to a larger extent.

Explosion of Bill of materials

Explosion of bill of materials refers to splitting of the requirements for the product to be
manufactured into its basic components; then by multiplication process we get the total
equipments. This is very effectively done with the help of “demand forecasts”. As we
have seen earlier, the very basis for material planning is the forecast of demand for the
end products. For calculation of equipments for various materials, explosion charts, are
conveniently used by the materials department. An explosion chart is a series of bills of
materials grouped together by combing the requirements for a particular end – product
or group of end – products. The above discussion may best be explained with help of the
following chart;

MATERIALS
PLANNING

BILL OF EXPLOSION TOTAL REQUIREMENT OF DELIVERY

MATERIALS CHART MATERIALS SCHEDULING

PRODUCT PRODUCT MIX PRODUCT

DEMAND
REQUIREMENT STRUCTURE
FORECAST
SS

AVERAGES EXPONENTIAL TREND

CORRELATION
SIMPLE OR OR SMOOTHING OR ANALYSIS OR
FORECAST
WEIGHTED

Fig Materials planning through BOM

Period and Suitability of BOM Technique

Bill of materials technique is ideally suited to engineering industries – both heavy and
light since her large numbers of components are required for manufacturing or
assembling and end-product which certainly required from various sources, which, as we
have seen, is a convenient method of knowing the total requirements for an end product.
There may be controversy so far as the period is concerned. It may vary from a month to
a year depending upon the reliability of information and forecasts made. A forecast tends
to become less reliable as the period goes on increasing.

Forecasts amply prove that they are reliable only to the extent to which the information
and data are reliable. If prejudices and personal pride has not crept in and the fed data
are nearly absolute, unbiased, and are based on sound judgment, then the forecasts may
serve the purpose well and period may even exceed one year. But seldom had these
conditions adequately fulfilled.

It is because of this reason that ideal period for materials planning are advocated to be of
three months. Planning on a quarterly basis is also safe in the present state of Kenyan
economy in which inflationary pressure is upsetting all calculations and market
conditions are far from satisfactory from both demand and supply points of view.

Owing to error in forecasting or change in the market conditions and the national or state
policy the materials (either all or some of them) may either be in short supply or in
excess. This surely would upset the plans, programmes and schedules. A materials
planning done on a quarterly basis may rectify the errors, apply the correctives and bring
the operation on the right track which in case of annual (or more) planning is rather
difficult, if not altogether impossible.

Past Consumption Analysis Technique

Where materials are consumed on continuous basis, the technique of past consumption
analysis for materials planning is conveniently used by the organization. According to
this technique, future projection is made on the basis of the past consumption data, which
is analyzed taking into account the past as well as future production plans. Statistical
tools like mean, median, mode and standard deviation are used in analyzing the past
consumption, projecting the future and tackling mild as well as wild fluctuations in
consumption.
This technique can be successfully used in process industries. This technique can be
fruitfully used for materials being used on continuous basis for which no straightforward
norms of consumption can be easily worked out in the organization, and also for those
materials which are either used directly or indirectly in the production process.

5.8 SOME GUIDELINES FOR MATERIALS PLANNING

Though for every organization guidelines cannot be provided in a limited treatise like the
present one but some of the general guidelines can be given which can be kept into mind
and effectively used by a materials planner for effective and reliable planning.

1. A long lead time

Lead time should be kept as long as possible to provide cover for the unforeseen
circumstances which may crop up during the planning period.

2. Analysis of operating environment

Careful analysis of operating environment of the firm is a must in order to guard against
possible demand fluctuations and seasonal variations.

3. A shorter plan period

A shorter materials plan period ensures reliability. Fortnightly or monthly materials plan
period is an ideal one. However, in Kenya quarterly plans are popular though a quarter is
not considered to be a shorter period for a materials plan this is sorter one. For a quarterly
materials plan analysis of operating environment becomes more or less a necessity. Also
lead time calls for proper scrutiny and sound judgment.

4. Computerization

Computerization of materials planning process saves time and energy and helps in
accurate forecasting. A system effecting saving in time and energy and offering better
scope for accurate forecasting is naturally ideal for any materials planning particularly
when materials planning are being done in advesse conditions and where economy is fast
changing and is not conducive to desired and healthy growth of industries, trade and
commerce. In such an economy one is required to handle wild demand fluctuations, and
a materials manager, in such a situation, is left with no alternative but to revise his
materials plans off and on with every demand fluctuation and change in economic
situation. Here computerization of materials planning process comes to the rescue of a
materials planner. Computerization of the process may help in effecting a change even
within the shortest period of 24 hours. Obviously computerization goes a long way in
proving the utility of materials planning and its fruitfulness in production planning
programming and scheduling.

5.9 MATERIALS BUDGETING

A budget is a co-ordinated financial estimate of the income and expenditure of an

organization related to a specified future period. It may be defined as “Budget is a plan of
action quantified in money terms for some future period”

A budget serves the following purposes:-

(i) Planning the activities of various departments,

(ii) Controlling such activities of the departments
(iii) Fixation of objectives and targets of all such activities of the departments
(iv) Closely watching the performance of various departments
(v) Detection of deviations etc, if there is any and
(vi) Application of correctives so as to help in achieving the objectives and targets.

Materials budgets

A materials budget is coordinated estimate of the consumption and purchases of

materials in an organizations relating to a specified period. The purp9ose of a materials
budget is:-

1. To plan and control purchases

2. To asses and make a provision for the financial requirement of such purchases
3. To plan and control the production schedule.
 4. To watch the activities of the purchases and materials control departments.
5. To suggest ways and means of improvements in the next budget estimate.

Factors governing drawing up of a materials budget

The following are the main factors which govern drawing up a materials budget

(a) The past rate of consumption and its ratio with production. The rate of
consumption plays a vital role in framing a materials budget since it is a factor
which gives two important points for careful study so as to help forming correct
estimate of materials for the ensuing period that is
(i) Period-to-period consumption of materials in relation to production
programme and the product produced. And
(ii) Period-to-period investment made. The ratio of consumption and
consequent production is also important as it helps in taking a decision
on the future course of action, particularly production planning,
purchases and sales planning which are directly dependent on this ratio.
(b) The production program me of the future specified period for which the materials
budgets is intended. Production programme is obviously one of the important
factors of the materials budget. It is the very basis of a materials budget. No one
can plan anything or estimate a future course of action unless he is in the know of
the objectives and targets to be achieved. And for achieving the target a budget is
required. The rate of consumption may remain more or less the same for a
labourer or a machine, but it often varies with the variance in production
programme. The rate of consumption is directly related to the production
programme which one has set for oneself and a materials budget is governed and
guided by this factor to a great extent.
(c) The financial burden and investment pattern. No amount of good intention on the
part of production programmes will help them in achieving targets and objectives
unless backed by a good financial commitment and a well-set out investment
pattern. The main task of the framers of materials budget is to allocate available
 funds in a manner in which maximum value is extracted from them without
disturbing the production programme. Here the efficiency of the framers is put to
test and the very success of a budget depends on the proper allocation of funds.
The means in every organization are scarce and the uses numerous. Tactful and
intelligent utilization will lessen the financial burden and set out a well-planned
and effective investment pattern.
(d) The materials cost. This factor too affects the materials budget in the sense that it
directly influences the financial commitment of the organization. A study,
therefore, of the cost trend of the materials is required. Future trend has also to be
studied and incorporated while preparing a materials budget.
(e) The demand and supply curve. Here also study of market conditions pertaining to
the demand and supply trend is to be made before venturing to draw up a
materials budget as the production schedule and financial commitments have to be
adjusted according to the trend in the market. A forecast, correct one, may for a
long way in achieving the purpose of materials budgeting. While setting a demand
curve due care should be taken of the storage loss due to circumstances beyond
human control, such as floods, transport bottlenecks, war etc.

5.10 Materials budgeting and accounting

From the above it is evident that accounting has to play a very important role in materials
budgeting. The adequate help of cost and stores accounting by way of providing up to-
date, reliable and required data to the materials control department enables it to base it
forecasts on the data so supplied. The cost and stores accounting are both to supply the
required information. Both of them are complementary to each other in this respect. To
watch the performance and to suggest corrective measures, the help of accounting has to
be taken. Hence accounting and materials budgeting together for achieving the set
objectives of the organization.

Materials’ budgeting helps in controlling the cost and thus makes the organization cost
conscious. Cost consciousness in turn makes the organization productivity conscious.
Every material requisition is considered according to its necessity, every man-hour is
utilized to its fullest capacity and every shilling spent is made to prove its worth. This is
achieving through cost and result analysis which is possible only through accounting.
Since materials budgeting aims at cost reduction, accounting again comes to the fore for
making the budget result, producing.

Techniques of drawing up materials budgets

One of the following positively correlated techniques is generally made use of for
drawing up a materials budget

a) Budget summaries
b) Manufacturing and trading account
c) Savings on investments in materials

Budget summaries

Budget summaries are summaries of various individual budgets of the organizations.

They placed in proper relationship with one another. They are viewed and analyzed and
help is taken from them in arriving at a certain conclusion for the purpose of
incorporation of a figure in a budget estimate. A material budget is grown up in relation
to production, sales and purchase budgets. Budgets summaries help in correlating each
one of them in broader perspective as budget summaries, usually accompanied by
reports, which at a greater length, deal with the variances and their reactions, and are
helpful in drawing conclusion for the next budget estimates.

The merits of the technique

(a) Budget summaries are concrete numerical standards which provide a good base
for the next budget estimates
(b) Budget summaries describe the position briefly and are arranged in such and
analytical and comparable from that they help in drawing conclusions correctly.
 (c) Budget summaries throw light on the activities of various departments. This
makes planning effective. Also objectives get correct definition. Thus
implementations part of the budget estimates becomes an easy task.

The limitations of the technique

a) Budget variations are always there. The variations may be of minor as well as of
major nature. Budget summaries may give equal importance to both types of
variations which ought not to have been treated on equal terms. The conclusions
and consequently, next budget estimates may give a picture which may not be a
true one.
b) Budget figures are often manipulated so as to balance the requirements and funds
available. This may result in faulty conclusions and thus the next budget estimate
may also become faulty. In such cases, budgetary control may also be a
troublesome and irksome job.
c) Budget summaries are merely numerical standards. They speak only about
estimates and a little bit of performance, but they do not ensure profitable
operations. No clear picture thus emerges from budget summaries so far as the
profitable operation the business is concerned.

Manufacturing and trading account

This technique is comparatively result-oriented as it is based on the performance of the

budget vis-s-vis the results. This account reveals in detail various items relating to the
opening stock purchases expenses on purchases, production, closing stock, working –in-
progress, etc, and finally the cost of production and profit made out of manufacturing
and trading process. This account is a good base, rather a good applied technique for
budget estimates. Of course, budget summaries cannot be done away with. The positive
help such summaries are of immense value for the framers of materials budget.
The merits of the technique

a) This technique is result-oriented and thus a good base for budget estimates
b) It stresses profitability aspect on each of the correlated budgets of the various
departments. Thus efficiency and performance become the keynote of various
budgets.
c) Pro rata analysis of the result is possible. Thus periodical and flexible budgets
become a possibility.

The limitations of the technique

a) It involves much paper work and thus becomes too heavy a burden for an
organization of relatively small size.
b) There may be cases in which proper allocation of expenses to one or other of the
items may not be feasible. Wrong inferences, thus may be drawn.
c) The result-oriented budget framing technique may result in interdepartmental
rivalry which ultimately may not prove to be good for the organization as a whole.

Savings on investments in materials

The overall performance of an organization can be judged by the profit it has made
during a specified period and a budget is a means to setting the objective of profit-
making in a right perspective through its estimates based on returns on investment. The
materials budget consumes the major portion of funds available in the organization;
hence it is appropriate to measure the performance of materials budget by finding out the
savings on the investments made in the past and possible expected savings in future. The
amount of savings achieved by any materials budget effectively is the success of any
materials budget and this can be better judged by the ratio of savings and investment in
materials.

The ratio of savings achieved to total investment as budget may be analyzed on the basis
of the following equations.
Saving = Savings X Value of materials utilized

Investiment Value of materials utilized Investment

Or

Value of products – cost of products = Value of materials utilized

Value of materials utilized Investment

The merits of technique

a) Objectives are clearly defined, which give a realistic approach in materials

budgeting.
b) It can also be effectively used in other inter-related departments
c) As detailed analysis is possible, a remedial action for disturbing trends may be
taken.
d) It makes possible the effective use of scarce means available to the organization.

The limitations of the technique

a) It lays too much emphasis on the financial aspects. Other important factors which
may curtail the investment and achieve savings are not taken care of.
b) The savings so arrived at are based on past performances. Future budgeting is
based on calculations. But the circumstances in which the savings are achieved
may not be present in the budget year in question. The result, thus, may be
misleading.
c) Much paper work, labour and calculations are required, but they may not
worthwhile for a small-sized business.

Before choosing any one of the techniques discussed above, the framers of materials
budget should take into consideration the points enumerated below.
 i. The objective and policies of the organization. Budget is a means and not an end in
itself, hence a well defined objective and policy will ensure effective materials
budgets, otherwise, it will simply be a waste of time, money and energy.
ii. The period of budget: budget, whether material or any other, may be of short term
or long term. Generally, a materials budget is of short term. The short term may
also be of three months, six months or even one year. This makes a materials
budget more effective and result producing.
iii. The data available. As has been discussed in the foregoing pages, the data, if
available as required, may make or mar the success and the effectiveness of a
budget. In all the three techniques discussed above the availability of reliable,
perfect, up-to-date and analytical data is very essential.
iv. Flexibility of budget. The flexibility of budget, particularly materials budget, is one
of the important points to be taken note of. The materials are subject to various
kinds of losses during the storage process, their demand may increase or decrease
according to changes in the production schedule. This requires flexibility so as to
make adjustments according to circumstances.
v. Repetition of past targets. Business is a growing and going venture. Repetition of
past targets in any budgetary provision is always in bad taste. It reflects the
unconcerned attitude of those who are responsible for running the organization. A
change towards betterment should always be the motto of the framers of any kind
of budget.

Purchasing Plan and Materials Budget can only be fixed to the accuracy of Sales and
Production Forecasts - normally not accurate to annual basis but requirement adjustment
throughout the production year

Materials Budget contains information concerning:

• Estimated materials prices for the period

• Timing of purchases to establish obligation rates for the period .

Forward buying can be arranged commensurate with planning levels and accuracy.

• Forward buying attempts to purchase quantities to levels approximating foreseeable

requirements.

• "Hand to Mouth" buying is buying material to satisfy current operating

requirements, oftentimes at less than optimum economic quantities.

Forward buying consists of advanced arrangements such as:

• Blanket Purchase Agreements

• Contract Purchases (IDIQ, Requirements, etc.)

Long term forward buying arrangements should include provisions to mitigate risks
associated with market volatility (swings either upward, to protect supplier, or
downward, to protect buyer)

Market Stability influences purchase timing

• Stable markets may allow orderly purchases of uniform quantities

• Unstable markets may provide opportunities to be either seized or avoided

• Proper market timing can be a hedge against rising prices of commodities

Volume purchased can influence prices (and also the cost of capital) while avoiding the
negative impact of numerous small purchases. Acquisition strategy and contract type are
important here.

It is important to emphasize that Strategic Materials Planning considers long-term

material requirements and market projections

• In strategic materials planning, the focus is on the corporate position over the long
haul, not short term gratification

• Potentially critical materials for future needs are identified and sources developed
• Consumer demand and product/materials innovation must be considered

• Political and economic environments in source countries must be assessed

• Competitor demands for like commodities must be considered

• Strategic materials planning should maximize benefits derived from second or

alternative sourcing agreements by injecting competition, ensuring product availability

• Materials projected in short supply should be considered for

substitution/replacement and vice versa

• Make or buy decisions should be included where outsourcing of components is a

concern or potentially risky

Review Questions
a) Define procurement plan
b) Explain the importance of procurement plan
c) Explain the process of establishing an effective strategic purchasing plan
d) Explain the factors that affects material planning
e) Describe the guidelines for materials planning
f)Describe the techniques of drawing up materials budgets

References

 Arjan Van Weele (2004), Purchasing and Supply Chain Management, PVT publishers, New
Delhi
 Benton W C (2007), Purchasing and Supply Management, Routledge, London
 Michael Quayle (2005), Purchasing and Supply Chain Management: Strategies And Realities,
Routledge, London
 Saleemi,N.A, stock control Saleemi publishers ,Nairobi
Sample Papers
DEPARTMENT OF BUSINESS AND SOCIAL STUDIES

Main Examination - May - August, 2010

BBM3112: GENERATION OF REQUIREMENTS

Time: 2 Hrs

Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO questions.

QUESTION 1

a) Explain the importance of procurement plan (4mks)

b) State the role of purchasing in new product development (6mks)
c) Discuss why firms outsource (8mks)
d) Identify items to be standardized (4mks )
e) Write short notes on the following:
 Standards ( 4mk)
 Simplifications (4mks)

QUESTION 2

a) Discuss the basic issues in make or buy decisions (12mks)

b) Explain the motives of outsourcing under:
 Focus on core competence. (4mks)
 Focus on cost efficiency/effectiveness and (2mks)
 Focus on service (2mks)

QUESTION 3

a) Explain various types of standards classifications (10 mks)

b) Discuss the importance of standardizations and simplifications (10mks)
QUESTION 4

a) Describe the process of developing a good purchasing descriptions( 15mks)

 b) Discuss various approaches to specifications (5mks)

QUESTION 5

a) Explain the process of establishing an effective strategic purchasing plan ( 12mks)

b) Explain the factors that affects material planning (8mks)
DEPARTMENT OF BUSINESS AND SOCIAL STUDIES

Special/Supplementary Examination - May - August, 2010

BBM3112: GENERATION OF REQUIREMENTS

Time: 2 Hrs

Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO questions.

QUESTION 1

a) Differentiate between turnkey and partial outsourcing(8mks)

b) Explain the conflicts that are likely to arise between engineering and other functions within
the organization (6mks)
c) Explain how simplifications are achieved (6mks)

d) Explain factors found by McQuiston to be core to a successful outsourcing

relationship (6 mks)
e) Identify the components of purchase descriptions (4mks)

QUESTION 2

a) Explain methods of communicating material needs((10mks)

b) Describe the purchase descriptions flow (10mks)

QUESTION 3

a) Describe the process of new product development (12mks)

b) Discuss the design of new product stage and the degree of its complexities(8mks)

QUESTION 4

a) Describe the guidelines for materials planning(10mks)

b) Discuss the techniques of drawing up materials budgets (10mks)
QUESTION 5

a) Explain the methods of standardization(10mks)

b) Highlight factors to be borne in mind while utilizing standards (10mks)