1.3 What Is Purchasing?

Before we define purchasing, let's take a moment to discuss how purchasing fits in your firm's value-added processes.

Supply Chain Management

Purchasing is a key function in a business field known as Supply Chain Management (SCM). You may be wondering, "What is SCM?" It is the value-creation engine of every organization. Your company—like every organization in the world—must do the following.

• Acquire inputs

• Transform inputs into highly valued outputs

• Deliver those outputs (i.e., goods and services) to customers

Simply put, your supply chain is an interconnected web of suppliers, service providers, and customers. Your goal is to make sure they all work together to create unbeatable value for the end customer.

Let's take a quick look at a typical supply chain. Imagine you are a purchasing professional at a manufacturer of Olympus brand liquid laundry detergent. The left side of Figure 1-1 is your upstream supply chain—that is, the network of suppliers providing you inputs. You buy from tier 1 suppliers, and tier 1 suppliers buy from tier 2 suppliers, et cetera. The right side of Figure 1-1 is your downstream supply chain or your customers. Your company operates its own network of warehouses and sells through multiple channels: distributors, on-line distributors, and direct to large retail chains (often called "national accounts" or "key customers").

As a purchasing professional, your job is to manage the key upstream relationships in the supply chain. Simply put, you buy the goods and services your company needs. To do this well, you must formulate sourcing strategies and select the right suppliers to ensure that the right inputs arrive in a timely manner, in good condition, and at the right cost. If you don't make great decisions, your firm's value-added operations can come to a complete standstill.

The SCOR Model

To create a shared vision of SCM, the Association for Supply Chain Management (ASCM) developed the Supply-Chain Operations Reference (SCOR)1 model shown in Figure 1-2. According to the SCOR model, if you want to maximize value creation, you must manage six processes. A seventh process called orchestration synchronizes these value-added processes into a holistic value-creation system.

• Plan: Planning processes help you develop plans to operate the supply chain; i.e., determine its requirements and obtain required resources.

• Order: Ordering processes help you work effectively with customers to recieve and effectively fill their orders. They provide the demand data needed to manage your upstream supply chain.

• Source: Sourcing processes help you build an effective sourcing organization (think policies, procedures, and measurement) and then select, manage, and develop the "best" suppliers.

• Transform: Transformation processes help you take inputs and turn them into a finished product that customers value and for which they're willing to pay.

• Fulfill: Fulfillment processes help you manage inbound delivery of raw materials and outbound delivery of finished goods and services to customers.

• Return: Return processes—sometimes referred to as reverse logistics—help you manage the return of products for any reason (e.g., customer service policy, product recalls, or environmental sustainability).

• Orchestrate: Orchestration focuses on measurement, data management, contracts, regulatory compliance, and risk mitigation to help you manage the overall supply chain.

As you look at the SCOR Model, know that purchasing and supply management (aka, source) is where your firm's value-creation efforts begin.

The Seven Rights of Purchasing

Supply Management can be formally defined as "the act of identifying, acquiring, and managing resources and suppliers that are essential to the operations of an organization."2

The good news: Supply management is easier to understand and far more fun than this definition lets on. A less formal definition is expressed by the Seven Rights of Purchasing, which say that effective supply management is . . .

• obtaining the right material

• in the right quantity

• for delivery to the right place

• at the right time

• from the right supplier

• with the right service

• at the right price.3

Let's dig a little deeper. As you looked at the seven rights, you may have noticed that two focus on what you are buying—that is, making sure you have the right stuff. The next two focus on assuring availability—on getting that stuff where you need it when you need it. The final three rights—supplier, service, and price—focus on making sure you are working with the best business partner for the purchase.

Buy the Right Stuff

If you have ever bought a piece of assemble-it-yourself furniture, perhaps you've had the following experience: Partway through the assembly process, you discovered that a critical piece was either missing or defective. As a result, you couldn't finish the assembly process—nor could you use the finished product.

The same is true in the business-to-business (B2B) marketplace. Partial deliveries or deliveries of defective product disrupt operations. You simply can't produce and deliver to plan. Of course, you could try to compensate for this by buying and holding lots of extra safety stock, but that solution is very costly—and it doesn't solve all of your problems. For example, what happens if defective parts slip past your incoming inspection process and are built into the product you sell to customers? When this happens, you can expect angry customers—and higher costs. If the defective part causes an injury, you might be sued. Buying the wrong stuff can damage your brand.

Assure Availability

Supply disruptions can cost you a fortune. For instance, if parts you buy don't arrive on time and you end up shutting down an auto assembly line, your company will lose $10,000 a minute (or more)—that's $600,000 an hour or $14.4 million per day.4 The same is true of purchased services. For example, in oil and gas exploration and production, companies that drill oil wells are racing to get the oil out of the ground first. A four-hour delay due to a late services provider can make all the difference.

Attain Lowest Possible Total Cost

Because most companies manage purchasing as a cost center, top management pays close attention to the price you pay for goods and services. One of the metrics your boss will use to assess your performance is purchase price variance, or how close the actual price was to what you budgeted. It is defined as follows:

Purchase Price Variance = (Actual Price – Budgeted Price) × Quantity Purchased

However, the purchase price may not be the best price available. There's a well-known term You get what you pay for (or more eloquently in Latin, Caveat emptor or Let the Buyer Beware). The right price is really the lowest "total cost" of buying, using, and disposing of the item. In purchasing, we call this the total cost of ownership (TCO), which is defined as follows:

TCO = Acquisition Price + NPVΣ(Ownership + End-of-Life Costs)

If you bargain too aggressively, you might get a low purchase price today, but drive up long-term costs as your suppliers scrimp on quality or quit investing in innovation. You might even turn a good supplier into an angry and resentful supplier. Worse, you might drive a key supplier out of business.

The bottom line: Companies place great emphasis on purchase price. Thus, you need to make sure you aren't paying above market prices for purchased inputs. But you want to obtain the lowest total cost of ownership, which almost always means paying a fair price—that is, a price that will help you build the most competitive team of suppliers.

Build a World-Class Supply Team

After looking at the seven rights of purchasing, you may have asked, "Which of these rights is the most important?" The answer is the right supplier. As the preceding discussion suggests, your choice of supplier affects all the other rights. If you don't select the right supplier, you will experience quality and availability glitches. Your total costs will be higher than your rivals' costs. As a result, you will be fighting tough, competitive battles with an inferior team.

The bottom line: As a purchasing professional, your job is to find, develop, and work with qualified suppliers to assure the timely delivery of high-quality inputs at the lowest total cost. To do this well, you will need to work closely with other departments—i.e., your internal customers—to design products and streamline the purchasing process. You will also want to start thinking about purchasing as managing the capacity and capabilities of your supply network.