Materials and Purchasing Management [1 ed.] 9789350432419, 9788183188715

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MATERIALS AND PURCHASING MANAGEMENT

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MATERIALS AND PURCHASING MANAGEMENT s. A. CHUNAWALLA B.Com. (Hons.). D.Pharma. M.B.A.

Communication Consultant, Benzer, Bor/vall (W), Mumbai - 400 103. chunawalla Oyahoo.com

( FIRST EDITION: 2008)

IBI GJIimalaya 60" where 60" = + 30" + 30"

Fig. 5.7

Six Sigma Management Technique This technique is the latest and highest form of quality management, and surpasses ISO 9000. Six Sigma means faultless quality right across the company management. GE, US practises this and its subsidiary in India. Godrej-GE is in the process of adopting Six Sigma standards. Some computer software companies have also adopted this technique . The Greek letter Sigma is the statistical short-hand for standard deviation. It really refers to the extent to which a process is capable of deviating from pre-set specifications without causing errors. The higher the sigma rating, the greater is this capability. Six Sigma allows variations of up to 6 times the standard deviation without causing flaws. Six Sigma philosophy is the same as that of TOM - reducing defects. The following table gives the defect rate per million and cost of poor quality in term of sales.

Outline of Materials and Purchasing Management

90 Sigma

Six cr Fille cr Four cr Three cr Two cr One cr

Defect Rate PPM

Cost of Poor Quality (% of Sales)

Less than 10% 10-15% 15-20% 20-30% 30-40% More than 40%

3.4 233 6210 66,807 3,08,537 6,90,000

Competitive Level

World Class World Class Industry Average Industry Average Non-com petitive Non-com petitive

It must be puzzling for you to settle for six sigma level of 3.40 defects per million parts, though three sigma level of 6,210 flaws is the corporate average. Just appreciate that even 3.4 defects per million in a product with 10,000 different components amounts to 34 defective products out of every 1,000. In other words, it means 34 out of every 1,000 customers will still be not entirely satisfied with your product. It explains why even six sigma is not the ceiling. The cost of poor quality for a six sigma company is less than 10 per cent, as against 15-20 per cent at four sigma levels.

Most of the output of a process will meet your specification (call it X). But some will deviate, to vary in extents, measured by the standard deviation (cr). So, some units will have a specification of X±1 cr, some, X±2cr, and some X±3cr.

The Six Sigma methodology tackles this problem in 2 ways. First, it widens the design, width, stretching the upper and lower specification limits so that even if the product ranges between X - 3cr and X + 3cr, it will function perfectly.

Fig. 5.B Six Sigma

Quality Control and Improvement

91

c D

New Scale

-00

-40

X

-20

+20

+40 +60

Oldl Scale

I I -30

I I -20

I -10

I

X

I

I +10"

I

I

I I

-60"

+20 +30

The second step: analysing and reengineering the process so that the value of sigma drops. Thus, if the upper and lower specification limits originally stood at ±30", they will automatically stand at ±60" now.

-40"

-20"

X

+20"

+40"

+60"

A Six Sigma Process should actually generate no flaws at all. But since, over the long run, every process shifts by ±1.SO", 3.4 parts out of every million will go even beyond the 60" level, generating a few defects.

Fig. 5.9

Wipro's Six Sigma Programme Wipro is dedicated to six sigma quality initiative. In simple terms this means redllcing the firm's error-level from 6,90,000 mistakes every million opportunities (one sigma) to 34 mistakes per million (six sigma). Wipro's several critical business processes were (1999) below Three Sigma. By March 2000, the company achieved four Sigma and by December 2002, Wipro reached six sigma in most of their key processes.

000

CJiAPTER 6

Materials Specifications Meaning Specifications are a detailed description or listing of the characteristics of materials, parts and components used in making a product. Specifications describe the quality of the product desired, in quantitative terms, through specifications. It should be noted that compiling specifications is a difficult task and it requires a good deal of time. It is a costly method of informing the suppliers about what is desired of the product, so far as the amount and labour to be spent for compiling specifications is concerned. But it is a better method of informing the customers what a product contains, i.e., what are the characteristics of the product and how it differs from the same type of products of other manufacturers. The following are the examples of specifications: (A) Specifications for "dome tweeters" used in stereo systems - made by Peico Electronics and Electricals Ltd., Kolkata. Type No. IPD 01630 4,8,15 ohms, Rated imparlance 1500 Hz to 20000 Hz Frequency response Operating Power 3 watts 72 mm Magnet dia. Dome material Textile 3 watts input for 90 cl B sound level Sensitivity Power handling capacity 50 watts enclosure (B) Engine specifications for the Peugeot XDP 4.90 diesel engine fitted i Mahindra NL 665 DP Mini Truck, Pick-up Van and Ambulance manufactured by Mahindra & Mahindra Ltd., No. of Cylinders 4 Bore - mm 90 83 Stroke - mm 108 Bore/Stroke Ratio Displacement - cc 2112 (92)

Materials Specifications

93

22.4 : 1 Compression Ratio R.P.M. (Max.) 4500 Max B.H.P. 75 Max Torque KG.m. @ 200 r.p.m. 13.3 184 Weight Kg. On the basis of such specifications comparison of the same type of products manufactured by different manufacturers can be made. Buying by specifications has become a very common practice for most of the business units because it is the easier way of describing their needs.

Importance The profitability and competitiveness of the products depends on the design of the products. The design depends on the specifications fixed in advance. Thus development of proper specifications is very important for any management. Only properly fixed specifications can contribute to a great extent to the firm's profitability. It is very difficult to reduce the cost of production by adopting labour saving devices or other devices resulting in increased productivity because of the expected labour resistance or strong protests from them. Cost reduction by way of changes in design may also invite some pressure from labour force but it may not be too severe. Control at the design stage really helps in reduction of material costs because it is the first stage. If the cost is not controlled at this stage, it will continue to be incurred until somebody else finds out the defect, e.g., if 40 parts are used instead of 30 parts (which would have become possible if strict control had been exercised at the design stage) to make a product, use of 40 parts will become a permanent feature, because once the design is fixed for a particular product, generally it is not changed, unless and until the manufacturers think otherwise. Thus the cost of 10 parts will be incurred unnecessarily. Sales volume also depends on the design. Thus design is very important for proper specification. It is very difficult to fix proper specifications because conflicting views of various departments are to be considered for this purpose, e.g., sales department desires that the product should be unique with special features, to increase the sales, while the engineering department considers design excellence as important which may make the production process more complicated and sales may not increase. Production department prefers such design which is very simple to work out which reduces the cost production per unit and also the quantity of materials or number of parts used per unit. All departments must work with full co-operation among them, in the interest of the unit. When design engineer prepares specifications without consulting any other department, the specifications become very stringent, which may create many problems. Skilful management can motivate the departments and solve various problems that may arise against fixation of proper specification. Proper specifications must serve the following objectives: (1) Specifications must be, as far as possible, simple and economical to produce. (2) Materials should be available easily in required quantity at reasonable prices. (3) Specifications must be such so that the product becomes acceptable to consumers. The best product may not have buyers in the market. (4) Specifications must ensure smoothness in production activity. The factory must function well without any obstacle. (5) It must be possible to check the conformance to the specifications. (6) It must be possible to substitute materials when it becomes necessary.

94

Outline of Materials and Purchasing Management Proper/right specifications result in increased sales, decreased cost and stronger competitive position. The following points should be considered while preparing the specifications. (a) Specifications must be as clear and explicit as possible, so that buyers and sellers both may understand the same thing in the same way. (b) Specifications should be written in such a way so that maximum number of suppliers can bid and misunderstanding can be avoided. If specifications are not practicable very few suppliers may bid, which minimises competition thereby making the choice by the buyers limited. (c) Specifications should not be written keeping in view a certain product only, because the competition will become very, very limited, e.g., suppose only one company makes a particular type of part called 'A.' Now a manufacturer states in speCifications that his/her firm will use that particular part (Le., IA') in making a machine. Here the firm restricts the competition by making it clear that the firm will be using that part, which only one company makes. Here the firm will have no other alternative than only to purchase that part from that sole manufacturer (company) only.

When and How Specifications should be Prepared? Generally a committee consisting of representatives of various concerned departments should be formed. The committee should include a design engineer, a production engineer, a quality controller, a purchasing officer, a sales officer etc. The design engineer should prepare the design of the product. Production department will consider the practicability of its production and cost of production. Purchasing department will consider whether the materials for its production will be available or not and the sales department will consider sales potential considering consumer acceptability. Quality control section should see whether the products have certain chemical and phYSical properties or not. Thus only after approval of the committee, the design is finalised with or without some changes. If deSign department only is made responsible for preparing the designs, it may prepare unnecessarily stringent speCifications, which may cause a great harm to the firm. Once the design is finalised, the specifications are reduced to writing with great care so that buyer as well as seller can have an idea about what they want or what they understand and it helps in making good purchasing. Efficient working of various departments such as design engineering, production, purchase, sales, stores, quality control etc. depends on good specifications written in clear and understandable terms. Sometimes the manufacturers prepare specifications for their products, e.g., different manufacturers of trucks, tractors, cars, scooters etc. have their own speCifications. It is not possible to manufacture such items as per the specifications of buyers. In case of military purchase or purchase of the items of special use, the buyers prepare speCifications as their needs and they inform suppliers/manufacturers, so that the suppliers/manufacturers can supply as per buyers' specification. Buyers and suppliers prepare specifications when standard specifications do not exist. In case of most widely used and highly competitive items, standard specifications are available. The products with standard specifications, manufactured by different manufacturers, will be the same. When products or goods are ordered on the basis of standard specifications, the buyer as well as the seller know what is required. Such items are available at reasonable prices. There exist many users and, therefore, the producers can sell their whole production at reasonable price. Standard speCifications specify the

Materials Specifications

95

standard of materials to be used, the process of manufacturer, the quality of workmanship, performance standard, method of checking their quality and performance etc. Standard specifications prove to be most helpful in simplifying the design and purchasing procedure. Moreover, inventory control and cost reduction become easy. Copies of standard specifications can be obtained from various sources such as manufacturers, government departments, testing laboratories, standard institutes etc. and therefore buyer and seller has not to spend time, money and energy for preparation of such specifications.

Types of Specifications Generally three types of specifications are used, i.e., technical, performance and brand name. Technical speCifications state the phYSical and chemical properties desired in the product. When the desired properties are in measurable terms they are called dimensional specifications. This type of specifications can be checked easily. Generally in case of oil, paints and metallic raw materials this type of specifications are used. Sometimes materials to be used and met~od of manufacture are also prescribed. This is another form of technical specifications. This happens generally in case of military purchasing, because military purchases are made as per the needs of the defence department, where standard specifications do not exist. Now the military requirement is a confidential matter and therefore the supplier/manufacturer has to follow the instructions and specifications provided by the defence department. In case of industrial purchasing, it is not so, unless and until the requirements of a particular unit are of special type or say unique. In case of industrial purchasing, generally the supplier/manufacturer knows what the buyer wants or what performance he/she expects from the articles purchased and therefore the supplier/ manufacturer uses the materials and methods of manufacture accordingly. Performance specifications describe in words the performance or use of the items to be purchased or the services that the product will give. Here the buyer gives importance to the performance of the product and not to the analysis of materials used or the dimensions of the product or the components used. It should be noted that the conformance to performance specifications can be determined by use of the product, while that of technical specifications can be determined by tests in laboratory. The supplier/manufacturer is not advised about the type of material or the process/method of manufacture to be used. The supplier is free to use materials and process/method of manufacture which he/she thinks suitable and he/she may take advantage of most up-to-date knowledge of technological development to provide the best product at the lower cost. When a buyer gives a supplier free choice to select materials as well as the process/ method of manufacture, the buyer must be sure of the supplier's reliability and capability. Unreliable and incapable supplier may cause a great harm. A supplier, not fully reliable, may suggest another more expensive and better materials than needed or he/she may not be able to supply the materials in required quantity. Only the reliable suppliers can supply the materials or products at reasonable prices and can, therefore, transfer the benefit of advanced technology to the buyers, because only they make use of advanced knowledge. Performance specifications are extensively used in purchasing highly technical military and space products and also complicated machines and machine tools. Sometimes buyers advise the suppliers to use specific methods or process of manufacturing and materials. Such practice is not advisable except in case of military purchases. Here the buyer becomes fully responsible for the performance of the products, so long as his specifications are met by the suppliers. Moreover, the benefits of advanced technology in form of new and improved methods of production etc. with which only the suppliers are familiar, may not be available to the buyer. Further, it is also very costly and time-consuming to prepare specifications and to inspect for

96

Outline of Materials and Purchasing Management

compliance. But when the buyers want to meet their specific needs or when the suppliers are too small to have research and development facilities, such practice can be adopted by buyers. Now sometimes specifications take the form of blue-print. "The blue-print is the most accurate form of description and is used when close tolerance or high degree of mechanical perfection is required. Its use is expensive not only because of the cost of the blue-print, but also its description of an item of special design that is costly to manufacture." This method is the most feasible method of description for items like castings, forgings, tools, fixtures, punchings, machine parts, etc., where extreme accuracy is a must. Moreover, blue-prints provide the basis for an accurate check on compliance, with specifications by the inspection department, when material is received. When it becomes very costly to develop performance or technical specifications or if such a practice does not prove satisfactory, purchases are made on the basis of brand names, e.g., in case of items like trucks, scooters, tractors, cars etc. It is not feasible for the buyers to develop specifications. There would be a small difference in each brand of different manufacturers, even though each product might be designed to provide almost identical performance at the same or slightly different price charged for the competing brand, e.g., prices of different brands of scooters - Bajaj, Priya, Alwyn-Pushpak, Falcon, Avanti, Vijay Super, Girnar, etc. are not the same. Price of an Ambassador car is different from that of Premier Pad mini. In case of such type of products each manufacturer would claim that his product is the best of all. But the buyers can judge the performance of each brand after using various products over a number of years and can decide the most satisfactory brand. The reliable and progressive manufacturer creates goodwill for his firm by ensuring the best performance of his products over a number of years. But the buyers have to keep a close watch over the working of different manufacturers and their products. The best products of the past may have become inferior due to change in quality specifications, etc. while the new manufacturers with most modern machinery may have come out with better products than the best products of the past.

Advantages of Specifications Buying (1)

(2)

(3)

(4)

When a buyer has to purchase or is required to purchase a particular type of goods from more than one supplier, specifications ensure the identity of goods purchased. Thus, the materials with identical nature can be purchased from different suppliers on the basis of specifications only. Specifications provide an exact standard to the inspection department of the buyer against which incoming materials can be inspected or measured or tested with great accuracy and this ensures uniformity in quality of materials purchased. Specification buying includes more suppliers to bid an offer because all of them know exactly what is required and they also know what are other suppliers are bidding for. Now increased competition proves very economical to the buyer in form of lower prices. Specifications are prepared considering various factors such as quality, sales potential, availability of raw materials, consumers' acceptability etc. This may result in simplification of design, reduction in the quantity of materials used, increasing the productivity, decreasing the cost of production, lower selling price etc. Thus buyers are more benefited by specifications, if the benefits mentioned as above are passed on to them by the suppliers.

Materials Specifications 97 (5) If the suppliers combine specifications with quality control measure, the buyers have not to worry much about the testing or inspection of the products purchased and in such circumstances buyers save money and time both, by dOing less complete inspection.

(6)

Specifications buying is a necessary step towards industry-wide standardisation and standardisation helps a lot in cost saving.

Disadvantages (1)

(2)

(3)

(4)

(5)

(6)

Specifications become inappropriate in case of patented items or items with brand names or items manufactured by patented process. Product of each manufacturer show slight difference, even though each of them might be designed to provide same type service, e.g., trucks, scooters etc. Product of each manufacturer is unique and the buyers purchase the products of a particular manufacturer because they have confidence in the unique skill of that manufacturer, e.g., Volvo Trucks, Honda Scooters, Maruti Suzuki car etc. Items purchased to specifications require detailed inspection to decide whether they are in conformity with specifications prescribed or not. This proves costlier. While items with brand names require only a casual check. When specifications become very stringent, many problems arise. In case of very stringent specifications, the buyer have to pay more than necessary for the items. Specifications buying proves economical only in case of large purchase. It is not a wise or a advisable step to prepare specifications for small purchases. Moreover, where the buyer has to purchase many types of items in small quantity, it may prove very harmful to prepare specifications for such items. When a buyer purchases items as per his/her specifications and if the product does not prove satisfactory even though the supplier has complied with the terms of the purchase, the responsibility rests with the buyers for unsatisfactory performance. Now once the specifications are fixed, it is in the interest of the buyer to review them. If the buyers do not review the specifications once fixed, considering technological developments, they may be thrown out of the markets by the consumers.

000

CJ..APTER 7 Sources of Supply: Vendor Selection and Rating Introduction Scientific purchasing involves identification, development and at times creation of the appropriate sources of supplier of materials, their evaluation and selection of the capable and willing vendor. This is a challenging task because it is not easy to discover all the sources that exist at a particular pOint of time. Even if all the sources are identified, some sources may not be tapped due to time, distance, quantity and quality constraints. Selection of the suitable supplier is both a right as well as a responsibility of the purchase department. It can contribute substantially to the fundamental objectives of the business enterprise. It is a continuous job. The decision is not to be taken once for all. The decision tends to be a complex one. It is not that the supplier bidding the lowest price is the best supplier. In fact varied economic and non-economic factors are considered while evolving the optimum decision. Different strategies are developed for acquiring different types of materials. The selection of supplier for standardized products will differ substantially from that for the nonstandardized products. A different consideration would be involved in acquiring the capital equipment, indirect materials, tools, stationery etc.

Sources of Supplier The best buying is possible only when the decision maker is familiar with all possible sources of supply in general, and their respective terms and conditions in particular. The purchase department should try to locate the appropriate sources of the supplier of various types of materials. This is also known as the "survey stage." A survey of the following will help in developing the possible sources of supply: (i) Specialized trade directories; (ii) Regional directories of chambers of commerce or such organization; (iii) Assistance of professional bodies or consultants; (iv) The purchasers' handbook or the buyers' guide; (v) The manufacturers' and/or distributors' catalogue; (98)

Sources of Supply: Vendor Selection and Rating

99

(vi) (vii) (viii) (ix)

Direct mailing of advertising literature; The advertisement in dailies such as "buyers' guide" section; The advertisement in specialized journals; The new product and process announcements as published in dailies (e.g., Economic Times) and magazines (e.g., Purchase); (x) Visit by supplier's agent; (xi) Film slide or movie; (xii) Trade fair exhibitions. The survey should be conducted by the purchase department in consultation with the Engineering, Rand 0, Inspection and such other departments which may contribute to a refined decision. It should be noted that this task is not confined to mere identification of existing source. Sometimes, it becomes necessary even to develop a source where none had been previously available. The survey stage is a positive function in the sense that it attempts to add more and more suppliers in the list, while the development of the approved list of suppliers is the negative process in the sense that a short-listing is made out of the available exhaustive list of the suppliers that match to the requirements of the buyer ..

Development of Approved List of Suppliers The survey stage highlights the existence of the source. A business inquiry is made with the appropriate supplier. It is known as an "Inquiry Stage." Here a shortlisting is made out of the given sources of suppliers in terms of production facilities and capacity, financial standing, product quality, possibility of timely supply, technical competence, manufacturing efficiency, general business policies followed, standing in the industry, competitive attitude, interest in buyers' orders etc. The exhaustive details about the supplier can be obtained from the advertisement, trade reference, direct business inquiry or through a personal visit. The objective of the inquiry stage is to locate those few suppliers who are capable of supplying the item in required quality and quantity who can be relied on as a continuous source of supply, who will keep their delivery promises and other incidental commitments and who offer competitive price and other condition of supply. In case of critical items involving huge economic values and high degree of technicality, the evaluation and selection of the prospective supplier will be made in a group decision. The group or a supplier survey team should consist of members from the purchasing department, production department, engineering department, quality control department, R and 0 Department. The supply survey team should conduct the exhaustive survey about the suppliers which will result into the preparation of the "approved list" of suppliers. The size of the approved list largely depends on the circumstances of each case. However, there must be more than one vendor because there may be no one best source in practice. The inclusion of more suppliers in the approved list facilitates the competitive advantage. It also ensures the availability of adequate supply. However, the policy of approved list restricts the choice only to the selected suppliers included in the approved list. Moreover, those who are not included in the approved list develop a feeling of a member of the black list. As this is a self-imposed discipline, the addition to the approved list should be left to the purchase department which will try to up-keep the list of highest standards.

100

Outline of Materials and Purchasing Management

Evaluation and Selection of the Supplier The purchase policy and procedure differ according to the type of items to be purchased. The evaluation and selection of the supplier differ accordingly. For the stores and supplies, the selection is more simplified. The selection of the supplier of the capital equipment requires distinct considerations and are discussed in a separate chapter on "Capital Budgeting." The evaluation and selection of the supplier of the critical items of high value requires detailed and exhaustive considerations. The bids are invited from the approved suppliers. The bid must specify the quantity description or specification of items to be purchased, required time of delivery, required point of delivery, mode of transport, mode of payment and of course price and all other special conditions having a bearing on the price. In the "Purchasing Handbook" edited by Aljian, it has been suggested that the following variables be considered while evaluating the quotations of the suppliers:

(1)

Cost Factors (a) (b) (c) (d) (e) (f) (g) (h) (i)

(2)

Delivery (i) (ii)

(3)

Price Transport cost - if not included in the bid, to be calculated by the buyer Installations cost, if any Tooling and other operation cost Incidence of sales-tax and excise duty Terms of payment and cash discount Price basis if multiple deliveries are involved Price subject to acceptance within certain specified days Price protection conditions such as fixed price, protection against reduction in price, price subject to escalation etc. Routing: It is the privilege of the owner of the goods. F.O.B. terms are extremely important in determining (a) the point at which the title to the goods passes from the vendor to the buyer, and (b) the responsibility for the payment of freight charges.

Design and Specification Factors

(a) Specification compliance. (b) Specification deviation. (c) Specification Advantages. (d) Important dimensions. (e) Weights. This should be considered in line with the demonstration of sample, experience of other users, reputation of the supplier, after-sale service, availability of technical personnel, availability of parts etc.

(4)

Legal Factors (a) (b) (c) (d) (e)

Warranty, Cancellation proviSion, Patent protection, Public liability and workmen's compensation protection, Federal Law and reputation compliance.

Sources of Supply: Vendor Selection and Rating

101

Evaluation of the Supplier The Suppliers are rated on the basis of their past performance with the company. purchasing is a repetitive and continuous process. The supplier once selected should be continued or dropped is a matter of judgement. The evaluation of supplier or popularly known as "vendor rating" provides v.aluable information which helps in improving the quality of the decision. In the vendor rating generally three basic aspect are considered - quality, service (i.e., timely delivery) and price. How much weight should be given to each of these factors is a matter of judgement and is decided according to the specific need of the organization, e.g., quality would be the main consideration in the manufacturing of the electrical equipment while price would be the prime consideration in a product having a tense competitive market. For a company procuring its requirement under the blanket correct with agreed price, the suppliers rating would be done on the basis of two variables only, viz., quality and delivery. The Development project Committee of the National Association of Purchasing Agents (U.S.A.) has suggested following three methods for evaluating the past performance of the supplier: (1) The categorical plan; (2) The weighted-point plan; (3) The cosHatio plan. (1) The Categorical Plan: Under this method the members of the buying staff related with the supplier like receiving section, quality control department, manufacturing department etc. are required to assess the performance of each supplier. The rating sheets are provided with the record of the suppliers, their products and the list of factors for the evaluation purposes. The members of the buying staff are required to assign the plus or minus notations against each factor. The periodiC meetings, usually at the interval of one month, are held by senior men of the buying staff to consider the individual rating of each section. The consolidation of the individual rating is done on the basis of the net plus value and accordingly, the suppliers are assigned the categories such as "preferred," "neutral" or unsatisfactory." Such ratings are used for the future guidance. This is a very simple and inexpensive method. However, it is not precise. Its quality heavily depends on the experience and ability of the buyer to judge the situation. As compared to another methods, the degree of subjective judgement is very high as rating is based on personal whim and the vague impressions of the buyer. As the quantitative data supported by the profits do not exist, it is not possible to institute any corrective action with the vendor. The rating is done on the basis of memory, and thus it becomes only a routine exercise without any critical analysis. (2) The Weighted-point Method: The weighted-point method provides the quantitative data for each factor of evaluation. The weights are assigned to each factor of evaluation according to the need of the organization, e.g., a company decides the three factors to be considered - quality, price and timely delivery. It assigns the relative weight to each of these factors as under: Quality 50 points 30 points Price Timely delivery 20 pOints 100 pOints The evaluation of each supplier is made in accordance with the aforesaid factors and weights and the composite weighted-points are ascertained for each supplier. To develop

102 Outline of Materials and Purchasing Management the problem further, assume that three suppliers - A, Band C are rated under this method, First of all the specific rating under each factor will be made and then the consolidation of all the factors will be made for the purpose of judgement. Quality Rating: The Quality of the materials is judged on the basis of the degree of acceptance and rejection. For the purpose of comparison, the percentage degree of acceptance will be calculated in relation to the total lots received, e.g., from A, B, and C the number of lots received were 80, 60 and 50 respectively, while the accepted lots were 76, 56 and 48 respectively. The acceptance rate will be ascertained on the percentage basis i.e., [

Accepted lots x 100] Total lots and will be multiplied by the weighted-point of quality factor (in this

problem quality is assigned 50 points) to get the quality rating of each supplier as under:

Quality Rating Supplier

Quality rating (6) = (4) x (5) 6

Total lots accepted

1

A B

80 60

76 54

95% 90%

50% 50%

47.5% 45.0%

C

50

48

96%

50%

48.0%

3

Percentage acceptance 4

Weighted point 5

Total lots received 2

Price Rating: The price rating is done on the basis of net price charged by the supplier. assume that A, Band C are as under: Supplier Terms of Agreement A B

Rs. 10 per unit with 5% discount plus 50 paise transportation charges. Rs. 11 per unit with 10% discount plus 40 paise transportation charges.

C Rs. 10.50 per unit with 10% discount plus 60 paise transportation charges. From the above data, the net price of each supplier will be ascertained as under:

Ascertainment of Net Price Supplier

A B C

Unit Price in Rs. Rs.10 Rs. 11 Rs. 10.50

Discount in

Transportation charges Rs.

0.50 (5%) 1.10 (10%)

0.50 0.40

1.05 (10%)

0.60

(5)

Net price (3) + 4 Rs.

= (2) 10.00 10.30 10.05

For the purpose of comparison the aforesaid net price will be converted into percentage [Lowest net prices x 1 0 0 ] . . . . . on the basIs of the lowest price, I.e., Respective net price and this percentage Will be multiplied by the weighted-point of price (in this problem price is aSSigned 30 points) to get the price rating of each supplier as under:

Sources of Supply: Vendor Selection and Rating Price Rating Supplier

Lowest net price in Rs.

Respective net price in Rs.

A B C

10 10 10

10.00 10.30 10.05

103

Percentage of (2) to (3)

Weighted point

100% 97.00% 99.5%

30% 30% 30%

Price rating (6) = (4) x (5)

30.00% 29.10% 29.85%

Rating of Timely Delivery: Timely delivery is a key consideration. The delayed deliveries should be discounted on the basis of timely delivery as under: Delivery

Points

Timely delivery 100% 1 day late 98% 2 days late 95% 90% 3 days late 4 days late 83% 5 days late 75% In our problem, let us assume that the average performance of the suppliers was as under:

Supplier A Timely delivery B 2 days late 1 day late C Here the percentage value of the specific delays, will be multiplied by the assigned weighted-paints of timely delivery (in this problem 20 points), to ascertain the rating of timely delivery as under: Rating of Timely Delivery

1

Actual rating of delivery 2

Weighted point 3

A B C

100% 95% 98%

20% 20% 20%

Supplier

Rating for timely delivery (4) = (2) x (3)

20.00% 19.00% 19.60%

Then at the end the consolidation of the individual ratings will be made as under: Consolidating Rating Sheet

Rating Quantity (50 points) Price (30 points) Timely delivery (20 points) Calculated total Rating

Supplier A

Supplier B

Supplier C

47.5% 30.00% 20.00% 97.5%

45.00% 29.10% 19.00%

48.00% 29.85% 19.60% 97.45%

83.10o~

104

Outline of Materials and Purchasing Management

Here supplier A with highest rating of 97.5% will be selected, because the selection is made on the basis of the maximum consolidated total rating. The supplier indicating the maximum rating is not necessarily the best supplier. The cut-off rate for the maximum rating can be prescribed by the company. A supplier with the maximum score, but falling below the cut-off rate, should not be selected. (3) The Cost-Ratio Plan: Under this method, the vendor rating is done on the basis of various costs incurred for procuring the materials from various suppliers. The cost-ratios are ascertained for the different rating variables such as quality, price, timely delivery etc. The cost-ratio is calculated in percentage on the basis of total individual cost and total value of purchase, e.g., the total delivery cost is Rs. 5,000 and the total purchases are Rs. 1,00,000, then delivery cost-ratio will be: 5,000 1,00,000 x 100 = 10% At the end, all such cost-ratios will be adjusted with the quoted price per unit. The plus cost ratio will increase the unit price while the minus cost ratio will decrease the unit price. The net adjusted unit price will indicate the vendor rating. The vendor with the lowest net adjusted unit price will be the best supplier and so on. Under this method, the most strategiC issue is the identification of various costs and their allocation among different variables and suppliers. Certain important heads of quality costs and delivery costs can be listed as under: Quality Costs

(i)

Visit to vendor's plant for approval of samples etc. (ii) Inspection costs (iii) Cost of defectives

(iv) Reworking costs (v)

Delivery Costs

(i)

Postage and telegrams

Telephones Visit to vendor's plant for expediting the delivery (iv) Extra cost for getting quick-delivery, e.g., costlier means of transportation

(ii) (iii)

Manufacturing losses on rejected items

All the cost-ratios are calculated for all the suppliers on individual basis. On the basis of the value of the each cost-ratio, the consolidated rating of each supplier is done in the manner as explained in a earlier discussion.

Buyer-Seller Relationship The continuity of buyer-seller relations helps in fostering the mutual benefits. The development and maintenance of satisfactory supplier is beneficial to both the dealing parties - the buyer and the seller. In fact, purchase and sale are the two facets of a single transaction: however, it is possible to fulfil the mutuality of interest. The selection of the supplier is basically an impersonal action, but intimacy develops in the course of time. Such a relationship can be created and maintained through the following actions: (i) Complete and clear communication as regards need, application and usage of the item; the scope of the product; and technical specialty of the product; limitation of the product; schedule of the probable requirements etc.

Sources of Supply: Vendor Selection and Rating

105

(ii) (iii) (iv)

Reciprocal understanding for each other's problems and constraints. Mutual confidence in statement and intent of both the dealing parties. To be considerate of each other's reasonable demand and elimination of undue demands. (v) Extended relationship beyond merely the contract fulfillment such as to suggest for cost reduction in manufacturing, packing, despatch, usage, accounting etc. (vi) Elimination of all chance of avoidable inquiries and unnecessary expedition. (vii) Continuous improvement in ordering method at buyer's end and supplier service at seller's end. (viii) Cultivation of personal contacts through liaison activities. The natural culmination of such warm relations is that representative of the seller becomes a member of the "buyer's team" and conversely the buyer becomes an esteemed member of the "vendor's family." It should be noted that such mutual relationship does not weaken the position of either party but in fact it helps in identifying the area of integration of objectives of both the parties which helps in serving the interest of each other. The loyalty towards the vendor always reaps some benefits in the long run. In fact, loyalty begets loyalty. The opportunism in buying or buying through "shopping around" may generate some short-term economic benefits. But in the long run such opportunism results in development of ill-feelings and dissatisfaction in the course of time. The vendor assures the uniformity of supply, assurance of supply, preferential allocation of quota under scarcity, valuable suggestion as regards probable position of supply and price, sympathetic treatment in case of crisis at buyer's plant etc. The vendor loyalty does not mean that the area of competition is eliminated or the search for the better source is abandoned. It simply means that the established supplier is given an opportunity to work out the best terms of the deal that are consistent with the requirements of the buyer, without sacrificing the interest of the buyer. In fact, continuous change in the supplier not only increases the cost of buying, but it also indicates the lack of reliability of buyer from the supplier's viewpoint which definitely proves costlier in subsequent buying. The legitimate buying and selling does not leave any room for the dishonesty in buyer-seller relations such as bribery, offer of gift articles, misrepresentations etc. However, it is very difficult to put a line of demarcation between fair or foul tactics in buying and selling, and it merely becomes a matter of degree and intent. The development of the personal relationship with the salesman of the supplier is good, but the loyalty must rest with the supplier because when salesman joins the competitor's firm, the business should not go with him. In fact, some salesmen hold a good command over certain key buyers and accordingly, they bargain their position. Similarly, the purchase officer should be made free from pressure of superiors in exercising the buying decision, If this is not maintained then purchase officer should not be held responsible for any form of failure of purchase function. The superior may not always act in the interest of the organization and thus may not be inclined to adhere to the standards. The purchase function shoul ! be handled autonomously through the independent purchase organization.

000

CItAPTER 8

Buyer-Seller Negotiations Introduction Negotiation is an important, interesting, costly and complex mechanism in the buying and selling process. Generally it is confined to the high value and/or large volume buying. It is superior to competitive bidding, another popular technique employed in high value and! or large volume purchases because unlike bidding, negotiation is a two-way process. In fact, negotiation provides a legitimate and ethical means for setting the transaction between the buyer and seller through the give and take tactics. It is not a process of stripping or trapping any of the party by other party but a healthy activity which eliminates the injustice to any of the parties of the deal. In reality, the successful negotiations result in satisfaction to both the parties. At the end of the deal, the dealing parties feel that they have reached to an agreement which is mutually beneficial. Negotiation means deliberations between the parties leading to an agreement. It is a business session between the buyer and seller for the purpose of settling some business transaction. Webster defines negotiation as,"conferring, discussing, or bargaining to reach agreement in business transactions." It is also defined as, "the process of working out a procurement and sales programme together, to the point of reaching a mutually satisfactory agreement." As competitive parties deal through the negotiation, the purchase deal of one party results into the sales deal of the other. Many times negotiation is considered as a price haggling, and thus is considered unethical. In reality, price is not the only, but one of the considerations in the negotiation. Moreover, it does not amount to exploitation of one party by the other, but it results in an agreement which is mutually beneficial.

Objectives of Negotiation The negotiation is an objective oriented process. All types of negotiation strive to attain one or more of the following objectives: (1) To settle a fair price. (2) To perform the contract in agreed time. (3) To exert control on the fulfillment of the agreed terms. (4) To seek maximum co-operation from the supplier. (5) To develop sound and sustained relationship. (106)

Buyer-Seller Negotiations 107 (1) To settle a fair price: To get price settlement is the core part of the negotiation. Both buyers and sellers consider their respective cost analysis of the product. Cost-data is the factual data. Of course, it is subject to some adjustments during the deliberations. However, the utility factor of the buyer (i.e., the intensity of the need) and the profit margin of the seller, provides sufficient leeway in the price settlement Both parties have their respective ranges of the price. Negotiation strives to develop a fixed point on these ranges which is considered satisfactory by both the parties. It should be noted that price fixing is sometimes qualified by the quantity of purchase, sustained buying from the negotiating supplier, transportation and other allied costs, insurance, etc. Clarification should be sought on all these issues while developing a fair price.

(2) Timely delivery: The objective of buyer and seller gets integrated on the issue of timely delivery because for the buyer it eliminates the situation of stock outs and the resultant losses, while for the seller, it enables him to liquidate his stock and the paraphernalia of costs attached to storing and to utilise his production capacity more effectively. Timely delivery is endangered when buyer fails to plan his requirements, or the planned requirements are not communicated to the seller. Seller fails to deliver in time when there is no commitment or there exists any ambiguity in commitment. Negotiation attempts to bridge such gaps on the side of both the dealing parties. (3) Fulfillment of the terms: Any negligence on the part of the supplier as regards quality, quantity, time of delivery, mode of delivery, pricing etc. greatly affects the interest of the buyer. Specific conditions can be deliberated at the time of negotiations and can be expressly provided in the agreement. Such type of effective plugging is not possible in any other form of contracting. It should also be noted that the conditions of the agreement are not always static. In fact, they change over a period of time. A prudent buyer never allows his agreement to be filed once it is agreed upon; he keeps it alive throughout the contractual period. He will remain alert on all issues and may also initiate the possibility of reopening the negotiations in case of need, considering the interest of his company. (4) To seek maximum co-operation from the supplier: Generally the supplier is put to a positive situation as compared to the buyer. So the buyer should try to develop all such tactics through which the maximum co-operation of the seller can be obtained. Cooperation begets co-operation. To get the maximum co-operation from the supplier, the buyer should try to co-operate with him in all respects, e.g., if all other things are equal or if the change in the supplier is marginally and temporarily beneficial, the supplier should not be changed. The environment of cordial relations, permits the supplier to reduce some of his operating costs and he willingly passes over some part of such benefits over to the buyer. (5) To develop sound and sustained relationship: The sound relationship between the buyer and seller can be developed through the frequency of transactions and the behaviour during the fulfillment of specific transactions. Such relations can be developed through courteous behaviour and recognizing the adversities of the other party and if possible, adjust to it accordingly, e.g., to help in meeting the financial crisis of the supplier by making prompt payments or advance payments, rescheduling of orders due to some accident at supplier's plant etc. A good supplier will definitely recognize the importance of such considerate buyers and will try to help them in all respects such as giving priorities of supplies in case of shortages, special concessional price offer, advance intimation about the forthcoming supply position, the information about the technological changes and its impact on the buyers' production etc. The negotiation involves two-way communication and it is not once and for all but it should be more or less of a permanent nature. Whether one

108

Outline of Materials and Purchasing Management

buys from the previous seller or not, the relations should be established on a sustained basis.

Need for the Negotiation Negotiation is a costly affair. It may involve a short-lived telephone talk to a series of discussion sessions consuming substantial time. Due to this the negotiations should be confined to the needy occasions only. Negotiation would not be desirable under following types of purchases: (i) Minor purchases. (ii) Purchase of low cost, very non-recurring items. (iii) Sporadic purchase of a fairly high value item. (iv) Branded items which are stocked by the supplier and are sold at the catalogue prices. (v) When supplier's proposals are considered satisfactory by the buyers. Negotiations would become necessary under following conditions: (1) Where situation is not conducive to competitive bidding such as lack of explicit clarity in the minds of buyers and sellers regarding specifications, existence of less number of sellers, urgency of the need etc. (2) The variables other than price such as quality, time of delivery, mode of delivery, incidence of transportation costs. etc. are required to be agreed upon. (3) Where the buyer desires to contract for the unused capacity of the seller rather than for the products manufactured by him. (4) Where the business risk involved in the deal cannot be determined accurately, negotiation should be preferred. Under such situation, generally, sellers charge high prices for the purchase to compensate against such business risks. When such risks do not materialize, the buyer stands loser under the deal. Mutual negotiation eliminates or minimizes such incidences for the buyer. (5) When the deal is for capital eqUipment and its tooling and set-up costs represent a large percentage of total costs, negotiation would be desirable for the beneficial deal. (6) When a long period of time is required to produce the items purchased or services performed, negotiation would become inevitable, e.g., deal for the turnkey projects, civil construction of some chemical plants etc. Under such deals it becomes highly necessary for the adjustment of prices according to the changing environment. (7) When frequent production interruption occurs due to the changing conditions, a series of negotiations would become necessary, e.g., change required in the contractual obligation caused by technological developments. (8) When seller is required to sub-contract a part of the deal and agreement of the buyer is necessary for such sub-contracting work, negotiation is the only means for settling the deal. (9) Where seller is the exclusive supplier of the materials, it becomes necessary to negotiate on prices and other terms for the purpose of preventing any unreasonable dictation by the seller. (10) Negotiation is necessary under jobbing contracts wherein individual needs are required to be settled.

Buyer-Seller Negotiations

(11)

109

It is desirable to negotiate for the items which are subject to price-fixation under the law. Under such situation price advantages can be tapped under the technique of "Concealed price cut", e.g., where two items, one being subject to price control are purchased from the same supplier the benefits can be adjusted in non-control items without distorting the price regulations.

Area of Negotiation Negotiation is a two-way communication wherein the dealing parties always have some issues on which the settlement is sought. All such issues provide the subject matter for the negotiation. It should also be noted that negotiation is possible only for those issues which are subject to settlement under various alternative sources. There cannot be any negotiation for an issue which has the one and the only solution. The popular areas of negotiation are: Price (1) (2) Quality (3) Quantity and (4) Service (1) Price: Price is the key as well as complex consideration in the negotiation. The buyer strives to prove that there exists keen competition in the market and so supplier should offer the most competitive price while the supplier would try to prove his indispensability and hold in the market and thus will try to strengthen his bargaining position. While negotiating on the price, each break-up of the price should be negotiated separately. In case of conditional price (e.g., f.o.b. price), the incidence of each condition on price shoutd be measured accurately. Sometimes instead of price negotiations, cost negotiations are carried on. Under such negotiations, deliberation are made on each element of cost. The usual break-up of the price along with the elements of cost is as under: Material cost XX XX + Labour cost Overheads: + Fixed XX Variable XX XX Cost of production XX XX + Profit margin Price XX The ascertainment of each element of cost is a technical matter and is subject to substantial deliberations. Especially the overhead part of the cost is more debatabte. However, reasonable agreement is possible on all these issues. (2) Quality: The quality considerations are also subject to debate and deliberations. The quality will be largely affected by the factors such as the dimensions of raw materials, material mix, quality control, processing method and even primary and secondary packing. All these issues should be deliberated and agreed upon expressly. (3) Quantity: The quantity considerations involve the negotiation on the issues such as quantity discount, commitment of the supplier to meet the future requirements, the guarantee from the buyer to place orders in future etc.

110

Outline of Materials and Purchasing Management (4) Service: The service aspect of the negotiation involves the considerations such as timely delivery, after-sales services, treatment of defectives and rejections etc. As settlement of agreement is a composite deal, the impact of all these factors should be weighed individually before finalizing the final deal.

Principles of Successful Negotiation Negotiation requires a specialized skill. The essential element in the negotiation is the bargaining between the individuals or groups of individuals, so the negotiation process involves the personalities, their motives, their strengths and weaknesses and above all a great deal of psychology. The following rules should be observed in carrying a successful negotiation: (1) The issues of the negotiations should be organized properly. (2) The buyer should carryon the negotiation on his home ground and as per his own arrangements. (3) The buyer should try to put himself in supplier's shoes. (4) The buyer should allow the supplier to do most of the talking. (5) Only one point be taken up at a time. (6) The talk should be directed towards proper person. (7) The discussion issues resulting in sustained conflicts be postponed for next session, if possible. (8) One should not fumble with excessive facts and figures. (9) One should try to avoid the emotional reactions to the presentation of the other, at the same time emotional touch to the presentation should also be eliminated. (10) If any party has to retreat on a pOint, allow it to do it gracefully. (11) The objective of any negotiation is to come at some conclusion and so try to avoid premature and hasty conclusions. (12) One should try to satisfy the emotional needs of the persons who are negotiating during the session. Paul R. McDonald has described the following attributes of a good negotiator: (i) He must be a clear, rapid thinker. (ii) He must express himself well and easily. (iii) He must possess the ability to analyze. (iv) He must be impersonal. (v) He must be patient. (vi) He must consider the other person's idea objectively. (vii) He must be tactful, have poise and self-restraint. (viii) He must possess a sense of humour.

The Strategy and Tactics of Negotiation Process The negotiation involves the communication between the buyer and seller either in short-lived or extended sessions. The parties to the negotiation must define the objectives of negotiation. In the line of the objectives, they should spell out the issues to be considered,

Buyer-Seller Negotiations

111

and the degree of importance to be given each issue. Negotiation is a game between two parties. The weakness of one is the strength of the other. Pre-negotiation preparations and good homework help in increasing the bargain position of the party. Seller's Strengths (i)

Absence of competition in terms of number of sellers or superiority of technical competence of seller's product. (ii) The seller's certainty of getting the contract. (iii) The intensity of the need of the buyer, e.g., short lead time, the need to balance the capacity etc. (iv) The scarcity of the products in relation to its growing demand.

Buyer's Strengths (i)

The extent of competition in the market.

Seller's Weaknesses (i) The intensity of the need to have the contact.

(ii) The existence of keen competition in the market. (iii) Dealing with the buyer who provides assured market for the products of the seller. (iv) The general economic conditions and industry trends adversely affecting the business of the seller. Buyer's Weaknesses (i) Dealings with the seller employing the monopoly in the market.

(ii) Compelling forces on the buyer to (ii) Ability to analyse the cost data turn to the specific seller only. effectively with special reference to seller's constraint~ e.g., to hire supplier's idle capacity. (iii) The intensity of the need of the buyer (iii) Large size of the order utilizing the to get the materials as quick as substantial part of seller's production. possible, e.g., emergency buying. (iv) Economic conditions and its adverse effect on the industry of which seller is a member.

(iv) The scarcity of the products in relation to its demands.

The complete knowledge about the issues covered under the negotiation helps the party developing the strategies and the tactics during the negotiation. Strategies and tactics are integral parts of the negotiation. The strategy deals with the planning for the negotiation directing the negotiations so as to reach a defined goal, while tactics deal with moves and manoeuvres which are employed in implementing the strategy. The strategy and tactics can be employed successfully only when the dealing parties become aware about the strengths and weaknesses of each other. The strategy and tactics should be developed on the basis of the knowledge about the strengths and weaknesses of the dealing parties. The information highlighting the strengths and weaknesses of the parties can be had from the published data about general economic condition as well as data about specific conditions of the industry and the company, pre-negotiation talks and behaviour of the parties, strength disclosed or errors committed during the negotiations sessions. During the negotiation session one should try to recognize the strength of the other party but at the same time should not succumb to it. Conversely, the party with the bargaining strength should be graceful to the other and should not hit hard on its weaknesses.

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Outline of Materials and Purchasing Management

Legal Environment and Negotiation The business houses are required to honour the laws and regulations enacted by the Government. Some legal enactments encourage the negotiations while some provisions restrict the area of negotiation. In India, the Monopolies and Restrictive Trade Practice Act (MRTP Act), discourages the further growth of large houses or firms controlling the production of certain items. Such facilities encourage the competition in the market and thus the bargaining position of the buyer is strengthened. The MRTP Act also discourages certain restrictive and unfair trade practices. Such environment puts the negotiation on a sound footing. On the other hand, the Patent, Trade Mark and Copyright Acts ensure the monopoly to certain firms and the thus strengthens their bargaining power. The price control measures of the Government imposed on certain essential commodities, restrict the area of negotiation on the price variable. However, there are certain tricks which open the avenues of negotiations even on fixed price items, e.g., concealed discount offer, as referred in the above paragraphs.

000

CI-IAPTER 9

Pricing Theory, Pricing Practices and Contracts PRICING THEORY (1) Importance of the Price in Cost Structure The main objective of materials management is to reduce the share of the cost of materials in the total production cost so that the selling price can be kept at the minimum level, as far as possible and sales can be increased resulting in the increase in total profit. It means that the materials manager has to work in such a way that maximum benefit can be derived from each rupee spent on materials. Now the cost of materials forms a major part in the total costs of production. Thus the cost of materials as a percentage of total costs of production may be 50% to 75% depending on the nature of business. Now the producers' goods are generally purchased for the manufacture of consumers' goods. The materials managers or the buyers of the companies, who are responsible for the purchase of producers' goods as they are considered experts in that, buy the goods for their companies keeping in view the total cost of production. They are required to purchase at the right price to reduce the cost of materials. A small reduction in price obtained by the buyer by successful negotiation results in the decrease in the cost of production to a greater extent. The following example explains the position. During the year 2005 Atom Ltd. has produced 1,000 units of a particular product with the total costs of Rs.1,000. The details of the costs are as under: Direct Expenses :

Total amount 6,000 2,000

Raw materials at Rs. 6 per unit Labour at Rs. 2 per unit

Overheads: Variable overheads at Re. 1 per unit Fixed overheads at Re. 1 per unit

1,000 Total cost

1,000 10,000 11,000

Sales at Rs. 11 per unit

1,000

Profit

(113)

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Outline of Materials and Purchasing Management

If the cost of materials is reduced by just 5% the total costs will come down from Rs. 10,000 to Rs. 9,700, i.e., by Rs. 300 (5% of Rs. 6,000). The profit will go up from Rs. 1,000 to Rs. 1,300 (i.e., by 30%). Thus a reduction of only 5%, i.e., only 30 paise per unit, in the cost of materials results in an increase of total profit by 30%. The following table shows that how reduction in the cost of materials increases the profitability of a firm at various levels of "Share of cost of materials in the total costs." Here it has been assumed that the firm produces and sells 1,000 units at Rs. 11 per unit and the total cost of production of that firm is Rs. 10,000, which includes fixed expenses amounting to Rs. 1,000. Table 9.1 Increase in Profitability Percentage of reductions in the cost of materials Share of cost of materials in the total cost in % age.

2

3

4

5

8

10

(Increase in profitability in percentage)

30 40 50 60 70 80

3 4 5 6 7 8

6 8 10 12 14 16

9 12 15 18 21 24

12 16 20 24 28 32

15 20 25 30 35 40

24. 32 40 48 56 64

30 40 50 60 70 80

90

9

18

27

36

45

72

90

As the percentage of the cost of materials in total costs increases, the saving or reduction in materials cost results in the relative increase in the profitability. Therefore, the materials managers must try hard to reduce the cost of materials by all efforts on his part. He can negotiate the price or can find out some other reliable sources of supply or can think of new substitutes. Higher cost of production affects the goodwill of the firm and its profitability. The firm with higher cost of production may be driven out of the market. All these factors may endanger the survival of the firm itself. The selling price of the materials or the purchase price of the materials is also affected by type of competition. So far as the business is concerned, competition means competition to sell more so as to maximise the profits. Now the strong competitor does always try to drive the competitors (sellers, producers or manufacturers) out of the market by offering large discount of reduction in prices or longer credit or gifts or prizes, etc. etc. to the buyers. The buyer on the other hand does always try to purchase the requirements of his firm at the lowest possible price. This makes competition very stiff. Different types of competitive conditions in the market affect the prices of the products or materials. There may prevail conditions of perfect competition or imperfect competition, i.e., monopoly, monopolistic competition, duopoly or oligopoly, in the market.

(2) Pricing in Perfect Competition Perfect competition is not a reality but it is only an assumption. Actually it does not exist. It is said that the interaction of the forces of demand and supply determine the price in perfect competition. It is true so far as the prinCiples of economics are concerned. Perfect competition prevails only when:

Pricing Theory, Pricing Practices and Contracts

(i) (ii) (iii)

115

There are many buyers and many sellers in the market. The products sold by various sellers are homogeneous. The buyers and the sellers have full knowledge of the prevailing price of the product in the market. (iv) Any unit can freely enter in the market, if the business is found more profitable or may stop to do the business, if it is not possible to carryon the business profitably. Now we will discuss the above assumptions: It is assumed that in perfect competition there are many buyers and many sellers in the market. Now when there are large number of buyers and sellers in the market, the forces of demand and supply determine the price. No buyer or seller has a control over the price prevailing in the free market, existing under perfect/pure competition. As there are many buyers and many sellers in the market, the share of any single buyer in the total purchases or the share of any single supplier in the total supplies remains very insignificant. Therefore, no supplier can increase the price by restricting the supply in the market or no buyer can decrease the price by limiting his purchases. It means that no single supplier or buyer can affect the purchases. It means that no single supplier or buyer can affect the price by his own action. In other words, no supplier or buyer can rule the price in his own favour. The supplier can supply any quantity, i.e., as much as he wants, at the prevailing price. The prices of many agricultural products and some other products like metals (tins, nickel, zinc, brass, copper, ferrous, aluminium, steel etc.), bullion (gold and silver), dyes, chemicals etc., which are traded on the commodity markets, are determined by the forces of demand and supply in the markets. The price of some of the commodities, which are not traded on the commodity markets, are sometimes widely publicized by producers' associations or co-operatives. The price may go up or may come down depending upon the changes in supply and demand. But it should be noted that only in short run the demand and supply affect the price. In the long run every manufacturer/supplier/producer has to consider the cost of production and the business prospect which affect the demand and supply also in the long run, e.g., when a buyer is optimistic about the future progress of his business and when he expects that prices will rise to a great extent in the near future, he will buy in large quantity for his firm and build up good inventories. He will not consider his present requirements and also the price which prevails at the time of purchase. If the buyer expects otherwise, he will use the built-up inventories and will not make new purchase. If the expectation of the buyer comes true, he gets the maximum benefit, e.g., when he has build up large inventories expecting a rise in prices and the prices have actually risen afterwards or when he has cut his stocks expecting a fall in prices and the prices have actually fallen after he has cut his stocks, he gets the maximum benefit. But he suffers too much, if he fails completely in his forecasting. During the short period the demand and supply generally do not change whatever may be the price. The supply cannot be increased quickly to meet the growing demand because it requires establishment of additional facilities for production and it takes time also. In case of fall in demand, the supply cannot be curtailed because the supplier has to continue his activities on account of various reasons, e.g., he may not be able to retrench skilled workers or he may not be able to close the continuous process plant to avoid certain damages, etc. In such circumstances the changes in demand bring high ups and down in the prices. Now if price increases after remaining stable for a particular period, the buyers start purchasing to build up inventories expecting further rise in price and this type of buyer's behaviour results in further rise in price. Such trend continues until the supply

116 Outline of Materials and Purchasing Management exceeds the demand. In the same way when price starts falling supplier will start selling in a big way with various discount and gift schemes, to avoid further losses that may arise from falling price. But the heavy selling results in further fall in price. The trend continues until the demand exceeds the supply. It is also assumed that under perfect competition products sold by various producers are homogeneous, ·i.e., there is no product differentiation, because different suppliers can charge different prices for their products if there is product differentiation. Here it is assumed that each producer charges the same price because the competitor of each producer also charges the same price and if anyone tries to charge slightly more than the prevailing market price, he will not be able to sell anything. Actually, the price differs from producer to producer for the similar type of product because of different brand names, trade marks, slight difference in design, user's confidence in the product, etc., e.g., various brands of tractors - Massey Ferguson, International, Ford, HMT, Eicher, Hindustan, Swaraj etc. are available at different prices. The same is true for scooters. It is also assumed that the buyers as well as the sellers have full knowledge of the prevailing price of product in the market. It is true, because, if the buyer has no knowledge of the price prevailing in the market, the seller may charge a higher price than that prevailing in the market. If the buyer is aware of the price of a certain product and if the supplier quotes higher price, the buyer may purchase from another supplier. If the supplier has no knowledge of the market price, the buyer may try to purchase the goods at lower price by giving him wrong information. It should be noted that the buyer may agree to purchase at a higher price or the supplier may agree to supply at a lower price even if they have full knowledge of the market price depending on the circumstance of their own.

Moreover, in perfect competition any unit can enter into the market, if it considers the business more profitable and may go out of the market, if it is not possible for the unit to do the business profitably. If the production and sale of a certain product proves abnormally profitable, more and more new firms may enter into the field and the competition may become stiffer. With the rise in production, the competition to sell may increase, the price may start to fall and the abnormal profit may diminish after a particular period and may even fall below normal level. The weak and inefficient firms may not be able to face keen competition from the efficient units. When they consider that their existence is in danger they will quit the field. As a result of this, supply will decrease, price will start to rise and the profit will get again to rise to reach the normal level. We have noted earlier that the forces of demand and supply determine the price in perfect competition. Out of the two forces, demand (buyers) and supply (suppliers) - the powerful force generally succeeds in dictating the price. If the buyers are powerful, they succeed in getting the prices reduced. Here the suppliers consider their cost of production and try to increase productivity or to reduce the cost of production to maintain the profitability. The suppliers try hard to improve the products and their quality as a result of buyers' resistance against higher prices, otherwise the buyers may find out the substitutes. In such circumstances only the efficient suppliers may survive. In the short run a supplier may earn high profit, but in the long run he will survive only if he proves himself efficient and examines his cost of production to measure his efficiency. No doubt, the powerful force (demand or supply) may dictate the price, but there are certain limitations. Suppose, there are very few buyers or there is no buyer at all for certain materials, the supplier may not sell the materials at throwaway prices. He may try to recover at least the cost of production, if not the total cost, then at least the variable cost. The following example clarifies the position :

Pricing Theory, Pricing Practices and Contracts

117

Cost of Production of 1,000 Units of Certain Materials Per unit Rs.

Total Rs.

Direct material

20

20,000

Direct labour

30 10

30,000

Other variable expenses Total variable cost Fixed charges Total cost of production

-60-

10,000 60,000 30,000 90,000

:. Total cost of production per unit = Rs.90.00

To recover the total cost, the supplier should sell the goods at Rs.90.00 per unit, which represents the total cost of production per unit. If the buyers are limited, i.e., the demand is much less and the supplier is forced to reduce the price, he can reduce the price up to Rs.60.00 per unit but in no case it is advisable for him to sell the goods at less than Rs.60.00 per unit. The supplier must recover at least variable expenses in the interest of the firm's survival, even if the buyers resist. To "recover at least that amount which the supplier has spent directly for the production of the goods is the only way for the supplier to ensure the continuity of his business. But if the other suppliers quote less than Rs.60.00 per unit, he must check his cost of production. Now if there are many buyers for certain materials and the supply of these materials is very limited, i.e., there is a wide gap between demand and supply, the supplier cannot charge as much as he wants, to maximise his profit. Suppose the total cost of production of a certain item, which is in great demand, is Rs.10 per unit. Here the supplier may not charge Rs.100 per unit, even if he is the only supplier. The exorbitant price of a particular product forces the buyers to find out the substitutes and attracts new entrepreneurs for the production of this product or its SUbstitute. This results in the increase in competition and the fall in the price. In perfect competition, the materials manager cannot change the price in his favour, but he must be able to forecast the price correctly and to determine the timing of purchases on the basis of his forecasting. Price is determined by the forces of demand and supply but he must be able to predict what the price will be at a particular time. But in reality, perfect competition does not exist except in theory only.

(3) Pricing in Imperfect Competition (a) General: Imperfect competition prevails when the buyers and suppliers are not in large numbers. It may exist in form of monopoly, monopolistic competition, duopoly or oligopoly. In most of the cases prices are determined by the process of imperfect competition and not by the forces of demand and supply as in perfect competition. Prices in imperfect competition are administered prices, which are quite different from prices determined by perfect competition. When the producers or suppliers are limited in numbers, the competition among them is comparatively less and the administered price may be high, which may result in huge profit to the producers or suppliers. When the producers or suppliers are not very few, the competition among them is keen and the price remains at a low level which affects the profitability of each producer or supplier negatively, even though each producer or supplier is free to fix such price which he wants to charge. Thus in imperfect competition, the skilled buyer has every chance of getting price reduction. His success depends on his capacity to negotiate with the suppliers or producers. The buyer or the materials manager

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must understand the pricing process, so that he can know how prices are fixed by the suppliers. On the basis of this knowledge, he can seek reduction in price keeping in view the quality of materials to be purchased. Now in imperfect competition the products of different producers are not homogeneous, i.e., product differentiation is there in imperfect competition. Each product is unique by itself, e.g., in case of tractors, International, Ford, HMT, Eicher, Escorts, Hindustan, Swaraj, Massey Ferguson, are the different brands which compete with each other. They are so far as the brand, outer design, special features, spare-parts used etc. are concerned. Therefore, the pries are also different for each brand of tractors. One producer may keep such price which is higher than charged by other producers. Moreover, the buyer also sometimes offers higher price for a particular brand of product, e.g., the buyer prefers Bajaj scooter, Massey Ferguson tractor, Colgate tooth-powder, Raymond's terry-wool suitings, moulded luggage (suitcases, brief cases etc.) from Blow Plast Ltd., worsted suitings from Vimal (Reliance) etc. etc. Product differentiation becomes helpful to the producer or supplier, who can convince the buyers that his product is different from the same type of products of other producers or suppliers and his product is better in quality, good looking in design and not too much complex. Once the supplier or the producer succeeds in establishing product differentiation, it becomes easy for him to charge higher price for his product and to earn handsome profit. Colgate-Palmolive (India) Ltd., is the best example. The prices of its products - tooth paste, tooth powder etc. - are comparatively higher and it earns handsome profit. Its products enjoy goodwill in the market. Its total share in the market is the highest among the producers of tooth paste, tooth powder and tooth brushes. By aggressive sales efforts and intelligent, attractive and eye-catching advertisements, the producers in many cases succeed in creating goodwill for their products and in establishing product differentiation. In such cases, the buyers also offer or pay higher prices for certain products of certain producers, even though the identical products from other producers/manufacturers are available at the lower prices. This is true not only for the consumers' products only but for industrial products also. The buyers of industrial products are comparatively more intelligent and therefore in many cases they succeed in getting the prices reduced to some extent. In such circumstances the manufacturers/suppliers have to consider buyer's resistance also and, therefore, even though the manufacturers/ suppliers are free to fix the prices of their products, they may not be able to fix the prices as they desire. But the renowned manufacturers/suppliers of certain products who have established market, can fix higher prices and stick to that whatever may be the market conditions or buyers' skill, if genuine product differentiations is there. Here the buyer has no alternative but to pay what the manufacturer/supplier demands for his products. (b) Pricing in Monopoly: When there is only one seller, he is said to be a monopolist. No other competitor or the substitute product exists in monopOly, and therefore the question of product differentiation does not arise. A monopolist can control the supply, because there is no substitute producer or a competitor who can supply materials. He dominates the market as well as the price. He can fix such price at which he can sell enough to maximum his profit. The monopolist may be an individual or a firm or a company or a corporation or an autonomous body or any other organization. A manufacturer/supplier having a major share in the market cannot be said a monopolist because other manufacturers/suppliers are also there having a minor share in the market, whose products can be slightly differentiated. A small Kirana shop in the remote village area, which is the qnly shop in that area, is a monopolist, so far as that area is concerned, because in that area that shop is the only seller. Railways may be considered as a nation-wide monopoly. Monopoly exists only when the entry of new firms in the field is blocked by various forces.

Pricing Theory, Pricing Practices and Contracts

11 9

It is to be noted that even a monopolist cannot charge grossly excessive price. If he does so, his sales may fall to a very low level, which may not be enough to cover his total costs. Therefore, he should first decide the quantity, which he should sell and then the price at which he can sell this quantity. A monopolist can charge different prices to different buyers. The skilled and intelligent buyers have a chance here, to seek price reduction. A monopolist gets the advantages of large-scale production, because he is the only manufacturer/supplier. Moreover, he has to spend comparatively much less amount for sales and distribution of goods than that which he would have spent in case of competitive markets. Therefore, it may happen that the price charged by a monopolist may be lower (even if it may be higher than the marginal cost) than it would be in competitive market. Sometimes, monopolist it would be in competitive market. Sometimes, monopolist restricts the output to maintain the price or to charge the higher price. (c) Pricing in Monopolistic Competition: In monopolistic competition there are many producers, with different products, which are not identical or homogeneous but are the close substitutes of each other. It means that product differentiation, i.e., a slight difference between the products of various producers exists, e.g., so far as the tractors are concerned, Ford, International, HMT, Eicher, Escorts, Kirloskar, Hindustan, Swaraj, Massey-Ferguson etc. are not homogeneous products. The same can be said for refrigerators like LG, Godrej, Whirlpool etc. The products in each category - tractors, scooters or refrigerators etc. are close substitutes of each other. Slight differences in outer design, brand names, spareparts used etc. are found in different products of various producers. If Massey Ferguson tractor is not available, one can buy any other brand from the market. The producers/ suppliers with famous and more acceptable brand name may be able to sell more. But competition between many firms protects the buyers because no firm can charge as much price as it wants without considering the price charged by other producers. The market or the output or the price cannot be controlled by any firm. No firm can follow an independent price policy. If one firm reduces the price, other firms may also follow the same practice. Each firm has to consider the price charged by others, while fixing the prices of its own products. In monopolistic competition the producers/suppliers have to spend money on advertising and publicity because other competitors are also there in the market to sell their own products. This increases the cost of production. In monopolistic competition the buyers have a chance of selecting the product. Moreover, as a result of competition the prices may remain at somewhat low level. (d) Pricing in Duopoly: In duopoly there are only two producers. They have to charge the similar price. Their products may be the same or there may be product differentiation. When there is a product differentiation, each producer will have his own group of customers. When there is no product differentiation. they should agree upon the price, otherwise price war may take place, which may drive any of them out of the market. Generally in duopoly the producers/suppliers agree to share the market. Duopoly may exist only in case of very limited number of products. (e) Pricing in Oligopoly: In oligopoly there are few producers, who compete with each other. Here also price war sometimes takes place to drive the competitors out of the market. As the producers are few, output remains limited, prices may be slightly higher than the average cost of production. The producers have to spend on advertisements etc., because there is competition to some extent.

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PRICING PRACTICES (1) Fixation of Price by the Supplier or Producer (a) Factors to be Considered while Fixing the Price: The producers/suppliers do not fix the prices on an ad hoc basis. Prices are fixed on the basis of scientific estimates made after considering the following factors : (i) Cost of production: This is the most important factor. It is not in the interest of the supplier to sell the materials at a price which does not cover the cost of production. In exceptional cases he has to sell at a price which is lower than the total costs, but it is not the general practice. Selling at a price which is lower than the total costs, may put the existence of a producers/suppliers into danger. The cost estimates must be reliable and scientifically arrived at. The elements of the cost of production include cost of raw materials, cost of labour and other costs which we shall discuss later on. (ii) Profit margin: The producer/supplier includes profit also, while fixing the price. He can sell at cost price and still he can exist, but the aim of every business unit is to earn profit. No unit may wish to exist for a long time, if it does not get profit. Each and every company or firm or any other type of business unit wants to earn as much profit as it can in the prevailing circumstances. The producer/supplier first determines the target for profit in relation to sales and/or capital employed. Suppose a firm has estimated the cost of production per unit at Rs. 20 and it wants to earn profit at 20% on the cost of production, the selling price should be fixed at Rs.20+20% of Rs. 20, i.e., at Rs. 24. If the firm wants to earn profit at 20% on the capital employed, then the total amount of estimated profit arrived at 20% on the capital employed will be added to the total cost of production and the selling price per unit will be obtained by dividing the total amount (estimated cost of production+estimated profit) by the number of units estimated to be produced, e.g., one firm has estimated that its production during a certain period will be 2,000 units at a total cost of Rs. 40,000 and will have to employ total capital of Rs. 30,000 as per the budget estimates on which the firm expects to earn at 20%. It means that the firm should fix such price, which can result in total sales proceeds of Rs. 40,000+20% of Rs. 30,000, i.e., Rs. 46,000. Thus the estimated selling price comes to Rs. 46,000+2,000 units which is equivalent to Rs. 23 per unit. But if the producer/supplier is less efficient, then the price fixed by him in the above manner may be higher than the price charged by other producers/suppliers. If the producer/ supplier is efficient, his total cost of production will be lower than the total cost of other producer/suppliers and he will be able to sell at a price fixed by him in the above manner and to achieve the profit objective. The price fixed by the efficient producer/supplier may , be slightly lower. But if the price fixed by such producers/supplier is higher, the buyers may not accept his products, even though the products are of the right quality. (iii) Competitor's price of the identical product: The producer/supplier must know what the other suppliers/producers charge for the identical products. The sales department of the firm must have latest information about the selling price of the competitors. Where the prices of the products of various producers are publicized, it becomes very easy for any producer/supplier to compare his price with the prices of other suppliers/producers. But when the prices are not publicized, the producer/supplier does not know directly about the price charged by the competitors. Buyers may have full knowledge about the prices charged by various producers/suppliers for the identical products, because the buyer can ask various producers/suppliers of the identical products for the quotations for their products. The buyer can negotiate the price on the basis of this information. He can also use the information for the selection of a right supplier, i.e., a right source of supply.

Pricing Theory, Pricing Practices and Contracts

121 If the buyer gives the information to the producer/supplier, the producer/supplier may reduce the price for that buyer to some extent and thus the buyer may get the benefit of a lower price. Competition among the suppliers/producers increases when they come to know about the prices charged by the competitors, which may result in establishing the price of identical products at the lower level. But the producers/suppliers of products with famous brand names or the producers/suppliers who are very well known for the quality and who have won the confidence of the buyers may not reduce the prices or in exceptional cases they may reduce the prices marginally, even if keen competition may be there. (iv) Demand: In the beginning producers/suppliers may not have the knowledge or information about the future demand of their products. They have to estimate or forecast the demand. Government surveys, various studies by experts, trade associations, publications of trade/manufacturers' associations, business magazines etc. are the sources of information. Sometimes inquiries from buyers become helpful in computing the demand. Now it is in the interest of the buyer to estimate the demand of the products of a particular producer/supplier, from whom he wants to purchase the goods. By past experience and knowledge of the markets, the buyer can know who are the leading producers/suppliers of particular type of products. The producers/suppliers whose products are in great demand may charge a higher price. Therefore, the buyer, in his own interest, should find out alternate sources of supply from where he can get the required materials easily at a lower price. The producers/supplier has to consider all the above factors. while fixing the selling price for his product. It is not an easy task. The supplier/producer having famous brand names for his products may fix higher prices for his products. But when the market is weak, keen competition also exists in the market and some other well-known suppliers/producers are also there in the market whose products enjoy good reputation, the supplier/producer may have to fix slightly lower price in the beginning to enter into the market. (b) How Supplier/Producer Estimates Costs: We have seen earlier that the supplier/ producer estimates the costs of products, but actual costs and estimated costs differ because costs cannot be estimated exactly unless they have been incurred actually. Changes in the market conditions, changes in Government policy, changes in national income or standard of living etc., make the estimates useless. But by estimating the costs, the supplier/ producer gets some idea about the future costs of production. Therefore, the method of estimating the future costs is not bad. It is a guide and it helps a lot to supplier/producer in controlling the actual costs. Now the costs of production can be divided into the following elements : (i) Direct material cost, (ii) Direct labour cost, (iii) Other direct costs and (iv) Overheads: (a) Factory/ Manufacturing overhead, (b) Administrative/office overhead and (c) Sales and distribution overhead. Overheads can be divided into fixed overhead and variable overhead also. (I) Direct material cost: Direct material is that material or a part, which is used directly in the product. The material cost which can be identified with and allocated to cost centres or cost units is the direct material cost. Direct materials can be measured and directly charged to a product easily, e.g., leather use, in making shoes or wood used for making furniture. But the materials like thread and buttons used in manufacturing dresses are not considered as direct materials because the time and labour involved in ascertaining its cost, to be chargeable to the product, may be too much, so that such cost is considered as an overhead. When products must be packaged, the cost of packaging material is also included in the direct material cost, e.g., the wrapper of a toilet soap. Other materials and miscellaneous stores used for production, which cannot be charged directly to the product,

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and also spare parts, tools etc. required for maintenance and repair are included in factory overhead. Now to calculate the material cost, the quantity of materials used in each unit is to be calculated first and the same is to be multiplied by the price per unit. To estimate the materials usage is a very difficult task. Changes in estimated price of materials and also incorrect estimate of materials' usage makes the material cost estimates useless. Sometimes the increase in the scrap during the process and the shrinkage also result in an increase in material usage ratio. (ii) Direct labour cost: It includes wages paid to workers who are directly working on the product or who are directly related to the manufacturing operations for the product. Direct labourers include all labourers, skilled or unskilled, engaged on a job or process, provided the time spent by labourers on the same job or process can be ascertained and the money value of such time can be charged to the job/process concerned. Wages and salaries to the persons, appointed for inspection of quality, maintenance and repairs, supervision of the work, materials handling are not included in the direct labour cost, because they all help in the production indirectly. Such type of labour charges are included in factory/manufacturing overhead. Here the manufacturing concern or supplier first estimates the number of different types of the workers, required for manufacturing operations at a certain level of productions. Wages to be paid to such workers, depending on the skill, are also estimated. Now considering the estimated production, the company can estimate the cost of labour per unit. The estimate of direct labour cost per unit may prove unrealistic, if the workers do not show standard performance or the workers do not get sufficient work on account of power failure, shortage of materials, machine break-down, etc. or if they adopt a go slow policy. (iii) Direct cost: Other costs which are directly incurred for a particular job or product are considered as direct costs, e.g., fee paid for design or drawing relating to a specific product is a direct cost for that product. In short the costs which can be identified with and allocated to cost centres or cost units are the direct costs. (iv) Overhead: All costs other than direct costs (material+labour+others) are included under overhead. Overhead is known as 'indirect costs' also. Generally overhead includes the cost of indirect materials, indirect labour and other indirect expenses, including services which cannot be conveniently charged directly to a specific product or cost unit or process. These costs cannot be identified with any specific job or product or process and cannot be charged to the same. Therefore, these costs are recovered from the products indirectly or charged to the products indirectly by apportioning them over various products manufactured in the factory during a particular period for which the indirect costs have been incurred. The overhead is divided into factory/manufacturing/production overhead, administration/ establishment/office overhead and selling and distribution overhead. (a) Manufacturing overhead: It includes indirect material cost, indirect labour cost and indirect factory expenses, which are connected with the manufacture/production of articles/goods, e.g., cotton waste and oil, small tools, depreciation on machinery, gas, power and coal used in production, salary of the factory manager, insurance, depreciation of factory building etc. Manufacturing overhead is charged to production on the basis of production or direct material cost or direct labour cost, or prime cost or machine hour-rate or labour-hour rate or any other suitable method. (b) Office overhead: It includes expenses of the day-to-day administration, e.g., office-staff salaries, director's fees, printing and stationery, postage and telegrams, depreciation and insurance for office buildings and office equipments, rent, rates and taxes

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123

for office building etc. Administrative/office overhead is generally charged to the production on the basis of factory cost. It can be charged on the basis of any other pre-determined method, which is found most suitable. (c) Selling and distribution overhead: Selling overhead includes expense for sales promotion, advertising, bad debts, salesmen's commission and salaries, other expenses of a sales office, samples, free-gifts, show-room expenses, market research expenses etc. Distribution overhead includes warehouse rent, delivery van expenses, insurance on stock of goods, salaries of warehouse staff, packing expenses, etc. These expenses are generally apportioned amongst the products on the basis of net sales value of quantity sold or office cost etc. Sometimes the overhead is also classified as variable overhead, semi-variable overhead and fixed overhead. Variable overhead varies in direct proportion to production/ sales volume, e.g., depreciation calculated on.the basis of machine-hour rate or commission to salesmen given on the basis of sales. Fixed overhead does not change whatever may Pe the production/sales volume, e.g., depreciation on office building, office rent, salary paid tc;l: certain personnel, etc. These expenses remain the same regardless of whether plant is operating at 100% capacity or only at 20% capacity. Generally the administration expense and ,'iome part of the selling and distribution expenses and also factory expenses fall under this category. Some of the expenses are semi-variable or semi-fixed which do not vary in direct proportion to the changes in production/sales volume but these expenses show a slight change e.g. when production shows on increase of 20% or 30% these expenses may show an increase of 3 to 5% and not exactly 20% or 30% as in the case of variable expenses. These types of expenses include an element of fixed cost which does not change and an element of variable cost which changes in direct proportion to the changes in activity, e.g., telephone expense include fixed amount of annual rent plus charges for trunk calls and extra local calls. Rent is an expense of fixed nature and expenses on calls are of variable nature. So far as the pricing is concerned, variable overhead is directly related to the product but the apportionment of fixed and semi variable overhead creates problems in pricing. It affects the pricing of a product. Now apportionment is made on some arbitrary basis, which may vary from producer/manufacturer to producer/manufacturer. Some may charge overhead on the basis of direct labour cost while others may charge the same on the basis of prime cost or on the basis of some other method. Because of this the cost of production for the identical products may differ from producer to producer. Suppose there are two manufacturers. 1,000 units of certain products have been manufactured by each of them. The details of production costs are as under: Particulars Direct materials Direct labour Other direct expenses Factory overhead Office overhead Selling overhead Profit margin Unit sold

Manufacturer A

Manufacturer B

2500 3000 1)00

2500 3000 500

1·qO% 9f the direct labour 50% of the' works cost Rs. 2 per u~it sold 10% of the total cost

60% of the prime cost 50% of the works cost Rs. 2 per unit sold 10% of the total cost

Full production

Full production

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Outline of Materials and Purchasing Management

The cost of production and selling price can be calculated as under: Table 9.2 Total Cost of Production Per Unit Manufacturer A

Manufacturer B

Direct materials

2.50

2.50

Direct labour

3.00 0.50

3.00 0.50

Prime cost Factory overhead

6.00

6.00

3.00

3.60

Works cost

9.00 4.50 13.50 2.00

9.60 4.80 14.40

15.50

16.40

1.55

1.64

17.05

18.04

Other direct expenses

Office overhead Cost of production Selling overhead Cost of sales Profit @ 10% of cost of sales Selling price

2.00

Thus the difference in the method of charging factory overhead affects the cost of production as well as the selling price. The intelligent buyer, who understands this, can negotiate the price in the interest of his firm, while purchasing the materials. (c) Profit-volume-cost Relationship: Total cost as well as profit varies with the variation in volume of production and/or sales. Fixed expenses do not change up to a certain level of production, but variable expenses vary in proportion to the changes in production and sales. Now the indirect expense (overheads) are apportioned or recovered on predetermined basis at the predetermined rates of recovery or apportionment. To determine the rates of recovery, the estimated production is conSidered. Thus the volume of production plays an important role in determining the overhead absorption rate, which affects of production. If actual production/sales volume exceeds the estimate, the fixed and semi-variable overheads are over-absorbed. Estimated overheads are absorbed fully when the actual production crosses the level of estimated production. The overheads recovered on excess production/sales show the excess recovery, which generates extra profit for the producer/supplier. In such circumstances, the producer or supplier can achieve the targeted profit even after a reasonable reduction in price. Over recovery or under-recovery of overheads may arise because the fixed and semi-variable overheads to not change in proportion to the changes in production/sales volume. The following example explains the above facts: Suppose a producer produces 1,000 units of a certain product and sells the same at Rs. 12 per unit, per year. He can increase the production up to 2,000 unHs per year without any increase in the fixed overhead. He has given the following details for the year 2001 for 1,000 I mits produced and sold: (i) Direct material cost: Rs. 2.50 per unit. (ii) Direct labour cost: Rs. 3.00 per unit. (iii) Other variable overhead Rs. 1.50 per unit. (iv) Fixed overhead: Rs. 3,000 per months. (v) Selling price Rs. 12.00 per unit.

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He can sell full production at Rs. 12 per unit up to 2,000 units per year. Details of cost and profit at different levels of production and sales can be presented as under to explain the cost-volume-profit relationship, which have been calculated on the basis of foregoing example: Table 9.3 Cost and Profit at Different Levels of Production and Sales Production in Units 1000 Units Particulars

Direct materials Direct labour Other variable overhead Total variable cost Fixed overhead Total cost Profit Sales

Per unit Rs.

1500 Units

2000 Units

Total Rs.

Per unit

Total

Per unit

Total

Rs.

Rs.

Rs.

Rs.

2.50 3.00

2500 3000

2.50 3.00

3750 4500

2.50 3.00

5000 6000

1.50

1500

1.50

2250

1.50

3000

7.00 3.00 10.00 2.00 12.00

7000 3000 10000 2000 12000

7.00 2.00 9.00 3.00 12.00

10500 3000 13500 4500 18000

7.00 1.50 8.50 3.50 12.00

14000 3000 17000 7000 24000

If the producer succeeds in increasing his production and sales to 1,SOO units, i.e., by SO%, his profit shows an increase of 12S%, i.e., an increase of Rs. 2,SOO over Rs. 2,000 and at a level of 2,000 units, his profit shows an increase of 2S0% against an increase of 100% in production and sales. The additional units produced cost him Rs. 7.00 per unit because the fixed overhead is absorbed fully at the production/sales level of 1,000 units. Therefore, the profit margin per unit increases with the increase in production. The producer can reduce the price by Rs. 1.667 per unit and can sell the goods at Rs. 10.333 approx. per unit at the production and sales level of 1S00 units or he can reduce the price by Rs. 2.S0 per unit and can sell the goods at Rs. 9.S0 per unit at the production and sales level and can still earn the same profit, which he earns at production and sales level of 1,000 units by selling the goods at Rs. 12.00 per unit. The buyers can form a group, i.e., they can unite themselves, to purchase the similar type of materials in large quantity and can succeed in getting the materials at a specially reduced rate, if they understand and want to utilize profit-volume-cost relationship in their favour. The producer or supplier may also be benefited because with the increase in production and sales, the cost of production per unit decreases. Therefore, he can offer the matecials at a reduced price. Even if he offers price concession to the buyers, total profit will increase. It means that when a company or a buyer is to buy more and more year by year due to continuous expansion of activities, the intelligent purchasing officer of the company or the buyer can ask the supplier to pass on the benefits to him by way of reduction in price. Now the reduction in price depends on the market conditions. If the supplier's market prevails, i.e., when the suppliers know that no supplier is going to sell similar goods at lower price, they will not reduce the price. In some cases, i.e., when buyer's market prevails, the buyer may succeed in getting the price reduced, even if the

126

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costs have gone up. In such case, the increase in costs is absorbed by the suppliers! producers. (d) Break-even Analysis:

(i) Break-even chart: We have discussed in (c) above that profit and cost of production are affected by the volume of production and sales. This profit-volume-cost relationship can be presented in form of chart which is known as break-even chart. The chart exhibits cost-volume-profit relationship at different levels of activity. It shows profit or loss at various levels of production and sales and also the level at which the firm makes neither profit nor loss, i.e., costs and revenue are equal at this level. The point at which this happens is called a break-even-point. The chart is very much useful to the producer or supplier for pricing decisions. He can easily know the effect of changes in volume on costs and profits. He can find out the costs and profits for his estimated production and sales with the help of this chart. If the efficiency of a producer increases, the cost of production will come down and the business will break-even at the lower volume. In the same way if he succeeds in getting more orders than his previous estimates, his profit will increase at a faster rate. Therefore, the buyer should not hesitate in seeking price reduction. Strong demand from buyers for reduction in price forces the supplier or producer to find out ways for increasing efficiency. But when the market is booming, i.e., the demand is much more than the supply, the supplier may not reduce the price. Generally, in such circumstances, the producers or suppliers do not care for break-even charts, but they try to sell as much as they can at the highest possible price and earn exorbitant profit. The following chart exhibits the cost-volume-profit relationship for the data given in Table 9.3. 35000

30000

25000 iii

a::

.5

'"

II) 10 20000

rn

~0

Angle of Incidence

U

\-"

:§ 15000 {?

Sales

10000

7200 5000 Fixed Cost '0-

",,,,

xo

o

u:U 500 600

1000

1500

2000

2500

Annual Production/Sales in Units

Fig. 9.1 Annual Production/Sales in Units

3000

Pricing Theory, Pricing Practices and Contracts

127

The chart shows that B.E.P. is reached at a sales volume of 600 units, i.e., at a sales revenue of Rs. 7,200. If the annual sales is of 1,000 units, the margin of safety is 400.units or Rs. 4,800. Suppose the selling price is reduced to Rs. 10 per unit, the B.E.P. is reached at a sales volume of 1,000 units, i.e., at a sales revenue of Rs. 10,000. Various types of B.E.P. charts can be drawn depending on the purpose for which they are drawn, e.g.: (i) Cash B.E. chart showing cash requirements for various expenses; (ii) Control B.E. chart comparing actual costs with budgeted costs; (iii) Analysis B.E. chart analysing various variable costs; (iv) Contribution B.E. chart showing contribution to fixed costs and profit; and (v) Profit-volume chart showing P/v/C relationship.

(ii) When to sell at below tne marginal cost: Generally the price of any product is determined on the basis of total costs of production. Expected profit is added in the estimated costs to determine the selling price. But sometimes the producer or supplier is forced to sell at below the cost of production per unit. Here the question arises as to what extent the price can be reduced. In the same way when a producer or supplier has received an offer from a foreign buyer to purchase goods at a lower price, the decision of its acceptance or otherwise is to be taken by the producer or the supplier. In such circumstances, the technique of marginal costing comes to the help of the producer/supplier. Price should be fixed in such a way, so that it can cover at least the marginal cost, if not the total costs (total cost = marginal cost + fixed charges). If the producer/supplier sells at a price which is equal to the marginal cost, the loss suffered by him will be equal to the fixed cost. But sometimes it may become necessary to reduce the price even below the marginal cost. Under the following circumstances the producer/supplier may reduce the price drastically: (a) When a new product is to be made popular in the market. (b) When a foreign market is explored. In such cases the supplier sells in the domestic market at a higher price and sells surplus production in the foreign market at a lower price. (c) When the surplus stock of materials liable to quick deterioration is to be disposed of. (d)

When a joint product is to be sold.

(e)

When keen competition exist in the market and the competitor is to be driven out of the market.

(f) (g)

When the workers, especially skilled, cannot be retrenched. When it is considered advantageous to keep the business going by lowering the price, instead of closing the same temporarily. When it is advisable to continue the activities to retain the old customers who may be lost to competitors, if the activities are suspended.

(h) (i) (j)

When it is advisable to keep the plant and machinery quite fit for production which may otherwise not be possible if the activities are suspended.

When it is necessary to use the existing stock of materials which are likely to deteriorate quickly. With the knowledge and understandings of the above circumstances the buyer can save substantial amount of money on purchasing by negotiating the prices with suppliers or by purchasing from foreign producers/suppliers at a lower price, than charged by the domestic producers/suppliers. If the buyer is sufficiently intelligent to understand the position of suppliers/producers considering the above-mentioned circumstances, he can surely save a lot of money for his firm.

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(2) Buyer's Pricing Decisions (a) Make or Buy or Lease Decisions: The pricing of materials, spare parts etc. affects the decision whether to make or buy or lease. The company will take such decision which will result in the reduction of cost of production. In case of spare parts required for the manufacture or assembling machine, the company has to decide whether to make component in the factory or to take it on lease. Generally no unit makes all the components or manufacture all that it wants for manufacturing/producing the articles. "U.S. Steel Corporation spends about a third of its sales dollar for outside purchases, even though it has completely integrated steel making facilities and also mines its iron ore, coal and limestone. Ford Motor Company makes all major parts of its automobiles and much of the raw materials used in making them, including steel, glass and so on. Yet Ford spends about half of its sales dollar on outside supplies more than twice as much as it spends on wages and salaries. * Thus the company will make something, buy other things and lease few things. So far as the decision to buy or make raw materials or spare parts or semi-finished goods is concerned, the company may buy from outside suppliers/producers under the following circu.mstances: . (a) (b) (c)

When the company has no facilities to make required articles. When the company can use money for more profitable activities. When the plant is operating at full capacity. Here for additional production it becomes necessary to establish additional capacity or the plant is to be operated beyond its normal capacity. In both the cases fixed cost may increase to such an extent, that the absorption of it may result in higher cost of production. (d) When it is comparatively more expensive to manufacture the articles in the company's factory. (e) When the existing idle production facilities can be used more profitably to make other articles, etc. (f) When the company has no skilled workers who can be entrusted the work of manufacturing the required components. (g) When the company has no patent-rights or is legally not empowered to make the required components, etc. (h) When the demand of the products is not of permanent nature but is only temporary or seasonal. (i) When the supplier has vast experience, skilled personnel and specialised equipments for the production of the required articles, so that they only can make the same at a very low cost. It will be advantageous to the company to make required components in its own factory in the following circumstances: (a)

(b) (c)

When the quality is important and the component is very important to the company's product. By making the component in the company's factory close quality control can be exercised. When the components can be made easily with the existing facilities and the company has considerable experience of manufacturing the similar items. If the demand for the components or materials is large and stable.

* Materials Management, Dean S. Ammer, p. 359.

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When the manufacture of the components requires large capital investment for creation of production facilities and the suppliers are unable or not ready to provide the same. (e) When the suppliers are limited and if it is considered unadvisable to rely on them. (f) When idle capacity exists and its use results in meeting a part of fixed charges, it is better to make spares etc. even if they are available more cheaply from an outside supplier or producer. (g) When the company can make the components more cheaply than outside supplier or when the material cost for making the component is lower than its purchase price. The firm manufacturing more than one item may have to decide to give up the production of less profitable items and to buy these items from outside. Sometimes, even if the firm can make the spares or semi-finished products or other goods more cheaply than suppliers, it does not make them. Profit-volume-cost relationship (the technique of marginal costing) helps in making decisions in all the above cases, mentioned in the foregoing paragraphs. Generally, any firm will make those items which yield profits to the suppliers or producers. "Both Ford Motor Company and Chrysler Corporation have built plants to manufacture automobile glass, but it is not coincidence that neither has shown any signs of building textile mills to make upholstery cloth for cars. Efficient glass producers earn about a 20 per cent return on their investment, while in the highly competitive textile industry even efficient producers consider themselves fortunate, if they average a 10 per cent return." (Dean S. Ammer, Materials Management, p. 301) When a firm makes some of the items required in the factory for manufacturing endproducts and buys other items from outside suppliers, its working is not affected by the strikes in the suppliers' plant or by the failure of the supplier to supply the items due to some unknown and known reasons. When the firm has facilities to manufacture the items which are at present purchased from outside suppliers, the suppliers or producers will remain cost conscious and will not increase the price of their products as per their desire. It is so because, the buyer is skilled enough to estimate supplier's/producer's cost of production and if the supplier/producer increases the price, the buyer will use his own plant to meet the requirements of his firm. The firm can, thus, reduce and also control the costs by splitting the items, i.e., by deciding what to produce and what to purchase from many items required. Now, if the firm has manufacturing facilities for the production of items required by it or if the firm makes the items in its factory, the manufacturing facilities should be kept upto-date. If the firm does not care for the development in technology, new methods of production, product development etc., the productivity as compared to other producers may decline and the cost of production for the articles manufactured in the factory may increase. If the cost is higher than the selling price charged by competitors or outside suppliers, the production of the articles in the factory may prove useless. While deciding to buy or to lease the following pOints should be considered : (i) Lease rent to be paid, if the machine is taken on lease. (ii) Other expenses to be borne by lessee. (iii) Amount to be invested for the purchase of machine. (iv) Interest to be paid on the amount invested, if it is borrowed. (v) Return on investment expected, if the amount is invested elsewhere.

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(vi) Life qf the machine and its scrap value at the end of its life. (vii) Repairs and maintenance expenses of the machine. The following example explains how the firm can decide whether to buy or to make. A firm has given the following information for 1,000 articles, showing estimated costs, elementwise, for the production its own factory : Rs.

Direct material cost Direct labour Variable overhead Total variable cost Fixed overhead Total cost

20,000 3,500 2,500 26,000 4,000 30,000

The firm has received an offer from the supplier that he would supply the articles at Rs. 25 per article, if purchased in lots of 1,000 units. The firm has to decide as to whether the offer should be accepted or not. Now the cost of production per article, if manufactured by the firm itself, comes to Rs. 26 per unit, if fixed charges are not considered. It is so because fixed charges are to be paid by the firm even if it does not produce anything. As against the cost of Rs. 26 per article, the purchase price is Rs. 25 and, therefore, if the firm has other plans to use the production capacity and other resources more profitably, it would prove beneficial to the firm to buy the articles from the supplier itself instead of making them in its factory. (b) How Buyer can Estimate the Costs: The buyer should be able to estimate, as accurately as possible the variable oosts of the items to be purchased as the suppliers do. The variable costs include cost of raw material used in the product and also the direct labour cost. Now to calculate the material cost, it is very very necessary for the buyer to have the correct estimate of the quantity of raw.materials used per unit and also the correct estimate of the price per unit of the raw materials used. Buyer can collect the information about the prices of raw materials used by the suppliers from various sources. Various sources of information include commodity markets where the materials are traded, suppliers of raw materials, trade magazines, commercial and financial news papers, trade associations, various department of Government etc. After the whole process stated as above is over, the buyer can calculate the material cost with reasonable accuracy. In the same way, he can estimate the approximate labour cost also. He knows much more about the supplier's plant and machinery, production process, other equipments, period of production cycle, types and number of labourers required to carry on the work etc. He can find out the rates of wages paid by the suppliers to such workers - from various sources, e.g., trade associations or employers' associations, labour unions, company's own personnel department etc. Government has fixed minimum wage rates for certain industries. Dearness Allowance rates are also publicized. Labour associations enter into agreement with various employers and, therefore, they can provide the details of wages and salaries paid by the firm. Thus the buyer can calculate labour cost also. The buyer can get overhead recovery rates also for various types of manufacturing operations from his own company's cost department. Thus the intelligent and skilled buyer can estimate costs with greatest possible accuracy.

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The buyer's cost estimates become too much useful for price negotiation. The buyer can fix the maximum as well as minimum price target on the basis of the cost estimates. If . the buyer has estimated that the price of a particular item should be Rs. 5 per unit and if he has received one offer ~o supply the items at Rs. 2 per unit and another offer to supply the items at Rs. 8 per unit, then before accepting any of these two offers. he will have to think twice. He should examine his calculations relating to the estimates first. If he finds that his calculations are accurate, he should enquire with the offerers as to whether they have committed mistakes in quotations. He should ask them to recheck their calculations. He can provide his data also for comparison, if the supplier or producer wishes so. Some large companies employ experts to estimate to the cost of various items purchased by them. Estimates are used (i) to prepare materials budget, (iO to negotiate prices and (iii) to measure the performance of purchasing department and its staff. The buyer can negotiate the prices on the basis of experts estimates. If the buyer's estimator, i.e., expert is competent, the supplier may be forced to recheck his calculations, after detailed comparison of the buyer's estimate. Generally the cost estimates are prepared for major and costly items only, because the procedure for preparing the cost estimates is expensive. If the items to be purchased are cheap or the quantity to be purchased is very small, the saving expected from negotiation will be much less and the preparation of cost estimates may prove costlier than the saving which may arise from negotiated prices, which are negotiated on the basis of buyer's cost. estimates. However, when the tender method of purchasing is used, the price can be brought down to the lowest possible level, where the cost estimates do not prove so much useful. Moreover, the cost estimates do not help the buyer under the following circumstances: (i) Where the suppliers are very few for some of the products and the products are very complicated. (ii) Where the suppliers can dictate the prices due to their monopolistic position·. (iii) Where one or two suppliers/producers have vast experience of supplying/ producing the articles, their prices may be the lowest as compared to the prices quoted by others. In all the above cases the buyer may not be able to get reduction in prices quoted by such suppliers/producers. However, the suppliers can use buyers' cost estimates to control their costs, so that they may not have to suffer due to keen competition from new entrants in the field. Once the buyer and the supplier agree on the price of the materials required, the buyer should not bow against the request of the supplier to increase the price. Sometimes, the supplier quotes lower price to get the order and afterwards when other parties are out of the picture he tries to take undue advantage and asks for the price increase. If the supplier is allowed to increase the price, he may adopt this practice every time. Therefore it is better to deal with that supplier/producer who has quoted somewhat higher price .t>hi;ln the lowest bidder. While selecting the suppliers/producers, the buyer should give preference to those suppliers who are supplying the materials since long and who are quality conscious, and keep delivery dates, even though their prices may be somewhat high. The new supplier may quote low price, but he may not supply right quality or quantity or he may refuse to supply the materials or inform the buyer at the last moment that he is unable to supply the materials at the price fixed in advance. Here the buyer would have no other option but to grant price increase, because generally legal actions are not preferred in business field. The buyer's cost estimates become helpful to the buyer himself in many ways. Sometimes the supplier/producer submits cost records to seek price increase, showing that

132 Outline of Materials and Purchasing Management the cost of production has increased too much. Now these records may be inflated. If the supplier wants his price to be increased by 10%, he may show in the cost records that his cost of production has increased by 20%. Then as a result of negotiation the supplier may agree to reduce the price by 10% and may still get an increase of 10% which he was expecting originally. Here the efficient buyer can compare his own cost estimates with the cost estimates of supplier. Now when the supplier has asked for the increase in the price, which does not look reasonable and the other suppliers of the identical goods have not increased the price, the buyer should try to persuade his supplier to postpone the increase in price. If he succeeds in doing so, the question of comparing his cost estimates with supplier's cost estimates does not arise. If the supplier does not agree, it becomes necessary for the buyer to compare his cost estimates with the cost estimates of supplier and to analyse and examine the details of the suppliers' costs to justify his demand for price increase. The supplier may have stated in his cost estimates, with details, that the prices of materials have increased by certain percentage and/or wage rates have also increased as per the details given. If his cost estimates and supplier's cost estimates differ widely, he should re-examine and verify the details of the cost estimates of his own and that of the supplier. The buyer can verify the price from the market or from the suppliers of the raw materials or the producers of the raw materials. He should also verify the details given about the estimated quantity of materials used per unit. So far as the wage rates are concerned they are governed generally by the Government legislations, wage agreements with labour unions etc. Information about the increase in wage rates given by supplier may not be reliable. If the rates of wages have not increased in any other unit of the same industry and labour statistics show that the rates have remain unchanged, the buyer should carefully go through the facts and figures given by the supplier stating that the rates have actually increased. He should also see whether the allocation of overheads has been done by selecting the base logically, because it also affects the cost of production. If most of the ,»,ork is done by the machine, overheads allocation on the basis of machine hour rate can be considered more logical and reliable. Selling overhead can be allocated on the basis of units sold or the total amount of sales but not on the basis of 'machine hour rate.' It does not mean that the buyer's cost estimates are used against the profit earned by the supplier. The buyer's estimates can be considered only as a control measure which helps the buyer in deciding whether to accept the supplier's demand for increase in price or to reject it. Generally, the buyer should not accept the demand for increase in the price without detailed examination of the information provided by the supplier. The supplier's calculations may not be proper, trustworthy and reasonable and therefore not justifiable. If the other suppliers have increased the price of the identical articles and the price quoted by this supplier has given benefit of reduction in costs by reducing the price in the past, the buyer should grant increase in price, because in such circumstances, the supplier's demand for increase in price can be considered reasonable and therefore justifiable. (c) Learning Curve Technique: It is said that efficiency and experience are interrelated. Efficiency of a worker increases, with an increase in his experience. (Sometimes the reverse may prove true.) For example, suppose a worker completes a job within 5 days for the first time. Now for the second time he may take less than 5 days to complete the same type of job. As he gains more and more experience of doing that job, the time required for completing that type of job may be lesser than before each time. Suppose a labourer takes 20 hours to complete the first job. The second lot may be completed within less than 20 hours. Now, if the second lot is completed within 16 hours, it means that the total hours required to complete the two lots decline by 10%. This is a 90%

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Learning Curve. It means that, if the first lot takes 20 hours time, the second lot will take 16 hours, the fourth lot will take 14 hours, and so on. The principle which works behind the learning curve is that "each job is performed more efficiently as it is repeated." The cost of any lot with any learning curve can be calculated with the following formula: log Vi = log V 1 - blogi where = Unit or lot number for which calculation is made, beginning with first unit or lot. = Direct labour hours required to produce i th lot or unit. Direct labour hours required to produce first lot or unit. = Slope of the learning curve calculated from the following formula: 2b = Learning curve rate e.g. for 90% curve 2b = 0.90 and therefore b = .152 In case of 70% learning curve, the hours required to produce 8th lot can be calculated as under: log Va = log (20) - (b) (log8) .. log Va = 1.3010 - (.515) (.903) .. log Va = 1.3010 - 0.4650 .. = 6.86 Va 2b Here :. B log2 = log.70 = .70 :. B :. B

=

log.70 log 2

=0.5146 = 0.515 Note: It is assumed that the first lot takes 20 hours for its completion. The calculations, are very tedious and slow and therefore 'Learning curve chart' is used. Learning curves are calculated for various levels of efficiency on a special log paper. North American Rockwell Corporation uses 80% curve. Supplier's direct labour cost is shown by the vertical scale and the output in units by horizontal scale. The curve slopes downward, which indicates that as the supplier gains experience, the labour hours required to complete the job decline. When articles to be purchased are complicated and quantity to be purchased is small and labour input is high, negotiation on the basis of buyer's cost estimates may prove useless, because supplier's cost decreases as his experience increases and this fact should be taken into account while negotiating prices. Thus learning curve helps the buyer in estimating especially labour cost, but is has some limitations. The learning curve is plotted assuming that the repeat orders are given for the same quantity as the previous orders. But actually the quantity differs each time and the change in quantity affects the price more significantly than the supplier's experience. However, the effect of the changes in quantity and experience on various types of items can be determined by studying cost changes on a number of items. North American Rockwell Corporation's material department has done this and has found out that 80% learning curve with various changes in purchase quantities results in the following relationship:

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Table 9.4 Percentage increase in quantity

10 50 100 150 200 500 1,000 1,500

Percentage of old price that should be paid for new order

67 63 60 57 55 47

41

37

Secondly, difference in price resulting from the use of various learning curves can be very large and therefore the buyer and the supplier may not agree on which learning curve should be applied. As the percentage increases, the decline in price becomes steeper. With 80% curve price on repeat orders would run 100, 80, 64, 51.2 and so on, while 60% curve, the price would run 100, 60, 36, 21.6 and so on. Thirdly, the learning curve cannot be applied in case of standard items on which a supplier is working with optimum efficiency, because a slight reduction in price is not possible in such a case. It cannot be applied to cost estimates also. Fourthly, this curve cannot be applied to all items. Lastly, the error made in estimating the price of the first order will not be corrected automatically by the use of learning curve for determining the price of a second order. The learning curve can be used for production control also. Productivity of men and machines can be measured and increased by using the learning curve technique. Suppose first job is completed by 10 workers within 10 days of 8 hours each, i.e., within 800 labour hours (10 x 10 x 8). If 90% learning curve is applied, the second job of the same type must be completed within 640 hours, i.e., the average labour hours required to complete each job decline by 90%. Thus, hours can be calculated for every succeeding job by using the learning curve. By calculating labour hours required for every succeeding job, automatic control on production can be exercised with the result the productivity will increase. To take the benefit of increasing productivity, materials in sufficient quantity must always be kept on hand, otherwise the increasing productivity will become useless for want of materials. The learning curve shows the empirical relationship between the number of units produced and the number of labour hours required to produce them. This relationship can be used by the production manager in scheduling production and in determining manpower requirements for a particular product over a given period of time. A number of words having same meaning for the learning curve have been developed by the American Productive Genius - such as improvement curves, progress curves, cost curves, experience curves, time reduction curves, production function and efficiency curves. The iearning curve originated during World War " in connection with studies of aircraft production. At that time Crawford and Strans made the study of airframe production, which showed that labour hours per unit of product declined by about 20 per cent as the production quantity of the item was doubled. While using the learning curve technique fcr analysing the costs, it is necessary to identify the factors which affect the slope of the curve (i.e., the factors that result in lowering costs) and also the importance of each of these factors. S. A.

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Billion in an article on "Progress Curves and Production Forecasting" in Journal of Purchasing of November, 1965 has selected the following factors which affect the slope of the curve: (1) Job familiarisation and task learning (workers and supervision). (2) Improvement in shop organization and production control. (3) Type of work and methods in use. Product (stage of development and complexity). (4) (5) The ratio of assembly hours to machine hours. (6) Tooling quality and co-ordination. (7) The extent of pre-production planning. The learning curve technique is based on the principle that as a worker repeats a job he becomes more efficient so far as his speed and skill are concerned. This results in a reduction in a labour cost. In case of complex process the reduction in labour cost will be greater. Now the same can also be said so far as the usage of materials is concerned. As the workers gain more and more experience and become skilled, the ratio of wastage of materials will come down. Generally, all types of costs will be lowered with increase in experience. As a worker goes on doing the same type of work repeatedly, his efficiency and skill increases which results in reduction in defective work and rejections, reduction in supervision work, more efficient scheduling and improvements in tooling. Management can exercise control over activities more efficiently. We have seen earlier that generally log-log paper, i.e., double-logarithmic paper is used to plot the data to draw the learning curve. Regular graph paper can also be used for plotting the data to draw the learning curve. But the curve drawn on double logarithmic paper looks like a straight line and it is easier to read the same, while the learning curve drawn on regular graph paper, gradually becomes flat as the number of units produced increases. In western countries learning curve technique is used in many industries other than the aircraft and missile industries. Winfred B. Hirchmann in his article on 'Profit from the Learning Curve' which appeared in Harvard Business Review of January-February, 1964 states, "No matter what products you manufacture or what type of operation you manage, there is a good possibility you can profit from the learning curve." Both - Government and commercial buyers - can also use the learning curve in developing (1) target costs for new products, (2) make-or-buy information, (3) delivery schedules, and (4) progress payments to vendors. When a buyer gives order for a special type of product required by his firm only, he can decide what to pay for the first lot, second lot, third lot and so on with the help of the learning curve. By reading the figures from the learning curve chart he can obtain the information relating to cost reductions and estimated prices. If a buyer knows that the supplier may require 20 hours to produce the first lot, he can find out by reading the figures from the learning curve that how many labour hours the supplier would require to produce successive lots. On the basis of this information he can negotiate with the supplier. Now he can decide whether to make or buy a specific part by comparing his learning curve with that of supplier's firm. The comparison will show the buyer whether he or the supplier will have lower average cost for the number of units needed. If the supplier's average cost is lower, it will be better to buy from him. Using the learning curve, a buyer can estimate how many units a supplier can produce or how much a supplier can produce over a specified time with a given labour

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force. He can know from this information, whether a supplier will be able to deliver the goods as agreed upon. He can schedule deliveries and can plan the production of his firm on the basis of this information. The learning curves show the labour hours required for various lots and from this information a supplier can calculate the labour cost for any given number of units to be produced. The supplier can, then, find out his financial liabilities for paying wages and other expenses and also the cost of materials. On the other hand, he can calculate what he will receive from the buyer over a specified time. The buyer can also calculate what he will have to pay to the supplier at the specified time on the basis of supplier's costs and then he can arrange for the payment for purchases as per the terms of the contract between his firm and the supplier's firm. Thus learning curve technique can be used in many ways, but when the data are incorrect, the result will be deceiving. The principle which works behind this technique is that the learning reduces the costs. But the economics of large-scale production may also reduce costs. Large-scale production cannot be equated with learning. Learning curve can be use for labour intensive industry or products only because where machines are used or where processes are automatic and share of manual labour is negligible. The output depends on the capacity of machines. In such a case, opportunity for continued learning is very little. Now learning varies from industry to industry, product to product, firm to firm etc. Therefore, only one rate cannot be applied to all the units or industries or for all types of products. The use of same rate (because someone else in the industry or very well-known unit has used it) may give misleading results. Learning curve technique is a time consuming technique which demands hard efforts. Therefore, it can be u~ed only when there is the possibility of substantial saving in expenditure on purchasing. When the amount involved is small, the use of this technique is not advisable. Whatever may be its limitations or disadvantages, it is an important tool in the hands of a buyer, which protects him against a supplier, by informing him about the would-be costs of a supplier for successive lots or units to be produced, so that a supplier cannot charge more for the goods supplied by him.

CONTRACTS (1) General: The buyer purchases his requirements from many producers or suppliers. Some suppliers quote a firm price,. i.e., fixed price. Some others agree to supply the required quantity at a price that may prevail at the time of delivery. In such a case the buyer cannot estimate the cost of production and the supplier is at a liberty to charge any price which he considers reasonable, because here only the quantity to be delivered is agreed upon. At the time of delivery the price charged by the selected supplier may be higher than that charged by other suppliers. Therefore, the buyer should take great care while selecting the supplier and also in entering into a contract with the supplier. Now the types of contracts vary depending on the agreements between buyers and suppliers. Contracts may be of fixed price or unfixed price. When it is not possible to fix the price, cost type of contracts are used which are called unfixed price contracts, because in such a case price depends on costs of the supplier's firm. So far as the delivery time is concerned contracts may be of two types - definite delivery type contract and indefinite delivery type of contract. When the quantity to be delivered and the date of delivery are fixed, definite delivery type contract is used. Where the quantity required or the time of use are not known, the materials are purchased only when they are required. In case of indefinite quantity contracts, the buyer agrees to purchase from the supplier the full

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requirements of his firm during a specified time. Generally maximum and minimum limits of quantitative requirements are fixed in advance but not the actual quantity required. Sometimes the suppliers quote fixed price, but insist upon some provisions for escalation in costs of materials and labour. Generally fixed price contract should be preferred, but in exceptional cases, e.g., where the contract is for the supply of materials for a very long period, the escalation provision can be accepted. If the escalation clause is provided, the supplier will not quote higher price because he is assured that he will be compensated for a rise in his costs, by way of reasonable increase in agreed price. If the escalation clause is not provided, the supplier will be tempted to quote higher price to compensate against the possible increase in costs in future. Sometimes the supplier may quote such price through an error, which may be unusually high or low. The buyer should be able to judge the existence of an error. It becomes his duty to inform the supplier and to ask him to recheck his figures and to clarify whether the price quoted is correct. If a particular article is available at Rs. 50 and the supplier has quoted Rs.10 for that, any buyer can say that there is an error. If the buyer accepts the offer with the knowledge of an error in the offer, he cannot claim damages, if the supplier refuses to supply the materials at Rs. 10 on finding out the mistake. Now the buyer should not only consider the price only, but also the other conditions, e.g., the terms of payment, terms of delivery (freight, insurance etc.), cost of special tools, if any, to be purchased by the buyer for the use of suppliers, other charges, after sales service, supplier's reliability, etc. Therefore, the bids should be compared after taking into account the above factors. It is not necessary for the buyer to accept the lowest bid or at least one bid. He may accept anyone of the bids received or may reject all the bids received. The lowest bid may prove costlier, if the above-mentioned factors are considered, because these factors affect the real or effective cost of the materials to some extent. Therefore, the buyer must carefully examine various quotations beforE taking final decision. Suppose supplier A has quoted Rs.10 per unit for the supply of 1,000 units at the buyer's place. He does allow cash discount, even if the payment is made within 15 days. Generally the company makes payment within 10 days. The company has nothing to pay against the cost of special tools required by the supplier. Now supplier B quotes Rs. 8 per unit for the supply of 1,000 units at the seller's place. Moreover, the buyer has to pay Rs. 2,500 to the supplier against the cost of special tools. The buyer has to spend 50 paise per unit as freight for the transportation of goods from the seller's place to his factory. Supplier B has agreed to allow a cash discount at 6% on the total amount to be paid to supplier, if the payment is made within 15 days. The following comparison makes the picture clear.

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Table 9.5 Effective Cost of Purchasing for 1,000 Units Particulars

Cost of materials

Supplier A Rs. 10,000 at Rs. 10 per unit.

Supplier B Rs. 8,000 at Rs. 8 per unit.

Cost of special tools

2,500

Freight

500

(50 paise per unit) Total cost

10,000

11,000

Less cash discount at 6% on total amount

660 Net cost 10,000

Net effective cost per unit

Rs. 10

10,340 Rs. 10.34

The price quoted by supplier B is lower by Rs.2 per unit and he also allows cash discount at 6% on the total amount of the bill. But if the purchases are made from this supplier, considering the above two factors - lower price and cash discount - the company would have to pay Rs.340 more because the real cost per unit comes 34 paise more. This happens because the buyer has to pay freight charges and also the cost of special tools, which supplier A does not charge. The benefit of discount allowed and of the lower price is more than offset by the cost of tools and the freight charges. The main aim of the buyer is to obtain the required materials at the minimum possible price and not any type of materials at the lowest price. He should also try to seek the reduction in prices wherever possible. The buyer enters into various types of contracts with suppliers not only to maintain the continuity in supply but also to maintain the cost of materials at reasonable level. The contract between buyer and supplier ensures availability of required materials at reasonable price. Now the possibilities of reduction in prices and the types of contracts depend on the types of materials, etc. Prices of certain articles are fixed by Government legislations or by the producers. In such cases the producers or suppliers do not allow a slight reduction also. When prices are not fixed, the buyer can negotiate the prices to get the same reduced. Sometimes, the buyer has to allow an increase in price afterwards, even if the price was fixed in the past. It all depends on the types and terms of the contracts. (2) Types of Contracts: (a) Contracts for the Purchase of Fixed-price Materials: (Fixed price Contracts): Sometimes prices are fixed by the suppliers and they do not allow reduction in prices in any case. Sometimes prices are fixed by the agreement between buyer and producer. In both the cases, generally the question of changing the price (reduction or increase) does not arise. Sometimes fixed price contracts are made with a condition that if the price index moves up or goes down by minimum prescribed figure, the price fixed will be reconsidered. Here the fixed price is automatically changed depending on the changes in price index. When prices for certain type of materials are fixed, it is not possible for the buyer to get the" prices reduced by negotiation and if the quantity of materials used by the firm or the company is very small, it is not advisable also for the buyer to spend time for negotiation to seek price reduction. The supplier, who sells materials to this company or firm at a fixed

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price, may also be selling the same materials to other buyers. Now, the supplier cannot sell the same type of materials at discriminatory price rates. When there is a legal control on the price, it cannot be changed. In many cases prices are fixed on the recommendations of the Bureau of Industrial Costs and Prices under the Ministry of Industries and Civil Suppliers. Government fixes the prices of agricultural products on the recommendations of the Agricultural Prices Commission. Now if the supplier charges different prices to different buyers for the same materials, it may badly affect the supplier's goodwill and no buyer may rely on him. If the supplier is convinced by the buyer to grant reduction in price, but if he is unable to reduce the price due to above-mentioned reasons, he may offer better terms to the buyer, which may amount to indirect price reduction. Thus on one hand he does not reduce the price and on the other hand he offers better or more favourable terms to the buyer which amounts to indirect reduction in price. The supplier can offer indirect reduction in the following ways : (i) Longer credit period and cash discount at increased rate: The supplier can offer cash discount at a higher rate for the payment made within a specified period or he can offer the same discount but can offer credit for a longer period, e.g., he can offer cash discount at 10% instead of 5% for payment made within 10 days or can offer 5% cash discount for payment made within 30 days instead of 10 days. Thus, the buyer may be given 5% more cash discount or credit for 10 days more. This affects the net price paid, e.g., Radiant Company purchased 1,000 units of materials at Rs.100 per unit. The net price paid in both the cases can be calculated as under: 10% discount instead of 5% discount

1,000 units @ Rs. 10 per unit Extra discount @ 5% Reduction in price per unit due to extra discount, i.e., 5% of the original selling price.

5% discount for payment made within 30 days instead of 10 days

Rs. 10,000 500

00.50

Rs. 1,000 units

@

Rs. 10 per unit

10,000

Here the buyer gets 20 days more to pay the amount with discount facility. The buyer can use Rs. 10,000 for 20 days more. If the interest rate at 18% is considered, he saves interest of Rs. 100 for 20 days, which he would have paid, if he were to borrow money. This amounts to 10 paise per unit, i.e., 1%.

It is good for the buyer to seek increase in the rate of cash discount, because a higher rate of discount proves more economical than to borrow for payment within the specified period to earn cash discount. (ii) Trade discount on large purchase: Generally, the suppliers allow trade discount for large purchases. The suppliers specify minimum quantity which the buyer has to purchase to avail of the discount facilities. Suppose a buyer is allowed 5% trade discount for the purchase of 10,000 units or more at a time. If the buyer's requirement is 2,000 to 2,500 units per month, he may not purchase 10,000 units at a time, because his financial resources may be limited or the materials required may be freely available in the market. Now to get the advantage of trade discount, he would have to purchase 10,000 units. In such cases, he can convince the supplier to give him discount for purchase of 10,000 units which are to be supplied, by monthly instalment of 2,500 units each. This will help both the parties. The supplier will be

140

(iii)

(iv)

(v)

(vi)

Outline of Materials and Purchasing Management

able to sell 10000 units which are to be supplied, by monthly instalments of 2500 units each. This will help both the parties. The supplier will be able to sell 10000 units with a condition to supply the same by monthly instalments of 2,500 units, and the buyer will be able to get the trade discount. Naturally, the payment for the materials will be made as and when materials are received. Thus the buyer will be able to purchase 2,500 units each month and still get the trade discount allowed on large purchases of 10,000 units or more. If the buyer has factories at various places, the purchases of the identical goods can be centralised for each plant, which may prove more economical because trade discount at a higher rate on such large purchases is not ruled out. Reduction in price through changes in specifications: It is not possible for the supplier to reduce price for a particular buyer for the identical items supplied to others also, or if such practice attracts legal actions, the buyer may suggest a small change in specifications and this change may help the supplier in proving that the materials supplied to a particular buyer (who has suggested a change in specifications) are quite different from the materials supplied to others. In such circumstances, the buyer and the supplier can negotiate easily for price reduction. Supplier can reduce the price for a particular buyer without attracting legal actions from other buyers or the government. The buyer who suggest a change in specifications and the supplier agrees to supply accordingly, the buyer becomes the only user of that type of materials. Discount on price reduction in fixed price items indirectly: Sometimes the buyer purchases two types of items from the supplier. Some of the articles are fixed price articles for which the supplier does not agree to reduce or does not reduce the fixed price for various reasons. Some of the articles are non-fixed price articles, for which the prices can be negotiated. Now the buyer can negotiate the price reduction on the total amount of purchases of fixed as well as non-fixed price materials. Now, if the supplier is convinced the price reduction will be allowed by him, but the total amount of discount will be deducted from the total amount of the purchases of non-fixed price materials only. There will be no change in the price of fixed price materials so that the supplier will be safe, as he has not allowed price reduction on paper so far as the fixed price materials are concerned. In short, the total amount of negotiated discount, i.e., discount on fixed price materials as well as on non-fixed price materials, is deducted from the amount of purchases of non-fixed price materials. It all depends upon the skill of the buyer. Hand-to-mouthIStockless purchasing: Many firms maintain inventory equivalent to 2 to 3 months' requirements. By reducing the stock level, funds can be released which can be used for repayment of borrowed funds or other purpose. Reduction in stock results in decreasing the stock maintenance cost, which affect total cost of materials. Reduction in the cost can be considered as a reduction in price indirectly. Now inventory level can be brought down, only if the supplier agrees to maintain required stock on behalf of the buyer or agrees to supply as and when the buyer requires materials. It means that the buyer can adhere to stock less or hand-to-mouth purchasing (which may reduce the cost of materials) only with the help of the supplier. This is another way of granting reduction in price, without actually reducing it and without showing the reduction on the bill or on any document. Allowing extra facilities or services, generally not provided: The buyer can persuade the supplier for after-sales service, if it is not provided or if provided, he can persuade the supplier to give the same for longer period than ordinarily given. Moreover, if the materials are supplied at seller's place, the buyer can convince him to supply the

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same at buyer's plant or godown. Packing and forwarding charges may also be omitted from the bill and supplier can charge, only the price of materials in the bill. The buyer can convince him to replace free of charge some spare parts etc., in case of purchase of machine etc., for a particular period. The supplier can advise the buyer on the better use of materials, on better storage and maintenance of materials purchased from him. Thus, the buyer can get several benefits, which can be considered a price reduction in indirect way. In theory, the price remains the same on paper. (b) Contracts for the Purchase of Non-fixed Price Materials: When the prices of the materials to be purchased are not fixed, negotiations play an important role in getting the prices reduced. The buyer may not accept the lowest bid. He selects the suppliers considering so many factors, other than the price. If the present suppliers do not agree or are not ready to reconsider the price or to grant reduction in price, even if it is possible and buyer's demand for reduction in price is reasonable, the buyer should try new suppliers or he can suggest his unit to make the items in its own factory, If it is possible to make such items with the existing facilities and resources at a lower cost than the purchase price. This may force the suppliers to re-examine their cost of production which may result in the reduction of costs as well as prices. The supplier may reduce the price under the following circumstances: (i)

Changes in specifications or design: If the minor changes in specifications or design as suggested by suppliers or by company's research and development department can result in reducing the cost of production, the buyer should consider this. The quality control experts from the buyer's factory can guide, whether the change would adversely affect the quality or not. If the quality remains the same, there is no harm, if minor changes in specifications or design, resulting in price reduction, are made.

(ii)

Use of low cost materials or substitutes: When low-cost materials are substituted, in place of high cost materials, for the production of certain articles, the cost of production comes down to a very low level without spoiling the quality of the product or without any change in the performance of the product. Various State Electricity Boards now use aluminium wires for mains instead of copper wires. Most of the electrical goods manufacturers now use more of the plastic materials instead of materials made of china clay. When the readymade articles are to be purchased, the supplier should be advised or asked to use such type of materials to reduce the price. Long-term contract: Sometimes suppliers agree to reduce the price, if the contract is made for a long period. In such circumstances, he considers himself safe and secure, because he can plan his production which may reduce his cost of production. The supplier can install necessary equipments and machinery for increasing the production to that level, which can meet the estimated demand considering the long-term contracts. If he is not sure of the demand for his products, he may not invest in new equipments, etc. Thus, if the supplier is ready to reduce the price on the condition of long-term contract, the buyer should try to enter into a long-term contract. This will help the buyer also because he will be able to get the materials at the fixed price and can estimate his cost of production easily.

(iii)

(iv)

To purchase related items with main item from the same supplier: Sometimes, the supplier offers to reduce the price, if the buyer purchases all his requirements from him with the main item. Purchases from one place save administrative costs as well as other costs, e.g., freight, packing, forwarding etc. Therefore, even if the prices are not reduced, the savings resulted reduce the total cost.

142

(v)

Outline of Materials and Purchasing Management

Slack season or seasonal purchasing: The supplier can supply the seasonal materials at a low price in the season only and some other materials in the slack season. The buyer should be able to judge, when the price will be lower. Sometimes the buyer enters into a long-term contract for the purchase of materials in a slack season and succeeds in persuading the supplier, to supply the materials at a reduced price during the tenure of contract. In such case, the buyer gets the benefit of a lower price, even though the supplier has to deliver the goods throughout the period of a contract. Here psychological pressure affects the supplier's decision to supply at a lower price. In a busy season, the supplier will not be ready to supply the goods for a longer period at a reduced price, even though the market circles anticipate recession. (c) Contracts with Cost-escalation Clause: The buyers always try to purchase the right type of materials at the lowest possible price. But sometimes, he is forced to offer higher prices to the supplier. As we know, the wage rates go on rising day-by-day on account of inflationary trends, Government legislations, existence of strong trade unions, etc. Cost of materials also increases day-by-day. If the price increase is not allowed to the supplier, he may not be able to exist. The supplier demands higher price for the materials supplied by him, because his cost of production may have increased with an increase in cost of labour and materials used by him. Therefore, it is logical to allow him to increase his prices within certain limits, so that he can meet the rising costs and can earn reasonable profit. The buyer can agree to give higher price only under the prescribed conditions and only if the terms of contract between the buyer and the seller provide for that. To protect the supplier and the buyer, a cost-escalation clause is included in the contract. In such type of contract, the supplier is allowed an increase in the basic price fixed, subject to certain predetermined conditions, e.g., increase in wages, raw material cost, taxes etc. In such type of contract, the supplier and the buyer agree that in case of increase in cost of production, the proportionate increase in price will be allowed by the buyer. When prices show an upward trend day-by-day, the supplier may not find it advisable to enter into a long-term contract for the supply of materials. Now to ensure regular availability of materials, it is necessary for the buyer to finalise such contract. Therefore, cost escalation clause is added in the contract, so that the buyer can persuade the supplier for long-term contract explaining him that he will not be at a loss even though his cost of production increases, because he will be compensated by allowing proportionate increase in the price. When the supplier asks for the price increase, he has to present his cost estimates before the buyer to prove that the costs have actually increased. The buyer or his expert will examine the estimates and will decide the quantum of price increase. (d) Cost-pius Contracts: In such type of contracts the supplier receives cost of articles supplied plus profit at a fixed percentage on the total costs. When special types of articles or spare parts etc. are manufactured by the particular supplier for this buyer only, the supplier is allowed to add certain percentage of profit on the costs. When a supplier enters into such type of contract with a buyer, he has to maintain cost records, because these records are examined by the buyer's cost experts before they are approved. Maximum limit of cost can be fixed here, because, if it is not fixed the supplier may not exercise any control on the costs and may not work efficiently. To avoid such situation, which may arise for want of some type of control and to make the supplier more efficient, incentive may be offered to him, e.g., if the supplier manufactures certain articles for the buyer at such cost which is within the limit fixed before, he may be offered a predetermined share in the savings effected by his efforts. Suppose a supplier saves Rs. 100, he may be offered Rs. 70 and benefit of Rs. 30 may be taken by the buyer, on the other hand if the supplier incurs more expenses, he will have to bear 70% of the excess costs and only 30% by the buyer.

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Therefore, inclusion of such prOVision in a contract, may force the supplier to increase his efficiency and to keep his costs at a low level as far as possible. Cost-pius contracts may be of the following types : (i) Cost plus profit at a fixed percentage of cost, where a supplier is allowed to add profit in the total costs at certain percentage of the total costs. His profit increases with the increase in costs. The supplier has not to worry about the result of his business activities because he is assured of profit at certain percentage. (ii) Cost plus fixed fee, where the supplier is allowed a fixed amount over and above the cost of production. The amount of fee remains fixed whatever may the cost. (iii) Cost plus incentive fee, where the supplier is allowed a fixed amount as fee over and above the cost of production, but sometimes provision is also made that if the supplier can reduce his costs below the costs agreed upon in advance, the benefit resulting from the reduction in costs will be shared by the buyer and the seller. The buyer can also offer the supplier a fixed fee plus a part of the savings in costs as agreed upon in advance. (iv) When the supplier and the buyer jOintly develop a product they can agree on the basis of sharing the costs. (v) When it is not possible to determine the time required to do a certain job and the materials required for dOing that job, particularly in case of machinery repair job etc., the amount to the paid to the party undertaking the work is determined on the basis of labour hours used for completing the job and the cost of materials used. Sometimes, materials are supplied. Rate per labour hour is fixed in advance which includes an element of overheads and profit. All the buyers do not enter into contracts with suppliers for all their requirements. Many items are purchased from open market, where the interaction of forces of demand and supply determines the price. When the demand is strong, the supplier can increase the price to that level at which he can sell the full production at the maximum benefit and can cover not only the present costs but also future increase in costs. During the boom period the increase in costs can be passed on to the buyers fully. In case of the standard materials, when the supplier or the limited number of suppliers can only supply the articles or goods, the buyer has no other alternative but to purchase the articles or goods at the supplier's price. When the demand is very poor and the supply exceeds the demand to a great extent due to various reasons, e.g., financial crisis, credit squeeze, large increase in production, free imports on a large scale, fall in exports, recessionary trends, etc. it may not be possible for the supplier to increase the price, even if the costs have gone up. On the other hand he may have to cut the price. Thus his profit margin may be reduced or he may incur loss. Under such circumstances keen competition between the suppliers takes place. The suppliers or producers offer various incentives or follow various tactics to get the business. They offer gifts (voltage stabilizer with refrigerator), bonus (one piece free with each six pieces purchased, two metres shirting free with each purchase of four metres of shirting etc.) and big discounts (off-season discount, special holiday discount or quantity discount etc.). It should be noted that restrictive trade practices - discriminatory discount policies, tie-ups, retail price maintenance etc. - are controlled by the Monopolies and Restrictive Trade Practices Act.

000

CJ.iAPTER 10 Purchase of Capital Equipment and Leasing Expenditure in business is either revenue expenditure, e.g., expenditure on materials, labour etc. or capital expenditure where benefits are realized over a period of time, e.g., purchase of a machine, construction of building etc. Capital budgeting basically deals with the planning of the capital expenditure. It is spending today to reap the benefits in future. There is substantial cash outflow today. The cash inflows occur gradually in future years. Distinction between the purchase of capital equipments and materials: The purchase function as applied to the capital equipment and to the materials and stores differ substantially. The distinction can broadly be classified as under: Equipment Purchases

Material Purchases

(1)

It involes detailed technical considerations (1 ) such as size, weight, speed, HP requirements, dimension, composition etc. This necessitates the technical study of the using department and also the technical consultancy of the supplier.

The material specifications are not so complex and technical.

(2)

The specifications are highly flexible. They can be changed under varying alternatives.

(2)

The material specifications are more or less very rigid.

(3)

It necessitates the investments of huge amount. It greatly affects the long-term capital needs and provision of immediate cash resources.

(3)

(4)

The purchase decision results into a long-term commitment. The decision once taken cannot be reversed or can be reversed at a great financial loss.

(4)

The investments in materials is circulatory in nature. Moreover, the immediate cash needs are not so high as in case of equipment purchases. The purchases of materials do not involve such characteristics. Wrong materials can be returned or can be disposed of at marginal losses.

(5)

The purchase decision is a combined decision. The participating departments are the using department, technical department, R&D department, financial department and purchase department.

(5)

(144)

The recognition of the need and its analysis is not so extensive as well as exhaustive. The purchase decision is more or less of a routine nature.

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145

Moreover, it requires the approval of the top management. (6)

The intensity of the need of the equipment (6) is not so grave as need for the materials. The purchase decision for the capital equipment can be delayed or even postponed.

The need for the materials is relatively intense. The situation of materials. stockouts is treated seriously and necessitates emergency purchases.,

(7)

The lead-time. (i.e., the time-gap between the order placing and receiving) is very long.

(8)

(8) The negotiation is the best method in selecting the supplier. The buying decision necessitates series of sessions.

The lead-time for material purchases is ' , relatively short. Longer lead-time is discouraged as it increases the need for more investments in inventories or results into stockout position. The vendor selection is made through quotations, competitive bidding and at times through negotiations. The negotiations do not involve detailed considerations like the negotiations for the equipments.

(9)

It is a non-recurring purchase. As the (9) economic life of the equipment is relatively long, the needs do not recur till next five, ten or even more years and that too with the changed specifications.

(7)

The prchase of materials is a recurring phenomenon. The subsequent purchase may facilitate the price advantage on previous purchases. Such arrangements are not possible in case of equipment purchases.

(10) The supplier selection process is relatively (10) The comparison of the suppliers' quotations is relatively easy. Though all difficult, because the specifications of the quotations differ in nature, it is possible various suppliers differ significantly and thus makes the comparison difficult. The to bring them on some common footings factors such as productivity, speed, for the purpose of comparison. labour savings, durability, etc. are such that they cannot be brought on common platform for the purpose of comparison. (11) The services such as demonstration, installation, trial operations, operator training, repair etc. are specifically required in case of equipment purchases.

(11) The purchases of materials do not need any of such considerations.

(12) It is necessary to maintain the detailed operating records of the capital equipments.

(12) The maintenance of records for the materials purchases is routine and mechanical.

(13) The purcahse decision of the capital (13) Such tax considerations have no equipment is affected by the tax policy. effect on the purchases of materials. Various types of depreciation allowances and investment allowance are available on capital equipment. Such tax benefits reduces the tax liability of the company. (14) As capital equipments are acquired for use, (14) various alternatives are open for acquisition such as purchases under instalment payments, purchase of used equipment, getting the equipment on lease, etc.

The materials are purchased for the purpose of being processed and so such its situation does not arise in case of materials purchases.

146

Outline of Materials and Purchasing Management

(15) The equipment purchases are greatly affected by the technological developments. The technological innovations shortens the economic life of the equipment and turn it into obsolescence.

(15) The time gap between the point of purchase and point of use of materials is so short that generally they are not affected by any research.

Procedure for Purchasing Capital Equipment The stages of purchase procedure for capital equipments as well as for materials are more or less the same. However, the contents of each stage differ substantially in both types of purchases. The purchase procedure for the capital equipment is described as under: 1. Initiation of need: The recognition of need is the first step in purchasing. The need for the capital equipment originates with the using departments which are generally the manufacturing departments, the plant service department or general management and office area. They are generally needed to reduce the cost, to increase the production, to increase the quality or to attain the higher productivity. They are purchased for the purposes of replacing the existing worn-out eqUipment or modernizing the manufacturing activities with a view to adopting the latest technology, or expanding the existing production capacity or diversifying in the new line of production. It should be noted that the intensity of the need is not so high as in case of purchase of materials. The purchase of capital equipment can be delayed or in some cases it can be postponed. 2. Equipment specifications: The specifications for the capital equipments are drawn by the needy department. They are drawn by the using department on the basis of past experience, conclusions drawn by the Research and Development Department and literature obtained by the purchase departments from the suppliers of such equipments. Sometimes, the manufacturing firms are consulted for the purpose and the specifications are drawn with the help of the representatives of such manufacturing firms. The specifications include considerations such as size, weight, dimension, speed, composition, cost and the special characteristics of the equipment. Certain complex machines and equipments require special efforts for drawing the speCifications. The assistance is generally obtained from the manufacturing firms or such preliminary studies. The presale engineering work is a part of the sales efforts of the manufacturing company. However, clarifications as regards the magnitude and the incidence of such cost of presale engineering work should be sought. When the supplier is yet to be selected and under such conditions any manufacturing firm is providing such service, a contract to such effect should be made with them. 3. Vendor selection: The sources of the supplier of the equipment according to the specifications drawn by the using department should be identified. The manufacturers' directory or purchase guide provide the details about the vendors. They can also be known through advertisements which appear in trade journals or visit of the representatives of the manufacturing firm. As compared to materials purchase, the short-listing of the suppliers should be minimized to two or three suppliers. The competitive bidding as applied in materials purchases would not be suitable in buying the capital equipment. For the purchases of standardized equipments, the suppliers quotations should be used for the purpose of selecting the supplier. In all other cases the negotiation would be proper method of vendor selection. For non-standardized equipment, the manufacturer will not be able to quote unless the buyer's plant is visited and the nature and characteristics of the equipments are studied thoroughly. Supplier's ability in supplying such equipment also vary considerably.

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147

Under such a situation, negotiation would be the appropriate method. The economic analysis of the equipment is also made at this stage. This analysis is made on the basis of the initial and subsequent cash outflows necessitated in acquiring the equipments and the expected returns from the equipment over its economic life. Generally, the yearly net cash inflows is projected till the economic life and such total cash inflows are compared with the cash outflows for the purpose of judging the economic advantage to be derived out of the capital equipments. 4. Order placing: The order is placed with the selected supplier. The purchase order of the capital equipment is specific as compared to the routine purchase orders placed for the materials purchases. It specifies the specifications, time of delivery, mode of transportation, methods of payments, post-purchase services etc. The emphasis should be made on the strict adherence to the conditions in fulfilling the order rather than the claim for the reimbursement of the damages caused by any lapses on the part of the supplier in executing the order. 5. Follow-up: The follow-up function in equipment purchases is distinct from that under materials purchases. Under equipment purchases, the installation of the equipment is carried on under the supervision of the technician of the supplier. Their assistance is also obtained for trial operations and providing training to operators. The after-sale services are also required in case of acquisition of capital equipments. All these do not arise in case of materials purchases. 6. Payments: As compared to the materials purchases, the mode of payment also differ substantially. As the absolute amount of the purchase of capital equipment is very high, the payments are generally made in instalments. In case of the assistance obtained from the financial institution for the purchase of capital equipments, sometimes the payments are made through the financial institutions.

Economic Analysis of the Equipment Purchases Capital equipment purchases basically differ from the materials purchases because the former represents the huge investments initially from which the benefits accrue over a longer period of time. In the literature on financial analysis the equipment purchases are treated as "Capital budgeting decisions" or "investment analysis", which provide more sophisticated treatment of this type of analysis. Here we concentrate on the discussion of the fundamental aspects along with the conceptual framework of the analysis. Capital equipment requires huge initial cash outflows, whose returns are expected to occur beyond one year. The returns are treated as net cash inflows which are generated through the operating use of the capital eqUipment. The net cash inflows are ascertained on yearly basis and they are available until the economic life of the equipment. The capital cost (i.e., the initial and the subsequent, if any, cash outflows) are amortized over the economic life of the equipment which is treated as annual depreciation. The yearly depreciation diminishes the value of the capital cost. In fact, the accumulated depreciation represents the expired value of the equipment which has been progressively charged to profit and loss account on yearly basis, while the unexpired value of the equipment represents the residual capital asset which is shown in the balance sheet of the company. Certain characteristics of the capital equipment purchases should be noted carefully as they directly affect their economic analysis. They are as under: 1. The initial cash outflow (i.e., the purchase price etc. of the eqUipment) is certain, while yearly net cash inflow is uncertain. The payment of the purchase price does not guarantee that the investment in equipment will yield a specified returns every year. If the

148 Outline of Materials and Purchasing Management equipment remains idle for the whole year or for many years, it may not yield any return. Thus, the degree of uncertainty of the returns (or net cash inflows) makes the analysis more complex. Moreover, the capital equipment is purchased for the following purposes:

(i)

For replacement of existing worn-out equipment.

(ii)

For modernization of the plant, for the purpose of adopting the latest technology.

(iii) (iv)

For the expansion of the existing production capacity. For the diversification in some new line of products.

(v)

For strategic purposes, such as investments in plant services like power generation, materials handling etc. and investment in personnel services such as canteen, recreation room etc.

The degree of uncertainty of returns (or net cash inflows) vary substantially in all the above types of investments, e.g., the degree of uncertainty of returns in case of replacement of existing equipment as much less than in case of diversified investments, because the company is venturing into a new line of product and thus their marketing and resultant returns cannot be predicted reliably. 2. The returns (or net cash inflows) are calculated on yearly basis, and such returns accrue over a longer period of time. The total returns over the entire economic life of the equipment is a key consideration in the analysis. The economic life of the equipment should be carefully defined by the management. It is not always the durable life of the equipment. Economic life represents the minimum number of years that the management assigns to an equipment on the basis of its competitive use. The economic life may be shorter than the durable life under the situation where the new technological development turns the existing equipment useless under the competitive conditions. This is known as technological obsolescence wherein the equipments are discarded even before they worn out for the purpose of maintaining the competitive strength. 3. The management prescribes certain minimum standards for the purchase of capital equipment. It is known as "cut-off point" in investment decision. If the proposed investment falls above this point, the proposal is accepted and if it falls below the prescribed cut-off point, it is rejected. Generally, the cut-off point is prescribed by the management conSidering the specific environments under which the proposed capital equipment is required to function. Under the different methods of capital budgeting decisions the cut-off point is decided as under: Method

1. 2.

3.

Paybackperiod (PBP) Accounting rate of return (ARR)

Net present value (NPV)

4. Internal Rate of Return (IRR)

Cut-off point

Certain No. of years, say, two years.

Decision rule

Proposals whose payback period is equal to or above PBP are accepted. Certain percentage of return The proposal whose rate of return on investments, say 25%. equates or exceeds the prescribed ARR, is accepted. The ARR is stipulated on the basis of degree of competition profit margin of the product etc. The cost of capital of the The proposal whose NPV is equal to or firm. above the specified cost of capital, is accepted. The required rate of return Only those proposals are accepted as determined by the whose IRR is equal to or above the· management. required rate of return.

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The Concept of Discounted Cash Flow The time value of money is considered under the discounted cash flow analysis. A rupee received today has more value than a rupee received after five years. A rupee received today can yield some returns if it is invested in the bank for five years. Thus, the value of the rupee received today is definitely higher than that of a rupee received after five years. It is interesting to note that the present value of a rupee received after 25 years and discounted at 20%, is just 1 paisa. Thus, a rupee received today and a rupee received after 25 years cannot be put at par. Such time-value of money can easily be ascertained with the help of ready-made "Present-value Tables." The present value tables explain the phenomenon of "discounting" which is just opposite to "compounding." Under the compounding process the present rupee is compounded at the given rate of interest to find out its terminal value, while in the discounting process, the future rupee is discounted at a given rate of interest to find its present value.

The compounded value or terminal value The compound value fannuls

The discounted value or present value Discount value fonnu/a

A P = (1+i)

A=p(1+i)

where p = Principal amount in Hie Note that here we are solving the beginning of the year, compound value formula for finding out .the value of P instead of A. i == Rate of interest n = No. of years during which the compounding is to be made. A = Aggregate amount at the end For example, if Rs. 1,000 is received of the period, i.e., prinCipal amount at the end of 3rd year, find out the present value if the funds are discounted in the beginning plus the accuat 10% rate of interest. mulated interest. For example, if Rs. 1,000 is deposited for 3 years @ 10% compound interest, how much will it fetch at the end of the 3rd year? A

=

P (1 + i)n

=

1,000(1+10%)3

=

1,000 (1.1)3

=

1,000 x 1.331

P

= =

A

(1 + i)n 1,000 (1+10%)3

= Rs. 915.10 The compounded value (or terminal value) and the discount value (or present value) tables are developed on the above-mentioned formulations. The use of ready-made present value tables simplifies the calculations involved in evaluating the purchases ot the capital equipments. Methods of evaluation: The following methods are employed in evaluating the purchases of the capital equipments : 1. Pay back period (PBP). 2. Accounting Rate of Return (ARR). =

Rs. 1,331

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150

3. Net Present Value (NPV). Internal Rate of Return (IRR). 4. All these methods are explained in brief in the following paragraphs. It should be noted that: (a) The PBP and ARR methods do not consider the time value of money, while NPV and IRR do consider the time value of money, i.e., all future cash flows are discounted at the given rate of interest. (b) ARR method considers the accounting profits, while PBP, NPV and IRR consider the cash flow. The basic difference between the accounting profit and the cash flow is only that much that, the accounting profit is nothing but the net profits accrued after depreciation provision, while cash flow represents the "net profits" plus "depreciation, i.e., depreciation is added back because it does not involve any actual outflow of cash. Depreciation is just an accounting adjustment which is considered for ascertaining the periodic net profits. (1) Pay Back Period (PBP) : Pay Back Period method is one of the most widely used method of evaluating the purchase of capital equipment. Pay Back Period is the length of the period required to recover the original investments, e.g., if Rs. 1,000 are required to purchase one machine whose life is three years and generates cash flows of Rs. 400, Rs. 300, and Rs. 600, then the PBP will be ascertained as under: I = Y1+ Y 2+ Y3··· Yn where I = original investments = Yearly cash flow Y n = No. of years. Rs. 1,000

=

300 400 + 300 + 600

=

2% years

If the investment generates uniform annual cash flow, then PBP

=

6

where, I

= original

investments

C = annual cash flow It should be noted that the PBP method ignores the time value of money and it does not consider the profitability beyond the payment back period. (2) Accounting Rate of Return (ARR) : Under this method, the rate of return is ascertained on the basis of the average net profit per annum and the average investment. Average an~ual net profit x 100 Average Investment The average annual net profit is ascertained by dividing the total net profit of all years by the number of years. The average investment is one-half of the original investment. The reason for taking one-half is that, the original investment gets depreciated over the life of the project and reaches to zero value at the end of the project, e.g., a capital equipment costs Rs. 5,000 and yields net profits of Rs. 1,000, Rs. 1,500, Rs. 2,000 and Rs. 2,500 during the four-year life of investment. Find the ARR. ARR

ARR

=

=

Average an~ual net profit x 100 Average Investment

Purchase of Capital Equipment and Leasing

= =

151

{(1,000 + 1,500 + 2,000 + 2,500) +4} x100 (5,000 x 1/2)

70% The ARR method, like PBP, does not consider the time value money. However, unlike PBP, it takes into account the entire profitability of the investment. The ARR method considers the accounting net profit which is ascertained on the accrual basis of accounting while all other methods considers the cash flow. Cash flow is ascertained by adding back the depreciation and all such non-cash adjustments in the net profit. (3) Net Present Value (NPV) : This method considers the present value of cash flows. The money has time-value and so to find out the present value of the cash flows generated in future, they are discounted at a given discount rate. The present value can be ascertained with the help of the ready-made present value table, a capital equipment costs Rs. 7,000 and during its life of 3 years, generates the cash flows of Rs. 2,000, Rs. 3,000 and Rs. 4,000. The discount factor is 10%. The present value of cash flow generated in first, second and third year will be as under: Year 1

Cashflow 2

*Present value 3

Period value (4=2x3)

2,000

0.909

1818

3,000 4,000

0.826 0.751

3004

2 3

2478 7300 aggregate PV

* Present value factor at 10% is obtained from ready-made present value tables. We ascertained the aggregate present values as above. Now net present value will be calculated as under: NPV = Aggregate PV - Original investments = Rs. 7,300 - 7,000 = Rs. 300 The proposal will be accepted if it results into positive NPV, and it will be rejected if the NPV turns to be negative. The above-mentioned formulation is also presented mathematically as under:

NPV=~+~+~ ... +~-I (1 + I)

(1 + Ii

(1 + i)3

(1 + i)n

where C = Cash flow of respective year. = Discounting rate. n = Life of the project during which the cash flow is geberated. = Original investment. It may be noted that the aggregate PV in the above formula is nothing but the summation of the discounted cash flow of respective years. The mathematical formula can be presented in a condensed form as under:

152

Outline of Materials and Purchasing Management

(4) Internal Rate of Return (IRR) : The IRR method, like NPV, also considers the time value of money as well as the total profitability of the project. Internal Rate of Return is the rate which equates the present value of cash inflows with the original investments. In other words, it can also be stated that it is the discount rate at which the NPV is ZERO because the aggregate PV of the cash inflow must equate the original investment. The fundamental difference between the NPV and IRR is only that, we discount the cash flow at given discount rate under NPV, and thus the NPV may turn in to negative or positive, while under IRR, the discount rate is not given, but we have to find out such a discount rate at which the NPV will be ZERO. This is done only through the trial and error method and with the help of intrapolation, between the two limits, e.g., a capital equipment costs Rs. 16,200 and generates the cash flow of Rs. 8,000, Rs. 7,000 and Rs. 6,000 during its three-year life. Find the IRR. Here the discount rate is not given but we need to know the discount rate for finding out the present value. We shall solve the problem under the trial and error method. In the first attempt, let us discount the cash flow at 14%, The aggregate PV at 15% will be Rs. 16,440. Our investment is Rs. 16,200 while aggregate PV at 14% is Rs. 16,449, thus it is higher but IRR is that rate which equates the aggregate PV to original investment. So the next try would be at that discount rate which will lower down the aggregate PV. Here, it should be noted that the aggregate PV and discount rate are inversely related. As we need to bring down the aggregate PV, we must take higher discount rate. Under the second trial, discount the cash flow at 16%. The aggregate PV at 16% will be Rs. 15,943. Thus, at 16%, the aggregate PV is lower than the original investments, i.e., Rs. 16,200. To sum up, The original investments = Rs. 16,200 Aggregate PV at 14% =, Rs. 16,449 Aggregate PV at 16% = Rs. 15,943 From the above, it can be concluded that the IRR is not below 14% and above 16% but it falls between 14% and 16%. The exact IRR can be calculated with the help of intrapolation which is described as under: IRR=A+ C~D(B-A) Where

A B C D

= = = =

Lower discount rate, i.e., 14%. Higher discount rate, i.e., 16%. Over recovery i.e. Rs. 249 (16,449 - 16,200) Under recovery is Rs. 257 (.16,200 - 15,943)

=

14 + 249 (16 - 14) 249+257

= 14+ 249 x2 506

= 4 + 1/2 (approximately) x 2 = 14 + 1 =15%

Purchase of Capital Equipment and Leasing 153 So, the IRR would be 15%. If the cash flows are discounted at 15%, the aggregate PV will be equal to the original investment.

Used Equipment The need for the equipment can be met either by buying (i) a new equipment or (ii) an used equipment. The existence of 'the used equipment market' facilitates acquisition of used equipment. Existence of used equipment market: Business firms buying the new equipment with the specified economic life are sometimes disposing of such equipment before the expiry of its economic life. Such unexpired use can meet the requirements of some other firms. The existence of such reciprocal needs provides a continuous market for the used equipment. The firms are disposing of their equipment before its economic life on the following grounds: (1) To adopt the new machine with innovative technology under the modernization programme. The old machine with reasonable future operational life are discarded for the purpose of maintaining the competitive strength. (2) When the firm decides to shut down a particular plant on permanent basis, it resorts to premature disposal. (3) When some equipment is purchased for certain specific contract, and that contract has ended. (4) Under the liquidation procedure, the creditors or the liquidators are compelling the owner to sell the equipment. Used equipment market has developed as a specialized commercial service. There are dealers who are dealing in this market. They buy the used equipments from their owners. They are specialized in this activity. They recondition the machine for the purpose, of improving its operating conditions and to make them attractive, so that they can fetch better price. They replace the worn-out and broken parts, they clean and overhaul it, the wearing surface is regrounded, the base is remounted, sometimes it is fully reassembled and it is polished and painted. There are brokers who work as an intermediaries between the 'buyer and the seller of the used equipment. Generally, the broker's services are required for the rare equipment which is not frequently dealt in the market. The used equipment can also be obtained from its owner directly. The owner gets better price than they get from selling it to dealers. Such deal is possible when the dealer advertises such sell or the buyer had known about it through some indirect sources. It is preferable to buy from the owner rather than the dealer because the margin of the intermediaries is eliminated. Under such a situation, it is possible to see the machine in its operating conditions before making the buying decision. Moreover, the owner can also provide the historical data about the machine. Such benefits are not available when the equipment is purchased from the dealer. On the contrary dishonest dealers try to hide the limitations of the machine. The used machine can also be obtained through bidding in the auction. Under the liquidation procedure, the assets are sold through open auction either by the creditors or by the liquidators.

Pros and Cons of used Equipment (1)

The purchase of the used equipment is advantageous as under: It is available at low cost. Generally, the unexpired life is always higher than the unexpired cost in relation to its historical price. When the purchases are made under the "as is and where is" condition, the cost of dismantling, transportation and installa-

154

Outline of Materials and Purchasing Management

tion at buyer's plant should be considered carefully, so that the apparent cheaper price may not prove costlier. (2) The used equipment is made available immediately. In case of purchase of new equipment, the time gap between the identification of need and actual receiving is very long. (3) The performance of the used machine can be inspected on the spot when it is in operation. Such facility is generally not available in case of purchase of new equipment. (4) When the buyer needs the equipment for the purpose of temporary operations, the· used equipment proves economical, e.g., to meet the requirement of "stand-by· equipment, to perform, temporary work or to execute short-lived project. (5) Sometimes the old brand is more suited to buyer's requirements when he is employing the services of such old brands in his plant. Sometimes such brand is not available in a market adapting to the technological innovations. Used equipments suffer from the following limitations: (1) The life expectancy is very short. (2) The operational guarantee is not available. On the contrary, sometimes the dealers employ trick to hide any limitation of equipment. Thus the onus is on the buyer to verify all details before making the purchase decision. (3) The used equipment cannot incorporate the benefits of the technological innovations. (4) The chances and frequency of machine breakdowns are very high. (5) The repair and maintenance costs are relatively high. It necessitates the maintenance of spare parts inventory. Sometimes, the cheaper used machine proves costlier in real terms. As the purchase decision is made on "as is" basis, the two offers are never identical (6) and thus the comparison is not possible. As the purchase of used equipment is a specialized and typical decision, due care should be taken while buying such equipment. Preferably, it should be purchased from the owner rather than the dealer. The operational condition of the equipment should be inspected at owner's plant at the time when it is in operation. The historical data regarding the time of purchase and degree of use should be carefully verified. While buying from the dealers, the services of the specialized persons should be obtained who is able to verify all the technical details presented by the dealer and who can also physically conduct certain operating tests. The price of the used machine should be carefully determined.

Leased Equipment The capital equipment can be either purchased or can be obtained on lease. When the assets are purchased, they are owned and possessed by the purchaser. When they obtained under lease agreement, the assets are owned by the lessor (Le., supplier of asset) but are possessed by the lessee (Le., the client) who enjoys the unrestricted use of the equipment during the tenure of the lease. In the overseas markets, leasing is one of the most widely accepted modes of financing the acquisition of capital equipment. In the U.S.A. it became popular in late 1950s while in the U.K. in late 1960s. However, the concept of leasing did not develop in India till recently. The leasing arrangements care gaining ground in our country and many of the private sector companies, financial institutions and commercial banks are developing their resources for creating leasing' facilities.

Purchase of Capital Equipment and Leasing

155

The leasing facilities offer numerous advantages to the lessee, of which elimination of the initial requirements of huge financial, resources is an important one. The leasing facilities are available in case of acquisition of certain standardized machinery and equipments such .as aircraft, ships, other vehicl.es, computers, office equipments, cranes, oil rigs, earth movers, lathes, boiler, power-generating sets, air-conditioners, air-blower. However, leasing can be tailor-made arrangements under which the equipments are supplied according to the suitability of the lessee. Many of the leasing companies try to accommodate the specific requirements of the lessee. The leasing facilities are provided through the lease agreements. The lease agreement creates debtor-creditor relationship. The lessor, instead of fund, supplies equipment to the lessee. The lessee agrees to pay the fixed periodic rental fees. On the completion of the tenure of the agreement, the lessee returns the used equipment to the lessor. In many of the cases, the option is given to the lessee to purchase such used equipment. The annual rental fees are decided on the basis of the interest cost, of the investments, tenure of agreement, risk of obsolescence, service charges etc. Generally, lessor considers the rapid amortization of cost of equipment. The lease agreement also provides for the protective provisions such as insurance, regular maintenance and service to the equipment observation of certain financial standards etc. In case of the default, the lessor is entitled to retain his property. As the lessee is not the owner of the property, he is not entitled to the depreciation and, investment allowances. However, the rent paid by him are tax deductible. The following specimen of the standard lease proposal will clarify the concept of the leasing: (1) The equipment will be supplied according to the needs, of the lessee. (2) The period of lease is 5 years. (3) The lessee will pay an annual rent on 37% of the cost of the equipment for five years. (4) The rent will be payable quarterly. The first instalment of rent shall be payable on the acquisition of the equipment and all other rents shall be payable in advance in the quarter immediately preceding the relevant quarter. (5) At the end of the 5th year, the eqUipment will be transferred to the lessee at 1% of the purchase value. (6) During the tenure of lease, the lessee shall be required to maintain and service the equipment as per the prescribed norms.

Advantages to the Lessee (1)

(2)

The availability of leasing facilities are advantageous to the lessee as under: It eliminates the need for huge financial resources, required in acquiring the capital equipments. The financial incidence is reduced to the periodic rent instead of initial capital cost of the equipment. The small firms can carry on their expansion, diversification programmes with the help of leasing facilities. Even large firms can expand their activities without showing any growth in their assets. Leased equipments are not shown in the balance-sheet either on the liability and/or asset side, but are mentioned by way of note below the balance sheet. Such situation represents the conservative form of financing. However, it should be noted that the high incidence of rent aggravates the danger of liquidity like highly levered firms. The disadvantages incidental to the ownership are avoided. The danger of obsolescence and terminal value losses are not to be borne by the lessee.

156

Outline of Materials and Purchasing Management

(3)

It provides greater degree of flexibility to the lessee. He can use, retain or return the equipment within the limits of the stipulated terms and conditions. (4) Leasing also avails the tax advantage. As the lessor is interested in rapid amortization of the capital cost, the· rent values are always greater. The rent charges are tax· deductible for the lessee. Thus, if he acquires the asset after the tenure of the lease, the assets are offered at a negligible price. Thus, the tax advantage under lease are greater than the usual depreciation allowances. (5) The restrictive conditions of debt financing, viz., inclusion of convertibility clause, appOintment of director, other restrictions on certain financial policies can be eliminated. If the equipment is acquired through debt funds, the imposition of the aforesaid restrictions will restrict the discretion of the management. (6) The problem of disposal of the used equipment is eliminated. The major disadvantage of the lease to the lessee is the high cost of rent. Leasing facilities are costlier in the long run. However, the high cost of rent should not be compared with interest cost of the acquisition of the equipment, but the incremental rent cost should be compared with other benefits which avails from the leasing. If such benefits outweighs the incremental rental cost of the lease, the leasing should be preferred.

000-

CItAPTER 11

Make-or-Buy Introduction Components that go into the production of many items are either made by the factoryowner or are purchased from outside suppliers. No car is a 100 per cent work of one factory, and no watch that appears on the market is without parts that are made elsewhere. What considerations are uppermost in management's mind when taking a crucial make-orbuy decision? Some important ramifications of this engaging problem are delineated here. Management in action is decision-making and some important indecisions are made in respect of the feasibility of producing materials within one's own plant rather than purchasing them from outside sources. It is an option of make or buy. Apart from this, organization may decide either to do processes of manufacturing in their own plant or to have part of the work done by outsiders. It is a practice of sub-contracting, and presents another form of the make-or-buy decision. Make-or-buy decisions are policy decisions arrived at after deliberations with several functional heads. However, the purchase department, best-informed as it is about various issues involved, takes an active part in making such decisions. In most of the cases, it communicates information and data to the upper management for chalking out a policy.

Factors affecting the make-or-buy decision Generally, four important issues merit attention in all purchasing decisions: quality, quantity, cost and service. These basic issues, as they affect the make-or-buy decision, would be elaborated to give a proper perspective.

Quality Considerations Compare the quality of the purchased item and the quality that the company could have achieved, had it made on its own. If there is no possibility of a very wide variation, quality considerations do not weigh heavily in making a make-or-buy decision. If there is a possibility of very wide variations between the two alternatives, quality factor becomes crucial in making one decide either in favour of make or in favour of buy. If a better quality could result when the company produces the item on its own, and therefore takes to making it rather than buying, should probe the matter further. How is it that no (157)

158

Outline of Materials and Purchasing Management

supplier has taken to making the desired quality? Are the Quality Expectations of the Engineering deptt. really necessary? Is there a possibility of getting the desired quality soon after a temporary period of shortages? Is the company competent to undertake the production of desired quality in its own plant? Absence of quality desired for in the market may indicate a situation where suppliers have not thought it worth while to make it considering the meagre, non-recurring demand for it. So economic viability of producing the desired item should also be considered by the manufacturer who opts for a 'make' decision. If the specifications of the engineering department regarding quality are more fastidious than necessary for the proper operation, or expected life for commercial standards of the item, there is room for relaxation in the speCifications so that the purchase of the item as available from outside becomes possible. However, this is a matter of expert review involving value analysis. An item for a new product is bound to be in short supply initially. But the situation is temporary. And so make-or-buy decision should be taken in this light, or else heavy financial commitment to making the item that results after taking 'make' decision out of temporary shortage would be reversed after much loss. The concern's own production facilities should be taken into account when any 'make' decision is taken. Are we technically competent to produce a better quality than can be bought? There must be some technical hitch, when the speCialist suppliers fail to meet the desired quality standards. Is it possible for the concern to do better by overcoming the technical difficulties which even the speCialist suppliers could not overcome? Make decisions are also the outcome of a legitimate apprehension that an outsider, having no financial stake in the finished product, may compromise with the quality of his supplies. When outside suppliers are chosen for supplying the components of a product there should be a procedure of quality control, rigid enough to eliminate sub-standard components. The concern should also come forward to provide technical know-how to smaller ancillary units to produce the component to desired standards. If the outside supplies are defective, it would jeopardise saleability of an otherwise good finished product. Unpatented designs or processes are generally not entrusted with outsiders to protect business interests by preventing others copying them for a prolonged period of time. Buying from outside has several reasons: (1) To take advantage of specialised activity of the buyer. (2) To take advantage of quality resulting from patents or production methods that the supplier controls. (3) To introduce flexibility with respect to quality of the part being purchased.

Quantity Considerations Quality and Quantity considerations differ with reference to one important issue Quality is fairly specifiable whereas it is not so with quantity. Quantity is always in a state of flux and it is related with time element. The correct quantity given under condition at a given time may not be valid at another time under changed circumstances. How much to buy - quantity - is a variable whereas, what to buy - assortment - is not. Considering upon the basis of quantity, the make decision is made when the supplies are likely to be too small to interest an outsider. However, it should be considered whether the order can be made enough to interest outsiders or a corresponding large inventory can

Make-or-Buy

159

be maintained to meet production needs. It is also seen if sundry small use items can be ordered with common specifications. It is also worthwhile to consider the economics of making a small use item on one's own, when the outsider has not thought it unprofitable to venture production on such a small scale. Based on quantity, another decision of making rather than purchasing is the possibility of closer co-ordination between quantity produced and quantity required. PPC thus becomes an easy activity. Quantity required may be so high that either a decision is taken to make it or to split the requirement among several suppliers. However, when the product is made with the help of dyes or patterns, split purchases are ruled out completely. Each supplier in such a case cannot be given dyes or patterns. Its costs are very heavy. Thus a large quantity requirement often has a slant towards make-decisions. On the contrary, an exceptionally large quantity may hamper production of the regular product line. It then becomes advisable to buy from supplier rather than to make the item.

Cost Considerations Cost has relevance in make-or-buy decisions when all other factors are equal, or else reasonable cost estimates of the variations should be included to make up for any inequality. Let us consider quality, quantity and service factors to be equal. Then the decision of make-or-buy rests on comparison between a known cost and an estimated unknown cost. The known cost is the price charged by the vendor, and the unknown estimated cost is the cost of making. If there is negligible difference between the two costs, the item should be purchased. In most cases, a known cost is rather more reliable than a slightly lower estimated cost. How the cost of making is estimated? It is a skilled job and the estimate is more reliable when it is calculated with skill and care. When the item is smaller, value-wise and quantity-wise, the task of accurate estimation becomes difficult. The estimation of the cost accurately becomes difficult when, overhead costs are to be allocated on an item that is made in the plant from the materials and on the machines being used for other items. If the item is such as stands out in a class by itself, the overheads are easy to allocate. Then there is a problem of the current level of production in the plant. A plant operating at or near capacity gives a different cost sheet of the item now being purchased than a plant having idle capacity would give. Idle capacity results in a high ratio of fixed costs to total costs. Therefore, additional output can be obtained with only a nominal increase in total cost. On the other hand, a firm operating at full capacity gives additional output at substantially increased costs. A plant with excess capacity can increase production by merely adding incremental costs that are variable in nature. A plant working at capacity, however, can give additional output only by increasing its capacity, thereby adding incremental costs of both fixed and variable nature. BEC (break-even chart) would make the point clear. A firm raises its output from 100 to 110%, incurring thereby incremental costs of Rs. 30 (Rs. 120 to Rs. 150 per unit) as a result of increase in fixed and variable costs. However, the same firm could have raised its output from 70 to 80% and incurred incre-

160

Outline of Materials and Purchasing Management

mental costs of only Rs. 8 per unit (Rs. 91 to Rs. 98), since the latter output range keeps fixed costs constant and increases merely direct costs. When the plant works below capacity, the cost of making should be determined by dividing the estimated volume into the increased variable costs. The purchase decision then would be taken for the item if its unit purchase cost equals or is less than the unit increase in variable costs. At any higher price, the decision is in favour of making, because it would be contributing something towards overhead costs. The plant operating at capacity presents a different situation. The options now open are to expand the facilities or go in for an outside purchase. In such a situation it is right on the part of the company to purchase from outside at any price less than the unit total costs making the item. If the requirement is meagre, the buyer may even be justified in paying an enhanced price rather than committing funds to expansion of facilities that may be left partly & utilised and partly unutilised. The above analysis of cost considerations, though apparently simple, involves difficult assumptions in practical situations. The time element looms large in any decision. A firm having a plant operating at 70% of capacity errs in changing from buying to making if projected sales of product line will require capacity production in a few years. Beside this, there is a difficult problem of classifying costs into fixed and variable expenses, exclusive of each other, whereas in practice, many costs are partly fixed and partly variable. Suppose we take a decision to make an item whose raw materials have not been previously purchased. In such a case, procurement costs in the short run are going to be fairly high. If the product being made is different from the regular product line, a line change in existing facilities is necessary sometimes along with trained manpower. Another consideration is the future trend of prices. Opportunity costs should not be lost sight of in any make or buy decision. Sometimes, for an item that is made there is only self-consumption and so the production should be high enough to allow economies of scale. An outside supplier with a regular clientele can enjoy many production advantages. Inventory is high when the item is internally made than when it is purchased from outside. Economic ordering quantity formula can be applied to a 'make' decision. EOQ where

= ~2US 10 u

= expected usage in units over time.

o

= Cost per unit (direct production cost when inplant production is

involved) = Inventory carrying charge as a percentage (including value of money

invested, insurance, and other overheads) ' .. _. s = set up costs or purchase costs (materials and supplies) Assuming no significant discount for volume and the same cost, irrespective of whether the item is purchased or made, the Economic Lot Size of manufacture will be greater than Economic Lot Size of purchase, resulting in a heavier carrying cost for the 'make' item. The illustration that follows stresses the higher EOQ, quantity required for an item with the same purchase cost and make cost.

Make-or-Buy

161

Manufactured Lot: Carrying charge = 25% Set-up costs = Rs. 100

Computation of Economic Lot size. Annual consumption : 100 pieces Purchase: Rs. 10 Cost to make : Rs. 10 Purchased Lot : Carrying charge: 25% Purchase costs: Rs.10

EOQ =

EOQ =

2x100x100 0.25x10

EOQ = 89

2.100x10 0.25x10

EOQ = 28

The higher the set-up costs to prepare for production, the greater the variation between the quantities for making versus buying. Transportation cost is one more element that may be higher in making than in buying. Raw materials may be bulky, contributing thereby to higher transport costs as compared to finished products which may involve less transport costs as they are lighter. One offsetting consideration is the fact that transport costs per 100 pounds of raw material is usually less than those for processed goods.

Service Considerations The guarantee of supply is an important service consideration. Generally, it can be said that supply is more assured when a company makes an item than when it buys it. Assured supply to the assembly line is often a reason for making rather than buying. Such decisions are valid for large industrial concerns where uninterrupted supply is necessary to prevent a break-down in the supply line. Making rather than buying items may enable a firm to give more assured and regular employment to its employees. Unfair practices of the suppliers may force a company to make rather than buy. The existence of a monopolistic condition provides a strong stimulus to make rather than to buy. Sometimes a company is compelled to devise a substitute for a patented item so as to protect against a "legal monopoly." One more factor merits consideration. A company may stop purchasing one item and start making it. But the company purchases several other items from other suppliers. The other suppliers may develop an apprehension that even the other items will finally be made by the company. The suppliers are not sure of constant business relationship and so there is a risk that the quality of service and the assurance of supply may be affected. One more consideration is about the effect of the make or buy decision on the buyer's flxebility. While purchasing, negotiations with various suppliers are possible and the suppliers can be selected as the occasion demands to get the right quality, the right quantity, at the right time and for the right price. Once a company starts making an item, the flexibility is lost. It becomes difficult to adjust quantity, or price (cost).

162

Outline of Materials and Purchasing Management

Other Considerations While deciding to make an item, attention should be paid to the availability of technical know-how. Even if technical know-how is available, its cost should be considered. Taxation policy of the Government should be considered while deciding to make the item. The contingency of war is another consideration bearing on the make or buy decision. In general, a new company that is still growing will tend to buy more items than a company that has reached maturity. The desire to make the company growth-oriented, the management may decide to make items it formerly bought. Industrial relations are reflected in make or buy decisions. Trade Unions often attempt to include in their contract causes that prohibit management from buying or sub-contracting items that can be manufactured in all its plants.

Subcontracting Subcontracting involves hiring another firm to perform some of the manufacturing process or to give subassemblies that will be incorporated into the end product. Subcontracting, in other words, is one method of buying instead of making and hence many of the factors discussed above influence the subcontracting decision. The term of subcontracting has come to be particularly associated with contractual arrangements between industrial concerns and governmental agencies. i Subcontracting has several advantages. It is the fastest method of increasing output. The buyer used manpower where it is located instead of shifting that manpower into his own plant. It enables him to use technical and management skills, already existing as a functioning unit instead of developing new units. It may avoid the need for new plants and equipment on the part of the buyer, since he, in effect, borrows existing facilities. Subcontracting checks over-expansion of productive facilities. Such over-expansion can create serious over-capacity if the demand is temporary. Subcontracting will generally save the buyer from incurring investment costs in specialised machinery and tooling which may not be usable for his regular production requirements. However, since the subcontractor does incur such costs, his operating costs still reflect them, and to some extent the savings may be more nominal than real. It is called the comparative cost factor to be considered prior to making the subcontracting decision. Another factor to be considered is the availability of the "market." Lastly, there is a factor of relative cost between doing the job in the plant and subcontracting for it. Some practical questions should be answered. To what extent should the subcontractor permit his facilities to be committed to one buyer? To what extent should a buyer assist a subcontractor in procuring materials, supplies, and tools? To what extent should technical assistance be extended? To what extent a subcontractor be financed? It is important to raise these questions and to answer them in the light of the particular situation and sound business principles.

000

CltAPTER 12

Value Analysis Value analysis which aims at a systematic identification, and elimination of unnecessary costs results in the increased use of alternative, less expensive material, cheaper designs, less costlier methods of manufacturing etc. to provide the same performance, quality and efficiency in a decrease of overall unit costs and consequently greater profits. VALUE ANALYSIS-PART I

A housewife is out shopping for vegetables. There are four varieties of tomatoes to choose from, costing Rs. 15, Rs. 20, Rs. 25 and Rs. 30 respectively. Which will she buy? Quality? All are of good "quality." Price ? Obviously not. Then the vegetable vendor won't be able to sell the other three qualities. The answer is simple. She will buy that quality which serves her purpose. For example, if her husband's boss is coming for dinner and tomatoes are required for the salad, the Rs. 30 variety will be the obvious choice. If she wants to make tomato rasam, then she will purchase the Rs. 15 quality. In other words, her choice will depend on the function the tomato is to perform. Each of the four varieties has a value and this value depends on the function it is expected to accomplish. This small example illustrates the approach of Value Analysis. ' Value Analysis is, in essence, a study of function. The function of a part, or material, or service is the job it does. Value is the price we pay for a product process, material or service required to perform a specific function in an efficient way. We get the best value when we incur the least cost for an essential function or service with the required quality and reliability. The task of Value Analysis is to ensure that all the elements of cost whether for labour, for material, for designing or for services, contributes proportionately to the function. Value analysis is a cost reduction technique and perhaps the most potent of all such techniques. Cost reduction is a very dynamic concept unlike, for example, cost control. In cost control we are aiming to keep cost within predetermined standards while in "Cost Reduction" our objective is to attack the costs themselves and eliminate them wherever possible.

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Definition There are various definitions of Value Analysis. Stated very simply: "Value Analysis is an organised procedure for efficient identification of unnecessary cost." Another definition states: "Value Analysis is the study of the relationship of design, function and cost of any product, material or service with the object of reducing its cost through modification of design or material specification manufactured by a mo~e efficient process, change in source of supply (external or internal), or possible elimination I)r incorporation in a related item." A more elaborate definition of Value Analysis as- given below throws more light on the fubject. "Value Analysis is the organised and systematic study of every element of cost in a part, material or service to make certain it fulfils its function at the lowest possible cost; it employs techniques which identify the functions the user wants from a product or service; it establishes by comparison the appropriate cost for each function; then it causes the required knowledge, creativity and initiative to be used to provide each function for the lowest cost."

How it all began? During the Second World War, one of the most serious problems faced by companies engaged in the war effort was the shortage of materials. This led to experimenting with substitutes, quite often in very unorthodox ways. In many cases, the experiments clicked and surprisingly there were a large number of instances where the substitutes were much cheaper and functioned more efficiently than the original material. After the war, Harry Erlicher, the Vice-President of PurchaSing, General Electric Co. (U.S.A.), felt that this problem of finding out substitutes could be done in a more scientific way and as a deliberate approach, rather than by an ad-hoc crisis approach. He entrusted this job to a team of engineers headed by Lawrence Miles. In fact it was Miles who coined the term Value Analysis and its synonym, Value Engineering. This team under his stewardship pioneered this technique and perfected it and, it is said, saved their company 200 million over a period of 17 years. In America, the technique is very widely used and is given a great deal of importance. In fact, the U.S. Defence Department insists that Value Analysis should be applied in all contracts in excess of $ 100,000. Mr. McNamara is on record as having said that in the year ending July 1965, the Defence Department saved $ 4.6 billion by using Value "Engineering without any adverse effect in our strength and combat readiness." In India, the technique is catching on, but slowly.

Types of Value It is usually difficult to specify value mainly because values change from person to person. Generally speaking, there are seven classes of value - economic, moral, aesthetic, social, political, religious and judicial. Of these, only the economic classification can be considered to be objective. It is the only one which can be measured. The others can be evaluated only subjectively.

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Within the class "Economic Value", there are four sUb-divisions: Use Value Properties which accomplish a use, a work or a service. Esteem Value Properties which make the ownership of that object very desirable. Cost Value Properties which are the sum of the labour, material, overheads, and other costs required to produce that object. Exchange Value - Properties that make the object possible of being traded for other items. It is apparent that only "Use Value" is objective.

In almost everything we buy, we relate what we get to what we have paid for - in terms of performance, reliability, appearrance etc. If we can collectively term these as "function" then we can express value in a mathematical way, i.e., Value =Function

Cost

By cost, we mean the total cost (e.g., of material, labour, overheads etc.) required to produce the article. If we keep the function constant, we see that'~ get greater value when our costs come down. Value can be increased: (1) When we reduce costs (2) When we improve function (3) By (1) and (2) together. (4) When we increase function by a disproportionately low increase in costs: Usually most of us lack the ability to measure value. In industry most of us are performance or delivery oriented and we hardly search for or get cost information. Practice of value analysis sharpens this latent ability to determine worth and measure value and more than all to eliminate unnecessary costs.

Benefits of Value Analysis There are several direct and indirect benefits which can accrue from the introduction and practice of Value Analysis. Some of these are : (1) A reduction in cost of existing products or systems. (2) Prevention of unnecessary cost in new products or systems. These two are quantifiable and can be easily measured. (3) The introduction of Value Analysis leads to overall cost consciousness and a general attitude change toward costs. (4) Product Value gets improved and the quest for new materials and processes gets encouraged; it provides a great boost for import substitution. (5) Systems relating to cost and estimating usually benefit from reorganisation necessitated by the wider use of cost information. (6) Finally, a greater return of investment results. In other words, greater profits accrue.

Causes of Unnecessary Costs Value Analysis attacks unnecessary costs. It would, therefore, be pertinent to find out how unnecessary costs arise, so that we may overcome or minimise these reasons.

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1. Lack of Information: Most people who design a product are quite often not too sure of the real needs of a user and usually over-design the product by providing it with features that the user just does not use. One of the facts of the Manager community is that they lack cost information. Most of them feel that they have a rough idea, but how rough is rough? The world is advancing exceedingly fast and new technology, new products, new materials and new processes are coming up almost every day. They create obsolescence in respect of the old materials or processes. Costs which were considered satisfactory yesterday become unnecessary today. In the face of competition the royal road to ruin is to adopt the methods of yesterday to the business of today. 2. Lack of Ideas: A survey done in the United States shows that most people use less that 5% of their creative abilities. "We have hardly any time" (to think?). Most of us want previously tried out materials, designs, processes and procedures. We jump at the first idea that works and usually do not bother to find out if better methods are possible. 3. Wrong beliefs, habits and attitudes: Most of us use our judgment more than it is valid and come to all kinds of wrong conclusions. Most of these conclusions will not stand a moment's scrutiny if tested out of the Bible. Some of the typical statements we might have so often made are : "It will set a nasty precedent." "It won't work." "Costs too much." "The public won't touch it.~ "It is impracticable." "The Production Oeptt. will have none of this." "Why change it - it works." "There is no other source of supply." "That is not our responsibility." "The Management will not accept it." "It's company policy." Such strong beliefs can kill cost reduction ideal before they are-christened and unnecessary costs will continue to be incurred. 4. Changed circumstances : Everyone likes progress but hardly anyone wants change, especially if that change affects him or his work. Circumstances might have changed, yet one longs to be conservative and continues the same features of yester-year. A typical instance of this nature relates to the Army. In the good old days when gun carriages were drawn by horses, there was a seven-man team-six for the guns and one to take care of the horses. Years after the horses were replaced by an automotive, the seven-man team was apPointed to manage the gun carriage obviousiy one man had no work. We can find innumerable such instances all around us only if we care to look for them. Value Analysis aims at a systematic identification and elimination of such infructuous or unnecessary costs, i.e., costs which do not improve the quality or efficiency of a product, or prolong its life or give it a better appearance, or provide any 'additional utility features.' In other words, Value Analysis results in the increased use of alternative, less expensive material, cheaper designs, less costlier methods of manufacturing and so on, to provide the

Value Analysis 167 . same performance, quality and efficiency resulting in a decrease of overall unit costs and consequently greater profits.

Tests for Value The following is a check-list of ten tests for value compiled by the Purchasing Deptt. of General Electric Co., U.S.A., and it is considered most desirable, if not absolutely essential, for every material, every part and every operation to satisfy these tests: (1) Does its use contribute value? (2) Is its cost proportionate to its usefulness? (3) Does it need all of its features? (4) Is there anything better for the intended use? (5) Can a usable part be made by a low-cost method? (6) Can a standard product be found which will be usable? (7) Is it made on proper tooling considering quantities used? (8) Do material, reasonable, labour overhead, and profit, total its cost? (9) Will another dependable supplier provide it for less? (10) Is anyone buying it for less? Value Analysis seeks answers to the following questions which may be asked about a complete product, a component or process: (1) What must this item or process do? What is its function? (This can usually be expressed in two words, e.g., a bulb "provides' light" or a paint "provides protection", or "enhances appearance." (2) What else does the item do? (If the item performs functions that are not needed, then it may be a symptom worth investigating to find out if there is a waste). (3) What does it cost? (4) What else could perform the same function? (5) What will be possible substitute's cost? It is usually said that one of the most important reasons for the success of Japanese business is the word "WHY" ? Having a constructive discontent of everything around them, it is said, is part of the Japanese character. The result is that they want change. This is exactly the philosophy of Value Analysis. Someone has described this philosophy by the following parody of the famous poem: Ours is not to do or die. Ours is to question WHY. Add to this, Kipling's famous six honest serving men: What, Why, When, How, Where and Who and the profile is complete.

Resistance to Change As we said above, change is the inherent basic philosophy on which V.A. is built. In any organisation or group, dissenters can be found. These individuals, knowingly or unknowingly, will use every means at their command to resist change. It is important to be able to recognise road-blocks and then take steps to overcome them.

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Outline of Materials and Purchasing Management Some typical reactions and possible ways of tackling them are as follows:

(1)

"We tried this a couple of years ago but it was not successful." (Conditions change. Why not try again now?) "It can't be done." (If it has not been tried how does one know?) (2) (3) "The customer is satisfied with the price as it is." (If this is so, he will be more satisfied and so will be many others if the price is reduced.) "Sampling is not as accurate as 100% inspection." (This is not always true but (4) in any case, does it need to be that accurate?) (5) This way of processing would produce too many rejects to the specification." (Then, are the design limits too tight?) (6) There is no other technique. (Have you looked for one?) People have a natural resistance to change which may be further conditioned by experience, but favourable experience will help to reduce the resistance.

*VALUE ENGINEERING -

A CASE STUDY

A Case Study of Engineering Firm The Value Engineering team of the firm works on ad-hoc basis and consists of 5-6 members who meet regularly to take part in discussions. These members belong to different departments like Foundry, Production Design, Purchase and Cost Estimation. The whole value engineering work is co-ordinated by a Value Engineer. The actual example taken here is a sub-assembly used in the main assembly of 3/4 inch Gun Metal Gate Valve. The example is dealt in the following six basic steps of Value Engineering Methodology. (1) Product selection. (2) Information gathering. (3) Defining the function. Speculating the different alternatives. (4) (5) Evaluation of the alternatives. (6) Selection and implementation.

Product Selection The item selected was a high volume low cost type. Annual requirement was about 80,000 nos. Also from experience it was presumed that the item could bs simplified and yet provide required or even better function at a lower cost. Potential for reliability less time for matching and assembly and reduction of rejection rate due to foundry defects appeared feasible.

*

A.S. Bedi, Leader Engineering Works, Jullundllf.

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Fig. 12.1 Sub-Assembly of 3/4" Gate Value.

Information Gathering All details of this product like cost structure process charts adopted in foundry shop. machining shop and assembly shop production records and weight of each component were collected. Drawings of sub-assembly and each component comprising this sub-assembly were drawn. Also related specification of the product given in national and international standards were noted down. During this phase it was observed that material cost was about 70% of the total cost. The major objective therefore was to reduce the unnecessary material.

Defining the Function This is the key-stone of the methodology. Each function is defined in a verb and a noun form. This two-word definition of different functions defined the problem very clearly and also a quantitative evaluation becomes possible. In the case under discussion the basic function of the complete. assembly was ascertained as follows : Some fluid was going in and the same fluid was coming out of the valve and the valve could be used to allow this "flow" to pass or it could be used to stop this "flow" - in this case fluid taken was water at maximum pressure of 200 psi at room temperature. So in this case the noun preferably a measurable quantity is "flow" and the verb is "controL" Water at maximum 200 psi - Control Flow - Water at max. 200 psi. The function of the other parts were tabulated in the following chart in Verb-Noun form. Part Bonnet

Checknut Spindle Packing Gland Gland Nut

Function (a) (b) (c) (a) (b)

Hold Pressure Guide Spindle Retain Gland assembly. Check - Vertical movement Allow Rotation Position-seat Prevent-leakage Leakage around spindle. Press-Packing Retain-Gland

Notes Max. pressure is 200 psi.

Movement is spindle.

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FUNCTION CHART Speculating Different Alternatives Alternatives are now blasted to achieve different functions part by part. This is the real creative stage of Value Engineering. All types of alternatives and suggestions given by the members of the team are noted down without discussing or criticising any idea at this stage. Criticism at this stage inhibits the free flow of ideas. Many times ideas apparently looking simple arid silly can prove very useful. Such types of sittings are commonly known as Brain Storming sessions. Persons outside the team should also be welcomed to give their suggestions. Sugg''3stion boxes to receive the suggestions can be introduced and awards can be given to useful suggestions to create more enthusiasm and a cost-consciousness among all employees.

Evaluation of Alternatives After collection of different alternatives these are analysed criticially from the point of view of practicability and relative cost. National, International and Company Standards are . referred to at this refining stage. In the case under reference, selected alternatives are given in the comparative chart and are also shown in the figure. A difference of Re. 0.80 per piece in cost price was achieved. The same idea was utilised in similar valves of other sizes.

Comparative Chart Material Manufacturing Process, Rejection etc. Part

Before VE

After VE

Bonnet

Gun Metal casting (85/5/5/5) was done. Machining was all over surface and also hexagonal ends were milled for wrench fitting. There was lot of rejection due to pin holes and blow holes etc., and also due to leakage under hydraulic pressure.

Forged from brass. Due to forging finish lot of machining avoided and also milling at Hexagonal portion became unnecessary. Rejection rate came to almost zero.

Check Nut

Lot of rejection due to gun metal casting. All over machining was done on capstan lathe.

Glan~,

Gun metal casting was used (except in the case of gland which was already from brass rod). There was lot of rejection due to foundry defects like shifting, blow holes, pin holes etc. Shifting was main defect.

Check Nut was replaced by a steel circlip. By using a circlip whole subassembly was made very compact. Also production in the assembly shop increased. Taken out from extruded brass rod. Machined on single spindle. Automatic Lathe (traube) which resulted in less rejection. Many times increase in production, more accurate

Gland Nut and Spindle

Also complaints from customers due to breakage of spindles.

Value Analysis

171 More machining and material waste.

dimensions which further led to interchangeability of parts and standardization . Customers' complaints were almost eliminated as strength of extruded brass rod was almost double the strength of cast gun metal. Also due to this fact diameter of spindle was slightly reduced . This way the whole subassembly became compact.

Some more cost saving ideas

Fig. 12.2 (A)

Fig. 12.2 (8)

(a) Split rings were used to replace shoulder and locking nut. A lot of material and machining costs were saved as previously stock diameter used was 1.1.116 inch and now only 5/8 inch stock diameter was used. (b) This was a bonnet of 3 inch Gun Metal Globe Valve. It was designed originally with a straight 5/8" diameter core through centre. There was about 20 per cent rejection due to foundry defects like shrinkage. By changing the shape of the core, more uniform section was achieved in the casting. Excessive material and machining costs were saved. Moreover the uniform section resulted in a much stronger casting.

Fig. 12.3

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Fig. 12.4 (c) Retaining ring replaced expensive bolted cover plates, eliminated drilling and tapping operations. It reduced thickness of housing, also assembly, and the dissembly process became faster.

000

CIiAptER

l'

Import Purchasing Foreign Trade Nowadays trade is not restricted within the boundaries of a nation but has spread throughout the world. Countries import those commodities which are not produced by them either because of cost disadvantages or because of physical difficulties, or even those which are not produced in sufficient quantities so as to meet the internal requirements. They export those goods which are produced in excess of internal requirements or in regard to which they have cost advantage. Foreign trade is handled both by private as well as government agencies. However, the number of individuals or agencies engaged in foreign trade is much less as compared to those engaged in the home trade. This is primarily due to the difficulties which come in the way of foreign trade. These difficulties distract most of the traders from entering into the field of various formalities necessary for the purpose dare enter this field. The various difficulties which are faced by a trader engaged in foreign trade are enumerated below: (1) Distance. (2) Diversity of language. (3) Difficulty in transportation and communication. (4) Risk in transit. (5) Lack of information about foreign merchants. (6) Special features of foreign markets. (7) Custom duties. (8) Remittance of Price. 1. Distance: Distance between different countries makes it difficult to establish quick and close trade contracts between the parties. Traders rarely meet one another and personal contact is rarely possible. Even though trade directories have made it possible to obtain information regarding the markets for various products still procurement of information regarding individual products and their markets is a tedious task. There is a great time lag between placement of an indent and receipt of goods from foreign countries. 2. Diversity of language: Different languages are spoken and written in different countries. This diversity of language poses another problem. The trader, wishing to establish trade relations with foreigners, must either know the language of that country or must (173)

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utilise the services of somebody knowing that language. Price lists and catalogues are to be prepared in foreign language, all correspondence is to be done in the foreign language, and even the advertisement is to be done in the language of that country. In Western countries, therefore, everybody receiving training in foreign trade must study one or two foreign languages. 3. Difficulty in transportation afld communication: Correspondence with foreign traders takes a long time. Of course, e-mailing has facilitated communication these days a great deal. Receiving the goods or their supply takes even a longer time and also involves a large expense which increases the cost of goods for the customers. During the war, transportation of goods becomes even more difficult and sometimes the customers are denied the use of foreign goods or the factories stop working for want of imported r~w materials. 4. Risk in transit: There is a greater risk in transit for the goods in the case of foreign trade than in the case of home trade. Goods are transported by ships which may sink due to hidden rocks or gales. Sea pirates also pose a problem. In the days of war the ships and the goods can be captured by the enemies. Many of these risks are covered through marine insurance, but this increases the cost of goods. 5. Lack of information about foreign merchants : It is often difficult to obtain information regarding the financial position and business standing of the foreign merchants. Traders have to depend upon correspondence alone for successful operations. Trans-portations are done on the basis of samples and catalogues. This difficulty has been removed to some extent by the establishment of such business institutions who provide confidential information about the merchants in their own countries. 6. Special features of foreign markets: Every foreign market has certain characteristics of its own. Its problems, its requirements, its capacity and trade customs are peculiar to itself. Thus extensive study of each foreign market is essential for success in foreign trade. 7. Customs duties: These days practically every country levies customs duties on its imports and exports. This is done with a view either to protecting its home industries or to earning revenue for the State. High tariff rates restrict the entry of goods in a country levying them and also limit its exports. Export duties are generally levied on raw materials so as to make them available for internal trade. Many countries enter into trade pacts to surmount the difficulties. For example, GATT, ECAFE, EGM, etc. are aimed at surmounting this difficulty. 8. Remittance of price: Use of different currencies makes it difficult to obtain payment of the price of goods sold. Fluctuating exchange rates make it difficult to calculate how much is to be recovered in one's own currency. Devaluation of a country's currency may mean a great loss to its importers. Again, the credit worthiness of the foreign party is difficult to ascertain. So long as the amount remains unpaid, there is always a danger of bad debts. The laws of many countries do not fully protect the interests of the foreign creditors. Existence of efficient banking system is essential for temitting the price quickly, easily and cheaply. Most of the above-stated difficulties have now been surmounted. The means of transportation have become very efficient and safe, reducing the risk in transit to the minimum. Correspondence is possible by air-mail and e-mail. Many institutions have been established to provide information regarding foreign merchants. Trade directories, Trade delegations visiting foreign countries and Trade missions also provide necessary information. Banks have facilitated the remittance of price and even the payment can be secured through banks. Insurance companies are there to remove the risk in transit. There are also

Import Purchasing 175 a large number of specialised agencies like the forwarding agents, clearing agents etc., who perform various functions for the importers and exporters for a very nominal" charge. Thus foreign trade has become more simple and less risky than before, though even now it is more difficult than the home trade.

Procedure a Purchase Manager follows while Importing from Abroad Goods can be imported either directly or indirectly. When a person wants to import directly, he places an indent upon the manufacturer producing the required items or upon the dealer dealing in them. But when he does not know much about the manufacturers or dealers in the foreign country, he resorts to indirect methods of importing. In this case, he places an indent upon certain specialised agencies known as export agents who will purchase goods for him and ship them according to his instructions. However, the following main stages in the import trade, no matter whether the goods are imported directly or indirectly, are required to be followed by every importer. ' 1. Placing an indent: When a person wants to import something, he places an indent either upon the foreign manufacturers or upon the export agents. An indent is an order placed abroad. The indent should clearly mention the quantity and quality of goods, method of payment, date of delivery, method of packing and marking, should contain instructions regarding shipment and insurance etc. In other words, it should be complete in itself and should leave no scope for doubt. The indent may be either a closed indent, or an open indent. In case of a closed indent, the importer clearly mentions the price at which or below which the goods are to be purchased for him or supplied to him. In the case of an indent, it is left to the export agent as to what price he pays for the goods, purchased on behalf of the importer. Having placed the indent, the importer will wait till he receives a letter of advice from the export agent. The letter of advice will give him information regarding the shipment and. regarding the method of procuring the documents. 2. Payment and Procurement of Documents: Having received the advice letter from the export agent, the importer will proceed to procure the documents like bill of lading, shipping bill etc., so that he may take delivery of the goods when they arrive at the port. Thus he will go to the agent of the exporter, will make payment and procure the documents. If the documents are against acceptance or DIA, he will be able to procure them by accepting the bill drawn by the seller. But if they are against payment or DIP payments in cash will be necessitated. 3. Appointment of Clearing Agent: When the importer has received the documents of title, his only concern is to take delivery of the goods when they arrive at the port and to bring them to his own place of business. But before the goods can be cleared from the port certain legal formalities are to be performed which involve much of time and mean some difficulty. Thus, if the importer does not live in the port town, he usually appoints a clearing agent to do the job of clearing the goods for him. Clearing agents are the individuals or firms engaged in the work of performing various formalities required before the goods can be removed from the ports on behalf of other. They charge certain remuneration for this work and save the importers much of botheration. Hence, the next step for the importer will be to appoint the clearing agents and to send all the documents to him so that as soon as the shipment arrives, he may take delivery of the goods and despatch them to the importer.

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4. Formalities by Clearing Agent : (a) Endorsement by the clearing agent: The clearing agent, having received the documents, will approach the shipping company and present the Bill of Lading for endorsement in his favour. If the freight has not been paid by the exporter, he will pay the freight and get the endorsement on the Bill of Lading. Sometimes the shipping company, instead of endorsing on the Bill of Lading, issues a separate order entitling the holder to take delivery of the goods. (b) Bill of Entry: The agent will now proceed to pay the customs duty so that as soon as the goods arrive at the port, he may remove them from the port. He will, therefore, fill in three copies of the Bill of Entry forms obtainable from the customs house. The Bill of Entry will contain full description of the goods due to arrive. Bill of Entry forms are printed in three different colours, viz., black, blue and violet. The black form is used for free goods, blue is used for goods to be sold within the country and the violet is used for goods meant for re-export. If the clearing agent does not have detailed and exact information about the goods, then he will prepare a statement called the Bill of Sight. In this statement he will give as much information as he possesses, stating that he is not in a position to give detailed and exact information. In such a case, the customs authorities complete the statement on the arrival of the goods. (c) Dock Dues: As soon as the shipment arrives, the clearing agent will submit two copies of the application to import, duly filled into the Landing and Shipping dues office and will pay the dock dues. He will receive back one copy of the Application to import which he will submit along with three copies of Bill of Entry, to the customs office. If the goods are not subject to any import duty, clearing agent is allowed to take delivery immediately after the forms are checked. But if duty is to be paid, he will pay the same and will then be allowed to take delivery of the goods. (d) Delivery of the goods and despatch by rail: Having performed all the abovementioned formalities, the clearing agent will take delivery of the goods, from the docks and will carry them to the railway station. He will then despatch the goods by rail to his principal and receive the railway receipt. (e) Advice to the importer: Then the clearing agent will write a letter of advice to the importer imforming him about the arrival of goods and their despatch by rail. He will enclose with it the railway receipt and a statement of his expenses and charges. 5. The importer is now in a pOSition to get delivery of the goods and thus as soon as the goods arrive at the railways station he will take delivery of the goods and carry them to his godown. Thus the whole procedure of importing will come to an end. Following are the documents employed in import trade: (i) Indent: An order placed abroad is called an indent. It contains full information regarding goods to be imported, their quantity, quality, mode of packing and marking, period of delivery, mode of payment and other instructions regarding shipment and insurance etc. An indent is a closed one where the price at which goods are to be purchased on behalf of the importer is clearly specified and no discretion is given to the export agent. It is open when no price is mentioned and this is left to the discretion of the export agent to purchase goods at the lowest cost price. (ii) Bill of Lading: A Bill of Lading is a document prepared by the shipowner, or by the master of the ship, or by other agent on his behalf. This document states that certain goods have been shipped on a particular ship and contain the terms on which such goods have

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been delivered to and received by the ship. This is, on the one hand, an acknowledgment of the receipt of the goods specified therein and on the other, a document of title. The owners of the bill is entitled to take delivery of the goods from the shipping company. This will is freely assignable and is sometimes called a "quasi-negotiable" instrument. Bill of Lading is made out in 'sets' usually of three bills. The stamped Bill of Lading is sent to the consignee who can take delivery of the goods by presenting the Bill of Lading to the Shipping Company. (iii) Bill of Entry: Bill of Entry is a document prepared by the importer for the purpose of paying the customs duties. It is prepared in triplicate and contains full information regarding the goods due to arrive. The Bill of Entry forms are printed in three different colours, viz., black, blue and violet. The black form is used for free goods, the blue form is used for goods to be used within the country and the violet form is used for goods meant for reexports. On the basis of the information given in the Bill of Entry, the customs authorities calculate the amount of duty and charge the same on the importer. Let us now discuss 1. Import Commission Houses and 2. Terms of payment to make our understanding of import purchasing clear and complete.

1. Import Commission Houses Import trade may be undertaken directly or indirectly. The business concerns may import goods by themselves or through professional import agencies known as indent firms or import commission houses.

Advantages of Indent Firms or Import Commission Houses 1.By virtue of their specialization in import technique they are always experts in carrying out complicated formalities of importing smoothly and speedily. 2.They develop direct connections with the exporters in foreign countries. They concentrate on a few lines of goods to be imported. Sometimes, they may enjoy sale or distributing agency rights from foreign exporters. Thus, they are well conversant with sources of foreign suppliers-names and addresses of foreign exporters, their terms of sale etc. 3.The small business concerns cannot afford to place large orders with the exporters who are reluctant to accept small foreign orders directly. The professional import commission houses can accommodate small orders of several local dealers. They act as order collecting agencies on behalf of foreign exporters. They collect small requirements of several local buyers and place a large order on the foreign supplier. 4.The professional import houses also enjoy a better credit in the foreign markets. They have established connections in foreign countries. In India, such professional importer are known as Indent Firms.

The Working of Indent Firms (Import Commission House) The indent firm has its representatives in foreign countries and thereby maintains upto-date information about the foreign manufacturers as well as the trends in foreign markets. It collects samples of goods in which it is interested. The indent house has also to appoint salesmen in its own country. These salesmen show the samples of goods to local dealers and if the dealer becomes ready to place the orders, they at once note down in their register the details of the order.

178

Outline of Materials and Purchasing Management The order given by the dealer is then rewritten on an Indent Form. It is in the form of a letter addressed by the customer who now becomes indentor, to the indent firm requesting the firm to purchase the goods specified in it. The indent firm takes out some more copies of the indent form and forwards one of them to its agent in foreign countries or to the manufacturer concerned. This order also contains the details of the goods as well as the mode of delivery and other relevant information.

2. Terms of Payment Documentary Credits : A credit for our purpose means any arrangement with a bank by which the bank undertakes to payor accept bills of exchange on behalf of a customer (importer). When the bank sets oat the arrangement in a letter, the document is called a "Letter of Credit" or simply a "Credit". When the bill is presented to the bank on whom it is drawn, the drawee (i.e. the bank) accepts it by signing across the bill a promise to pay at the end of the period. Accepted bills are often called "Bank Acceptance." One country's exports are the other country's imports and the documentary credit is one of the links between the two. A documentry credit is an undertaking by a bank that it will undertake by payment of a sight bill or acceptance of a term bill. A documentary credit i.e. a Letter of Credit may be either revocable or irrevocable. The revocable credit may be cancelled at any time, but an irrevocable credit cannot be cancelled without the consent of both parties, and, therefore, provides much greater protection to the exporter. Naturally, the importer is the arranger or opener of the credit, the exporter being the beneficiary, and the two must agree on all details affecting its conditions. The importer gives all details affecting its conditions. The importer gives the instructions for the opening of the credit (in favour of the exporter) to his bank. The importer specifies the exact particulars, such as the description, quality, quantity, and the price of the goods to be supplied, the documents which he expects to receive and method and the latest date of shipment, the nature of the insurance to be effected, the validity of the credit, and whether it is irrevocable or revocable.

Documentary Bill on the Importer Many importers may prefer to make payment in their own country against a draft or a bill drawn on them by the exporter and the shipping documents giving title to the goods are usually attached to such a bill. The exporter arranges to send the bill and all shipping documents through his bank to be surrendered to the importer (buyer) only against payment or acceptance of the bill of exchange. If the Bill is drawn at sight or on demand, the importer will receive documents against its payment (DIP). If the bill is to have a certain maturing period, the accompanying documents will be received by the importer on its acceptance (DIP). The exporter permits such D/A or DIP terms of payment provided the importer is known to be of good standing and it considered a reliable party. The exporter after despatching the goods as per order will prepare an invoice and draw a bill of exchange either on the importer or on his specified bank and forward the following documents to the importer direct or through his banks. (1) A bill of exchange-demand or time. (2) A full set of "clean" steamship company's Bills of Lading through to the port of destination. (3) Foreign Invoice (in duplicate).

Import Purchasing

(4) (5) (6)

179

Consular invoice (in duplicate). Certificate of origin if required. Certificate of quality.

Procurement Through Canalising Agencies Some items are imported through canalising agencies only. For example, procurement of raw materials like copper, steel, aluminium is done through canalising agencies. The procurement is quite costly, since the procurement price is based upon rate contract and these agencies add their own administrative cost to the procurement prices. The price advantage of spot buying at a time when prices are falling is lost to the canalising agencies. If the industries are allowed to purchase directly form the international market, the industry would be able to buy it at a lower rate and also arrange for early shipment.

000

CIiAPTER 14 Independent Demand Inventory Inventory in common parlance is called stock of any item or resource used in an organization. Since so much capital is committed to inventory and it affects the delivery of finished products to the consumers, inventory management is an important operation. Inventory management influences several other functions such as operations or production, marketing and finance. By definition, inventories facilitate production or satisfy customer demands. Inventory system is a set of policies and controls which monitors and determines the levels of inventory. Inventories conventionally include raw materials, work-in-process, component parts, supplies and finished goods. Operations is a transformation process in which the inputs are raw materials and the output is the finished goods.

Suppliers ----+~ ... Material Raw

,.

----1~~1

Production Work in Process

----l~~ Finished -~~ Customers Goods

Inventories here are equated with stock of materials: This is a narrow view. Broadly speaking, inventory is an idle resource that has potential economic value, thus taking in its ambit idle workers as inventory. But apart from materials other idle resources are considered as capacity. Inventory is a product at some point in conversion and distribution process, whereas capacity is the potential to produce. In the service industry, inventory refers to the tangible goods to be sold and supplies necessary to administer the service. In the production process, inventory stocks are located at various points. These are inter-connected through flows. A stock is replenished at a particular rate which is called the supply capacity. The rate of stock depletion is called demand. Inventory is a buffer between the different demand and supply rates. The analogy of a water tank illustrates the concepts of flows and stocks.

(180)

Independent Demand Inventory

181

Supply~

Ram

l ____

t

Inventory

f

----...Demand

L.....:,r_e_I____

Ram

Just as the water enters the water tank, supply enters the productive process. The flow of water from the tank is analogous to demand. The water level is equivalent to inventory. It is a buffer between demand and supply. If the demand is greater than supply, the water level goes down till the demand and supply rate balance each other or till the water is depleted. If the supply is greater than demand, the water rises up. One can also imagine a series of inter-connected water tanks with varying inputs and outputs.

Raw material usage

Output 1st stage

Output 2nd stage

~8~S~J;G;niShded L_

SuPPI;es_Stav.: I

~~~~~~~~ ~

~

~

customers

~

Inferior Scrap Scrap Scrap quality material Why do we study inventory management? We have to answer two questions: (1) When should we order the items? (2) How large our order should be? If there is an year, contract given to a supplier the 'how many to order' becomes 'how many to deliver.' Purpose of Inventory There are several reasons to carry inventory: (1) (2) (3) (4) (5)

To protect against uncertainties in supply, demand, and lead time. To maintain independence of operations, e.g., a supply of work centre allows it flexibility of operations. To allow flexibility in production scheduling. To allow economic production and purchase. To provide for transit.

Inventory Costs The following four types of costs are considered in calculating inventory size: (1) Holding (or Carrying) Costs: These relate to those costs which are incurred to carry the inventory items in stock for a period of time. It is expressed as a percentage of rupee value per unit of time. An annual holdjng cost of 15 p.c. means that it will cost Rs. 15 to hold Rs. 100 of inventory for a year. This broad category includes costs for storage, handling, insurance, pilferage, breakage, obsolescence, depreciation, taxes and

182 Outline of Materials and Purchasing Management the opportunity cost of capital. When items are carried in inventory, the capital is tied up and is not free to be invested in other things - a case of foregone opportunities for other investments. This is assigned to inventory as an opportunity cost.

(2) Set up (or Production Change) Costs: Production of different products requires procurement of the necessary materials, arrangement of specific equipment set ups, filling of the required papers, changing time and materials and moving out previous stock of materials. It means paperwork costs and the costs to set up production equipment for a run. When set up costs are heavy, there is an economy in having large runs. Set up time can be reduced by changes in production system and product. Though set up cost is considered fixed, it can be changed by changing the design and management of operations. Were there no costs in changing from product to product it would have been possible to produce smaller lots, leading to lowering of inventory levels and savings in costs. (3) Ordering Costs: These are the costs associated with the placement of an order. This cost remains the same irrespective of the items ordered. These costs include clerical costs of making an order, expediting it, receiving it and so on. Transportation costs are a part of ordering costs. Even if the item is produced within a firm, there are ordering costs. Tracking an order is also a part of the ordering costs. (4) Stock-out Costs : There is an economic cost when we run out of stock. If the customer has to wait because of backlogging an item for the customer, there is loss of future business. It is an opportunity loss. If the material is not on hand, there can be a lost sale; with consequent loss of current and future profits. When the item is depleted, we cannot entertain its order till the stock is replenished. There is a trade off between carrying cost to satisfy demand and costs resulting from stock out. This is what is known as shortage costs. Inventory management is cross-functional. Marketing tends to avoid lost sales. Finance tends to minimise capital costs. Production tends to keep inventory at level that assures smooth scheduling and production control. These objectives may run counter to each other. We have to take a cost optimization approach from the combined effects for individual costs. Besides cost consideration, there is time consideration which impinges on inventory cost.

Independent vs. Dependent Demand While studying inventory management, it is important to understand the distinction between independent and dependent demand. Demand can be attributed to the end item or can be attributed to the item itself. The predictions of inventory are based on how demand is attributed. Independent demand is influenced by market conditions outside the control of operations. The demand, in other words, is independent of operations. Finished goods inventories and spare parts for replacement have usually independent demand. Dependent demand is related to the demand for another item. When a product is made up of parts and components, the demand for these is dependent upon the demand for the final product. In an automobile company, the demand for cars is an independent demand decided by the market forces and the demand for tyres is a dependent demand decided by the production of the cars. Sales forecast is an essential input to decide the quantity of independent demand. The forecast is adjusted by certain extra quantity. In this chapter we will examine models to take care of the independent demand.

Independent Demand Inventory

183 The approach to inventory is based on the demand pattern. Replenishment philosophy is appropriate for independent demand. As the stock depletes, it is replenished. When the inventory starts to run out, an order is placed for more material, and the inventory is replenished. On the other hand, requirements philosophy is employed for dependent demand items. The amount of stock ordered is based on requirements for higher level items. More material is ordered only when required by the need of the end product or higher-level items. Mere depletion would not lead to the order of raw material or work-in-process.

Classifying Models Inventory systems are of two types period models.

fixed-order quantity models or fixed-time

Fixed order quantity models are also called the economic order quantity (EDO) and the Q model. Fixed-time period models are referred to as the periodic review system and P Model. models are related to an event and P models are related to time. In models, order is initiated when the event of reaching a specified re-order level occurs. This event depends upon the demand for the items, and can occur any time. In P models, the order is placed at the end of a pre-decided time period. What matters is the passage of time. While using models, the inventory must be continuously monitored - it is a perpetual system. Here records of inventory are updated on every addition to or withdrawal from the inventory. In P models, inventory is counted only at the end of the review period. and P models: There are some more differences between the • In P models the average inventory size is larger to protect against stock out during review period. • Since average inventory is lower in models, it favours more expensive items. models are suitable for critical items because of close monitoring and quick response to a stock out.

a

a

a

a

a

• a

• a models record additions, withdrawals and so are time-consuming. The following table shows the distinction between the Point

Order quantity Time Record Size of inventory

a and

P model.

Q

P

Fixed-Order Quantity Model

Fixed-Time Period Model

Constant When inventory drops to recorder point - R Each time the addition or withdrawal is made

Maintenance

Less than P Time-consuming since monitoring is perpetual

Types of items

Expensive, critical, vital items

Variable When the review period arrives - T Counted only at review period Larger than Q

Outline of Materials and Purchasing Management

184

Q System As we know by now that in this system the inventory is continuously reviewed - it is also called, therefore, continuous review system. When the stock position drops to a predetermined order point, a fixed quantity is placed on order. As the order quantity is fixed, the interval between orders will vary depending upon the random nature of demand. The stock position or inventory position is defined as : On-hand + On-order - back ordered quantities. We have to see whether the stock position is less than or equal to the re-order point. If yes, we issue an order for exactly Q units, not more or less. In the Q system, there are two parameters Q and R. It is assumed in the simplest model that all aspects of the situation are known with certainty. The annual demand, the set up costs, the holding costs are all known. It is good basis to understand inventory models, through in practice the assumption of complete certainty is not valid. The optimal order quantity model assumes: (i) Constant demand and uniform demand throughout the time period. (ii) Constant lead time (time between the order is placed and goods received) (iii) Price per unit of product is constant (iv) Inventory holding cost is based on average inventory (v) Ordering I set up costs are constant (vi) All demands for the product will be satisfied (no back orders)

Saw-tooth Effect The following diagram illustrates the saw-tooth effect relating Q and R (see fig.14.1)

"C

~Q

~

c

o

R-H------~--r-----~--+-----~~-r------~-+-------

!L

I

!L

!L

I

I

IL ,

Time

Fig. 14. 1 Saw-tooth effect In the above diagram, we can see that when the inventory position drops to point R, a recorder is placed. This order is received at the end of period L which is constant here.

Economic Order Quantity (EOQ) This celebrated model was developed by F.W. Harris in 1915 and came to be extensively used through the efforts of a consultant named Wilson. It is known after Wilson, though it is originally developed by Harris. EOQ and its variations are still popular for independent-demand inventory management.

Independent Demand Inventory

185

Trade-off between Ordering Frequency and Inventory Level If we order small lots, the ordering frequency will increase but there will be low average inventory. If we order larger lots, the ordering frequency will decrease but there will be more inventory to carry. The trade-off between ordering frequency and inventory level can be represented by a mathematical equation using the following symbols: D = Annual demand rate S = Cost per order placed or setup cost C = Cost per unit H = Annual holding cost per unit of average inventory. Often, holding cost is expressed as a percentage of the cost of the Item. As such H = iC where i is carrying interest rate (per cent carrying cost) TC = Total of ordering cost plus holding cost per year The annual ordering cost is = (Cost per order) (Orders per year) Ordering cost per year = SD/O In this equation, D is the total demand annually. 0 units are ordered at a time. Thus D/O orders are placed in a year. This is multiplied by S, the cost per order placed. The annual holding/carrying cost is Holding/Carrying cost per year = (annual carrying rate) x (unit cost) x (average inventory)

=

0 H 2

=

iCO/2

In this equation, the average inventory Is 0/2. A maximum of 0 units is carried just as a batch arrives in inventory. The minimum amount carried is zero units. The depletion rate of stock is constant, and therefore the average inventory is 0/2. The carrying rate per year (i) multiplied by the unit cost (c) gives the holding cost of one unit in inventory for a year. This unit charge multiplied by the average inventory level gives the total hiding / carrying cost per year. The total annual cost of inventory then Total cost per year = ordering cost per year + carrying cost per year :rC ~. sOIa + iCOI? ... (1) I In this equation, the annual purchase cost of procurement cost DC is ignored since it is constant independent of O. It will not affect the minimum TC.

186

Outline of Materials and Purchasing Management Total Cost SD/O + iCQ/2 \

"

"

~.

,

Carrying cost iCQ/2

Ordoring cost '-- -- -, __ . SD/Q

.'

~--------'--------------

EOO

Fig. 14.2 Graphical Representation of EOQ Formula In Fig. 14.2 TC vs 0 are plotted. Each component of TC is shown separately along with the total. As 0 rises, the ordering cost falls as fewer orders are placed per year. At the same time, the carrying cost rises as more average inventory is held. Thus ordering and carrying costs are offsetting - one falls while the other rises. This is the tradeoff between ordering and carrying costs, because of which TC has a minimum. Here the slope of the curve is zero. We can find the value of 0 that minimizes TC by using calculus. We take the derivative of TC and set it equal to zero, and then solve for the resulting value of O. TC

=

SD/O + iCO/2

SD iC = -02 +2"=0 SD

0

=

-~

02

=

iC

0

=

iC +2

2SD

~2SD iC

... (2)

This equation 2 is the classic Wilson economic order quantity (EOO) which minimizes the cost of operating the inventory. We have taken minimum cost on annual basis, but any unit of time can be taken, provided D and i are compatible. For instance, if D is expressed in months, then i should also be expressed in months. This simple model assumes constant demand and lead time. Hence no safety stock is necessary. The reorder point R is therefore R

= dL

d

= =

where L

average daily demand (constant) lead time in days (constant)

...

(3)

Independent Demand Inventory

187

Average Inventory The order quantity and the average inventory shows a constant ratio of 1: 1/2 and is maintained uniformly. This is because we have assumed a constant rate of depletion of inventory between two periods over a period of time. The following diagram illustrates this. Maximum Stock = Batch Quantity Average Inventory = 1/2 Batch Quantity Batch Quantity

-----. lime Fig. 14.3lnventroy holding at a constant rate of depletion

Let us suppose that by one single order we receive the total annual requirement. It is received on 1st January. It is consumed uniformly over the year. On 31st Dec. we will have no stock. Our average inventory holding during the year will be 1/2 a. Let us again suppose we will hold the inventory during each of the twelve months. We shall place our orders in such a way that supplies are received on the 1st of every calendar month. In other words, supplies come in twelve equal installments. Here we hold maximum inventory at the beginning of the month, Le., 1st of every month. There is depletion at uniform usage rate till it reaches zero at the end of the month. In this case also the average inventory is half the order quantity. Let us imagine a third situation where supplies are received twice a year, Le., 1st Jan. and 1st July. Here also the average inventory is 1/2 a over the six months period. Average inventory is thus always half the order quantity or delivery size. Example: Economic Order Quantity Find the EOa on the basis of the following data

Ordering cost

= 1200 units = Rs. 10 per purchase order

Cost per unit Hiding costs per unit

= Re. 1 = 24%

Annual demand

Eoa

=

= =

J~S 2x1200x10 1x24/100 316 units approx.

Limitations The EOQ derived in equation 2 has limitations on account of the restrictive assumptions made. The cost assumptions are notional and are not found in real life. The unit cost of purchase varies in practice. T~le lead times are not constant. The demand is erratic. The rate of consumption is not uniform. The application, thereforem of this formula as it is, is not possible. Discounts on quantity also distort the formula. Lead time variations are pretty common. If the usage rate is not uniform, there will be stockouts. Buffer stocks

188 Outline of Materials and Purchasing Management are, therefore, necessary. The formula will have to be adapted to meet these limitations, but then it becomes complicated. The significant idea that emerges from this discussion is that of the total cost. Whatever may be the situation, if one arrives at the total cost, then EOa can be found. The idea of minimizing the total-cost equation is basic to all lot-sizing formulas and situations. Fixed-Order Quantity Model with Usage During Production

The total cost equation assumes the receipt of the ordered quantity in one lot, which is not true always. In several situations, there is production of an inventory item and its usage at the same time. It is relevant when the output of one part becomes input of the other part of the production system, e.g., aluminum extrusions being produced to turn out aluminum windows. There are also contractual arrangements with the suppliers, e.g., six month mater!al requirements or one year requirement being covered through one single order and with deliveries spaced out weekly or more frequently. The total cost equation for such situation is TC where

= sOia +

d

=

P

=

(p;pd) aH

constant demand rate production rate (which exceeds the rate of usage. Otherwise a would be infinite, resulting in continual production)

Differentiating with respect to a and setting"the equation equal to zero, we get

Eoa

= ~2SD H

P (p-d)

... (4)

Graphically this model is shown below:

=

Number of units hand

Build up Production rate usage rate (p - d) ~

Q

,,

,,

Production taking place

,, No production; usage only

R~-------+------~--~~~~------~~--------~--

L Time---. Fig. 14.4 Fixed Order Quantity Model with Usage during Production

Independent Demand Inventory

189

Example: Optimal Lot Size A component of product x (let us call it X1) is produced in another department. X1 is produced at the rate 200 units per day. The assembly line uses X1 component at the rate 80 units per day. Considering the following data, what would be the EOQ of component X1?

=

80 units

= =

20000 (80 units x 250 working days)

Cost of Production (S) Set up

=

Rs. 100

Annual Holding (H) Cost

=

Rs. 1 per unit

= =

Rs. 14 each

Daily usage (d) Annual demand (D) Daily production (P)

Cost of component

X1

(C)

Lead time (L)

200 Units

7 days

The EOQ would be EOQ

=

2SD P H'(p-d)

100 . ~ U 't = ~2 (20000) 1 200-80 m s 2582 units =

We can find the re-order point R by R = dL = 80(7) = 560 units. It means that an order of 2582 units of component

X1

should be placed when the stock drops to 560

units

Safety or Buffer Stock We have assumed in the above discussion a certain demand at constant rate. Mostly, demand varies from day-to-day and is not constant. Safety stock has to be maintained to protect against stockout. Safety stock is defined as the additional amount of stock carried to meet more than the expected demand. But if more and more additional stock is carried, it means holding of unnecessary additional inventories. When less is carried, there are chances of a stockout. Management then faces the risk or production hold ups. Such uncertainties require precise treatment of safety stocks. The following diagram illustrates the situation. Normal Delivery

Normal Delivery

Normal Delivery

Safety I-------'''------~:::r----""''==_----...."",,=__i-­ Stock

Zero

Srock~-------------------------------------------------------

Time--+ Fig. 14.5 Inventory Model Under Conditions of Uncertainty

190

Outline of Materials and Purchasing Management There are two causes of stockouts. Stockout could be a result of the higher rate of usage or excess consumption. Stockouts could be due to delayed delivery. Stockouts could be the result of both these factors. Safety stocks provide the necessary cushion when consumption is at a higher rate or the normal delivery period is exceeded.

Probability Approach Safety stocks are treated with two approaches - probability approach and expected number approach. Probability approach considers that demand will exceed some specified amount. The inventory objective could read, the safety stock is set at a level where there is 6 per cent chance that the demand will exceed 100 units. The expected number approach considers the expected number of units which will be out of stock. The inventory objective \ could read inventory level is to be set such that we can meet 96 per cent of the orders for the unit (or be out of stock 4 per cent of time). In the first approach, the probability of exceeding a value is considered. In the second approach, we are concerned with how many units we fall short of. The value of R can be based on either stockout cost or stockout probability. Stockout based on cost formulations are cumbersome. Therefore stockout probability is commonly used as a basis to determine Q. The probability of a stock out over a period of time is determined by plotting a normal distribution for the expected demand and see where the amount on hand lies on this curve. If the demand is expected to be 100 units, and the standard deviation is 20 units, the probability of being stocked out with an opening stock 100 units is 50 per cent. Half of the month, the demand is expected to be greater than 100 units, and half of the months less than 100 units. If the order of 100 units is received at the commencement of the month, in the course of time there will be a stockout for six months of the year. As a precautionary measure, we might carry an additional 20 units. Though the monthly requirements would be ordered the same way, the delivery would be so scheduled that the items arrive while 20 units are still in stock. This is the concept of safety stock which provides the cushioning against probability of stockout. Look at the appendix Standard Normal Distribution. Move 1 standard deviation right to the mean. It gives a probability of 0.3413. We need to add 0.5 to this. It comes to a probability of .8413. Therefore 84 per cent of time, we would not expect to face a stockout, and 16 per cent of time, we would face a stockout. If our ordering frequency is every two months, the expected stockout would be (.16 x 12) = 1.9 months or approximately 2 months. The companies commonly set 95 per cent as the probability of not stocking out. It means they carry about 1.64 standard deviations of safety stock or 33 units. (1.64 x 20 = 32.8). It does not mean an additional order of 33 units each month. It means scheduling of the receipt of the item at a time when 33 units are still in inventory. The expected stockout is approximately 6 months per year, or a stock out in 1 month of every 20 months.

Service Level {1}

Service Level is an extensively used concept in inventory management. A 100 per cent service level indicates that all the demands of the customers would be met from inventory. The stockout percentage is equal to 100 minus service level.

Independent Demand Inventory 191 If an annual demand for an item is 10000 units and the service level is 95 per cent, it means that 9500 items can be supplied immediately from the inventory and 500 units are short.

Service level can be expressed in three ways : Service level is the probability that all orders will be filled from the stock during (1) the replenishment lead time of one reorder cycle. (2) Service level is the percentage of demand filled from stock during a given period of time (say a year). (3) Service level is the percentage of time the system has stock on hand. Each of these definitions would lead to a different re-order point. To simplify the matter, the first definition is accepted. The reorder point is based on the probability distribution of demand over lead time.

Stockout probability

-S-

M=1-c

R

Demand over lead time

Fig. 14.6 Probability Distribution of Demand Over Lead

The reorder paint is set high (greater than zero) to reduce the stockout probability. We assume normal distribution of demand as it is realistic for independent demand inventory problems. The reorder point is

R = where R = = m = s Safety stock is

S where

m +s

reorder point mean (average) demand over the lead time safety stock given by

= = =

~

=

m+~cr

cr

Z safety factor G standard deviation of demand over lead time We can rewrite then

R

192

Outline of Materials and Purchasing Management

Reorder point is set equal to the average demand over lead time m plus a specified number of standard deviations (J to protect against stockout. Even service level is controlled by controlling z and the standard deviations used. A high level of z leads to a high reorder point and a high service level If we know the service level desired, we can determine z and m - from the table given here. Table: Normal Demand Percentages

z 0 .5 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0

Service Level (%)

50.0 69.1 84.1 86.4 88.5 90.3 91.9 93.3 94.5 95.5 96.4 97.1 97.7 98.2 98.6 98.9 99.2 99.4 99.6 99.6 99.7 99.8 99.9

Stockout (%)

50.0 30.9 15.9 13.6 11.5 9.7 8.1 6.7 5.5 4.5 3.6 2.9 2.3 1.8 1.4 1.1 .8 .6 .5 .4 .3 .2 .1

Independent Demand Inventory

193

Example: Consider the following data : Average demand

100 units per day

Lead time

4 days of supply from the vendor

Standard deviation of daily demand Desired service level

75 units 95 per cent

S

Rs. 100 per order

= 20% per year C = Rs. 100 per unit Continuous review system is used to manage inventories. The warehouse is open five days a week, 50 weeks a year or 250 days a year. Average annual demand

=

250(100) = 25000 units per year

=

2(100)(250)100 100(.20) = 500 units

The EOa is

Eoa

The average demand over the lead time is 100 cases a day for four days. Therefore m = 4(100) = 400 cases. The standard deviation of demand over lead time is

.J4 (75) = 150 units.

Note: The standard deviation of demand over the five day lead time can be arrived at from the daily standard deviation assuming that the daily demands are independent. In the present case, the variance is additive. The variance for 4 days is 4 times the daily variance. This equates to 0"2 The 95 per cent level requires a safety factor of z

R

= 1.65 (see the table).

= 4(75)2 or 0" = .J4

(75).

Thus we have

m+zO" 400 + 1.65 (150)

= 648 The a-system deviation rule is to place an order for 500 units whenever the stock position drops 648 units. On an average 50 orders will be placed per year, and there will be an average 5 working days between order. The actual time between orders will vary, however, depending an demand.

P System There are systems in which finished goods are not reviewed continuously, but periodically. A supplier may make deliveries periodically, say every fortnight. The delivery van comes once a fortnight. The stock position is reviewed once a fortnight, and order is placed if materials are needed. There is an assumption that the demand is random. The previous EOa assumptions are valid except those of constant demand and no stockouts. At the time of review, the stock is brought by ordering to a target level which covers demand till the next periodic review plus the delivery lead time. The ordered quantity varies with the target level set. P system, as this is called, is also known as the fixed-orderinterval system, or fixed-order-period system or just the periodic system. In a formal way, periodic system reviews the stock position (on hand plus on-order) at fixed periods P and orders an amount equal to target inventory T less the stock position at each reviews.

194

Outline of Materials and Purchasing Management

The following graph illustrates the P system: Start from curve line

T

Stock on Hand

L~

1+---1 P

---l.~1

~

...--+-- p

-----l~

...---+- p

-----l~

Time

Fig. 14.7 Periodic Review System The stock position drops erratically until the fixed review time is reached. At this point, a quantity is ordered to upgrade the stock to the target level. The order comes later, after a lead time L. The cycle of usage, reorder and stock receipt is repeated.

a

In the system, there is reorder point R. In P system, there is no R but target inventory T. There is no EOO in P system since the ordered quantity changes according to demand. In the P system, the order interval is fixed and not the order quantity. There are thus two parameters, P & T. The relationship between optimal value of P and EOO is as follows:

P

=

aiD

Substitute this in the EOO formula. We then have

P

=

... (5)

The above equation 5 provides an approximate optimal review interval P. In case of highly irregular demand, this approximation is very poor. The target inventory level is set by a specified service level. It is so set that it covers demand over lead time plus review period. Such coverage is necessary as the stock would not be ordered till the next period; and it will take lead time to arrive. A service level is achieved by covering demand over time P + L at the average level plus a safety stock. We thus have

T = m' + s' Where

T = target inventory level

... (6)

Independent Demand Inventory m' = average demand over P+L

195

s' = safety stock The safety stock is so set that the desired service level is assured. Safety stock is given by s' = z cr' cr' = the standard deviation over P + L where z = safety factor In order to control the target inventory and consequent service level, we have to control Z.

Choice between P & Q Systems Both these systems are in vogue for independent demand inventory management. The choice between them depends on management practices and economics. P is, however, chosen when • Orders are placed and delivered at specified intervals, e.g., orders of beverages to a grocery or general stores. • Multiple items are ordered from the same source and are to be delivered in one consignment, e.g., shades of paints from the same manufacturer. • Inexpensive items not maintained on perpetual inventory system, e.g., nuts and bolts to fill up the bins; the size of bin determining the target inventory. In P system, there are no cumbersome records and there is scheduled replenishment; P system, however, carries a larger safety stock than the Q system. Q system is used for expensive items where there is a need to hold down the investment in safety stock inventory. There are hybrids of P&Q systems in practice. One such system uses min-max decision rules and periodic review. There is a reorder point (min) and a target (max). At the periodic review, there is no order if the stock exceeds the min. and if it is below min, the order is placed so as to shoot up the stock position to the max level.

Special Purpose Models In both the Q and P models we have discussed so far, the common characteristics are the constant cost of the units irrespective of the order size and the continuous reordering process. We shall consider two new models. In the first model, the unit price changes with the order size. In the second model, there is cost-benefit analysis. Price Break Models: Here the selling price varies with the size of the order. This is a discrete change. The larger the order size, the lower the price. For instance, cost per unit would be Rs. 5 for orders between 0-499 units, Rs. 4.5 for orders between 500-999 units and Rs. 3.90 for orders of 1000 and above. In such a situation, EOQs can be calculated for each price and at the paint of price change. But all EOQs may not be feasible, e.g., some EOQ may suggest a quantity where cost per unit would be higher. The total cost of each feasible EOQ and the price break order quantity is tabulated and the Q with the minimum cost is chosen. If the holding is cost is expressed as a percentage of the unit price, it is not necessary to compute EOQ at each price. The largest order quantity or the lowest unit price is solved first. If it gives a valid Q, it is the answer. Or

196 Outline of Materials and Purchasing Management else the next largest order quantity or second lowest price is derived. If this is feasible, the cost of this Q is compared to that of the price break Q above. The lowest cost decides the optimum Q.

Single Period Models: These problems pertain to short-lived items purchased frequently or placing orders to cover just one demand period. A newsboy has to order papers every day - the question is how many he should. Here the classic economic approach of marginal analysis can be used. The optimal decision is one where the benefits derived from stocking an additional unit are less than the costs for that unit. Of course, benefits and costs are based upon the problem, e.g., marginal profits and marginal costs. When stocked items are sold, the optimal decision is to stock that quantity where the profit from the sale or use of the last unit is equal to or greater than the losses if the last ,unit remains unsold. Symbolically, it is MP ~ ML MP = profit from the nth unit if it is sold where = loss from the nth unit if it is not sold ML We can introduce probability of occurrence in the marginal analysis without affecting its validity. P(MP) ~ (1 - P) ML where P = probability of the unit being sold (1 - P) = probability of the unit remaining unsold Solving for P, we get ML P ~ MP+ML According to this equation, the inventory size can be increased till the probability of saving the last unit added is equal to or greater than the ratio ML (MP+ML).

Miscellaneous Systems Many of the assumptions in the inventory models are unrealistic. There are two challenging tasks in inventory management - maintaining adequate control over each item and record keeping. In practice, three simple systems are used - optional replenishment system, one-bin system and two-bin system. Two more techniques are used for better control - ABC analysis based on analysis of items in terms of their contribution to value and cycle counting for improving record accuracy. Optional Replenishment System: Here inventory level is compulsorily reviewed at fixed frequency, say weekly and items are ordered to replenish the stock which might have dropped below some cutoff. The maximum inventory level (M) is computed based on demand, ordering costs and shortage costs. Since ordering takes time and costs, a minimum order size (Q) can be established. Inventory position (I) is subtracted from the replenishment level (M) when the item is reviewed. This gives us q. q = M-I If q is equal to or greater than Q, order q, or else ignore it till the next revision. If q ~ Q, order q Two Bin System: This is the earliest system of inventory control. The items are placed in two bins out of which one is emptied first before using the second one. The

Independent Demand Inventory

197

second bin contains such a quantity that ensures replenishment of the first bin. The replenishment arrives when the second bin is empty. When delivery arrives, both the bins are again filled in. Both the bins are located together. There can be just a dividing line between the two bins. Inventory here is so separated that part of it is held in reserve until the rest is used first. When the quantity is finished in the first bin, a reorder is placed for a fixed quantity, generally based on EOO. during the lead time, the second bin supplies the required item. The total level is equal to the mean expected demand during the lead time plus the safety stock.

198

Outline of Materials and Purchasing Management ABC analysis underlines a very important principle: 'Vital Few - Trivial Many.' In inventories, a few items account for most of our inventory value as measured by rupees usage (demand times cost). If these few vital items are controlled closely, we can control most of the inventory value. ABC analysis, indicates that a large number of items account for a small rupee volume. ABC analysis puts the items into three categories -

A Items constitute the top 15 per cent of the items, B items the next 35 per cent and C items the last 50 per cent. Thus Band C items though many in number contribute less to the value. ABC analysis segregates all items of inventory on the basis of rupee value or annual usage. Such categorization enables one to pay the right amount of attention, effort and expenditure as merited by each item. The segregation has been plotted in the following diagram:

1010-

~ 80I-

~

"E

8... 8.

60I-

~

~E

A Items

40I-

::::J

U

20I-

S Items

C Items 15

I

I

I

I

30

45

60

75

l I

90

Cumulative percent value

Fig. 14.9 ABC Analysis The above analysis enables a manager to exercise appropriate control over each item. A items merit tightly controlled inventory system with constant attention. B Items require formal inventory system with periodic attention. C items use a simpler system designed to cause the least trouble to the purchase and stores department. The following table illustrates the treatment of these categories A items

B items

High consumption value

Moderate value

Very strict control

2. No safety stock

Moderate control Low safety stock

3.

Frequent ordering

Once in 3 weeks

4. 5.

Weekly control statements As many sources as possible for each item

6.

Rigorous value analysis

Monthly control reports Two or more reliable sources Moderate value analysis

1.

C items Low cons.umption value Low control High safety stock Bulk ordering once in 6 months Quarterly control reports Two reliable sources for each item Minimum value analysis

Independent Demand Inventory 7. 8.

9.

199

Accurate forecast in materials planning Minimisation of waste, obsolete and surplus Maximum efforts to reduce lead time.

Estimate based on past data on present plans Quarterly control over surplus and obsolete items Moderate efforts

Rough estimates for planning Annual review over surplus and obsolete materials Minimum clerical efforts.

Procedure for Making ABC Analysis The entire procedure for making ABC analysis can be summarized in the following steps: (1)

Calculate rupee annual issues for each item in inventory by multiplying the unit cost by the number of units used in a year.

(2)

Sort all items by rupee annual issues in descending order.

(3)

Prepare a table showing item No., Unit cost, annual units issued and annual rupee value of units issued.

(4)

Starting at the top of the list compute a running total item-by-item issue value and the rupee value of consumption.

(5)

Compute the cumulative percentage for the item count and cumulative annual issue value.

The normal items in most organizations show following pattern: (1) 15% to 10% of top number items account for 70% of total consumption value. These items are 'A' class. (2)

15% to 20% of the number of items account for 20% of total consumption value. They are 'B' class.

(3)

The remaining number of items account for the balance 15% of total consumption value. They are 'C' class items.

Illustration: The following is the table which gives you the list of materials used by one industrial unit. Classify the items into A, B, and C categories. Table

Symbol

Item

Annual Consumption (Units)

Price (Per Unit) in Rupees

A

Benzyl Penicillin

5,000

10

B

Dexamethasone

650

10

C

Mannitol

D E F

Chlorxylenol Ampicillin Gentamicin

1,800 4,200

18 1

60 6,500

G H

Tetracycline Trifluoperazine

8 6 5 1

2,500 4,200

Outline of Materials and Purchasing Management

200

50 100 100 50 2,000 20 30 80 200 750 300 20

Imipramine

J

Diazepam

K

Streptopenicillin

L M N

Oxytetracycline Analgin

0

Prednisolone

P Q R S T

A.P.C.

Phenobarbitone

Sui phone Vitamin C Aluminium Hydroxide Aspirin

10 7 35 8 0.25 10 6 0.15 0.50 4 7 10

Solution: The first step is to construct a Ranking Table by aSSigning ranks in descending order to annual usage of the inventory items. (Starting with the highest annual usage value). Table

Symbol

A B C D E F G H I J K

.L M N

0 P Q

R

S T

Annual Consumption Unit

5,000 650 1,800 4,200 60 6,500 2,500 4,200 50 100 100 50 2,000 20 30 80 200 750 300 20

Price Per Unit (Rs.)

10 10 18 1 8 6 5 1 10 7 35 8 0.25 10 6 0.15 0.50 4 7 10

Annual Usage (Rs.)

50,000 6,500 32,400 4,200 480 39,000 12,500 4,200 500 700 3,500 400 500 200 180 12 100 3,000 2,100 200

Rank

1 5 3 6 14 2 4 7 12 11 8 15 13 16 18 20 19 9 10 17

Independent Demand Inventory 201 Soon thereafter, cumulative annual usage and cumulative percentages are calculated in the 3rd and 4th columns. Items A,F,e account for 75.5 per cent of total annual consumption and are therefore A category items (15 per cent). Items G,B,D (another 15 per cent) contribute approximately 15 per cent to annual usage. They are B category items. The remaining 70 per cent items contribute roughly 10 per cent to annual usage, and are therefore e category items.

Table Items

Annual Usages

Cumulative Annual Usages

A

50,000

50,000

31.12

A

F

39,000

89,000

55.39

A

e

32,400

1,21,400

75.55

A

G

12,500

1,33,900

83.34

B

B

6,500

1,40,400

87.38

B

D

4,200 4,200

1,44,600 1,48,800

89.99 92.61

B e

K R

3,500

1,52,300

94.79

e

3,000

1,55,300

96.66

e

S

2,100 700

97.96 98.40

e

J

1,57,400 1,58,100

I

500

1,58,600

98.71

e e

M

500

1,59,580

99.02

e

E

480

1,59,580

99.32

L

400 200

1,59,580 1,60,180

99.57 99.69

0

200 180

1,60,380 1,60,560

99.82 99.93

Q

100

1,60,660

99.99

C C C C C C

P

12

1,60,672

100

C

H

N

T

Cumulative Usage Percentage

Explanatory Note on Cumulative Percentage Total cumulative usage is equal to 100% Annual cumulative consumption

= 1,60,672

Annual cumulative consumption for A item = 50,000 1,60,672 : 50,000 :: 100 50,000 x 100 1,60,672 = 31.12 Annual cumulative consumption for B item 1 ,40,400 1,60,672 : 1,40,400 :: 100 100x140,400 = 1,60,672

87.38

Category

202

Outline of Materials and Purchasing Management

Other Versions There are other versions of ABC analysis which are discussed here briefly.

VEO Analysis: The possible consequences of material stock outs when demand arises from the basis of VED analysis. The cost of shortage depends upon the seriousness of the situation. Items are grouped as V (Vital), E (Essential) and D (Desirable). Items

Remarks

Strategy

V

Most critical, high opportunity cost of shortage. Hust be available in stock whenever demanded.

Percentage of risk should be quite small. High level of service is called for.

E

Quite critical. Substantial opportunity cost of shortage should be available in stock by and large. No serious consequences of non-availability. Can be stocked.

Can take a relatively higher risk of shortage.

D

Risk that can taken is even higher.

A.T. Kearney's Classification: In an industry, the components can be put into three categories. The first category consists of vital but not critical components. The buyer can leverage large volumes for lower costs using strategies like centralized purchasing. The second category consists of critical components. Here, a few vendors supply these components. The bargaining power of the buyer is, therefore, weak. Mostly negotiations are carried out for a long-term deal to obtain lower prices. The third category consists of commoditised inputs. Here there is little to choose by way of price or quality. It is, therefore, necessary to reduce the transaction costs. It is necessary to identify which raw materials are vital, critical and commoditised. We can design the strategies to deal with them accordingly.

FSN Analysis: All items are not required with the same frequency - some are required regularly, some occasionally and some once in a while. FSN Analysis places the items in three categories: Fast Moving (F), Slow Moving (S) and Non-Moving (N). Inventory policies and models for these three groups are different. Theoretical models have validity for F items with regular consumption. Spare are slow moving (S), and require special management. Disposal policies are designed to control dead-stock. SOE Analysis: This classification runs like this: S = Scarce Items D = Difficult (to procure) Items E Easy (not difficult to get) Items HML Analysis: This analysis is based on the cost of the item. H

=

High Cost Items

M

=

Medium Cost Items

L

=

Low Cost Items

Inventory Accuracy and Cycle Counting There can be a discrepancy between the actual inventory and the" inventory records. Though the physical count and records must tally within some specified range, there are several reasons for their not tallying:

Independent Demand Inventory

•

203

Access to inventory to both authorized and unauthorized persons.

• Misplaced inventory • Records are lost • Location not recorded properly • Storage at several locations • Replacement of inventory on account of cancellation of customer's order. Several steps are taken for record accuracy: • • • • • •

Store-room is locked Record accuracy becomes a criteria for performance appraisal Record-keeping mechanism for in-store and production floor inventory Educating personnel about the significance of record-keeping Only authorized transactions are allowed Count inventory frequently, and see their agreement with the records. One of the methods used is cycle counting. Cycle counting is an inventory counting method. Here inventory is counted frequently, rather than once a year or twice a year. It is necessary to decide which items deserve counting, when they will be counted and by whom they will be counted. In a computerized environment, the computer generates a counting alert when • Inventories are low and counting is easier • •

A back order is written Post-activity counting where activity is specified

• Using ABC analYSis. A period of counting is carefully chosen; say week ends when there is less activity in the stores. Counting cycle depends on the manpower availability. Counting can be outsourced. Full time cycle counters can be set up devoted to this task only. Some firms aim at 100 per cent accuracy, whereas some allow a variation between 1-3 per cent. Of course, for A items the variation between phYSical count and records must not exceed ± 0.2 per cent. It can be ± 1 per cent for B items and upto ± 5 per cent for C items. Safety stock may be provided to factor in the variation.

Inventory Control in Services We shall examine how inventory control works in service organizations such as a big retail outlet having many inventory items called stock-keeping-units (SKUs). SKUs of each item run into a large number, say socks are available in two fabric varieties - cotton and synthetic, three sizes (extra large, medium, small) and four colours. Thus there are 24 (2 x 3 x 4) different items. SKUs run into thousands in a big departmental store. Manually EOQ cannot be computed for each item. How then is the inventory managed? The department is divided into major product lines - say shirts and trousers. Items are classified according to prices. The items are sourced from the distributor who handles the products of many manufacturers. This way Orders and despatch time are minimized. The distributor's salespeople visit the store and take the count of inventory available. The distributor's salespeople take the order as per the replenishment level decided by the buyer. This saves time. The typical lead time is 2-3 days. The safety stock is, therefore, low. The lead time demand plus expected demand are covered by the replenishment level.

204

Outline of Materials and Purchasing Management There is no formal method of assessing the stockout and establishing safety stock. It is because the items are far too many. The department's items are counted in terms of value. The replenishment level is set as rupee allocation.

Each department plans monthly value for inventory. Inventory balance, monthly sales, items on order are tabulated. That gives us open-to-buy figure - the unspent figure of the budget. This is the amount available to the buyer for the following month. When seasonal increases are expected, in demand, there is a large open-to-buy position. The replenishment levels are raised. Creating a higher stock of goods on hand. Practically, open-to-buy is utilised at the commencement of the month. Some funds are reserved by the buyer for special purposes and to restock fast moving items.

205

Independent Demand Inventory

Appendix

Uniform Lot Delivery Inventory can be delivered in instalments, rather than in one single lot. A producer may build up inventory at a constant production rate, or a retailer may receive consignment in several lots. The following diagram illustrates this:

Inventory Level (1 - DIP) Q

Time

Fig. 14.9 Uniform Lot Delivery There is both production and consumption. There is slow build up of inventory. The inventory is then depleted as only consumption occurs. Imagine units being produced at the rate of P units per year and consumed at the rate of 0 units per year where P > D. Then the average inventory level would be Q

2

=

Minimizing the resulting expression for TC the EOQ would be Q

=

2SD

iC(1-D/p)

There the EOQ would be somewhat greater than the ordinary EOQ since (1-D/P) is less than 1. As P approaches 0, EOQ becomes greater, which in other words indicates a continuous production. When P is very large, the above EOQ formula is closer to the ordinary EOQ. While deriving ordinary EOQ, we assumed one lot delivery of inventory which is tantamount to an infinite production rate P.

206

Outline of Materials and Purchasing Management

APPENDIX Three Costs Associated with EOQ The total material cost consists of the actual material cost as paid to the vendor and also the expenses incurred for placing the order, processing the order, receiving the material, inspection and inventory carrying cost. These additional costs are generally grouped under th ree heads : (A) Ordering Cost (B) Receiving and Inspection Cost (C) Inventory Carrying Cost (A) Ordering Cost: (1) Preparation of indents requesting purchase. (2) Inviting quotations from suppliers. (3) Analysis of quotation. (4) Financial approval by the competent authority Placement of the purchase order to the Vendor. (5) (8) Receiving and Inspection Cost: (1) Physically receiving the material and inputed transport cost, Railway Freight, if any. Preparation and Processing of Documents for incoming Material. (2) (3) Inspection of the materials (By the Actual Indentor) (4) Handling the Materials to place them in Custody of Stock Holders. (5) Processing the invoices, bills and other documents to the Accounts Departments. (6) Payment of the bills and other related work in Finance Wing. Often Ordering Cost and Receiving and Inspection Cost are clubbed together and referred as Purchasing Cost or Procurement Cost. It can generally be taken as the sum of these two. Procurement Cost can be expressed as cost per order and is quite independent of the quantity or value of the material procured. (C) Inventory Carrying Cost: Any material held in storage represents Capital that has been locked up. Hence a corresponding interest charge is incurred. The other changes are also incurred because material is held in storage are: (1) Taxes. (2) Insurance. (3) Losses in Handling and Storage. (4) Losses due to Obsolescence. (5) Rent for Building, if stores building is on hire. (6) Opportunities. The inventory value if deposited with bank would have incurred interest or invested in any other liability. These costs are directly proportional to the value of inventory held and the sum of all these costs is the inventory cost. It is generally expressed as percentage of Inventory Value.

000

CIiAPTER 1~ Dependent Demand Inventory: Materials Requirement Planning (MRP) In a manufacturing organisation, inventory management is very complex in view of the numerous products, processes, parts and uncertainties. Priorities keep on changing. The demand is erratic. Still, managers do not give up. They use a computerized planning and control system called materials requirement planning (MRP). Even service organisation such as restaurants, hospitals, power generating companies can also benefit from the use of MRP. MRP is most valuable in companies employing assembly operations and least valuable in fabrication industries. MRP is moderately useful in process industries. In the previous chapter we have studied the distinction between the independent and dependent demands. Independent demand pertains to the demand decided by market conditions for the finished products and spare parts. Inventories in such situations are managed by the Q and P systems discussed previously. Dependent demand inventories are dependent on demand for higher level parts and components upto and including master production schedule. To illustrate, raw materials and work in progress are used in man,ufacturing o~ganization to support the manufacturing process itself. In a restaurant, the ingredients used-in recipes depend upon the menu offered. These inventories are managed by MRP or just-in-time (JIT). Simple MRP Model

Let us take a product A, made up by three parts of B and two parts of C. Diagrammatically it looks like:

A

I

+

~ C (2)

B (3)

Further, let us suppose B itself is made of one part of D and two parts of E. Similarly part C is made of 3 parts of D and 3 parts of F. The product structure then works like. (207)

208

Outline of Materials and Purchasing Management A

I

+

C (2)

B (3)

I

I

+

+

D (1)

+

+

F (3)

D (3)

E (2)

Fig. 15.1 Product Structure of A Let us suppose we require 100 units of A. We therefore need Part B Part C

3 x Number of As 2 x Number of As

Part D { 1 x Number of Bs + 3 x Number of Cs Part E

2 x Number of Bs

Part F

3 x Number of Cs

3 x 100 2 x 100

= 300 = 200

1 3 2 3

= 600

x 300 x 200 = 900 x 300 = 600

x 200

Let us consider the procurement time for these items (either making it or buying it from outside). Suppose these parts are produced as under:

Time to Produce (in Weeks)

Product/Part .A

1 2 2 3 1 1

B

C D

E

F We can then produce a time schedule chart showing when all materials must be ordered and received to meet demand for A. The following is the MRP for 100 units of A. Weeks

1 A B

C D

E F

Required date Order placement Required date Order placement Required date Order placement Required date Order placement 900 Required date Order.placement Required date Order placement

2

4

3

5

6

7

100 100 ~ 300, \ 30O:r-. 1\

r

~ ~

r-

200. l:t v 900 t\ /

6001

j

600" 600J

60(l

J

200 v

A Lead time = 1 weeks B Lead time 2 weeks C Lead time 2 weeks D Lead time 3 weeks E Lead time 1 weeks F Lead time 1 weeks

= = = =

=

Fig. 15.2 MRP for 100 Units of Product A in Period 7

Dependent Demand Inventory: Materials Requirement Planning (MRP) 209 The MRP Chart shows which items are required and when. We know how A is made and the time required to procure each part.

This example makes it obvious how cumbersome it would be to develop an MRP for thousands of items. It is practically ruled out. We require a great deal of data about the stock position, and the product structure. This calls for the use of a computer. The emphasis therefore would be on the files required for a computer programme and the architecture of the system. However, the logic behind the MRP remains the same as in our simple example. In india MRP has become popular after the computerization process started in full swing past 60s. It is a precise schedule of priorities of production and are-scheduling mechanism for revising plans as changes occur, keeping inventory at a low level and still meeting the demands as they arise. MRP is a computer-based time-phased production planning and inventory control system.

Basic Elements MRP consists of four basic elements: (1) The master production schedule which drives the MRP. (2) The bill of materials (BOM) or product structure file. (3) The inventory status file which carries the necessary data. (4) The MRP software package that contains the necessary logic. We shall examine all these four elements or files one by one.

Master Production Schedule It deals with the end items or output of the production function. All future demand for work-in-process and raw materials are dependent on the master schedule. Past demand does not always get extension in future. And this is kept in mind while planning for raw materials and work-in-process. Master schedule allows management to control customer service, Inventory level and manufacturing costs. Master scheduling is delegated to a cross-functional team. Aggregate plan indicates general operational range. Master schedule specifies exactly what is to be produced. These decisions have interface with other functional areas of business. First trial master production schedules are run through an MRP programme. The planned order releases generated are the detailed production schedules. They are checked to ensure the availability of resources and reasonableness of completion time. Master schedules feasibility is thus checked. Sometimes it can be resource-hungry after product explosion. It then requires modification. MRP programme is then run again. The parts explosion process assumes that master schedule is feasible with respect to capacity. Master schedule is an input for parts explosion to produce shop orders and purchase orders. The shop orders are put into a capacity planning routine and checked by materials planner to determine the availability of sufficient capacity. If it is not available, either capacity or master schedule is not feasible. Master schedule should not be inflated and should reflect realistic capacity constraints. Inflationary schedules expect more output under pressure which makes order due dates invalid, thus breaking down the system. The following diagram illustrates the aggregate plan and the master production schedule for bedsteads.

Outline of Materials and Purchasing Management

210

Month

1

2

Bedstead production

800

850

~ 2

1

3

4

350

Type I 200 Type II

75 75

100

Type III

5

~ 7

6

150 100 100 125 175

8

200

Fig. 15.3 The Aggregate Plan and Master Production Schedule for Bedsteads. In the upper portion of the diagram, the aggregate production plan of bedsteads by weeks has been given. The lower portion shows a master production schedule classifying the bedsteads and the quantity planned by week. This will be followed by an MRP programme. Master production schedule is the starting point for the disaggregation process. It states how many and when each of the bedsteads are required.

Time-fencing MPS MPS should have an element of flexibility. Many factors decide this - production lead time, commitment of parts and components to a specific item, buyer-seller relationship, excess capacity available and the tendency to make or not to make changes. Time-fencing ensures a reasonably controlled flow through the production system. Time fences are shown in the following diagram: Frozen Capacity From customer orders

Moderate

"-

~

Flexible Forecast and available capaci ty

18 15 Time in weeks ---.

26

Fig. 15.4 MPS Time Fencing There are opportunities to introduce changes. MPS in the above diagram is frozen till 8 weeks, with no changes or minor changes. A moderate period allows changes in specific products if parts are available. A flexible period allows any variation in products, provided that the capacity is maintained constant, and no long lead times are involved. Masters schedule developed on weekly output requirements is based on what are called weekly time buckets. When master schedule is updated weekly, a parts explosion programme is run to generate new requirements. It is called regenerative MRP system.

Bill of Materials (BOM) A particular finished product is made up of materials, parts and components. They are arranged sequentially. The BOM is a structured list of all this. It contains the complete

Dependent Demand Inventory: Materials Requirement Planning (MRP)

211

product description. The BOM file is an important input to the MRP program, the other inputs being MPS and inventory records file. What a recipe is to a cooking dish, the BOM is to the product. It is also called product structure file or product tree. The BOM should be error-free, otherwise proper materials would not be ordered, and the product would not be assembled correctly, and would not be dispatched. Consequently, the available parts will wait in inventory and the misSing parts will be expedited. It is very expensive to have a flawed BOM. Some companies have different BOMs used by departments such as engineering, manufacturing and costing. The BOM fed to the computer must be fault-free, and must represent the structure of the product faithfully. In organization where the BOM is .used just for referencing, and not as material planning too, it become difficult to have a single BOM. BOMs are constantly revised in the light of product redesign and this is facilitated by having engineering-change-order (ECO) system. The following diagram illustrates a BOM for product S :

S

I U (3)

T (2)

I

~

V (1)

t

W(4)

~

X (2)

I

•

Y(5)

t

Z (4)

Fig. 15.5 BOM for Product S Consider product S which is made of two units of part T and three units of part C. Part T in its turn is made of one unit of part V and four units of part W. Part U is made of two units of part X, five units of part Y and four units of part Z. Previously, BOM files have been listed as on indented file. Indentation signifies components of the item. This is not suitable for computerization. The amount of each item needed at lower levels is compared by expanding (exploding) each item and summing it. A more efficient system is to store parts of data in a single level explosion. Indented Parts List

S

Single Level Parts List

S T(2)

T(2)

U(3)

V(1 )

W(4)

T

U(3) X(2) Y(5)

Z(4)

U X(2) Y(5)

Z(4) Fig. 15.6 Parts List in Indented Form in a Single-Level List.

212

Outline of Materials and Purchasing Management

In single level explosion, each item and component is listed showing its parent the number of units needed per unit of its parent. It obviates duplication. The above 15.6 shows both the indented parts list and the single-level parts list for product S. Low Level Coding : If the identical parts appear on the same level for each product, material requirements can be arrived at easily. Consider a product D shown in 15.7. 0

~

2

;

H

3

~

I

J

a

b

D

D

t

I

tK

~

J

I

H

~

K

end Fig.

; l I

jt

~

F

and Fig.

tF

F

I

J

I

1 1

4

K

tJ

K

Fig. 15.7 Product D Hierarchy (a) expanded to the lowest level of each item in (b) Consider for instance item F which is an input to both D and E. Item F therefore needs to be lowered down to level 2 (see Fig. 15.7b) to bring all Fs to the same level. If all identical items are at the same level, computer scanning across each level becomes easier and summarization is also easier.

Inventory Status or Records Each item of inventory forms a separate file in computerized inventory. It can carry a very wide range of information about an item. Some of the details attached to an inventory item are given in the following diagram: Item master data segment

Part No. Order Qty.

Description Setup

Scrap allowance Inventory status segment

Allocated

L

Cycle

Pointers Control Balance

Safety stock

Std. cost Previous usage

Class

Other details Period 1

2 3 4 5

Total

6

7 8

Gross requirements Scheduled receipts On hand Planned order releases Subsidiary segment

Order details Pending action Counters Tracking

Fig. 15.8 Inventory Status Record Source: Joseph Orlicky, Materials Requirement Planning, New York: McGraw-Hili, 1975.

Dependent Demand Inventory: Materials Requirement Planning (MRP)·

213

The MAP programme accesses the status segment as per the specific time periods or time buckets. The MAP programme travels downwards from product structure and explodes requirements at each level. Sometimes, identification of the parent item which caused material requirement is called for. The MAP programme creates a peg record file; which allows us to trace the material requirement upwards in the product structure through each level, identifying each parent item that caused the demand.

MRP Computer Programme This programme work on the inventory file, the master production schedule and the BOM file. MPS provides a list of end items in specified time periods. BaM describes the material and parts needed to make each item. The stock position is shown by the inventory file. The MAP programme accesses the segments of the inventory file, and at the same time refers to the BaM to compute the quantities of each item required. This figure is corrected by taking into consideration the on-hand amount. The net requirement is offset or setback in time is factor in the lead time for acquisition of the material. The present BaM and inventory files of the company may require modification to suit the MAP system. The MAP programme may ignore the capacity constraints, in which case the capacity is balanced by the master scheduler manually. The output is examined in terms of feasibility. The MPS is adjusted with correct imbalances. The programme is run again. This process is reiterated till the output is acceptable. There can be multiple master schedules, for each major product line and they compete for resources. As a whole, they have to optimize resource utilisation and due dates for the system as a whole.

Output Reports MAP accesses the BaM, MPS and inventory file, and generates a wide variety of reports. These are classified as primary and secondary reports. Primary Reports: These are the usual reports for production and inventory control such as planned orders to be released, order release notices to execute the planned orders, changes In due dates to accommodate rescheduling, cancellations or suspensions on MPS and Inventory status data. Secondary Reports: These could be planning reports for inventory forecasting performance reports to point out inactive items, and to determine lead times-actual and programmed and quantity usage and cost - actual and programmed and exception reports to point out discrepancies. As MAP has expanded into MAP II, there are several additional reports.

Net Change System It is a form of MAP where charges can be made as they occur on a real time basis. Here constant updation of the system is called for. It is preferred to a regenerative MAP system. Net change systems however are 'nervous' sometimes because of constant order changes. Suppose a customer cancels an order for week two, consequently leading to cancellation of all purchase orders (Pas) and shop orders. Suppose another customer enters the scene and places an exactly similar order for week two. There is immediate addition of pas and shop orders into the schedule. This is what is known as the nervous system.

214

Outline of Materials and Purchasing Management

Net change systems can be modified to respond to unplanned or exceptional occurrences.

Structure of the MRP System The typical MRP system is shown in the following diagram :

Forecast of Demand

Master Production Schedule (MPS)

Bill of Materials (BOM)

• - - - - - - - - - - -" : :

Materials Planning (MRP Computer Programme)

~

u

ro

.0 "0

OJ OJ lJ..

1 1 1 1 1 1 •

r

________1

Fig. 15.9 Structure of the MRP System Master production schedule (MPS) is at the top of the diagram. It is determined by the customer orders, aggregate production planning and forecasts of demand. The MRP programme is at the heart of the system. It is driven by three inputs - MPS, BOM and inventory records. There are two types of outputs - purchase orders going to the vendors and shop orders going to the factory. Before the execution of the shop orders, it is checked whether sufficient capacity is available. If so, the shop order is placed under the control of the shop floor control system. If the capacity is not available, a change must be made in the capacity or the MPS through the feedback loop shown. The orders under shop floor are monitored to make sure they are completed on time. The above diagram represents an MRP system to control inventories and capacity. Though computerized inventory system were in use for years, they were independent of the scheduling system. MRP links them together. It creates specific schedules to identify the specific parts and materials acquired to produce the end items, the quantities needed and the dates when orders for these materials should be released or be received or completed within the production cycle.

Dependent Demand Inventory: Materials Requirement Planning (MRP)

215

Purposes of MRP: Joseph Orlicky in his seminal work on MRP (1975) has defined three principal functions of MRP as follows: Inventory:

Order the right part Order in the right quantity Order at the right time Priorities: Order with the right due date. Keep the due date valid. Capacity: A com plete load An accurate load An adequate time to view future load If the MRP system given in Fig. 15.9 is used approximately, all the three functions described by Orlicky can be achieved.

Philosophy of MRP Materials should be expected when their lack would delay the overall production schedule. Materials should be de-expedited or delayed when the schedule falls behind and postpones their need. Behind schedule orders are traditionally got back on schedule. When an order's completion date is delayed, there is not appropriate rescheduling. As a result, later orders are expedited, but earlier orders are not rescheduled for later.

Advantages of MRP Competitive Pricing: Reduced Sales Prices Reduced inventory Reduced set up costs Reduced idle time Better customer service Better response to market demands Guides when to expedite and deexpedite Delays or cancels orders Changes order quantities Changes order due dates Helps capacity planning

Disadvantages of MRP MRP may not get top management support. It is considered just a manufacturing system, rather than a business plan. Top management should recognize MRP as a strategic planning tool. MRP has been sold as a stand alone system, rather than a part of the total system. MRP should be integrated to JIT. MRP requires accuracy to function correctly. MRP is criticized for being too digit in scheduling, deviation from which is quite difficult.

216

Outline of Materials and Purchasing Management

Three Different Types of MRP MRP can be used in a variety of ways. It leads three different types of MRP systems. Type I : An Inventory Control System It releases manufacturing and purchase orders for the right quantities at the right time to support the master schedule. Work-in-process and raw material inventories are controlled through proper timing of order placement. This system does not control capacity planning and shop-floor modules. Type II: A Production and Inventory Control System It is used to plan and control inventories and capacities. Here orders are checked to see if there is sufficient capacity available. If it is not available, either the capacity or MPS is modified. It has a feedback loop between the orders launched and MPS. It is also called a closed-loop system. Type III : An Enterprise Resource Planning System (ERP) It is a company wide system to plan and control all resources - inventory, capacity, cash, personnel, facilities and capital. MRP is integrated to other SUb-systems accounting, sales and marketing, HR, finance through common database. As the same information is used for working, co-ordination is possible amongst all resources - not just materials and capacity.

MRP

vs Order-Point Systems

Order-point systems are not suited to manage dependent demand inventories. Before the advent of MRP, there was no alternative but to use order-point systems. The distinction between order-point systems and MRP is summarized in the following table: Table: Comparison of MRP and Order Point Systems Point of Distinction

MRP

Order Point

Demand

Dependent

Independent

Ordering Philosophy

Requirements All items to be controlled

Replenishment Follow ABC analysis

Control Forecast

Master Production Schedule based

Past Experience

Lot Size

Discrete

EOa

Demand Inventories Controlled

Predictable WIP and raw materials

Random Finished products and spare parts

The basic difference is that MRP is based on requirements dictated by production schedule, whereas order point systems believe in replenishment as and when the inventories get depleted. In manufacturing this is relevant since the demand for components is lumpy. Suppose a lot is scheduled. Components are needed then for that lot. But demand is then zero, until another lot is scheduled. Had we used the order point systems for such lumpy demand pattern, there would have been material on hand even during long periods of zero demand. Order point systems extrapolate the past into the future to have a forecast used to replenish stocks. In MRP system, the requirement in the MPS are used to order materials. It is future-oriented. MRP is not based on ABC classification. An item is not complete till even a small trivial part is available. It is necessary to control all the parts in MRP, even C

Dependent Demand Inventory: Materials Requirement Planning (MRP)

217

parts. In view of the lumpy demand, lot sizing is discrete in MRP systems. Order-point systems are ourward-oriented because the objective is to provide a high customer service level at low inventory-operating costs. MRP on the other hand is manufacturing-oriented or inward-oriented, as it is based on the requirement of the MPS.

000

CIiAPTER 16 Receiving and Store-Keeping Introduction: The aim of any business activity is to increase the value of the original resources which are risked by the owners in the venture. The aim of the manufacturing operation, which is an important facet of the business activity is the timely manufacturing of the desired products of specified quality in proper quantities at least possible cost resulting in the increase in the value of the resources. The efficiency of the manufacturing operations largely depends on the efficient functioning of the receiving and stores operations. Receiving and storing are the service functions and involve much of the paper work. The benefits out of an efficient receiving and storing are bound to outpace the cost of administering them. Moreover, there is an ample scope for simplifying and standardizing the paper work involved in these functions. Receiving and storing are the key considerations in the materials management because (i) the quality of the end product largely depends on the quality of materials received, (ii) the smooth and uninterrupted production flow is dependent on the efficient stores function, (iii) the stores organisation acts as custodian of stock items and (iv) above all these functions directly as well as indirectly affect the production cost. The direct production cost is reduced by strategic location of stores ensuring quick issue and elimination of production stoppages caused by waiting for materials. It indirectly reduces the production costs in terms of reduced investments in materials, storage space and insurance, elimination of pilferage and theft, obsolation, reduced handling cost etc.

Store.s Functions The important function of the stores are as follows: (a) (b)

Receipt Storage

(c)

Retrieval

(d)

Issue

(e) (f)

Records Housekeeping

It receives and accounts inventories. It stores and preserves the inventories protecting them from damage, pilferage and deterioration. It helps easy accessibility to materials and ensures optimum space utilisation. Materials can be located and retrieved with ease. It satisfies the demands of consuming departments by proper issue of inventories on receiving the requisitions. It keeps proper records of the issue and receipts. The space is kept neat and clean so that material handling, preservation, storage, issue and receipts are done satisfactorily. (218)

Receiving and Store-Keeping

219

(g)

Surplus stock

Scrap and surplus disposal management is a function of stores.

(h)

Verification

Physical verification and purchase initiation to avoid stockouts.

(i)

Co-ordination & co-operation

To interface with production inspection and inspection department.

Receiving of materials: Receiving is an important control point in the material control system. It is sometimes considered that receiving is a routine clerical work where the materials shipped by the supplier are received unpacked, checked and compared with the packing slip. In fact receiving is something more than this. Lee and Dobler in their "Purchasing and Materials Management", stated that, "any problem or error in specific purchase transaction should come to light during the receiving operation." If the problem (shortage in quantity, damaged material, wrong item shipped etc.) is not detected and corrected during the receiving operation the cost to correct the mistake later is much higher. Many hours are frequently spent in determining what really happened and rectifying the situation. Hours are required to correct the error that could have been corrected at the receiving station in minutes. Receiving procedure: The receiving involves much of the paper work and it varies from firm to firm. However, the key issues involved in the receiving function are commonly described in the following standard procedure: The receiving division unloads the goods at the delivery bay and verifies the condition of the consignment to satisfy that it is not received in a damaged condition. The receiving clerk opens the conSignment and verifies the contents with the packing Slip and the purchase order. The details are recorded in the separate report which is popularly known as lithe goods received note or GR note." The goods received note is an important document because it is the only document with the firm which signifies the details of the materials it has received. This document is used as the basis for invoice payment, for continued purchase negotiation and for closing the order. Generally, the receiving clerk counts or weighs the physical volume and the apparent condition of the goods. If there is discrepancy between the physical volume and packing slip or purchase order particulars, it is recorded on the goods received note. The condition of the consignment is also recorded. The copy of the goods received note is sent to the purchase department and other needy departments. The next step in the receiving process is the inspection of the materials. The inspector compares the quality of the incoming materials with their speCifications with help of gauges, visual tests, chemical, electrical or mechanical tests, laboratory tests and such other tests. He reports his finding on the receiving report. The inspection report may be a separate form or it can be a part of the goods received note. The inspection report is sent to the purchase department and such other departments. If the materials are rejected, the purchase department immediately informs the supplier and seeks his instructions about the mode of their disposal. The supplier may ask for the return of materials for reworking or he may scrap them. If the returning of the rejected materials involves high transport cost, the supplier may prefer to have the buyer either rework or scrap them at buyer's plant at supplier's cost. The supplier is not given any credit for the rejected materials or it is adjusted to the terms agreeable to the parties. Rejection should be considered in the light of the accounting adjustments only. In fact it poses a distinct problem of non-availability of materials. Prompt action should be taken to replenish the rejected items with a view to eliminating any chances of production stoppages caused by stock-outs.

220

Outline of Materials and Purchasing Management When the materials are accepted, they are sent to the stores section for their proper record and storing. All relevant departments are informed about the receipt of the materials.

Store-Keeping: Need for storing: In stores room the inventories - like raw materials, work-in-progress, finished goods bought-out components consumable stores, spares and scraps - costs heavily to the organisation. Moreover, the inventories, which are stored in the stores room, represent the idle investments of the capital resources. So sometimes it is argued that can one do away the storing function? The answer is in the negative. The store-keeping has proved its indispensability in the modern business world due to following reasons: Type of inventory (1 )

Raw materials

Reasons for holding the inventory

(i)

(ii)

Pre-operation seasoning.

(iii)

To reap the price advantage available on seasonal raw materials.

(iv)

To safeguard against the stockouts caused by prolonged lead time or high rate of consumption. Large order placing avails certain economies like cost of order placing.

(v)

(2)

Work-in-progress

Hand-to-mouth buying is not feasible due to the quantum and frequency of use and the distantly located source of supply.

(vi)

The imported raw materials or materials received under quota system are generally purchased through a single order and are stocked till their use.

(i)

To balance the production flow.

(ii)

To eliminate the ideal capacity of machines.

(iii)

To even out the imbalance in the demand and supply position.

(3)

Consumable stores

(i)

The daily consumption is too insignificant to have daily purchases.

(4)

Spares

(i)

The rate of consumption is very low and so they are purchased in bulk and are stored for future requirements.

(5)

Ready-made components

(i)

When the components are bought rather than made, it is essential to buy them in advance of their requirements so that the production flow may not be interrupted due to lack of components.

(6)

Scraps

(i)

They are disposed of in bulk.

As noted above, the store-keeping is a service department, 50 the principal objective of the stores function is to provide that service most economically. The fundamental considerations of providing this service economically is to maintain the value of the stores in the stock at the lowest possible level and to make the required inventory available at all times. These two aspects are mutually exclusive in nature. If more inventories are stocked, they will be availaole at all times. However, such action will fail to keep the value of the stocked items at the lowest possible level. Conversely, if less inventories are stocked, such action will keep the value of the stocked items at low level, but it may equally create the chances of stockouts. The disadvantages of high level of inventories and lower level of inventories are as under:

Receiving and Store-Keeping

221

High level of inventories

Low level of inventories, it will result in stockout resulting into

(i) (ii) (iii) (iv)

Locking up of working capital High insurance charges More storage space Deterioration in the quality of materials

(i) (ii) (iii) (iv)

Production stoppages. Idle production capacity. Idle labour time. Liability of fixed overheads.

(v)

Chances of theft and pilferage

(v)

Failure to meet delivery order etc.

(vi)

Evaporation of alcoholic

As maintenance of high level or low level inventories is mutually exclusive, the efficiency of the stores function lies in the skill that strikes the balance between the two. Identification system of materials: When innumerable items are stocked in stores room it is essential to codify them for their quick identification. Codification is a technique of assigning brief names to the items stocked in the stores room, decided on some scientific basis, e.g., when "BS 24, 25" is used to describe "the round brass rod of .25 inch, in diameter," one can understand the importance of codification in describing the items. The materials codification is advantageous as under: (i) It describes the item briefly thus saying the time in writing and describing. (ii) It facilitates the quick identification of the item in the stores-room, e.g., when we write BS we talk of brass. The first digit "2" represents metal, second digit "4" speaks about round bars etc. When materials codification is accompanied by location codes, it facilitates exact location of the materials inside the stores room. (iii) It facilitates the matching of minds between the production department, stores department and various divisions of the same organisation. Generally, alphabets, numbers or combination of alphabets and numbers are used as the codes. In numerical codes, the 3 to 4 elements of numbers, the binary code with 1 and 0 element or the decimal codes are used. In the alphabetic codes twenty-six alphabets are used as elements. The alphabets are used as pure alphabetic symbol or as mnemonic code which serves as an aid to memory, e.g., BS for Brass Screw. It is also possible to use both letters and numbers as 2 for general class (rod) and 4 for specific class (round) code elements, e.g., BS 24.75 which describes the brass metal round rod with .25 inch diameter. It is also possible to use the colour scheme for the quick identification of materials. Generally, colour codes are used to distinguish the various grades of metals like steel, brass, copper, bronze. The objective of the codification is quick identification and short description. However, the brevity should not be at the cost of clarity. This is achieved through the construction of the codes on some scientific basis. Generally, code construction is made on any of the following methods: (i) Mnemonic method: Under the mnemonic method the alphabets are used as an aid to memory, e.g., BS for brass screw. They can be applied effectively only when the stock items are few in number. Its application becomes difficult as the number of items increases . . (ii) Random method: Under this method the numerical and/or alphabetic codes are assigned on random basis. It is flexible, as it is possible to add the new number or letter in sequence in case of addition of new item. However, the codes are constructed arbitrarily rather than on any scientific basis.

222

Outline of Materials and Purchasing Management

(iii)

Scientific method: Under this method the codification is done by dividing the stock items into a number of groups or classes and then to assign a symbol to each class. The class is then divided and sub-divided again until the individual item is identified, e.g., first digit for metal (say 1). Second digit for type of metal (say 3 for aluminium). Third digit for the shape (say 2 round rods). The additional digit with decimal point may describe the size of the metallic item. Thus coding will be done as under: 11 - Steel 12 - Brass 13 - Aluminium. and 132.75 for aluminium round rods of .75 inch diameter. Generally, block system is used to describe the main class and the subclass, e.g., 11 to 20 for metals, 21 to 30 for liquid items and so on.

Location and Layout of the Stores The store room is commonly described as a "place for everything and everything at its place." The first part of the phrase refers to the provisions of adequate space for the materials while the latter part highlights on the scientific location and layout of the store room. The point of receiving the material and the point of use are not always the same. In between them, the materials are housed in the store room. The store room provides the space for materials. The storage space may be in the form of constructed buildings or godowns, temporary structures or even in the form of vast open yards. The size and the type of the storage space is dependent on varied factors such as number of items to be stored, quantity, characteristics of the materials to be stored such as liquid, fragile, weight, dimension, cost, chances of evaporation etc. While deciding the storage space, due consideration should also be given to the space required for movement of material handling equipment inside the store area. The ways inside the store room are divided between the main tracks and side streets. The main track must provide for two-way movement and the side streets for one way. Every cubic inch of the store room costs to the organisation. For the economic use of the stores area, vertical stacking within the limits of the height of the ceiling, weight of the materials, capacity of the container etc, is done. For the economic use of the space and efficient handling of the materials various types of stores equipment are used. Lee and Dobler have mentioned that the following eight types of equipment are commonly used in storing materials: (1) Pallets and skids. Open and closed shelving. (2) (3) Cabinets (with or without counters). (4) Bins. (5) Stacking boxes. (6) Special storage racks. (7) Gravity feed racks. (8) Outdoor platforms and racks. The location of the stores is also an important consideration which has a direct bearing on the product cost. The basic principles of stores location are - straight line

223 Receiving and Store-Keeping movement with minimum of backtracking, minimisation of handling, rehandling and internal transportation costs, minimisation of waste motion for personnel and reduced human hazards, efficient utilization of storage space and provision for the flexibility and expansion of the store area. The materials are stored at one central godown or in the godown located at distant places. Where the materials are stored is distantly located godowns, receiving materials from various suppliers and issuing materials to remotely located production centres. The optimum stores location is decided on the basis of clearly defined objective function with the help of quantitative techniques or through the computer programming. The stores location will differ according to the divisibility of the total storage space, type of business activity say multi-product operations, manufacturing operations carried on at multi-plants located at distant places, type of production processes such as continuous processing, job-order production, assembling etc. Fundamentally, the raw materials should be stored in the vicinity of the starting point of the production operation work-in-progress between first and following operation, finished inventories near the shipping area, spares, tools and stores somewhere in the central storage area. .

Stores Organisation The stores manager assisted by storekeeper manages the stores. He either reports to the materials manager or to production controller/manager. The problem of centralized storing versus decentralized one should be decided on the basis of their undermentioned relative merits and demerits which are mutually exclusive in nature.

Merits of Centralized Storing (1)

Bulk buying in few orders with the advantage of quantity discount and transportation cost.

(2)

Possibility of standardization of materials reducing the variety of items stored.

(3)

Reduced investments in inventories.

(4)

Reduction in administrative cost.

(5)

Reduction in the requirements of the personnel.

(6) (7)

Reduced storage space and other incidental expenses. Greater safeguard against pilferage and theft.

Demerits of Centralized Storing (1)

Increase in the material handling cost.

(2)

Possibility of bottlenecks and the resultant delays.

(3)

Possibility of communication gap between the user of the item and its supplier.

(4)

In absence of proper designing of the routine work, the administrative cost may go up.

(5)

Greater danger of loss by fire.

224

Outline of Materials and Purchasing Management Principles of Efficient Layout of the Stores The following aspects should be considered while administering the layout of the stores: (i) The floor area should be adequate and should suit to the specific characteristics of the materials stored, e.g., liquid, inflammable, fragile etc. (ii) The floor load must be adequate. (iii) The gangways should be wide enough to take any stores trolleys and must allow to be withdrawn from bins and racks. (iv) Weighty items should be stored as low as possible. (v) The items which are used most frequently should be located near the issuing windows. (v.i) Obstructions such as poles, partitions, staircases etc. should be reduced or eliminated. (vii) The stores racking should not prevent the normal movement of air and temperature distribution. (viii) Water-proofing must be assured in the stores area. In the production area, a leaking roof is immediately observed while in the stores area, it may be so obscured due to stored materials and that considerable damage might be done before it is discovered. (ix) In the vertical stacking the load should be distributed evenly and should be broken by intervening shelves. It should not touch the ceiling height otherwise it will prove a hindrance in case of fire fighting. (x) The stores area should be equipped with the handling equipment such as crane hoists etc. and the computing and weighing scales. (xi) It must provide safety to the personnel and security to the items stored. (xii) A location system should be devised so that it may pinpoint of any item stored inside the store room.

Approaches to Stores Location The problem of the materials inside the store room is tackled with the help of the following three approaches: (1) Fixed location; (2) Random location; and (3) Zoned location. (1) Fixed location: Under this approach a specific fixed place is assigned to each item of the material. The allocation of the space is made on any of the following basis: On the basis of supplier. (i) (ii) On the basis of similarity of the item. (iii) On the basis of the jOint issue of the items. (iv) On the basis of the size and frequency of the use. The last basis is more efficient and economical. Under this approach, the fast moving items are stored nearest the point of issue, and the slow moves in the remote areas. (2) Random location: Under this approach, the materials are stored at any vacant place available in the store room. This approach is workable where the stores function is operated by one or two persons and the storing is required for only few items. The location is memorized by the store-keeper. This is the most unscientific method with its many drawbacks.

Receiving and Store-Keeping 225 (3) Zoned location: This approach divides the total storage space into different zones. Popularly there can be three zones: (i) for bulk stock, (ii) for reserve stock and (iii) indirect materials like spares and consumable stores.

Zones can be devised on certain other basis also like, liquid materials, metal bars, inflammable materials, costly materials, dangerous materials etc. Zone approach attempts to avail the maximum benefits out of the available space and other storing facilities. Location coding: As the materials' codification helps in identifying and describing various items of the materials, similarly the location coding also helps in beating the specific material item in the stores area. Location coding is desirable especially where the large number of items are stocked in big godowns located at different places. The same principles of code classification are followed while constructing the location code. The location is identified in terms of number of warehouse (if more godowns are maintained) row, column, racks, shelf, bin etc.

Storing of Materials It is commonly observed that a store-room is "a place for everything and everything at its place." As we have noted that there exists a time gap between the point of receiving and the point of the issue of materials, it becomes inevitable to store the materials. The materials are stored in the store room and the storage space may be in the form of constructed godown, temporary structures or even open yards. Various types of stores equipment such as pallets, skids, shelves, bins, boxes, drums, tanks, racks are used for the purpose of economic use of the storage space and efficient handling of the materials. The materials are stored till they are requisitioned by the production departments or the specific jobs. The stored materials are issued to the respective production department or job against the authorised materials requisition. The stored materials are pending for issue. They should be preserved till they are issued. The materials represent the money value, so they should be safeguarded against fire, deterioration of quality, mixing, evaporation, theft, pilferage etc. Proper and adequate storage facilities should be provided for all types of materials according to their specific requirements. The materials should be physically verified periodically with the stores records, the storage. Space should be cleaned regularly the storage facilities should be checked frequently and the entry to the storage area should be restricted to the authorized persons only.

Record-keeping of Materials Materials represent the money value. It is nothing but the application of financial resources and hence their proper records as regards the quantity as well as value should be maintained properly and efficiently. Proper record-keeping becomes inevitable even for accounting and costing purposes. Up-to-date stores records help in determining the quantity of respective material items on a particular point of time which provides the guideline for the fresh purchase or disposal of the materials, the valuation of stock on any particular point of time representing the asset value locked up in stores items and provides the basis for charging the various production departments or jobs who have received the materials from the stores room against materials requisition. The store records can broadly be classified into two: (1) The bin card and (2) the stores ledger.

226

Outline of Materials and Purchasing Management (1) The Bin Card: The bin card or the stock card is usually attached to each bin, shelf or other form of containers. The bin cards of the items stored in the open yards like coal, are kept at the desk of the store-keeper. They are used as record of the quantities of each type of material received, issued and on hand each day. They contain only the quantity column and they are not considered for accounting the price of the materials. The pricing is recorded in the stores ledger card which is discussed in the following paragraphs. Usually the bin card specifies the location; the description of materials, maximum, minimum and reorder level; date; receipt; issue and balance specifying only the quantity etc.

Bin Card Bin No .............. Material Code No .............. Stores Ledger Folio ............ Date

Qty. Received

Max. Qty ..................... Ordering LeveL ............ Minimum Qty ................. Qty. Issued

Balance

Remarks

It is used as basis for verifying the physical stock and the stores ledger accounts. (2) The Stores Ledger: The objective of the stores ledger is to keep the proper record of the respective materials specifying their quantity as well as value. It is a record which charges the respective departments or the job at the price of the materials issued to them. Generally, stores ledger is maintained on the loose-leaf card basis and separate card is kept for each material item. The stores ledger card specifies the account number, location, description of the materials, unit measurement, maximum, minimum and reorder level, debit, credit and balance columns under the description of receipt, issue and balance specifying both the quantity and the rupee value. It is also a practice to keep the column such as outstanding order, units reserved or units appropriated for special jobs. The outstanding order column helps in reviewing the actual and the probable supply picture which serves as a guide in scheduling the production. The reserved column earmarks the materials for strategic needs and is not considered for ascertaining the stock in hand for the purpose of recording. The appropriated column ensures the execution of certain specific orders without any interruption. The provision of these and other columns is decided on the basis of the need of the organisation. When the store-keeper issues materials to any department or job against the material requisition, a copy of material requisition is sent to the stores ledger clerk. He makes entry in the "issue" section of the card, specifying the date requisition number, the department or job, the quantity, the unit cost and the total cost. Finally, the new balance is calculated and entered in the balance column.

Issue of Materials The materials stored in the stock-room are issued to various jobs or production departments against the authorized materials requisitions. The issues are recorded in the store ledger and the respective jobs or production departments are debited with the price of the material issued. As the time of purchase and the time of issues are mostly different and the market price of the materials tends to vary, the problem of pricing the materials

Receiving and Store-Keeping 227 issued necessitates certain policy formulation. It is an important consideration not only under stores management but also for costing and pricing policies. The fundamental consideration is whether to price the issues at historical price, i.e., the original purchase price, at the replacement price, i.e., the prevailing marker price at the time of issue or at some other price.

Material Requisition Material required for............ (Specify Job or Process) Department.. ................ Sr. No.

Description

Requisitioned by

Code No.

No .................... Date ..............

Quantity Rate Demand Supplied

Approved by

Amount

Material Issued by

Entered on Stock Register Page No.

Received by

Fig. 16.2 Material Requisition The various methods are used for pricing the material issues which are based on different principles. The following are the important methods of pricing the material issue: (1) First In First Out Method (FIFO Method): FIFO method, as its name suggests governed by the principle that the materials which are received first are issued first. The issues are priced at the cost price of the oldest consignments till it gets exhausted. As soon as the oldest lot is exhausted the issues are priced at the cost price of the next of oldest lot in the sequence, e.g., the following transactions occurred during the first week of April, 1993: April 1 200 units purchased @ Rs. 5 per unit 500 units purchased @ Rs. 6 per unit April 3 April 5 300 units issued to job No. 1001 The issue of 300 units will be priced as under: Rs. From the first lot: 200 units @ Rs.5 = 1 000 Remaining 100 units from second lot = 100 units @ Rs. 6 600 1,600 The value of the closing stock of 400 units (i.e., second lot 500 units less 100 units issued will be costed @ Rs. 6, i.e., the value of closing stock would be Rs. 2,400. (2) Last In First Out Method (LIFO Method): LIFO method reverses the procedure as followed under FIFO. The cost of the last lot of materials received is used to price the issues until that consignment is exhausted, then the next lot of pricing is used and so on through the successive lots. This method is based on the premises that the materials which are issued to the jobs should carry the cost of the most recently purchased materials, and that is why it is also known as the "replacement cost" method. It should be noted that like

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FIFO method, the actual physical handling of the material in the bins and shelves in the sequence of purchases is imaginary. It is considered only for pricing the issues made from the stores, e.g., the following transactions occurred in the stores department during the first week of April, 1991: April 1 500 units purchased @ RS.5 April 3 : 300 units purchased @ RS.6 April 6 : 400 units issued to Job Order No. 1086 The issue of 400 units on April 6, will be priced as under: First 300 units @ Rs. 6 = Rs. 1,800 Remaining 100 units @ Rs. 5 = Rs. 500 Rs 2,300 The closing stock of 400 units will be priced @ Rs. 5, i.e., Rs. 2,000. (3) Average Cost Method: Under this method, the issues are charged at a price ascertained from the common pool made up of the varied prices of a several lots. It is advantageous to use this method when the prices are subject to constant changes. In the periods of rise or fall of materials prices, an average cost tends to even out the extreme price changes. The upward and downward trends are moderate as contrasted with the steep rise or fall under the FIFO and LIFO methods. The average price is calculated in different ways as under: (1) Simple average of the stock on hand at the price of the issues. (2) On the basis of the simple average cost of each kind of material on hand at the close of the month, and to apply it for all issues made during the following month. (3) On the basis of the simple moving average wherein the earliest price is dropped the moment the new purchases are made and cost of such fresh purchases will be included while arriving at the new average. It should be noted that instead of the simple average wherein only the unit cost is considered for calculating the average cost to be charged to the issues, weighted average cost can also be used. Under the weighted average cost, along with the unit cost the quantity of the units is also considered, e.g., the following two lots were purchased during April, 1993: (1) 1,000 units @ Rs. 3 (2) 5,000 units @ Rs. 5 The simple average cost would be Rs. 4 only (i.e., RS.3 + RS.5 + 2) while the weighted average cost would as under: Unit cost Rs. (1 ) (2)

Weighted average cost

3 5

Weight

Weighted cost Rs.

1,000 5,000 6,000 = =

3,000 25,000 28,000 28,000 6,000 4.67

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229

(4) Replacement Price Method: This method is also known as market price method under which the material issues are priced at the prevailing market price on the date of the issue. This method is based on the principle that the materials issued for any job on a particular day should be charged at the rate at which they could be replaced immediately from the fresh purchases on the same day. In short, material issues are priced at the prevailing market price on the date of as consumption. This method is applicable to the raw materials of standardized grades which are traded at the commodity exchanges such as cotton, cereals, certain metals etc., because the prices of such items are quoted in the newspapers and it is relatively easier to ascertain the current market price. The main advantage of this method is that it considers the current market price which is more significant with those of the pricing policies. It enables the comparison of the operating efficiencies with those of the competitive units. The comparison between the purchase price and the issue price (i.e., the market price) reflects on the efficiency or otherwise of the purchase department. The main drawback of this method is that it distorts the data for the accounting purpose which necessitates the adjustments in the Stores Ledger. There is bound to be a discrepancy between the purchase price and the issue price. The difference between the market price and the purchase price is adjusted to the 'Price fluctuation reserve account' which indicates the efficiency or inefficiency of the purchase department. (5) Standard Price Method: Under this method, the material issues are charged at a predetermined, budgeted or estimated price which reflects a normal or an effected future price. Generally standard price is fixed after the careful examination of the current market price, trend of the price, market conditions etc., so that a fairly correct average standard price may be predetermined. The standard price is made applicable for a definite period say a month, a quarter or a year. The material receipts are recorded at the actual price while the material issues are costed at the predetermined standard price. So there is bound to be the discrepancies between the standard and the actual price. The difference between the actual price paid and the standard price charged is recorded to a separate 'Price Variance Account.' The standard price is revised periodically, if the discrepancies go beyond a particular limit. The main advantage of this method is that the pricing of issues becomes a simplified function. Like FIFO, LIFO and average cost method, the issue price need not be ascertained after each receipt or issue of materials. However, it is not advised if the materials involve frequent and substantial price fluctuation. (6) Actual Price Method: Under this method the material issues are priced at the actual acquisition cost of the respective materials. This method is applicable where the purchases are made for the specific jobs and are kept physically separate in the store room. Each material receipts is recorded in separate stores ledger card and the material issues are costed at the actual acquisition cost. This method is relatively awkward, however, it is advised where few costly items are used in the processing and where non-standardized materials are purchased to meet the customer's specification. It is more suitable to the jobbing industries. (7) Inflated Price Method: This method of pricing is based on the principle of uniform spreading of normal wastage on the residual units. There are certain types of normal wastage which are incidental to materials usage, e.g., loss of breaking the bulk, evaporation etc. The cost of such normal wastage is absorbed by the good units through charging the material issues at inflated price, e.g., 100 units at Rs. 15 were purchased. This material is subjected to 10% normal wastage so the total cost of Rs. 1,500 (100 units x Rs. 15) will be spread over 90 (100 units - 10 units normal wastage) good units, and the issue of the

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materials will be charged at an inflated price of Rs. 46.67 (Rs. 1,500 x 90 units) instead of Rs.15. In conclusion it should be noted that the material pricing should be on the basIs of the acquisition cost of the materials. The acquisition cost should consider the net price of the supplier and the transportation charges which are 'the visible costs.' They should also consider certain invisible costs like the cost of ordering, receiving, unpacking, inspection, insurance, storing etc. The precise cost analysis of these aspects requires exhaustive treatment which is beyond the scope of this book.

Replacement of Materials Receiving and issuing of inventories are the common and recurring phenomena in a manufacturing organisation. When the inventories fall below a particular level, they are replenished by the fresh purchases. The prescription of reorder level (ROL) is an important technique of inventory control. It fundamentally deals with "when to order" to replenish the inventories. Recorder level is a predetermined point, and when the existing stock of inventories reaches this point or falls below it, the purchase action is initiated to replenish them. The ROL is mentioned in the bin-card of each inventory item. What should be the quality of replenishment order is also a matter of policy. Generally, size of the order is determined on the basis of the economic ordering quantity (EOO), which is also an important technique of inventory control. The reorder level is decided for each important item of inventory on the basis of the following considerations: (I) Lead time, (i/) Average periodiC consumption (say, daily consumption), (iiI) Safety stock. Reorder level is decided as under: ROL

= (Lead time x average

daily con sum ption) + Safety stock.

Illustration: The following data relate to one basic Average daily consumption Lead time Safety stock Size of the order

raw material item: 50 units 4 days average 2 days' consumption 300 units

Solution:

= =

(Lead time X average daily consumption) + Safety stock (4 days x 50 units) + 100 units = 300 units. The minimum level of the inventory will be the safety stock. The reorder level (300 units) is 200 units above the safety stock (i.e., 100 units). The order will be placed for 500 units when stock the reaches to 300 units, i.e., ROL. As it takes four days to get materials after placing an order, the fresh stock of 500 units will arrive at a time when the stock had reached to 100 units, i.e., the safety stock. Thus, the safety stock will be the minim um level of inventory. The maximum level of inventory would be as under: = Safety stock + Reordering quantity Minimum level ROL

=

100 units + 500 units.

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231

The ordering level is controlled through the following techniques: (1) Two-Bin System: Under this system, the inventory item is divided into two parts. One part is active one from which issues are made. The other part is kept reserved and touched only when the active part is exhausted. It is also known as the "bin reserve" system. When the reserve part is touched, a fresh order is placed to replenish the stock. The reserve part becomes active and the earlier active part which is exhausted is replenished with the fresh stock. The fresh order placed for the fixed quantity. The quantity in the reserve part serves as a reordering level. It is not necessary to provide for two separate bins. It is a notional presentation. The two parts can be segregated even by the line. This method is applicable to low-cost, high-volume items which have consistent usage. This method docs not involve any record keeping. (2) Mini-Max System: Under this system, when the inventory item reaches to a predetermined minimum level, it is replenished by the fresh purchase up to the predetermined maximum level. The minimum level serves as a reordering point. The fresh order is placed for that much quantity which shows deficiency in maximum level. Thus, the size of the order is variable rather than fixed. Like the two-bin system, this method is applicable to low-cost, high-volume parts with consistent usage. (3) Imprest System: Under this system, the reordering is made at regular time intervals. The maximum level of each item is predetermined. At a particular fixed period, say after one week, a fresh collective order for all the items will be placed. The size of the order will be decided on basis of the shortage indicated by the existing stock in relation to the maximum level. Thus, the quantity of replenishment will exactly equate the quantity consumed during the period. The size of the order will vary considerably. Physical verification of materials: Proper stock records are kept in the bin-card as well as the stores ledgers. When the materials are received or issued, they are properly recorded and the new balance is struck at the end of every transaction. Principally, the bin must contain the quantity which is shown in "balance" column of the bin card. But sometimes, the book-balance and the quantity physically does not tally. The important reasons for such discrepancies are as under: (1) Wrong recording in the bin card. (2) Placement of the material in the wrong bin. (3) Mixing in adjacent bin. (4) Loss due to breaking the bulk. (5) Evaporation of alcoholic materials. (6) Pilferage etc. However, such situation emphasises the need for physical verification of the materials stocked in the stores room. There are the following two popular methods of the stock verification: (A) Periodic inventory verification, and (B) Perpetual inventory verification. (A) Periodic inventory verification: Under this method, all items of the stores room are verified through counting, weighing, measuring etc. at the end of the specific period, usually the last day of the accounting year. They can also be verified at the end of every quarter or six months. However, in the light of the huge task of verification, usually they are verified only once and that too on the last day of the accounting year. It is also required by the accounting system to value the stock-in-hand on the last day of the year for the purpose of preparing the annual accounts. The issues are not made during the verification

232

Outline of Materials and Purchasing Management

to the size of the inventory. Additional staff is employed for the huge verification task. This method gives correct picture of the stock-in-hand on tlie last day of the accounting year. (8) Perpetual inventory verification: Under this method, the verification function becomes a continuous function rather than a year-end function. All the items are verified rotatively on the continuous basis. Under this system all items are not verified at a time like year-end verification. Generally, those items which have reached a minimum level are selected for the verification. This policy reduces the burden of verification. The verification work is arranged in such a way that every item is verified twice or thrice during the year on rotation basis. This system does not necessitate the employment of any special staff for verification. The store-keeper carries on the verification work according to his convenience. Moreover, it is easy to locate the reasons for the discrepancies promptly. In fact, it serves as a deterrent to pilferage. Such control is not possible under year-end verification. The main limitation of this method is that the valuation of the ending inventory is made on the basis of book figures rather than on the basis of actual physical verification.

Disposal of Waste and Scrap The waste and scrap consist of the following: (a) Spoiled raw materials. (b) Rejected components. (c) Defective parts. (d) Obsolete stores and equipment. (e) Wastes from the production departments like cut-pieces of metals, scraps, chips etc. (f) Non-returnable containers and packing cases. Such wastes and scraps involve some commercial values. They should be disposed of periodically and proper credit of the amount realized should be taken in the books of the accounts. Such disposal also releases the space in the stores room.

Automated Storage/Retrieval Technology has been applied to storage function where automatic material handling systems are used for the unit load type storage retrieval system. When different quantities of different materials are to be retrieved, semi-automatic system of handling is used. The operator undertakes a tour of the stores and fills up the required stores. To facilitate this system, items like nuts and bolts are stored in pairs, location is made scientific, a picking list is carefully prepared, a single operator moves along an aisle, sequencing is done of stops in a single picking tour optimally.

CASELET: COMPUTERISATION OF STORES Let us recapitulate a case of Minolta Photo Co. Ltd., Mizuno plant. Since a large inventory of parts tie down a large amount of capital and expenditure on maintanance, Minolta has adopted the Minimum Inventory System. Here a bare minimum amount of parts is kept in automated computerised store. The supplier delivers a day's requirements according to a strict schedule during the day. In case a part falls below a certain level, the concerned employee gets the necessary supply by pushing a button. It increases the overall competitiveness of the product. What do you think India should learn from Minolta?

000

CIfAPTER 17 Waste Management Management of Surplus and Scrap Waste Management (WM) has several dimensions - engineering, economic, geographic, social and management. Its basic purpose is to minimise the overall waste in a given system. Waste here refers to waste of all kinds of resources, but especially the material resources which constitute a significant portion. Some waste is inevitable in any cc:wersion process of inputs into outputs. To reduce waste, we have therefore to maximise the use of resources. Resource Management and Waste Management are thus supportive to each other.

Classification of Waste Waste can be classified on the basis of: (1) resources wasted (2) origin (3) property recoverability (4) Waste Resources: Material resources like solids, liquids, and gases can be wasted. Energy resources like physical, human and solar energy can be wasted. Time resource can be wasted. Capital in the form of capacity, equipment, machine hours and inventory can be wasted. Services like communication, transport, health etc. can be wasted. Life or human resources, data and information may also suffer wastages. Origin of waste: It could be industrial, residential, commercial, office, municipal construction and demolition, agricultural etc. Property: Materials wasted are either hazardous or non-hazardous. Recoverable: Wastes can be recovered into some useful resource, material waste recycled. Non-recoverable wastes are lost with time. Waste exists in myriad forms - non-workable components, excess inventory, machine downtime, re-work, non-conformance, warranties. Any activity that does not add value is a waste. Re-work is the biggest non-value added activity that a company performs. If we reduce the unnecessary activities or eliminate them, costs will come down drastically. (233)

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Outline of Materials and Purchasing Management

MEASUREMENT OF WASTE =

Waste(W) Input (I)

=

Total Waste Total Input

Net Waste

=

Total Waste - Waste Recycled within the system

Net Wastivity

=

Net Waste Total Input

Wastivity Gross Wastivity

Wastivity and Productivity Waste is an indirect measure of productivity. If wastivity is checked, the effect, productivity will be automatically improved.

Causes of Waste Various causes are responsible for wastes. An illustrative list is given below. The highest waste causing factors are considered to be critical. Table: Causes of Waste

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

Faulty planning and policies, systems and procedures Faulty organisation structure Environmental pressures Tardiness Lack of accountability Unawareness of technological advances Non-responsiveness to automation/computerization Wrong specifications, standards, codes Wrong raw materials Lack of inventory control Lack of proper storage, layout of facilities, handling of material Communication gaps Faulty work-method Less emphasis on PPC Lax supervision and control Wrong recruitment/selection policies Lack of motivation/incentives Poor working conditions Unsafe practices Poor IR: Industrial Relations Maintenance failure Power failure Distribution problems

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235

(24) Less attention to waste segregation and collection (25) Technological obsolescence (26) Miscellaneous causes. Systematic Approach to Waste Reduction (1) First of all the total waste in the whole system is recognized. (2) Then the stages at which waste is generated are identified. (3) (4)

Then the sub-stages are identified in which above wastes can be put. Then waste-reduction programme is implemented at each stage by planning correcting action and eliminating the cause.

Waste Collection System Wastes affect the environment, the organisation, the public health. Waste collection consists of transporting the waste. It is a major cost element, and if efficiently handled, may reduce the overall cost of WM. Waste collection consumes 80 p.c. of waste reduction programme. The following factors govern the waste collection: (1) Separate the waste at source. (2) Make arrangement to collect it in suitable containers of the right material and right size. (3) Depending upon the generation rate of waste, make arrangements to collect waste from time to time. (4) Offer incentives to segregate waste at source. (5) Carry the waste to the salvage industry for ultimate reuse. (6) Make suitable arrangements to collect both the organic and inorganic wastes.

Recycling of Wastes The wastes can be recycled/reused. For this purpose, suitable recycling projects are created. In recycling, the waste is used as input to the same process/system, e.g., recycling of foundry scrap. In reuse, the waste is used as input to some other process/system, e.g., sugarcane bagasse is used to prepare paper. In reuse of waste, we may generate power or by-products, e.g., bio-gas generates electricity/fuel and molasses produces alcohol. In reclamation, the damaged, rejected or undesired outputs are converted by repair or processing. Recovery is a general term to indicate gain of resources from wastes.

Waste Disposal System Waste can be classified by two categories in terms of its disposal (i) Salvable waste They have the salvage value, e.g., scrap rejected goods, surplus and obsolete items. (ii) Non-salvable waste They have no salvage value, but need further processing and treatment for disposal.

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Outline of Materials and Purchasing Management

Disposal of Salvable Waste Scrap

Management of Surplus and

Introduction Eventually surplus is usually not an inspiring word, every manufacturer unwillingly and yet unavoidably manufactures surplus. To make matters worse, surplus is more-oftenthan-not, associated unglamorously with 'Junk' and 'Scrap' heaps. Consequently surplus is seldom considered an enchanting business activity and therefore, it rarely receives the management attention it deserves. This is highly deplorable because the total cost of production is the sum of cost outlays on labour, materials and direct overheads less any return from the successful sale of all kinds of surplus materials. Strikingly enough, often scrap volume is high enough for the proceeds of sale to rank as an appreciable secondary income source. Hence, profits can be maximized when all elements affecting costs are fully controlled.

What is Surplus? Industrial surplus is defined as those materials which are in excess of the reasonable operational requirements of the concern. Surplus is the state of an item when stock is likely to last longer than a reasonable period or when it is no longer required for use. , Surplus stock generally arises on the following occasions: (1) When purchases have been made in larger quantities than the usual requirements. However, when inventory controls pursued with one diligence, such situation will not generally occur. (2) When operations are suddenly curtailed. This applies mostly to production materials, specially, raw materials and components although tools and certain general stored items also may become surplus in this manner. (3) When, at the materials procurement, on account of some error or miscalculation that has crept in, of course, inadvertently, the wrong item has been purchased. (4) When the usual materials are rendered useless due to change in materials specifications to illustrate, if the specification normally used for manufacturing a component is EN3B2 "dia steel bar and that has been changed to EN3B3" dia or something else, the original material is, naturally turned surplus. (5) When a project is completed, some quantities of the items, used for the commissioning of the project are bound to be left out. This is surplus. To illustrate, if a building is constructed by the concern itself, it is most common to find that certain quantity of material used for the purpose, e.g., cement, steel bar, wire mesh etc., are left unutilized - they are termed surplus. In this connection, surpluses emanate from three primary sources: (a) Scrap and waste. (b) Surplus, obsolete or damaged stock items. Surplus, obsolete or damaged equipment. (c) Let us explore each of the above components of surplus.

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237

(A) Surplus from Scrap and Waste Wastage, spoilage, empty drums and bags which are not returnable to suppliers, broken and worn-out tools which are beyond repairs, irreparable parts of machinery, turning and borings from machines are all commonly termed as 'scrap.' Wastage: A residue or pieces cut of raw materials during the manufacturing process is wastage. Since, not all the materials injected into production processes are converted into finished products, surplus from production process are inevitable and common feature in every concern. To illustrate, take a company that stamps disks from the copper strip. During the operation, 10 to 15 per cent of copper is left out and that cannot be used elsewhere in production operations. This residue is called "wastage" and must be disposed of as surplus-scrap item. It is highly impossible for any firm to get rid completely of this type of surplus; however effective and intelligent production planning, handling of issue from stores and control can sizably contribute to reduce it. To illustrate, if there is a requisition for a piece of 3' x l' size steel sheet, it should be issued from cut pieces if available, instead of a large sheet. Similarly, a 2' x 3' piece should be issued from 3' x 6' sheet instead of from that of 4' x 8' and so on. Spoilage: Surplus that is generated from inefficient use of production machinery, carelessness and poor purchasing are spoilage (wastage) of resources. Items spoiled among the course of manufacture or storage are also spoilage. Spoilage may involve loss of machine hours as well as man-hours. Special care should be extended particularly during storage of perish-at-time items so that spoilage is avoided.

(8) Surplus, Obsolete or Damaged Goods (Stocks) Items which are degenerated out-of-date - mostly superseded by a better design and sophisticated technology - are known as obsolete items. It is quite unreasonable to expect sales forecasting and production planning to match exactly in reality. It is a variety, though not absolutely impossible. In case of over-anticipation, enthusiastic and optimistic sales forecasting, excess materials are found in the stores. Further, constant, continuous, sweeping, successive and rapid changes take place with its sky-rocketing pace in the designs and specifications of the materials and components. So the slow-moving items are surplus in this fast moving society. As a consequence, obsolete products and their parts constitute a continuing source of surplus materials. Besides, the lag between production planning and its actual commencement as well as commencement of production and its completion is very vital. The longer the time period in between there are more chances that either technical or product changes neatly sweep the schedule of materials. The ease with which technology can generate surplus is highlighted by the single but very eye-catching fact that in many concerns today over 50% of the products sold did not even exist just 10 years ago. Moreover, excessive forward buying as well as planned over-buying are another common and yet profound source of surplus materials. These entail the hazard of surplus from obsolescence, deterioration and errors in stock-taking and record-keeping.

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Outline of Materials and Purchasing Management

(C) Surplus, Obsolete or Damaged Equipment All machines and equipment at some pOint in their life become surplus for two primary reasons - one, they wear out with passage of time and secondly, they become technologically obsolete with the invention of better technology machines. It is, however, a normal and yet noteworthy experience of all that, in today's rapidly advancing technological system, it is the second factor above that counts for surplus rather than first one. In this sense, machines or tools seldom worn out, they have to be replaced in view of changed circumstances to avail better functioning and efficiency. In addition, the steady improvement has been a greater change particularly for capital expenditure programmes. The capital investment conceded the best and prudent in light of present state of technology is obliterated, preposterous and non-sensical with the years succeeding in future. Every manager, therefore, has been at his wit's end and makes haunting efforts to prolong the life of its capital equipment as long as possible. But for the fact of the reasons of obsolescence, breakdowns, introduction of new products or new methods of production, replacement of major capital assets even buildings becomes mandatory. For the fact that these obsolete equipment or components can be modified to the latest design or sold to the original user of the original design, they prefer but to dispose of them as surplus - even as scrap in some extreme cases.

Disposing of Surplus When the material has been categorised as surplus, it is the Reclamation Department or Purchasing Department to take charge of it. Unlike sale of other items of the organisation, disposal function is entrusted under the purview of Purchasing Department rather than Sales Department. The reason lies in that the Purchasing Department that undertakes buying of diversified materials, parts, tools equipment etc., has reasonably better knowledge of who else uses the same material, that what can be the alternative uses, and how and where the same can be put to use in own concern. Based on this set of preCise and ready information, Purchasing Department comes out disposal function with utmost efficiency and profitability. To put more Sales (Marketing) Department has much to look after its major products and in these days of keen competition, it can't afford to divert its efforts for such second grade sales function. So disposal of surplus if thrown to Sales Department would mean overburdening the back that has already been at its full swing. Doubtless to say, the Purchase Department can serve well in this regard. The information regarding the surplus item can be well served to the authority concerned in the specified form. A model of it is annexed as Annexure 1.

Disposal - Where to be made Disposal of surplus can take the following routes, to enlist the possible channels. (A) Circulation within the concern. (B) Return to supplier. (C) Direct sale to another firm. (D) Sale to dealers or brokers. (E) Sale to scrap consultants. Sale to employees. (F) (G) Donations to educational institutions.

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239

Each of the above is discussed as under: (A) Circulation within the concern: Circulation of surplus items, if surplus can be put to some alternative productive use, in the same concern is best of all the disposal programmes. This channel has some added features. Use of surplus items on the concern itself negates all possibilities of 'Bargain Loss' or 'Deal Reduction' that is a common phenomenon in other disposal programmes. Further, the administrative cost is saved to a greater extent, when the surplus item(s) is (are) put to use somewhere also within the concern, that otherwise would have been a must to get rid of these surplus in the profitable manner. (B) Return to supplier: If the surplus materials are not found useful in the concern, the next best method is to return these to the suppliers. Most often, suppliers as a courtesy to good account allow return of surplus materials. This may particularly be allowed for the items which do not perish with time and are not rendered obsolete so swiftly. Depending upon the account to trace, size of the order, material's intrinsic value, its degree of contamination etc. even scrap items are also allowed to be returned to the suppliers. This method finds favour particularly with precious materials whose residue quality (Le., surplus to the concern) is capable of same definite use somewhere else. The sum that such deed fetches mostly covers the original cost for surplus items and equals a reasonable compensation for scrap items. (C) Selling to other firms: Alternatively, the firm may resort to open market and find out some concerns using the same materials that is lying with the concern as surplus stock. The clients for surplus items encompass mostly the competitors, although some users in other spheres of activities can't be ignored. For scrap items, sales is said to be ideal when the production surplus scrap is the raw material of another concern. Compared to the first outlet of surplus and scrap, this channel is a bit costlier, since the sincere efforts to identify the alternate potential users of the concern's surplus items, to be in touch with them, to persuade and to sign the deal inevitably involves a cost outlay in items of administrative cost and human efforts. (D) Selling to Dealers-Brokers: Where the concern is not in a position to lay its access to the potential users of the surplus materials directly, the sale of such item to the dealers or agents is the best channel open to it. The dealer acts as an intermediate agency to relieve the concern of its surplus accumulation and to acquire the requirements for the users. The inlet of funds under this channel is reduced to the extent that the dealer or broker or agent charges commission. However, this method does not necessitate the cost of finding out and entering into the deal with the customer from the open air. In spite of that, such dealers constitute an excellent outlet for surplus materials. Such disposal may be effected by (1) Inviting offers from time to time. (2) Public Auction. (3) Annual Contract. When the concern adopts first method - Inviting offers at a regular interval (say quarterly, or half yearly) or as and when it thinks necessary, it releases the advertisement for the sale of surplus, in the local dailies; on 'WHERE IS AS IS' basis. The tenders from the parties interested are invited. On the basis of comparative study of the tenders received, and the organisation's specific requirement the most suitable tender is accepted.

240

Outline of Materials and Purchasing Management At the public auction, dealers bid against each other and the highest bidder is sold the surplus. Unlike inviting tenders, public auction may not be found suitable for it proves danger of bidding on mutual understanding. The annual contract system is the best and cheapest of all the methods. Under this method, a contract is entered into with the carefully selected dealer to off-take the entire surplus as may be generated from time to time during the year for the terms and conditions negotiated at the time of contract. This method has a definite and conspicuous advantage that the concern is relieved of both its rations to dispose of the surplus items in the sense that the surplus will be automatically removed from time to time. There will be no large accumulation of surplus overcrowding scrap with all possible fire and pilferage or deterioration hazard. At the same time the valuable space in the factory will be saved. Besides, the cost and efforts of the concern to trace out the most suitable dealer each time are commendably saved. (E) Sale to Scrap Consultants: The salient aspect in management of scrap and surplus items is that it is the buyer who is more well-versed and informed regarding the items than the seller. But on the other hand, though revenue received of scrap and surpluses is a sizable sum, it is quite negligible in comparison with that of the company's regular product line. Further the varieties of surplus are so diversified in grades and kinds that it is practically difficult, though not (totally) absolutely impossible for any concern to deal with them. As a solution to this, the services of scrap consultants come as a rescue. The scrap consultant renders the services of his preliminary survey for scrap and surplus items and their handling procedures. He then, on the basis of his wide experience in the profession, recommends in his report for segregating, grading, handling, weighing and accounting for the company's accumulated surplus stock. The programme is implemented under direct audit and periodic survey of the consultant by the supervisor (the person-in-charge) of its scrap and surplus programme. The negotiations from time to time with suitable parties bring a ready disposal of the company's surplus. In return, the consultant is paid a commission on sales of scrap and surpluses. This channel, though not invaded in its right perspective, can be a better outlet for surplus items. (F) Sale to Employees: Some scrap items or scrap items at times, are sold to the employees. If surplus is the result of overstocking or technical obsolescence and the materials are in new or good condition, or if they are odds and ends of scrap described by do-it-yourself employees, this can be a satisfactory method of disposal of surplus stock. On the other hand, if the surplus are not in fully satisfactory condition, such sales, regardless of their attractive price, can be a source of resentment on the part of employees towards the employer. Most of the concerns do not find this method favourable because of its inherent potential disadvantages. Many sophisticated firms do not sell used surplus to their employees. Especial/j scrap tools and equipment should not be sold to the employees, since such a concession might encourage scrapping of serviceable tools and equipment. Besides, the dissatisfaction is commonly witnessed among the employees emanating such sale. Further, it often entails a high cost of paper work and imposes an administrative burden on ensuring complete impartiality in the sale. (G) Donation of Educational Institutions: At present time, schools and colleges and even university departments actually need machine tools and other type of industrial materials for instructional use in laboratories. The disposal of surplus in this direction is a rare

Waste Management -

Management of Surplus and Scrap

241

phenomenon in the industrial realm. Though this alternative does not yield anything for the surplus or scrap items, it earns a favourable public image in the community. This is an evidence for the company's enlightened, concern with its social responsibility. In this sense, the sum that a concern has to forgo in respect of any such surplus item gifted to the educational institutions, can be very well treated as the premium to avail of higher community confidence.

Conclusion On the whole, the management of surplus and scrap has its unique features particularly for the manufacturing units which require high usage of consumable items. Processing materials are so frequently likely to be confronted (affected) with the grave problems how to yield best of the surplus items? The industries which suffer swiping and swift generation of its plants and equipments, machinery and tools on account of rapidly developing technologies from time to time are also the victims of high stock of surplus and even scrap heaps. So much so with this, scrap industry is characterised by a market of its uniqueness. In the true sense, scrap is usually, intended to be bought rather than sold. The practical bias to the management of surplus scrap accumulation reveals that no market or regular demand can be created for such surplus stocks as it is a common phenomenon with regular trade commodities. No means of advertising, howsoever effective in its application, can do well in this typical industry. The reason underlying rests that the demand is a delivered demand completely dependent on the sale of firm's products and conversely for the raw materials. As a result, when the requisitionists knock at the door, the items must be ready on hand to be delivered. Once missed the opportunity, it is incumbent upon the manufacturing unit to maintain the large inventories till another indent is received for the items from the user dealer.

Outline of Materials and Purchasing Management

242

Annexure I Surplus Plant Equipment *No.

Date: From Whom?

*Name of Equipment *Model-Size: *Capacity: *Location: *Additional information Excellent

How does it operate today? (See on the back for instructions)

Good

Fair

Poor

*Why is to so surplus/discarded/demolished/obsolete Reasons ...........................

....................... Value

Purchase Price Rs.

Today Rs. *If modernished, what would it cost? Rs. When will it be available?

*What would it cost to replace? (Rs.) *Estimated cost to scrap (Rs.), Remark

*Reviewed by

Date

Store-keeper Departmental head Accountant Works Manager Divisional Manager Mode Recommended . Hold for

futur~

Transfer

Sale

Final Decision Date

Purchase No.

Donate

Waste Management -

Management of Surplus and Scrap Annexure II Disposal of Non-Salvable Waste

243

These are processed to reduce storage, facilitate disposal to recover resources, to get conversion products and energy and to minimise the environmental effects. All wastes with no further value are ultimately disposed by the following techniques:

Mechanical Processing Volume is reduced by compaction, baling. Size is reduced by shredding. Components may be mechanically separated, especially from solid wastes.

Thermal Processing Thermal Processing reduces volumes and generates energy and by-products. Incineration converts toxic gases into harmless gases. Solid wastes are subjected to destructive distillation.

Bio-Processing Composting, fermentation, hydrolysis are commonly employed.

Ultimate Disposal Left-over wastes with no value are disposed on or in the earth (land filling) or at the bottom of the sea.

244

Outline of Materials and Purchasing Management

Annexure III Scrap Disposal Item

M.S. Scrap

Gunny Bag Scrap

Cable Scrap

M.S. Cut and Rusty Drums

Waste Material

Categories (i) Heavy melting scrap (ii) Structural and fabricated scrap (iii) Cast iron scrap (iv) Pipe and light scrap (v) Machine shop turning and boring scrap Cement Bags Sugar Bags Nylon Bags Mixed Bags (other than nylon and cement) Torn bags Copper Aluminium Miscellaneous In Chemical industries, corroded drums of different sizes. Good drum Filter Cloth

Polythene bags White Black Paper Fibre-drums

Scrap wood - Good wood from machinery packing Waste-firewood

Method of Disposal Scrap is segregated in different categories to realise better value rather than selling it as mixed scrap.

Can be sold to manufacturers directly. Segregation is essential

Clean and burn insulation Segregate. Can be given to cable suppliers to adjust its value or be sold as scrap. Sell them with light scrap.

Cut and spread them in sheets and sell as corrugated sheets. Segregate into cotton, nylon and torn categories. Dispose in separate lots. -Bundle them size wise, preweigh them.

Remove food drums and sell them separately. From the rest, remove the plywood, steel ring and sell them separately. Press the drums and sell them as fibre drum paper scrap. Keep for repacking, sell the rest Sell separately

Waste Management -

Management of Surplus and Scrap

Stainless Steel Scrap (i)

New plate and pipe cut pieces

(ii) Used pipe and other nonmagnetic scrap (iii) M.S. and S.St. mixed scrap (iv) S.St. turning and boring scrap (v) Equipment scrap. (vi) M.S. and S. St. mixed equipment and spares scrap

245 Segregate into different categories scrap from workshop to realise better value

246

Outline of Materials and Purchasing Management Annexure IV

For the past 20 years, Metal Scrap Trade Corporation Ltd. (MSTC) has developed expertise in the field of scrap by studying the market variables, the price trends, the categorisation of scrap and the demand pattern of the actual users and emerged as a pivotal body engaged in the disposal of ferrous and non-ferrous scrap in the domestic market. Today, MSTC besides acting as selling agents to the integrated steel plants arranges the disposal of scrap, surplus and obsolete stores of over 30 public sector companies. And with good reasons. MSTC arranges prompt disposal of all types of industrial, re-rollable and melting scrap, miscellaneous surplus items including machinery and equipment, barges, locomotives, vehicles, motors, bearings, tools, high-speed steel and non-ferrous scrap, etc. and thus helps in generating liquidity for the units. For speedy and efficient disposal MSTC itself conducts auction. MSTC has an uptodate set-up for collating market intelligence and price data and keeps track of supply/ demand patterns. Located in Kolkata, the nerve-centre of steel and scrap, MSTC had 3 strategically located regional offices that give you an opportunity of availing of its assistance and expertise. MSTC also has a subsidiary - FSNL specialising in scrap recovery from slag dumps. The addresses are as follows: Metal Scrap Trade Corporation Ltd. (A Government of India Company) 225-F, Acharya Jagadish Bose Road, Kolkata-700 020. Gram: METSCRAP. Regional Offices at :

Raheja Centre, Flat No. 607 (6th Floor) Nariman Point, Mumbai - 400 021 Sucheta Bhavan (4th Floor), 11A, Rouse Avenue, New Delhi - 110 002. 11 Block, Kormangala, Bangalore - 560 034.

000

CItAPTER 18

Materials Handling Equipment Raw-materials sourced from vendors are kept in the stores. These are issued to the operations department and move within the plant from one process to another. Finished products move to the shipping section. Materials handling is involved in the movement of materials within the stores, from the stores to the production department, within the production departments and to the shipping section from the production department. It is basically movement of materials from one place to another. Materials can be moved manually or mechanically. Mechanically, they are moved with the help of different types of material handling equipment. Such movement includes lifting, dropping, positioning, holding, releasing, stacking etc. Materials are moved either as a single item or in a lot. About 20% of the total production cost is traceable as the material handling cost. Thus material handling function enjoys a pivotal role in the production engineering. The relative percentage will vary according to the type of product, plant layout, production method, availability of resources like men, machines, etc. The importance of material handling under the modern production system has increased to such an extent that the production of material handling equipments itself has become a major industry of its own. Materials handling and plant layout: The physical distance and the frequency of movements of the materials in between the processes largely depends on the plant layout, i.e., the arrangement of the machines and plant services inside the plant area. The product layout with continuous system of prodction will require less time and cost of material handling. While under the process layout with intermittent production system - the to-andfro movement of the materials - possibility of waiting for the processing and necessity of the inspection for the purpose of quality control will increase the time-span of the materialstay as well as the cost of handling. Good layout is one which reduces the material handling to" the minimum. Both functions are so closely connected with each other that they cannot be considered isolated. Material handling and production control: It should be noted that material handling is a distinct activity falling within the jurisdiction of the production management. It is not a part of the production control but it is closely associated with the function of the production control. It is largely concerned with routing of function of the production control activity and to some extent the scheduling of the production activity. Analysis of the material handling problem: The material handling is an inevitable function in the manufacturing process. The material handling problem is analysed as under: (247)

248

Outline of Materials and Purchasing Management

(1)

The establishment of objective, e.g., to reduce the material handling cost.

(2)

Collection of factual data, e.g., type of materials to be handled, weight of materials, transportation area, type of material handling equipment and its capacity of handling.

(3)

Analysing the data, i.e., if the objective is reduction of material handling cost then the collected data should be arranged in such a way that it brings out the cost advantage available by reducing the transportation distance or by handling the materials in group.

It should be noted that materials handling problem should not be considered isolated but in relation to other factors, e.g., if the reduction in material handling cost increases the need for more investment in materials or reduces the quality of the product to be handled, then it should also be considered. Application of principles of material handling, e.g., to minimize the movements, (4) use of gravity principle, use of principle of containerzation etc. (5)

The formulation of solution should be drawn.

in relation to the set objective proper conclusions

Comprehensive materials handling programme: The materials handling problem is not considered isolated but is considered in the context of the following factors: (1) Type of the product; (2) Plant layout; (3) Type of production system; (4) Factory building ; (5) Production planning and control ; (6) Packaging ; (7) Material handling equipment. (1)

(2)

(3)

(4)

(5)

(6)

Type of the product: The material handling programme is largely affected by the characteristics of the product itself. The material handling services are largely governed by the bulk shape weight fragility liquidity etc. of the materials. Plant layout: Plant layout affe.cts the material handling programme in terms of the sequence of the movement and the distance to be moved during the processing. Type of production system: As compared to the continuous production system, the intermittent production system poses the specific problems affecting the material handling programme. The problems of waiting (popularly known as bottlenecks) and rushing create the necessity for reservoir of materials in substores or possibilities of slacks in the production. Both these situations have a direct bearing on the material handling programme. Factory building: The factory building with its various features like floor strength, ceiling heights, types and strength of roofs, door locations and sizes, partitions, stairs, width of the aisles etc., have a decisive effect on the material handling service. Production planning and control: Material handling function is not a part of the production planning and control. However, the routing and scheduling functions of the production control are closely related to the material handling services. The routing prescribes the sequence for the flow of the materials during the processing while the scheduling decides timings of the processing. Both these functions presuppose the availability of the efficient material handling system. Packaging: The handling of materials during the processing is facilitated through the pallets while the finished products are packed in the specific containers. Generally wooden boxes, cardboard cartons etc., are used for packaging the

Materials Handling Equipment 249 finished products. The packaging of the finished products should be of a convenient size so that they can be handled easily. (7) Material handling equipment: The material handling programme should be developed in the context of the existing material handling equipments. Their performances should be evaluated from time to time and necessary changes may be made in the light of the economic benefits available from such changes. ThuS material handling is not a sporadic piecemeal function, but a comprehensive programme having a close inter-dependence with many aspects of the industrial management.

Principle. of material handling : Material handling is a technique the efficiency of which is governed by the following principles : (1) The first principle of material handling is not to handle the material at all. The materials should be moved as little as possible. The selection of produ9tion machinery and the type of the plant layout should be such that the material handling may be eliminated as far as possible. (2) The time of each move should be minimized. This can be attained through shortest routes and use of mechanical material handling equipment in place of manual labour. (3) The distance of each move should be minimized. This can be attained through use of shortest routes and elimination of back-tracking. (4) The principle of "unit load" should be applied. According to this principle the materials should be moved in lots rather than on individual basis. The optimum number of pieces should be moved in one unit. The concept of containerization and palletisation is applied in deciding the unit load. The principle of unit load avails the economies in the form of reduced loading labour cost packing cost elimination of damage and pilferage savings in time and the effective utilization of material handling equipments. (5) The gravity should be used wherever possible as it is the cheapest source of motive power. Re-handling and back-tracking of the materials should be avoided. This can be (6) attained through proper layout and efficient routing and scheduling. (7) The appropriate material handling equipment should be selected so that the safety, efficiency and flexibility can be maintained. (8) The design of the container, pallate, drums etc., should be such that they may entail economy in handling and at the same time the material damages during the transit may be reduced. (9) The material handling service should not -interfere with the production flow. (10) The safety of the people must be taken care of. (11) The provision of the stand-by facilities should be made so that the sudden breakdown may not paralyse the operatior:ls. (12) The check-up repairing and maintenance of the existing material handling equipments should be made periodically. (13) The material handling services should be evaluated periodically and necessary changes should be incorporated whenever it is possible.

250

Outline of Materials and Purchasing Management

Types of material handling equlpments : Various types of material handling services are required to be performed during the production processes such as, (:) Lifting, holding, dropping. (if) Loading, unloading. (iiI) Positioning. (iv) Moving. (v) Stacking etc. All these services can be performed manually. However, if the modern complex production system, manual material handling is efficient as compared to mechanized material handling. Moreover it is more dangerous. So many types of material handling equipments have been developed to perform all these services. Various types of material handling equipments performing the different as well as similar types of functions are available. They can be classified on various bases, like (a) Types of equipment: (1) Cranes and hoists, (2) Conveyors, (3) Chutes, (4) Trucks, Tractors and Trailers, (5) Rails (6) Ropeways and cableways, (7) Pipelines. (b) Type of services: (1) Lifting, (2) Moving, (3) Positioning, (4) Stacking. (c) Nature of materials handled: (1) Loose, e.g., granules, (2) Pieces and parts, (3) Bulk, (4) Boxes, (5) Barrel, (6) Liquid. (d) Space of movement of equipment: (1) On the floor, (2) Above the floor, (3) Overhead, (4) Beneath the ground. Relative mobility of equipment: (1) Travel between fixed points (2) Travel over wide areas. For the purpose of simplified presentation, various types of material handling equipments have been explained in the following paragraphs on the basis of the above. mentioned classification (a) viz., "Types of equipment." Types of equipments: Some important types of material handling equipments are as under: . (1) Cranes and hoists : They lift and move the loads of varying sizes. The lifting capacity is subject to limitation. The service is available between fixed points. They are operated hydraulically, pneumatically or electrically. The important types of cranes and hoists are as under: (/) Overhead bridge crane (Fig. 18.1) (iI) Jib crane (Fig. 18.2) (iii) Gantry crane (Fig. 18.3) (iv) Electrical hoists.

Fig. 13.1 Overhead Brdl,e Crane

Materials Handling Equipment

251

Fig. 18.2 Jib Crane

Fig. 18.3 Gantry Crane (2) Conveyors: Conveyors primarily perform the movement of uniform load between the fixed pOints. There may be fixed or portable conveyors, straight or circular ones. The materials are fed to the conveyor from some other source at the point of start. They are carried by the conveyor to the point of destination. They are dropped or fed to another conveyor with or without the change in the direction of the flow of materials. They are most suited where the flow of materials is continuous. The conveyors along with the movement of materials also perform additional services like regulation of the pace of production of adjacent operations, positioning of material during handling and temporary storing of materials between the injection and ejection points. They are driven with the help of power or without the power through gravity. The important types of conveyors are as undN : (i) Belt conveyors (Fig. 18.4): It may be flat or elevatea with upward or downward flow of materials. The material of the belt should be suitable to the materials to be moved. Generally rubber covered canvass, steel plain fabric perforated sheets or woven wires are used as belts. The fixed or portable belt conveyors are used according to the requirements of the production processes and systems.

252

Fig. 18.4 Belt Conveyor (ii) Roller conveyors (Fig. 18.5): Roller conveyors are flat, circular or spiral. They are driven through gravity. Generally materials having flat bottoms are moved, otherwise boxes or pallets are used.

Fig. 18.5 Roller Conveyor (iii) Bucket conveyors: Bucket conveyors are used to move the granular, powedered or liquid materials. The movement may be vertical or flat. The vertical movement may be continuous wherein buckets are hooked in a sequential circular manner or discrete where the buckets are hooked for lifting. These handling equipments are generally power driven. The lift is a special type of bucket conveyor with a discrete vertical movement. Generally they are used for the processes housed in a multistorey building. They are also used in superstructure building construction. Generally detachable trolleys are used in which the materials are. moved. The trolleys are hooked in the lift for lifting or delifting. The movements may be made with the help of chains or ropes. (3) Chutes : Chutes are the handling equipments which are statics in nature. They handle the material between fixed points. They move the light materials and small jobs which can slide down under the gravity. The previous process feeds the materials to the chutes which are slided down under the gravity. The chutes may be straight or a spinal one. Where the sliding down process tends to be slow, the vibrating chutes are used where the materials are moved downwards through vibrations. (4) Trucks, tractors, and trailers: The trucks are used to move the heavy materials over varying paths. They are either hand-driven or power-driven. Generally two-wheeler (Fig. 18.6), three-wheeler or four or more wheeler trucks are used to carry and to move the heavy loads. They can move easily and effectively on the properly designed roads. A special mention may be made of a fork lift truck (Fig. 18.7) which is widely used by the industrial organisations. In the fork lift truck the fork is attached to the column on the

Materials Handling Equipment

253

truck. On the flat base of the fork the boxes or pallets are stacked. The fork generally moves vertically 4 to 5 feet high. The stacked pallets move along with the truck. The operator operates the truck as well as the fork till the materials are unloaded at the designated depository point. Tractors perform the same role as trucks. Trailers containing rmaterials are attached to the trucks or tractors and move along with them. Tractors are detachable. Trailers are generally two wheelers. They are nothing but the large-sized pallets or buckets. Dumpers are special types of trucks with a flexible base. The base is elevated to unload the materials. Generally they are more suited or the granular materials.

Fig. 18.6 Two Wheeler Cart

(5) Ralls: For the transportation of heavy materials inside the plant area locomotives are used as the materials handling equipment. The two fixed points are joined by the railway tracks. The wagons or trolleys containing the materials are moved by the locomotives between the two fixed pOints. These handling equipments are popularly used in steel industries where the materials to be handled are heavy and where the processes are located over the vast areas.

Fig. 18.7 Fork Lift Truck

Voltas in collaboration with Lancer Boss, U.K. has introduced recently extra heavy duty Forklift trucks upto 42 tonnes capacity. Lancer Boss known for their excellence in design and engineering, winners of 3 consecutive British Design Council awards, have a wide range of trucks for general and special applications. Lancer Boss technology is now brought to India by Voltas - an organisation which has built a reputation for manufacturing, marketing and after sales service.

254

Outline of Materials and Purchasing Management

(6) Ropeways and cableways : Like railways the materials are moved with the help of the rope or cable tracks. The trolleys are handled on the ropes and are moved vertically between two fixed points. It is the overhead device and is used in the hilly areas. Where the space cannot be spared on the floor for the movement of material handling equipment, the overhead movement of materials with the help of ropeways or cableways can solve the problem to some extent. (7) Pipelines: Pipelines are material handling devices popularly used for the movement of granular and liquid materials. Pipelines of various sizes are used for moving the liquid materials between the processes. Generally the galvanized metal pipes glass lined or stainless steel pipelines are used according to the characteristics of the materials to be passed through them. Pipelines are installed between two fixed pOints. They are concealed inside the floors or walls or are exposed and installed on overhead space where the storage tanks are mounted on ceiling area. Then the liquid materials may first be pumped in the storage tank and then are distributed by gravity flow to the pOint of use. The consumption can be controlled through the installation of meters. Pipelines can also be located inside the machines. They are popularly used in dairy industry, oil refinery, fertilizer industry, water supplies etc. Economics of materials handling: The American Society of Mechanical Engineers (ASME) has developed certain formulas for estimating the economies that are possible with the application of certain equipment to a material handling problem. The following factors in the handling costs are taken into account and are indicated by letters : (I) (i/)

(iii) (iv) (v) (VI) (vii) (viii) (XI) (x)

= percentage allowance on investment. = percentage allowance for insurance, taxes etc. C = percentage allowance for maintenance.

A B

0 = percentage allowance for depreCiation and obsolescence. E = yearly cost of power, supplies and other items in dollars.

= yearly saving in direct labour cost in dollars. T = yearly saving in fixed charges, operating charges or burden in dollars. U = yearly saving or earning through increased production in dollars. S

X = percentage of year during which equipment is used. I = Initial cost of the equipment.

255

Materials Handling Equipment

Formulas The relations between these factors are expressed in following formulas : (/)

Maximum justifiable investment in dollars (i.e., Z) I

Z = (S+ T +U-E)X A+B+C+D (iI)

Yearly cost of maintaining the equipment (i.e., Y)

(iii)

Y = I (A + B + C + D) Yearly profit from the operation of the equipment above simple interest (i.e., V)

(iv)

V = [(S + T + U - E)XJ - Y The estimated rate of profit (i.e., P) V P=-+A

I

(v)

Number of years required for amortization of investment out of earnings (i.e., H)

H= 100 P+D

Advantages of a Good Material Handling System The following advantages are availed of from the efficient material handling system: (1) Good material handling system minimizes the movement of materials, moves them continuously and at maximum rate which are advantageous as under:

(i) Shorter operating cy.cles. (ii) Reduction in handling cost. (2) It eliminates unproductive handling of materials like back tracking rehandling etc. (3) It reduces idle machine capacity thus ensuring better turn over of investment. (4) It reduces the idle time of labour - workers are required to keep pace with the production processes supported by good handling system. Moreover they are freed from physical work of moving and positioning materials. It eliminates the factory hazards and thus increases the safety of the operators. (5) (6) The quality of the materials is maintained through minimum human touches, elimination of breakages etc. (7) The factory area is used most effectively. Unproductive overhead and floor areas are used most productively. (8) It avails greater economy in store-room and facilitates material issues. (9) It helps in maintaining effective production control. (10) It helps in providing better customer services due to (/) (iI) (iii)

Reduced operatinQ cost. Better quality of products and Timely production.

000

CIiAPTER 19 Classification and Codification More-often-than-not, a large inventory with unnecessary item is a result of erroneous naming system. It becomes difficult to identify materials when they are accessed by trade or brand names. It is rational to put them into classes in accordance with their characteristics. We proceed from the general to more specific. All materials and parts which are closely related are brought together. It leads to clarity. Class characteristics are assigned numerical codes for use in storage and purchasing. Sometimes there is multiplicity of codes for the same item. It has to be avoided. Coding in a rational manner reduces the material cost, and reduces the routine work. Codification leads to easier identification, and reduces ambiguity.

Methods of Classification and Codification First of all, the basic characteristics of all materials used in an organization are studied. These materials are placed in broad classes and sub-classes. The profession is logical - from kind, type and size. An illustration can be given. Materials could be rawmaterials, work-in-process, mechanical, electrical and chemical materials, lab reagents, office equipment and stationery etc. Such broadly classified groups are given codes or symbols which are simple, flexible and easily adaptable.

Codification Systems The following codification systems are generally used: (1) Alphabetical system (2) Numerical system (3) Decimal system (4) Mnemonic system (5) Combination of alphabetical and numerical system (6) Brisch System (7) Kodak system (1) Alphabetical System: The first alphabet of the name of the material becomes the starting point of codification. Codes are allotted to alphabetically arranged groups of material. (256)

..

Classification and Codification 257 The grouping is on the basis of its nature and use. The class of each item is indicated. The following example would make this clear. Class: Raw Materials

Group

Iron Iron Iron Iron Iron Iron Iron

Code

Bar, MS Bars, Bright Steel Mould Melted Ore Pig Sheets, MS

IR-BA-MS IR-BA-BS IR-MLD IR-MEL IR-OR IR-PG IR-SH-MS

The system is prone to duplication. Coding mistakes are likely. It is suited only when there are limited number of items. (2) Numerical System: Numerals, either single or blocks or with dash/stroke are assigned to the items. For instance, Materials Raw Materials Iron melted Iron pig

Simple Number 01 05 06

Block Number 1-1000 1-10 11-20

Dash/Stroke 15 15-1 or 15/1 15-2 or 15/2

Simple number is assigned to each material. There is a provision to keep some other number aside for other items. Blocks group items of similar nature under one block, e.g., raw materials under block 1-1000', oils and lubricants under 1001-2000, packaging material under 2001-3000 and so on. All these blocks are sub-divided, e.g., metallic sub-blocks of iron, copper, nickel, steel etc. Each sub-block can continue like 1-100,101-200 and so on for the respective metals. Dash/stroke number improves upon the block system. The main element or material is separated by a dash-stroke. In short, numerical system consists of groups and sub-groups with digits assigned to them. illustration of Numerical System: The basic digits for machine bolts may be 38, and the next two digits may indicate the diameter. Additional digits can be added to deSignate length. Code No. 38161 383815 38782

Part Description Machine bolt, 1/6" dia 1" long Machine bolt, 3/8" dia 1Y:z" long Machine bolt, 7/8" dia 2" long

(3) Decimal System: Decimal system utilizes digits between 0-9. Each digit has significance. Usually 7-8 digits are enough to cover all items. These can be extended to 10 digits to accommodate any characteristic of the material desired to be described. The material is put into a broad class, then a group, subgroup, type, size, grade, shape, condition etc. The digital numbering will be proceeding from the broader to the narrower characteristics. This is sequential numerical decimal system of coding. The following diagram illustrates this :

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Outline of Materials and Purchasing Management

x

X .X Condition Shape

L - -_ _ _ _.

Grade Size

' - - - - - - - - Type Sub-group ' - - - - - - - - - - Group L - -_ _ _ _ _ _ _ _ _

Class

Fig. 19.1 Dlgltsl Code Structure

1f

If any class demands more than 10 subdivisions, the one-digit decimal system can be replaced by two-digit system. The following diagram illustrates this. .

X

X X X XX XX XX

CondItion

Shape L - -_ _ _ _ _ L - -_ _ _ _ _ _

L - -_ _ _ _ _ _ _ _

L - -_ _ _ _ _ _ _ _ _ _ _

L - -_ _ _ _ _ _ _ _ _ _ _ _

Grade Size Type Sub-group Group

Class

Fig. 19.2 Digital Code Structure with Two Digits for Certain Chllrac __tlcs.

In an engineering unit, the materials can be put into 10 broad classes : Raw materials (0) Steel sections (1) Castings, forgings (2) Mechanical assemblies (3) Work-in-process (4) Electrical equipment (5) Capital machinery (6) Jigs, tools, fixtures (7) Fuels, lubricants, chemicals (8) Miscellaneous (9) Correct placement of decimal pOint is very important. Wrongly placed decimal point will make the whole system disorderly.

259

Classification and Codification

Illustration An automobile company assigns the number 15 to an assembled wheel. The following codes describe the component parts.

Code No.

Part Description

15.1

Tyre

15.11 15.111

Valve stem Valve

15.112

Valve cap

15.2

Brake drum

15.3 15.4

Nuts Disc

15.51

Inner bearing

15.52

Outer bearing

(4) Mnemonic System: Mnemonics are the alphabets which help memorization, e.g., Ms stands for Machine Screws. There can be further additional letters to indicate the metal, e.g., MSC stands for Machine Screws Copper. In mnemonic codes, parts also may be included, e.g.:

Code

DescrIptIon

EFl

Electric Fan large

EFS

Electric Fan Small

EFM Electric Fan Medium (5) Combination System: Mnemonic and numerical or decimal system can be combined. A plywood manufacturer can code 'it as follows:

Code No.

DescrIption

PW 161

Plywood 1/6" thick 1st grade

PW 122 PW 381

Plywood 1/2" thick 2nd grade Plywood 3/8" thick 1st grade

(6) The Brlsch Classification: The codes in Brisch Classification are wholly composed of numbers, are of constant length and generally contain six to eight digits. The first digit covers a broad classification of all the materials into 10 main classes and the value ranges from Zero to Nine and indicate the classes concerned. For example, in an engineering organisation, the classifications are: (0)

Organisation and operation

(1)

Primary material

(2) (3)

Brought out commodities Components to user's own design

(4)

Sub-assemblies and assemblies

(5) (6)

Tools and portable equipment Plant and Machinery

(7)

Building and Utilities

260

Outline of Materials and Purchasing Management

(8)

Scrap

(9)

Reserved

Each of these divisions are broken into sub-classes, and each of the sub-classes are divided into finer classes till the final symbolic description of an item is complete. An Example of a SlgnHicant Code: 10 3 05 1510

Hand Tool

~

Punch . Shank Type - - - - - - - - - - '

Dimension

Fig. 19.3 In the above example, the first two digits denote the major group. The major group can accommodate 100 classifications. 1st and 2nd digits

-

Major Group

00 01

-

Raw Materials Vacant

02 03

-

Packing materials lab Chemicals

04-05

-

Civil Stores

56-49 90-96

-

General Stores

97

-

Spares Scrap

98

-

Stationery

99 - Finished goods now 06-49 can be classified as: 06-13

-

Tools

14-39 40-49 06-13

-

Hardware and consumables Electric item Comprises of the following groups:

06

-

Cutting tools F.inishing tools

-

Hand tools

-

Measuring tools Vacant group

08 10 12 07,09,11,13

261

Classification and Codification

3rd Digit: Sub-group of Major Group (for Hand tools) o - Hammers 1 - Chisels .2 - Blades - Punches 3 4 - Wrenches and spanners 5 - Pliers 6 - Screw Drivers 7,6,9 - Vacant sub-groups 4th & 5th Digits: Type (for Punches) 00 - Neck Punch 01 - Eyelet Punch 02 - Handnail Punch 03 - Nail Punch - Starting Punch 04 - Shank Punch 05 06-99 - Vacant 6th, 7th, 8th & 9th Digits denote the dimension of the Punch, 10th digit may be included as a check digit which can be computed in many ways. For example, multiply the first digit by 9, the second by 6 and so on and sum the product. Divide the values by 9 and the remainder is the check digit which can assume values from 0-9. In the end it must be added that the task of assigning codes to new items must be centralized and consistent, so that uniformity is ensured. (7) Kodak System: This system has been developed by Eastman Kodak Co. N.Y., USA. It is a versatile system. Instead of using decimals, it uses hypes. It is also a numerical system. The basis of classification is the purchase category. Each group is assigned numerical code. Sub-grouping is done as usual. A 10-digit numerical code is used to indicate three groups where each group is separated by hyphens, e.g., xxx-xxxx-xxx. There are 100 basic classifications of all materials. The first two digits 00-99 denote the number assigned to any class to identify an individual item. Each class is divided into 10 sub-classes, alphabetically arranged. It denotes the third digit. Within each sub-class, a kind of item is denoted by significant numbers such as 00, 10, 20, 30, 40 upto to 90 and these are arranged alphabetically. This constitutes the 4th and 5th digit of the numerical code. This system is flexible enough to accommodate 10 times more items of new\ kind without any hitch. The 6th and 7th digit of the code denote the types The 6th and 9th digit are given to the sizes. The 10th digit is left free to incorporate any minor variation.

Illustration First Step: Materials are placed in groups: Class Code

00-10 11-20 21-30

Name of the Material

Raw Materials Capital goods Mechanical goods

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Outline of Materials and Purchasing Management

31-40 41-50 51-60 61-70 71-80 81-90 91-99 Second Step: We select a class of

CIsa Code

Electrical goods Chemical equipment Chemical goods Furniture Office materials Fuels, lubes Miscellaneous mechanical goods (21-30) and sub-classify it.

Items

21 22 23 24 25 26 27 28

Hand tools Cutting tools Machine tools Millstones Abrasives Hardwares Nuts and bolts Fasteners and so on Third Step: Within each class, we can arrange the kinds. We select the sub class of hand tools for this purpose.

C/sss

Sub-Class

Kinds of Tools (Handtools)

21 0 Spanners 21 1 Wrenches 21 2 Pliers 00 00 00 00 00 00 00 00 00 00 00 00 21 9 Hammers With digits assigned for kind and type, the code works as follows: 210-xx xx-xxx 210-00 xx-xxx 210-10 xx-xxx 210-20 xx-xxx 210-30 xx-xxx xx-xxx 210-40 210-50 xx-xxx 210-60 xx-xxx

263

Classification and Codification

210-70 210-80 210-90 Digits assigned to kinds. 210 xx 210 00 210 00 210 00

xx-xxx xx-xxx xx-xxx xx 00 10 20

xxx xxx xxx xxx

210 00 90 xxx Digits assigned to types. Fourth Step: Size is assigned after kind and type. Each type is arranged as per the size by assigning numbers in a descending order. They form 8th and 9th digits in the code.

Advantages and Disadvantages of Codification A rational codification system helps correct identification, are events overlapping and decreases variety. It makes record keeping easier. Inspection is rendered easier. The' major disadvantage is that it is often misunderstood. Whenever there is error, deciphering the code becomes difficult. Moreover, over-crowding in a group may lead to confusion.

000

CIiAPTER 20 Purchas'ing Personnel Management In the wake of the introduction of new processes and patterns of internal administration and control and rapid changes in production technology, it is inoperative that the production techniques and raw material components be watched and re-evaluated constantly. ABC analysis, EOQ (Economic Order Quantity), EDP (Electronic Data Processing) etc., are of considerable help for the interfunctional cooperation in the purchasing arena. These changes and many others have resulted in a "new breed" of purchasing personnel. They are at par with other company executives as far as the chara-cteristics/traits necessary for success, education and experience are concerned. This chapter deals with personnel management matters as they apply to the purchasing department. Such personnel management can be described as the job of procuring, developing, compensating, integrating and maintaining the personnel of the organization with the objective of securing maximum production with the minimum of effort and friction, and with a proper regard for the well-being of the individual. The following can be said to fall under the scope of this chapter: (1) Role and responsibilities of purchasing personnel. (2) Qualifications for purchasing. (3) Recruitment and selection. (4) Induction. (5) Training. (6) Compensation.

Role and Responsibilities of Purchasing Personnel In an industrial unit, purchasing personnel have a sound footing because the whole organization is based upon the purchasing activity. Therefore, he should be well-conversant with the job, industrious, tactful and intelligent. There is nothing wrong if I say that there are three main functions of an industry Purchasing, Manufacturing and Selling, where purchas~ng precedes the rest. So it is extremely important that purchasing is planned well and is co-ordinated with other functions. This adds to the responsibilities of purchasing personnel. (264)

Purchasing Personnel Management 265 All the activities starting right from the letter of intent or ordering of the commodity to the verification as to the goods received are as per the order, fall under the purview of purchasing agent. Firstly, the letter of intent comes to the purchasing agent. He verifies its authenticity and confirms that the order placed is for right quality, right quantity and at right may make relevant time. If he feels that the order is proper, he endorses it or else change in it. Then he chooses the supplier and places an order and sees that the goods are received at right time and at right place. However, there are a few suggestions to make to avoid certain loopholes in the above process: 1

ne

(1)

The authority to place an order should not be vested in the hands of a single person. Instead, a group of two or three persons should be authorised for the same. (2) There must be two or more than two suppliers to choose from so as to avoid certain malpractices. (3) Annual purchases should not be made for every commodity. (4) If there is a "tender" system, then whoever accepts the tender should be authorised to open it. (5) The supplier should be disbursed in full in the stipulated time limit. (6) If the goods are rejected, then they should be despatched to the supplier as soon as possible. (7) The organization should keep an eye on the person, authorised to reject the goods so that he does not misuse his power. (8) The purchasing agent should constantly look for cheaper and better goods. (9) If a single person is vested with the authority of ordering and rejecting the goods, then the organization should not rely fully upon his decisions because individual's decisions are likely to be biased or may turn out to be false in certain cases. (10) The purchasing agent should try to build contacts with new parties and maintain friendly relations with older ones which can supply the goods at a cheaper rate. (11) Overstocking and understocking should be avoided. The purchases should be made at right time, for right quality and quantity, and at right place. (12) The records should be maintained properly. It is obvious that the purchasing personnel can help the organization save a lot if he is a bit more careful about his duties and responsibilities.

Qualifications for Purchasing Position The qualifications for individuals who aspire for Purchasing Agent position or Purchase Manager Position may be categorised as under: (1) Personal characteristics. (2) Education. (3) Experience. The personal characteristics or traits required of purchasing personnel resemble to those in any other field of business. However, the degree of importance attached to each

266 Outline of Materials and Purchasing Management trait may differ. The following is the List of major traits and so no attempt has been made to make it exhaustive.

Job Knowledge: The purchasing personnel must be well-conversant with the job. They must thoroughly know their functions, role and responsibilities. This is by far the most important characteristic. (2) Initiative and Imagination: Purchasing personnel are constantly faced with situations which call for initiative and imagination. The continual search for alternative sources of supply or alternative materials is but one area where initiative is important. It also frequently happens that unexpected requirements necessitate locating materials and supplies in unusual places and on short notice. (3) Decision making ability: It also requires due consideration as a manager has to take sound and practical decisions. Secondly, he has to arrange to take calculated risks to take responsibility for his decisions. (4) Dependability: It is very much possible that the stresses and strains of the job may break down the person. So purchasing personnel should be able to withstand the odds and should fulfil one's expectations. (5) Planning and organizing capacity: Pre-planned and well organized activity can contribute a great deal towards cost reduction. Therefore, abilities to plan and, organize work so as to make best use of men, materials, machines and other resources available are taken into account. (6) Controlling ability: Establishing the standard of performance, observing the deviation and introducing corrective actions form an important part of the purchasing personnel's function. (7) Leadership: Purchasing personnel should strive to develop in others desire and willingness to work together for the attainment of common goals. (8) Tact: Many purchasing agents consider tact the most important single personal characteristic. The reason for this is the crucial importance of maintaining sound and friendly vendor relations. A tactless person may inadvertently antagonise a supplier whose goodwill and co-operation have been cultivated over many years. (9) Learning ability: A good purchasing agent must have an inquiring mind. He must always be seeking information about his company's products and processes and must study the suitability of every supplier's offerings. He must constantly learn more about his company's requirements and the availability of alternatives for meeting those requirements. (10) Cost consciousness: Purchasing agent can save a good deal of his company's money if he properly plans the purchase and, if he is a bit more cost conscious. (11) Creativity: The purchasing agent should have innovative abilities. He should contribute new ideas for finding out new ways of working. (1)

Education No one type of educational background is universally considered to be best for developing the qualifications of a student preparing, for a career in purchasing. However, a trend towards employing college graduates is distinctly evident in today's hiring practices. Organisations prefer management qualifications with specialisations in materials and

Purchasing Personnel Management 267 purchase. Institute of Materials Management also conducts specialised courses-both regular and through distance education.

It is more advantageous to employ such college-trained individuals because they are likely to bring with them sound educational background. Such theoretical knowledge, when applied to actual business operations, would prove very, very useful. Secondly, they require less time for getting trained in particular field. Moreover, they are generalists, which means that they have definitely an edge over others.

Experience Business experience is almost universally considered to be necessary for purchasing personnel in the higher-ranking positions. The experience may be acquired in lower ranking jobs in purchasing, or in related business fields such as selling, storekeeping, production or office-management. Some larger companies secure employees for positions above the clerical level by building up a pool of college-graduate trainees. These trainees are enrolled in an extended programme of indoctrination and on-the-job training, which relates them through the major sub-divisions of the company. During the training period those with an aptitude for and an interest in purchasing work can be selected out of the larger group and eventually assigned permanently to the purchasing department.

Recruitment Recruitment is the process of searching for prospective employees and stimulating them to apply for jobs in the organization. It is termed "Positive" as its objective is to increase the selection ratio, that is, the number of applicants per job opening. (a) Sources of Employees: The sources of employees can be classified into two types: Internal and External. Filling a job opening from within the organization by way of internal transfers or promotion, has the advantage of increasing the general level of morale and providing more information about job candidates through analysis of work histories within the organization. Further they need not be inducted as they are aware of the organization. Finally, the individual who has been transferred from any other department, say production, is likely to bring with him considerable knowledge that will be of material help to him and to his department. (b) Recommendations: The purchasing personnel hired through the recommendation of present purchasing employees or others within the company occasionally prove successful because employees in the department are aware of the traits desirable for purchasing work, and if they are persons of sound judgment, their recommendations are likely to have merit. (c) Advertising: Advertisements furnish the majority of recruits from external sources. Such advertisements generally results in a large number of responses but frequently not many from promising prospects. Even when job-specification and job-summary are included in the advertisement to permit self-screening, there will be a large proportion of unacceptable applicants. The main advantages of this source of recruitment are: (1) Advertisement can be placed in media read by particular groups, e.g., Auto Guide is generally read by persons who are related with automobiles in some respect or other.

268

Outline of Materials and Purchasing Management (2) To enable a firm to reach men who are currently employed somewhere else. (d) Employment Agencies: The applications can be sought by using the employment agencies both public and private. Public employment agencies have proved their worth in the fields of unskilled, semiskilled and skilled operative jobs. In the technical and professional areas, however, the private agencies appear to be doing most of the work. The public agency and selected private agencies provide a nationwide service in attempting to match personnel demand and supply. (e) Campus Interview: The use of college and university placement offices for securing purchasing personnel is increasing in importance as the trend towards employing college graduates in purchasing positions continues. This is a highly specialized form of recruiting and most of the large companies that now use this source recruit simultaneously for a number of different divisions within the company. College recruiting is frequently handled by the personnel department of the firm. Many colleges and universities have facilitated the recruiting of employees by establishing placement bureaus, providing facilities for interviews, securing recommendations of faculty members and compiling records of scholastic achievements of applicants. (f) Casual Applicants: Unsolicited applications, both at the gate and through the mail, constitute a much used source of personnel. These can be developed through provision of attractive employment office facilities and prompt and courteous replies to unsolicited letters. (g) Nepotism: The hiring of relatives will be an inevitable component of recruitment programme in family-owned firms. Such a policy does not necessarily coincide with hiring on the basis of merits but interest and loyalty to the enterprise are offsetting advantages.

Selection Procedure In the hiring procedure varying methods are used to discover significant information about an applicant, which can then be compared with the job specification. Though there is no standard procedure adopted by all firms, the following is an example of a typical method: (1) Preliminary interview, (2) Application blanks, (3) Reference checks, (4) Tests, (5) Employment interview, (6) Physical examination, (7) Final selection. These steps are not always followed by all the firms. Some firms may not find it usefOI to keep physical examination or preliminary interview whereas some other firms may add to the above list by introducing one more step, that of supervisor's approval. Preliminary Interview: The preliminary interview is usually very short and has as its object the elimination of the obviously unqualified. The more obvious facts and impressions are of the type generally obtained in an initial interview. Appearance, facility in speech, health, suitability for the post etc., are quickly evaluated. Applicants are often asked why they are applying for a job with this particular organization. Salary requirements are ascertained. Many firms do not bother to initiate any paper work at this early stage. If the applicant appears to have some chance of qualifying for existing job openings, he or she is given the application blank to fill up.

Purchasing Personnel Management 269 Application Blank: There is a striking similarity in the application blanks used by most of the concerns. That is precisely the reason why it gives one the impression of "When you have seen one you have seen them all." Such blanks contain a number of questions designed to secure backgr0l1nd information about the applicant that will be useful in evaluating his qualification and capacity for the position under consideration. These questions relate to such matters as the applicant's personal and family background, his health, his educational and work experience and his current family and living conditions. Correctly structured questions when properly evaluated aid immeasurably in the evaluation of an applicant. The use of application blanks before interviews enables a company to weed out those applicants who are obviously not qualified for the post. So there is no use in allowing them to appear in interviews and tests. Secondly, the application blanks serve as a good starting point for the interviews and provide a sound basis for verifying the honesty of the applicants. This is accomplished by formal or informal checking on some of the statements made on the blanks and by consulting the references given. Recently, there is a trend towards using weighted application blank. The relationship between certain biographical data ordinarily requested on the form and success on the job is studied. If the specific value of any of the factual items can be determined, these items can then be weighted. In general, the approach is that of studying carefully the qualities of both-your present successful employees and unsuccessful ones. If one group possesses certain qualities and other does not, these may well be distinguishing characteristic. The weighted application blank must be established and used with caution. First, objectives must be determined. Many firms have established as the prime objective the selection of more stable workforce to decrease labour turnover. They have discovered and utilized the particular data that denote stability - facts relating to marital status, sex and age. A second problem is concerned with the breadth of coverage of any particular factor in success. The factors which have been found to be useful in predicting success of one organization may not turn out to be of any utility to another conglomerate. So every firm must develop its own application blank. Further, no firm should try to select an employee solely on the basis of one or two important facts. The application blank constitutes only one step of a long and complicated hiring procedure. Besides, no one factor on a blank is weighted sufficiently to have great impact on the final decision. However, one thing should be remembered that weighing is just one more attempt to improve the accuracy and the selectivity of the various steps in the hiring procedure. References: There is a raging controversy as regards to the utility of the reference checks in selection procedure. Some managers feel that little usable information is obtained, owing to the reluctance or inability or refusal of the reference giver to cite factual information. Others believe that if references are checked properly, a great deal can be learned about a person that an interview or tests cannot elicit. Experience tells that the closer one can get to the reference-giver, the more accurate and valuable is the information obtained. That is the reason why personal visit is more useful than any other methods like checking on a telephone or writing a letter of reference etc. Psychological Tests: The next step in the procedure outlined above is that of testing. There is dichotomy among employers concerning the value of tests. Again, there is a great diversity of tests available. All psychological tests used for selection may be conveniently divided into three categories: Intelligence tests, Personality tests and Aptitude tests.

270

Outline of Materials and Purchasing Management The use of intelligence tests is based on the assumptions that intelligence can be measured and that there is some relationship between intelligence and success in purchasing. However, neither of these two assumptions has been proved beyond doubt. There are a number of tests that can be used for measuring intelligence. Some measure mechanical intelligence (the ability to manipulate objects), others measure abstract intelligence, and still others measure the ability to understand people (Le., social intelligence tests).

Personality tests are used to rate an applicant on such traits as self-confidence temperament, emotional maturity and other personality traits that would appear to be important as a measure of success. Interest tests are designed to reveal the extent to which an applicant's interests coincide with those of people who have been successful in the field. Aptitude tests are designed to measure the natural ability of an applicant in the field for which he is applying and his inherent fitness for the work. Aptitude tests have been found to be quite reliable in measuring mechanical or clerical abilities, but in testing for positions requiring judgment and mental abilities, the aptitude tests have not proved to be of much value. The selection of personnel through psychological tests is in an early stage of development. Such tests, therefore, should be viewed as a supplement to established procedure and the results of tests should be compared with later success on the job. If this is done for enough people over a sufficiently long period of time, it may lead to validation of some of these types of tests. So that at a future date they may become a more reliable selection device. Employment Interview: The basic purpose of the employment interview is to obtain significant information about the applicant. Sometimes it happens that no other step can adequately extract the desired information and that there is no alternative but to resort to such interviews. And, in fact, it gathers much highly subjective as well as important information. However, the purchasing agent should understand that it is as important for him to sell the company to the prospective employee as it is for the applicant to sell himself to the purchasing agent. In order to accomplish these, the purchasing agent must get the applicant to talk freely. This can usually be achieved by discussing the job and the company for a short time until the applicant feels at ease, and then asking questions designed to get the applicant to talk about himself the subject he is most familiar with. An important element in a fruitful interview is a detailed plan of the ground to be covered during the interview. It is due to this reason, that experienced companies have introduced patterned interviews. Some companies have also introduced depth interviews and stress interviews, each one having its own merits and demerits. Physical Examination: The physical examination is an employment step found in most business. It can vary from a detailed examination and matching of an applicant's physical capabilities to job requirements, to a simple check of general physical appearance and well-being. There are at least two objectives behind such physical examination. Firstly, it serves to ascertain the applicant's physical capabilities. Can the applicant work continuously for 8 hours? Can he lift 10 kilograms weight? Is his eyesight normal? etc. Secondly, it is like a check-post which prevents infectious diseases from entering into the organization. It is obvious that this is a continuing objective and will constitute part of regular workload of a medical department after personnel are hired and placed. In the suggested pattern of selection, the physical examination is located near thE end. It does not mean that this sequence should be rigid. Some firms place the examinatior relatively early in the process.

Purchasing Personnel Management 271 Selection and Placement: With physical examination, the selection procedure comes to an end. The company rejects those who are unsuitable and retains those who have successfully crossed all the hurdles. This is called final selection. After a person is selected, he is placed on a suitable job. This is called placement.

Induction The induction function immediately follows placement and so sometimes it is considered to be part and parcel of hiring procedure. The new employee is likely to start his job with enthusiasm and zeal. So it is absolutely necessary that his initial enthusiasm and hope is kept alive in order to enable the employee to maintain a high level of performance over a period of time. Quite often the employee loses the enthusiasm as time lapses and settles down to an uninspiring and gloomy routine. To avoid this, induction programme is a must. So induction is concerned with the problem of introducing or orienting a new employee to the organization. He is made aware of the organizational objectives, policies and procedures etc. Training: Training basically means a programme of progression through. various purchasing duties until a satisfactory degree of competence has been acquired by the trainee. The major objectives for training the purchasing personnel are: (1) To increase the effectiveness of purchasing department. (2) To boost the morale of an individual. (3) To widen the span of control. (4) To reduce the costs involved in purchasing. (5) To increase the organizational stability and flexibility. Enhanced knowledge would naturally lead to greater effectiveness of an individual. If a person knows the fundamentals, he is sure to do the job in a far better way than a layman; same rule is applicable here. Secondly, the possession is needed as security and ego satisfaction consequently boosting one's morale. Thirdly, a. person who knows his duties and responsibilities would naturally consume less time of his boss, thus, indirectly helping to widen the span of control of his superior. Fourth, objective does not need any explanation as it is based on the principle that a well informed person would be able to find the ways and means to do a particular thing. Further, it is one of the major functions of purchasing personnel. Lastly, the ability of an organization to sustain its effectiveness despite the loss of key personnel can be developed only through creation of a second line of trained replacements. Thus the stability can be ensured.

Training Techniques The training techniques can be classified jnto three types: Formal education or university training. (1) (2) Training new employees. (3) Training the existing work-force. Formal Education or University Training: Again there are, three types. The first type includes the degree-diploma courses with some sort of specialization in purchasing, e.g., B.B.A. or M.B.A. with Materials Management as special subject. Thus, a student may join such programme and get specialized in the field of purchasing and materials. After that he may join any conglomerate and part with the benefit of his knowledgl

272

Outline of Materials and Purchasing Management The second type of training for purchasing sponsored by educational institutions consists of extension courses or special programmes, e.g., evening classes run by certain universities, or certificate courses run by certain private institutes. Such programmes are found to be fairly useful in imparting basic skills and knowledge. The third type of formal training consists of special short-term crash programmes designed by the universities or f.l.M.'s etc. They are usually ranging from the time duration of one week to one month. This training is designed specifically to meet the needs of experienced purchasing personnel. It may also involve seminar presentation. However, such programmes are hardly found to be of any material use. The reason behind it is that usually they are of very short duration. Secondly, the participants become egoistic. They feel they are superior to others with a sad result of deteriorating performance. Training New Employees: New employees are like raw materials introduced in a manufacturing process. For converting them into finished output, they have to be trained in certain aspects in which they are found to be lacking. Such training caD also be termed as job-training. There are various methods for training new employees.

The first method is on-the-job training. Under it, the worker is put on a machine or on a specific job in the factory. He is instructed by an experienced employee or a special supervisor. No special school has to be opened for the trafnees. Even in the course of their training they continue to add to the output. Usually the experienced workers acting as instructors have neither the time nor inclination nor the competence to provide suitable instructions to the trainees. The method can, therefore, be successful only if the trainees are well qualified and show enough interest in the trainees. The second method is vestibule training. A vestibule is the entrance through which one has to pass before entering the main rooms in a house. In vestibule training, therefore, the workers are trained on a specific job in a particular portion of the plant premises. An attempt is made to create working conditions which ·are similar to the actual working conditions. After training employees in such conditions they may be put on similar jobs in the organization. This enables the workers to secure training in the best methods of work and to get rid of initial nervousness. The third method involves semi-formal classes or seminars. This method can be fairly useful if the beginners from several companies are collected into groups and taught under combined auspices or with the aid of a convenient college or university. The seminar method is usually best for handling the continuing training of experienced personnel. This method works best with a small group of five to twelve persons and relies heavily on group partiCipation in the discussion rather than on the lecture method of teaching. One variation of this method is case-study. It was first introduced by Harvard School of Business, later adopted by I.I.M.s and other institutes. Under it, the partiCipants are given a case to analyse and find out the problem underlying and the best solution to solve that problem. Usually there are more than one solution and so the skill lies in selecting the best one out of them. . Another variation is known as role-playing. The individuals taking part in the training are assigned specific "business parts" to be acted out in some typical situation which has been previously planned by the instructor. If skilfully planned and executed, the situation can be made so realistic that the partiCipants forget that they are playing a role and act as they would in a real situation. The leader of the session can point out the strong and weak pOints of the performance after it is over and thereby enable the trainees to learn by doing. However, it is not suited to all the subjects that must be covered by a training programme, but it does serve as a stimulating supplement to the usual methods of presenting training

Purchasing Personnel Management 273 materials. Principles, policies and procedures are examples of matters that must be covered by means of lectures or round-table discussions. Training Existing Workforce: Success of any organization generally and largely depends upon the skill, knowledge and capability of the existing workforce. Therefore, if they are found lacking in these respects, they need to be properly trained. Such training is also effective for their advancement to higher-ranking positions within the department. Such education is based on the fact that learning never ceases. Even with a stable and successful purchasing department, it is sound practice to continue the training of personnel throughout their business careers. The first method for training existing workforce is informal group discussions. However, a point to be emphasized at this juncture is that it should not be dominated by the older employees. At the same time it should be coordinated in such a way that actual training is accomplished. Again, the participants should be enough motivated for such group discussions. Otherwise, it will turn out to be a farce. Further the participants should forget their individual differences for the time being otherwise the whole session would be diverted from its purpose.

The second technique i.s that of job-rotation. However, a major setback of this technique is its prerequisite. It pre requires a company large enough to permit job-rotation. It involves, as its name suggests, rotating a person from one job to another after a stipulated time limit. Thus he learns that duties and responsibilities of various jobs by his own experience and consequently becomes better qualified for promotion. The third technique is that of talks and lectures delivered by business leaders or professional associates sponsored by such groups as the local management association or chambers of commerce etc. Trade papers and pamphlets on pertinent purchasing subjects also provide substantial training to experienced personnel. Finally, some universities sponsor training sessions and institutes that provide a valuable means of keeping abreast of new developments in the field of purchasing. Compensation: The most popular method for compensating personnel is straight salary method. It involves paying per unit of time worked rather than per unit of work performed. This is because of the fact that it is very difficult to measure the performance of an individual. It is too subjective to be measured. However, if the company wishes it may introduce the job-evaluation system and compensate the purchasing personnel with it. In both the above cases, upward revisions in the rate of compensation may be made from time to time, depending on general salary level, quality of employee's work, company policy and other business conditions. For the same purpose, performance appraisal can also be introduced so that the employee can be advised of his shortcomings and rewarded for his improvement with a salary hike. It can also be used to measure one's relative proficiency and ability. Purchasing personnel are also entitled for the companywide bonus or incentive plans. However, such plans are, almost invariably related to company profits. Intangible Compensation: Purchasing personnel receive intangible rewards which others miss. Firstly, the challenging and rewarding meetings with salesmen and other representations of sellers give them "inner" satisfaction. The buyer is in a position to award business to the seller and as a consequence receives the most courteous and attentive solicitude of the seller's representatives. Secondly, they derive satisfaction from the authority which is delegated to them. They are authorised to spend large sums of their company's money (as it forms one of the

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three major functions). Other two being production and sales. Another real benefit received by purchasing personnel is the opportunity to gain an overview of the firm's operations and the inter-relationships and interactions of the various departments within the firm. Again, because of its close alliance with production and sales, its help is constantly sought by these departments in finding new or alternate materials, securing technical assistance, determining sales or marketing trends or even joining with the company's sales representatives in a presentation to a customer who is, also a supplier. This variety of endeavour and feeling of accomplishment and self-importance are challenging, rewarding and satisfying.

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CIiAPTER 21 Evaluation of Purchasing Performance 1. EVALUATION IN GENERAL (A) Introduction Purchasing is a service function. Like all other service functions, the fundamental objective of purchase department is to provide the efficient services with minimum costs. Moreover, it should also endeavour to improve and maintain high employee morale resulting into initiative and extra efforts. Creation of any form of organizational set-up baSically considers the cost benefit analysis. To justify, the existence of any department or section, the benefits must outweigh the costs. Over and above the establishment cost of the purchase department, the following costs should also be considered: Over expenditure on items purchased or services obtained. (1) (2) Cost of stock-outs. (3) Cost of failure of efficient negotiations and obtaining favourable terms and conditions. (4) Cost of failure to supply information to management and other needy departments. Additional cost of expediting the procurements. (5) (6) Cost of not providing satisfaction to outside customers. (7) Cost of failure in excessive stock piling. (8) Cost of failure to dispose of surplus or obsolete plant, equipments, materials or scrap at the maximum price. (9) Cost of measuring the efficiency of the purchasing department.

(275)

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(8) Need for the Evaluation Evaluation is a control function, which tends to be a continuous one. However, the specific need of the evaluation arises due to following reasons: (1) Management fails to identify any problem, but is dissatisfied with the current affairs. (2) Numerous complaints are received from various departments. (3) Numerous complaints are received from the vendors and outsiders. (4) The cost of purchasing operations seem high. It seems that the purchasing department is overstaffed. (5) (6) The integrity of the purchasing staff has become questionable. (7) The operations may seem efficient, but it may be at the cost of the employee morale. (8) Failure to achieve planned progress. (9) The need of the management to have performance records for subsequent reviews. While evaluating the performance of "the purchase department, it should be clarified that whether the performance should be measured in terms of quantity or quality. Of course, the simultaneous consideration of quality and quantity gives better results. Similarly, it should also be specified whether the evaluation shall be done by internal staff or by the outside agencies. It also becomes necessary to select the most appropriate method from among the methods available for measuring the performance of the purchasing departments. All these aspects are considered in the following paragraphs:

(C) Qualitative and Quantitative Evaluation The important quantitative aspects which should be considered while evaluating the purchasing performance, are as under: (1) The favourable price advantage should be considered in terms of advantage through favourable negotiation, competition, cash and quantity discount. (2) Value analysis suggested by purchasing department resulting into reduction in cost of raw materials, supplies through substitutes. (3) Standardization resulting into reduced cost of goods, freight, paper work etc. (4) Reduced inventory holding decreasing the rupee value by stock less buying, better scheduling, better deliveries, improved transportation etc. This also reduces the inventory carrying costs. Increased return through better classification of scrap and salvage, higher price (5) and faster disposal. (6) Reduced administrative departmental cost through blanket purchasing, automation, reduced paper work, efficient follow-up thus reducing the cost of personal requirements, and services. (7) Reduced rejects through better suppliers. (8) Advantage from shortest routing and econom ical packaging etc. The quantitative aspects of purchasing are considered as under : (1) Development of purchase pOlicies and procedures. (2) Centralization of purchasing function.

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277

(3) (4)

Selection of better staff and provision of training. Development of good condition of functions and their optimum distribution within the department. (5) Good working relations with other departments. (6) Good relations with the suppliers. (7) Active participation in company, professional and community affairs. (8) Purchasing of better quality products without the corresponding increase in the costs. (9) Improved deliveries. (10) Reduced frequency of rush orders. (11) Awareness of reciprocal dealings. (12) Awareness of make-or-buy possibilities. (13) Suggestions for the improvements in the products, policies, procedure etc. (14) Contribution to the short and long-range goals of the company. (15) Creation of favourable purchasing climate conclusive to top efforts. The quantitative advantage should be presented in the rupee value. The qualitative considerations should also be measured in quantity terms by using grade system of rating. The combined advantages from the quantitative and the qualitative aspects should be. considered while evaluating the role of purchasing department.

(0) Agency for Evaluation Generally the following two aspects are required to be evaluated: (1) The efficiency of the departmental operations. (2) The performance of the personnel in the purchasing department. The performance of the purchasing department is evaluated by the following agencies: (1) Internal agencies (2) External agencies The internal' agencies refer to the use of the company personnel. It is again subdivided into two parts : (i) Internal check system, wherein the work of one person or one section is checked by the other person or section of the purchase department. Internal check system controls the performance of all, and the performance is evaluated without any extra cost. (ii) The other method is the use of internal auditor. Over and above the accounting areas, the services of the internal auditor can also be utilized for measuring the performance of the purchase department. The external agencies refer to the use of the professional agency or consultants for the evaluation work. The external agencies are expert in the field. Though, it is a bit costlier as compared to internal agencies, it proves more valuable and unbiased evaluation. Generally the following aspects are studied by the externals: (1) Does the purchasing department have the responsibility of making all purchases for the company? (2) Does it have the adequate authority to go with this responsibility?

Outline of Materials and Purchasing Management

278 (3)

Is the company using the manual of purchasing policies and procedures?

(4)

Is the purchasing department buying at the right quantity, price and obtaining good service?

(5)

Does the purchasing co-operate with other departments of the company and vice versa?

(6)

Are the relations with the vendors and outsiders good?

(7)

Are operating costs of the purchasing department in line with the comparable companies in the industry?

(8)

What is the calibre of the purchasing executive?

(9)

Does the purchasing department contribute substantially to the company profits?

(10)

Is purchasing contributing its share of new ideas to the company?

(11 )

Does purchasing have a planned programme of operations and savings such as value analysis, training, cost reduction, inventory control etc.?

(12)

What specific measurement does the purchasing executive employ to determine the efficiency of his department?

(E) Methods of Evaluation The following methods are popularly used in evaluating the performance of the purchasing department: (1) Form and reports (2) Flow chart (3) Graphs and Charts (4) Checklist (5) Ratios.

(1)

(1)

Forms and reports: Standard formats are designed to evaluate the performance on regular basis. The actuals are compared with the budgeted figures. The variances and discrepancies are ascertained. They are properly analysed and interpreted. The responsibilities are located for failures, negligence, inefficiency etc.

(2)

Flow chart: The flow chart is an ideal method of depicting the normal procedure for performing the specific function. The flow chart indicates the "Time-Frame" of the job, e.g., the initiation of purchase function, order-placing, follow-up, expediting, order progress, order closing etc.

(3)

Graphs and Charts: Graphs and charts are generally used to represent trends and relationships among various variables. In the evaluation of the purchasing function, graphs and charts are prepared to represent total orpers placed versus price-adjustments, change in orders, goods rejected etc.

(4)

Check-list: The check list method is an effective method of evaluating the overall performance of the purchasing department. An exhaustive check list items pertaining to organization of the department, mode of paper processing, poliCies, procedures, reporting etc. are preparing for the purpose of evaluation. The evaluators are required to put 'yes' or 'no' tick against each item. The rating is made on the basis of total number of 'NO' ticks. If the numbers of 'NO' items are more, the department is considered weak on organization, control and direction fronts. Some important check-list items are as under:

Organization (i)

The department is quite productive.

(ii)

The authority-responsibility division is clear, balanced and logical.

Yes

D D

No

D D

Evaluation of Purchasing Performance

(2)

(3)

(4)

D D

D D

Organization chart, list of jobs, responsibility centres are available.

D

D

Purchasing manager spends reasonable time in directing the department.

D

D

D D D

D

D D

D D

(iii)

The purchasing function is centralized.

(iv)

Close relations with engineering. material control and manufacturing.

(v) (vi)

Fonns (i)

Request for quotation form are used.

(ii)

Purchase order numbers are controlled.

(iii)

Acknowledgment copy of purchase order is returned by the vendor.

(iv)

Blanket purchase orders are used wherever possible.

(v)

Travel requisition used for the repetitive purchases.

D D

Records and Files (i)

Few purchase orders are in open file with small balance due.

D

D

(ii)

FollOW-Up file is maintained on delivery promises.

D

D

(iii)

Price history records of repetitive parts are available.

D

D

Reports (i)

Periodic (say monthly or quarterly) purchase summary reports are prepared.

D

D

(ii)

Periodic reports about the savings are prepared.

D

(iii)

Performance appraisal of personnel is maintained.

D D D

Commodity wise lead-time reports are published on regular basis. Policies and Procedures

(iv)

(5)

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D D D D D

D

D D D D

(i)

Statement of policies are available for vendors.

(ii)

Frequent purchases for the same part not permitted.

(iii)

Few purchase orders are given without requisition.

(iv)

Rupee purchase and approval limits are established.

(v)

Scrap sales are conducted by sealed tenders.

(5)

Ratios: The ratio technique tries to develop the meaningful relationship between two variables. Sometimes absolute variables are considered to measure their relationship with the past or comparable units. In the evaluation of the purchasing function, generally, following variables and ratios are used: (i) Number of orders placed: The number of orders should be minimized. Order placing involves the cost of paper processing and the ancillary

D D

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Outline of Materials and Purchasing Management costs. The number of orders can be reduced by defining ECONOMIC ORDERING QUANTITY (EOQ), use of blanket purchase, travel requisition for repetitive purchases etc. (ii) Total rupee value of the orders placed: The rupee value of the order must bear a close relation with the cost per order. Similarly, total ordering cost and the total rupee value of orders must have some sensible correlation. (iii) Ordering cost per order: It is ascertained by total ordering cost to be divided by the number of orders. It should be kept minimum by defining the economic size of the order. It should be noted that the size of the order and inventory carrying costs are directly related. A trade-off be struck by defining EOQ, (iv) Number of invoices processed: The vendor's accounts are settled through the processing of invoices. The invoice processing should be in consonance with the number of orders, and rupee value of the orders. (v) Total rupee value of invoices processed: The above variable focuses on the number of invoices processed, while in this ratio the total value of the processed invoices are considered. It should be related with the total value of the orders placed during the period under consideration. (vi) The percentage of cash discount obtained: The advantage on the cash discount is sometimes higher than the cost of capital of the firm. So, if the liquidity position of the business permits, efforts should be made to tap the cash discount advantage offered by the vendors. It would also be of interest to know the percentage volume of purchases on which cash discount is tapped in relation to total purchases. (vii) The number of small orders handled: Order handling involves some costs. Efforts should be made to club small orders, or the need for the small orders be eliminated by some other technique. The value of small order must bear a sensible relation with the ordering cost. (viii) The number of rush orders handled: Handling of rush orders is always costlier. In case of emergencies, extra efforts are made for procuring the materials through costlier means of communication, speedy transportation and unfavourable price bargain. Rush orders indicate poor planning. Efforts should be made to minimize rush order situation. (ix) Number of orders overdue or late for delivery: Such situation indicates poor follow up and sometimes necessitates rush ordering. It should be minimized as far as possible through follow-up and expediting. (x) Number of changes in the purchase time: It indicates the changes in the market conditions and the awareness of the purchasing department to such changes. (xi) Number of "notifications of goods received" held at the end of each period: Such notifications are the slips that are being held, waiting for invoices that are more than say 10 days. (xii) Purchases to sales ratio: This ratio is generally around 50%. However, it is closely related with the profit margin on the-sales value. Lower the ratio higher will be the profit margin and vice versa.

Evaluation of Purchasing Performance 281 (xiii) Number of employees in the purchasing department classified as buyers, clerks, etc.: The number should bear the logical relationship with the volume of work handled by each section.

(xiv) Ratio of purchasing to total employees: This ratio indicates the importance or otherwise of the purchase function. It may also indicate illogical and lop-sided organizational set-up. (xv) Cost of purchasing as a percentage of the total purchases: This index indicates the degree of efficiency of the purchase department. Lower the percentage, higher the efficiency. (xvi) Cost of purchasing as a percentage of total sales: This also indicates the efficiency of purchases. Like above ratio, the percentage value and efficiency of purchasing department are inversely related. (xvii) Purchased materials price index: It indicates the fluctuations in the prices of the materials purchased and pinpoints the need for purchase planning for reaping the benefits of price fluctuations. (xviii) Storing or inventory carrying cost as a percentage of value of materials stored: Storing or carrying costs comprise the cost of fund blocked, storage space, cost of insurance, pilferage, obsolescence etc. As it is related with the value of materials stored, it should be ascertained accordingly, and should be kept as minimum as possible through efficient inventory control. (xix) Loss due to stock-outs: Frequent stock-out position indicates poor inventory control. Various stock levels should be defined clearly in line with the lead-time and expected variation in the consumption of items. The safety level be prescribed for key items and their issues be confined only to emergencies, and extra efforts be made to replenish them. (xx) Inventory turnover: The net sales to average inventories held in stock indicate the favourable situation as with little inventory holdings and other ancillary costs, more sales volume is attained which results into greater profits. It also increases the liquidity of the business. Inventory turnover can further be broken into Raw materials turnover, which is indicated by the ratio of net sales (a) to average raw materials held in stock. High raw materials turnover indicates efficient utilization of raw material resources. Generally, raw materials are stored in terms of "30 days average consumption." High turnover decreases the time-span of raw materials holding. (b) Work-in-progress turnover is the ratio of net sales to average workin-progress blocked in the production processes. High level of workin-progress indicates efficiency of the production planning and control. (c) Finished goods turnover is the ratio of the net sales to the average finished goods maintained as stock. High turnover indicates that there exists, a high degree of harmony between production and delivery of finished goods. High level of finished goods holding indicates high degree of locking of funds because it freezes not only the cost of goods manufactured but also the margin of unearned profits.

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Outline of Materials and Purchasing Management (xxi) Inventory to current assets: As indicated by the quinquennial studies of the corporate sector conducted by the Reserve Bank of India, on an average, the ratio of inventory to current assets is more than 50%. Efforts should be made to reduce this ratio, because high ratio indicates stockpiling which reduces inventory turnover and liquidity of the business. It adversely affects the profitability of business.

The break-up of the inventories into raw-materials, work-in-progress and finished goods and its ratio with the current assets will give a more clear picture about the inventory holdings. (xxii) Inventory to total asset: As per the studies conducted by the Reserve Bank of India, more than 30% of the total assets are represented by inventories. Efforts should be made to reduce the percentile composition of the inventories in the total asset package. It will increase the inventory turnover and resultantly the profitability. This ratio is more or less similar to the above and hence this can also be broken into raw materials, workin-progress and finished goods.

2. EVALUATION THROUGH MANAGEMENT AUDIT Introduction Management Audit is a recently developed concept. It is a tool by which the efficacy of M.B.O. (Management by Objectives) is tested. The organization as a whole has been set up to achieve certain predetermined objectives, and each department has its own objectives but these should be in conformity with the overall objectives and they must contribute towards overall organizational objectives. Management Audit examines the procedures, plans and operations to see whether they contribute to objectives. Management Audit ensures optimum utilisation of human resources and physical facilities by pointing out the deficiencies in management practices in different functional areas of business. In today's large business, problems take a longer time to reach surface and leave little room for solution. Management Audit anticipates problems and helps them solve in time. Statutory Audit is basically concerned with the truth and fairness of the Balance Sheet and Profit and Loss Account. . Management Audit has the following characteristics: (1) Management audit is the audit of the whole process of management. Management standards are used to evaluate the performance. (2) It is essentially an integrated approach. It is concerned with the effectiveness of management as a whole. (3) It is a continuous process. (4) It emphasises opportunity cost, rather than historical cost. (5) It is constructive in spirit. (6)

It is essentially a Management service and it concerns itself with the intensive· analysis of information needs and availability of relevant information to management, for decision making purposes. In short, Management Audit includes operational audit which reviews and appraises the effectiveness, efficiency and economy with which the operations are carried out. It views each and every activity and operation with reference to environment, It must be understood that Management Audit should be continuous and must go hand-in-hand with management.

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Inter-Departmental: Functions of business are all interrelated, and hence purchase is not to be considered as an isolated function, but as a function that is affected by and affects other functions like sales, finance and production. The areas that merit investigation at the hands of the auditor are : (1) Is departmental authority regarding purchases to be made clearly understood? (2) Is authority in respect of quantum of goods to be purchased clearly understood? (3) Which department has been authorised for selecting the sources, and are there approved source lists on hand ? (4) Which other departments assume purchase responsibilities? (5) What 'say' does the purchase department has with regard to procedures or . changes that affect vendors, order quantums, or specifications? Auditor is especially concerned with healthy organizational procedures so as to discourage what is known as 'Management by Crisis.'

(2) Policies Policies framed should touch upon all the major aspects of the purchasing process. Purchasing Manual may serve as a starting point of enquiry. Policies in the manual reflect the purchase philosophy of the management. Policies should be approved by the Board and they are binding on all employees. Policies that merit enquiry are: (1) Policies regarding revision of specifications or requisitions. (2) Policies regarding source selection. (3) Policies regarding the getting of a bid. (4) Policies regarding contractual obligations. (5) Policies regarding conflict of interest, gifts, and entertainment. Policies should be precise, expressive, practicable and enforceable. They should be known to have been enforced. Audit Programme as regards policies should be flexible to accommodate the necessary information that will have to be sought on the individual merits of each case. There cannot be a stereotyped list of questions that would apply to all the companies.

(3) Procedures Procedures are devised to translate policies into action. Procedures provide and standardize routines. Procedures offer standards of performance. Purchase Audit is successful only when it probes this area to its depth. The following tabulation will pin-point the items that should receive the special attention of the aUditor.

(a)

Item of Enquiry

Scope of Enquiry

Requisitions

(1) Review of formal purchase requisition. (2) Who has defined authority to initiate a purchase requisition? (3) Whether prescribed procedure is being followed?

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Evaluation of Purchasing Performance

(b)

P.O. Control (Purchase Order Control)

(1) Issue of P.O. (2) Purchase order numbering as control mechanism.

(c)

Vendor Analysis

(1 ) Selection Process. (2) Financial stability. (3) Technical competence. (4) Element of favouritism whether present.

(d)

(e)

Transportation and Price

Discounts

(5) Constraints on selection through unionization. (1 ) Inspection of P.O. to appraise the transportation conditions and prices. (2) FOB points, freight terms, methods of determining routings. (3) Economy of transport to be reviewed. (4) Review of bidding procedure. (5) Examination of comparative prices. (6) Reasons for not selecting the lowest bid. (7) Price omission on PO should be analysed. (8) Price Revision decisions. (1 ) Receipts of trade and cash discounts on final settlement of bills. (2) Record of discount on the orders.

(3) (f)

Adjustments

Taxes should be spot-checked.

(1 ) Adjustment of complaints procedure. Purchase return procedures. Additional processing by the purchaser - control. (1 ) Procedure to take, make or buy decisions.

(2) (3) (g)

Make or Buy

(2)

(h)

Surplus sale

(i)

Off-plant inventory

(j)

Petty cash purchases

Financial obligations of the decision. (1 ) Sale of scrap-weighment, priCing inventory control. (2) Materials worth purchase returns should not be passed off as scrap. (3) Materials which can be utilised by the other department should not be disposed of as scrap. (1 ) Supplier holds the inventory for processing or conversion, the ownership of which rests with the purchaser - valuation of such material, stock-verification of such material. (1 ) Control with a view to have proper receipt and lowest cost. (2) Control procedures for emergency purchases.

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286

(k) (I)

Employee purchases Receipt Procedure

(m) (n)

Vendor payment Ethics

(1) (1) (2) (3) (1) (1)

Procedures of reimbursement. Arrival control at warehouse. Check-out control at warehouse. Procedure to handle shortages. Control to guard against collusion. Malpractice not to be encouraged in broader interest of the company.

Procedural audit also pays attention to out-of-the way methods of placing orders, viz.: (1) Blanket orders. (2) Orders that are not specific. (3) Contract orders.

4. EVALUATION AND REPORTING Control mechanism engages the attention of the auditor. Objective standards of purchasing performance are examined. Reporting against these standards is also examined. Performance review is a must on a continuous basis. Audit specially attends to (1 )Objective basis of performance appraisal. (2)Whether department as a whole objectively assessed in terms of clearly established goals. (3)Feedback system. In years to come, purchase audit would become a key word owing to the increased importance of purchase department and its functions.

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CIiAPTER 22 Legal Aspects of Purchasing 1. IMPORTANCE OF LEGAL KNOWLEDGE

It

The purchasing executive deals with a large sum of money, because it is he, who is responsible for placing orders for the purchase of goods and services involving a great deal of corporate finance. And therefore it is inevitable for the purchasing executive to know and understand the legal aspects that are relevant to his profession. It is very very necessary for him to have the basic knowledge of the legal aspects related to his duties and responsibilities. It does not mean that he must be a lawyer. He may not be aware of all the branches of law, but he should have or he should acquire basic knowledge and understanding of the basic laws governing the purchasing activities, to avoid litigation against himself as well as against his company. The purchasing executive should have a working knowledge of the following laws which are very important for any purchasing executive for successful career: (1) Law of Contract (The Indian Contract Act, 1872) (2) Law of Agency (Secs. 182 to 238.of the Indian Contract Act, 1872) (3) Contract of sale (The Sale of Goods Act, 1930) (4) The Negotiable Instruments Act, 1881 (5) The Indian Arbitration Act, 1899 and (6) Provisions regarding the carriage of goods by land, sea and air stated in various Acts. Failure to understand the legal implications of the job on the part of the purchasing executive may put the company into an awkward position. In case of controversial matters or complicated Situation, the company should seek legal advice from experts, i.e., legal advisers. It is not advisable to rely only on the legal knowledge of the purchasing executive in such circumstances. Professional legal advice is a must for major contract involving large sums of money or extending over a long period of time like in imports. Contracts should be standardised after scrutiny by the company's legal department. All the clauses used for routine purchases should be drafted by the company's lawyer or the company's legal department. In spite of all legal precautions taken by the purchasing executive or the materials manager, there are bound to be some loopholes. Hence, after taking sufficient precautions in the contracts, emphasis should be on mutual trust and confidence. In commercial (287)

288 Outline of Materials and Purchasing Management transactions law suits involving buyers and sellers are common but they are very rare in industrial purchasing. In most of the cases purchasing executives and their suppliers amicably resolve their disputes. As far as possible litigation should be avoided for the following reasons:

It is costly. If the company prefers litigation, it has to spend large amount for legal fees and other experts relating to the law suit. (ii) It is time-consuming. Decision is awarded after a very long time. It may run into months and sO,metimes into years. (iii) Outcome of any court case is not certain. Nobody can predict what will be the result of any court case. (iv) In case of favourable court decision also damage done is not covered fully. Thus litigation results in a big monetary loss, if legal fees and other expenses paid are considered. (v) The company executives have to attend the courts. They have to prepare the papers and have to collect and provide information. Executives have to spend too much time for all these acts. (vi) Sometimes business operations are disrupted. Because of the above reasons litigation is generally not favoured, by the business units for settling the disputes. Business units generally prefer friendly negotiation to solve the disputes much more effectively and at a lesser cost. It is said that the best way to avoid litigation is to find out new reliable and co-operative suppliers with proven performance and sound financial position. (i)

2. LAW OF CONTRACT General: Each commercial transaction gives birth to a contract. Now the purchasing executive is the only person in a company who has to deal with many suppliers for the procurement of goods and services. His dealing with suppliers results in many transactions. Thus he becomes responsible for the birth of many contracts. Hence it is inevitable for him to know about the law of contract, the validity of contract and remedies in case of a breach of contract. It is his duty to protect the company against potential legal problems, which may arise from the purchase contracts made with suppliers. He must take a great care while entering into the contract, so as to make it legally binding the other parties. Therefore, it is advisable for the purchasing executive to have some basic knowledge of the law of contract. As per the Indian Contract Act, 1872, "An 'Agreement enforceable by law' is a contract." It means that a contract consists of two elements: (1) An agreement and (2) its enforceability by law. An agreement is the promise or set of promises, forming consideration for each other. When the proposal is accepted by the person to whom it is made, it becomes the promise. Thus an agreement is an acceptable proposal. Thus Agreement = Proposal/offer + Acceptance In other words, an agreement comes into existence only when there is a proposal or an offer by one party and the acceptance of that proposal or offer by the other party. Suppose Shri A has offered or proposed to sell his own bungalow to Shri B. Now, if Shri B accepts the proposal, an agreement takes place or it is said that agreement between Shri A & Shri B has taken place. If Shri B does not accept the proposal, the proposal becomes meaningless, i.e., agreement does not take place.

Legal Aspects of Purchasing Now as per the Contract Act, an agreement enforceable by law is a contract.

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Thus, Contract = Agreement + Enforceability by Law It means that all agreements do not give rise to a contract, because some agreements, e.g., social agreements, are not enforceable by law. Social agreements do not give rise to legal obligations. They cannot be challenged in the court of law. Suppose 'G' proposes to 'M' to go to Mathura and 'M' agrees to do the same. Here agreement comes into existence. Now if 'M' fails to join 'G' for a trip to Mathura as previously agreed for the reason unknown, 'G' has no right to go to the court against 'M' as per the Contract Act, because such social agreements are not enforceable by law. Therefore such agreements are not considered as contracts in the eyes of law of contract. Thus all contracts are agreements but all agreements are not contracts. Sometimes contracts arise without any agreement. They may arise out of the conduct of the parties. They are totally implied. Here agreement does not exist first. Suppose a TV dealer sends a TV to '0' without any order from him and '0' accepts the same and starts to use TV, the contract comes into existence. '0' becomes liable to pay the price of TV.

Essential Elements of Valid Contract All agreements are contracts, if they are made by the free consent of the parties, competent to contract, for a lawful consideration and with a lawful object and are not hereby expressly declared to be void. They must have the following elements to be a contract: (a) Offer and Acceptance: There must be a definite offer by one person to another. An offer is a proposal made by one party to another, to enter into a legally binding agreement. "A proposer signifies his willingness to do or abstain from doing anything with a view to obtaining assent of the other by such act or abstinence." The offer may be expressed or implied. Express offer is made by expressed words, spoken or written, e.g., (i) A house owner says to a painter "Will you paint my house for Rs. 2,OOO?" This is an express offer. (ii) An advertisement regarding 'reduction sale' is an express offer. Here it is a written offer. An offer may be implied from the conduct of the parties or the circumstances of the case. This is known as an implied offer, e.g., various divisions of State Transport Corporations publish their time tables. The time table of the particular division is an implied offer on its part to carry passengers for a certain fare, from one place to another as stated in the time table, subject to the terms and conditions as laid down by it. The offer when made to a specific person is called a specific offer, e.g., P says to Q, "I will sell you my car for Rs. 50,000." Here P has made an offer to Q, only. When the offer is made to the world at large, it is called a general offer, e.g., an advertisement in the newspaper by a manufacturer of ceiling fan or refrigerator or television or radio etc. is a general offer to the public. Such an offer may be accepted by anyone and when it is accepted by a certain person, it results into a contract. To become an offer the proposal must satisfy the following conditions : (i) The offer must be such, which shows an obvious intention on the part of the offerer to be bound by it. It means that the offer must be such, when accepted, as to create legal relationship. (ii) The offer must be definite, unambiguous and certain, e.g., X has three houses. He says to Y, "I will sell you my house." Here, the offer is not definite. (iii) The offer must be communicated to the offeree.

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Outline of Materials and Purchasing Management A contract emerges from the acceptance of the offer. Acceptance is the expression of the acceptor's willingness to be bound by the terms of the offer. When a person to whom the offer is made, signifies his assent thereto, the offer is said to be accepted. When a purchasing executive sends an order to the supplier for purchase of goods, it is only an offer and not an agreement. Agreement comes into existence only when the supplier accepts the proposal with all the terms and conditions stated by the purchasing executive. Request made by the purchasing executive to the supplier for sending the quotation is not an offer from the viewpoint of the purchasing executive. But the quotation received by the purchasing executive in reply to his inquiry is an offer from the supplier to sell the goods or services as per the terms and conditions of the quotation. If the purchasing executive/the buyer accepts the quotation without asking for changes in any term and/or condition of the quotation, it results into a birth of an agreement. However, changes in the terms and conditions of the quotation can be made with mutual consent. When the supplier does not agree with the changes in the terms and conditions as demanded by the buyer, agreement does not exist. If the changes in the terms and conditions of the offer as suggested by the offeree, i.e., the buyer/purchasing executive are not objected by the offerer in writing, i.e., by the supplier, the offeree's terms and conditions become a part of the contract. When the terms and conditions of the offer clearly states that no change in terms will be accepted, original terms and conditions form a part of the contract, even if the party accepting the offer has stated different terms while accepting the offer.

When an offer and an acceptance contain conflicting terms, all the terms except the conflicting terms form a part of the contract and the conflicting terms are omitted from the contract. Now the offerer can revoke the offer at any time before the other party to whom the offer is made accepts it. The offerer can state the last date for acceptance of the offer and up to this date the offer remains valid. To be legally effective, the acceptance must fulfil the following conditions: (i)

The acceptance must be absolute and unqualified. Suppose A offers to sell his house to B for Rs. 40,000 and B replies that he will purchase the same for Rs. 35,000. Here B's reply is not an acceptance but it is a counter-offer.

(ii)

The acceptance must be communicated to the offerer. A buyer/purchasing executive sends an order for purchasing the goods. To conclude a contract, the supplier must communicate his acceptance by delivery of goods or in any other acceptable form, e.g., e-mail reply, reply by post etc.

(iii)

The acceptance must be according to the mode prescribed. If the offerer insists that the offer must be accepted in the prescribed mode only, the acceptance must be given accordingly.

(iv)

The acceptance must be given within a reasonable time. If the time limit is specified, the problem does not arise. If the time limit is not specified, acceptance must be given within a reasonable time. A made an offer to B on 1st January, 2006 to sell his house for Rs. 15,000. B accepted the offer on 30th June, 2007. Here, A can refuse to sell his house because it can be said that B is not accepting the offer within a reasonable time.

(v)

The acceptance cannot precede an offer. It means that the offer cannot be accepted, before its existence.

(vi)

The acceptance must show an intention on the part of acceptor to fulfil the terms of the promise.

(vii)

The acceptance must be from the party or parties to whom the' offer is made. When A offers to sell his car to B, only B can accept the offer and not any other party.

Legal Aspects of Purchasing 291 (viii) The acceptance must be given before the offer lapses or the offer is withdrawn to make the acceptance legally effective.

(ix)

It should be noted that an acceptance must be communicated to the offerer, either expressly or by conduct. Mental acceptance is no acceptance at all. (b) Legal Relationship: There must be a common interest of the parties to enter into legal relationship. In case of commercial and business agreements the presumption is usually that the parties are intended to create legal relationship, while agreements of a social or domestic nature do not contemplate legal relationship and therefore they are not contracts. When the buyer/purchasing executive and the seller/ supplier enter into a contract, the buyer promises to buy from the seller certain materials at predetermined price and the seller promises to deliver the materials as per the terms of the contract. Here both the parties are bound by mutual obligation. If both the parties are not bound or legal relationship is not created no contract exists. (c) Consideration: Consideration is the element of support to the contract. It must be there in every agreement. Consideration means something in return. The consideration is recompence given by the party contracting to the other. In other words consideration is the price for which the promise of the other is bought and thus the promise given for the value, is enforceable. When two parties enter into a contract, one party gives something to the other party and gets something in return from that party, e.g., R agrees to sell his table fan to S for Rs. 500. R gives his table fan to S and gets Rs. 500 in return. The amount received by him is the consideration for him. Now S gives Rs. 500 to R for the table fan and gets the table fan in return. The table fan is the consideration for S. Legal rules as to consideration are as under: (i) The consideration must be at the desire of the promisor. (ii) It may move from promisee or any other person. The consideration must move from the promisee. If any other person furnishes it and the promiser has no objection, one can say that it has moved from any other person. (iii) It may be past, present or future. When the consideration by a party for a present promise was given in the past, it is said to be the past consideration. Present consideration is given at the time of promise, i.e., 0 purchases goods worth Rs. 500 from P for cash. Here goods received by 0 is the present consideration for him and the amount which P receives is the present consideration for P himself for the goods delivered by him. Future consideration passes subsequently to the making of contract. (iv) The consideration need not be adequate. It means that the parties to the contract are free to determine the value of their promises. What they consider is the proper value of their acts is the consideration. As per the law the consideration must exist. It is not necessary that "something in return" must be equal in value with "something given." P can sell his own house worth Rs. 50,000 to Q, for Rs. 500 only. If P has given free consent to agreement, it is not void even though the consideration is inadequate. (v) It must be real and not illusory, i.e., it must be of some value in the eyes of law. The consideration which is physically or legally impossible or which is uncertain or iffusory, is not real consideration, e.g.: (1) A promises to bring the moon on the earth, if B pays him Rs. 1,000. Here A's promise is physically impossible of performance. (2) A firm employs B as a sales manager and promises to give reasonable salary. Here the promise by the firm is unenforceable because the consideration is uncertain.

Outline of Materials and Purchasing Management Generally an agreement made without consideration is void. But an agreement made on account of natural love and affection between the parties, a promise to compensate a person for his voluntary services and a promise to pay a time barred debt are the exceptions. (d) Capacity to Contract: The parties who enter into the contract must have the capacity to do so, i.e., persons entering into a contr~ct must be competent. A person is said to be competent to contract if (i) he is of the age of majority according to the law to which he is subject, (ii) he should be of sound mind, (iii) he is not disqualified from contracting by any law to which he is subject. The flaws in capacity to contract may arise from minority, lunacy, idiocy, drunkenness and status. It means that only competent parties can make valid contract. The purchasing executive! buyer, while entering into a contract with the supplier or his agent, must see whether the other party is competent to contract or not, e.g., a minor can be an agent. An agreement with or by a minor is void and inoperative. Suppose a purchasing executive enters into an agreement with a minor for purchase of goods worth Rs. 20,000. He pays Rs. 2,000 in advance and agrees to pay the balance at the time of delivery. Now a minor refuses to deliver the goods and returns the amount received in advance. Here the purchasing executive can do nothing for the breach of the contract because the agreement is void. Moreover, if a minor does not refund the amount, the purchasing executive cannot recover the same. If a minor has received any benefit under a void agreement, he cannot be asked to compensate or pay for it. However, contracts with the minor may be enforced at the option of the minor only. (e) Free and Genuine Consent: All agreements are contracts if they are made by the free consent of the parties. Two or more persons are said to consent when they agree upon the same thing in the same sense. Consent is said to be free when it is not caused by (i) mistake, may be of fact or law, (ii) misrepresentation, (iii) fraud, (iv) undue influence or coercion. When there is no consent, there is no contract, and when there is consent but it is not free, the contract is voidable at the option of the party whose consent is so caused, e.g., when A signs a document under the threat from B, his consent is not free. Here, the contract is voidable at the option of A. The ignorance of law is no excuse. No party can get any relief on the ground that the particular act had been done in the ignorance of law. The ignorance of foreign law is a mistake of facts and the agreement becomes void. Misrepresentation is the misstatement of a material fact or facts made innocently with an honest belief of truth without any desire of deceiving the other party. Fraud exists when a false representation is made knowingly or without belief in its truth or recklessly, not caring whether it is true or false and the maker intended the other party to act upon it. It also exists when there is a concealment of a material fact. The party defrauded can rescind the contract or can sue for damages or can insist on the performance of the contract. A contract is said to be induced by 'undue influence' when the relations subsisting between the parties are such that one of the party is in a position to dominate the will of the other and uses his position to obtain an unfair advantage over the other. When a person is compelled to enter into a contract by the use of force by the other party or under a threat, consent is said to be caused by coercion. Coercion is the committing, or threatening to commit, any act forbidden by the Indian Penal Code or the unlawful detaining or threatening to detain, any property, to the prejudice of any person whatever, with the intention of causing any person to enter into an agreement, e.g., when A lends money to B under the threat or A signs a document under the threat, his consent is said to be caused by coercion. Here the contract is voidable at the option of A.

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Legal Aspects of Purchasing 293 (f) Legality of Object: The object of every agreement must be legal. Every agreement of which the object or the consideration is unlawful, is void. If the primary object of a contract is legal, but one of its ancillary object is illegal, the contract may be either void or valid, depending upon the seriousness of the illegality and the extent to which the illegal part can be separated from the legal part of the contract. The purchasing executive should see that the contract does not include illegal part which can be separated from the legal part. This happens when he purchases goods at discriminatory price or at a price which violates fair trade practices of business. A contract is illegal on the ground of immorality, where the consideration is an act of sexual immorality or where the purpose of agreement is the furtherance of immorality and both parties are aware of it.

An agreement is said to be opposed to public policy when it is injurious to the welfare of the society and in both of these cases the agreement made is void. The consideration or object of an agreement is unlawful (i) if it is forbidden by law, (ii) if it is of such nature that, if permitted, it would defeat the provisions of any law, (iii) if it is immoral or opposed to public policy, (iv) if it involves injury to the person or property of another. An unlawful agreement is not enforceable by law. No action is allowed on an illegal agreement. (g) Agreement Declared Void: The following agreements have been expressly declared to be void by the Contract Act and hence they are not enforceable by law: (i) Agreements made by incompetent persons, i.e., minor, person of unsound mind etc. (ii) Agreements made under a mutual mistake of fact, i.e., where both parties are under a mistake as to a matter of fact, essential to the agreement. (iii) Agreements, the consideration or object of which is unlawful. (iv) Agreement, the consideration or object of which is unlawful in part. (v) Agreements made without consideration. (vi) Agreements in restraint of marriage. (vii) Agreements in restraint of legal proceedings. (viii) Agreements in restraint of trade. (ix) Agreement by way of wager: Here one party promises to pay money or money's worth on the happening of some uncertain event in consideration of the other party's promise to pay if the event does not happen, e.g., R promises to pay Rs. 100 to S, if India wins the first cricket test match against Pakistan, in consideration of the promise of S to pay Rs. 100 to R if India does rot win. Here the future event is uncertain at the time of contract. (x) Agreements, the meaning of which is uncertain, 'X' agrees to sell oil to 'Y.' Here the quantity and kind of oil is not certain. Hence the agreement is void. (xi) Agreements to do an impossible act. (h) Legal Formalities: Contract is the relationship existing between the parties, who enter into a contract. Contract is not a physical thing like machinery or materials etc. which we can see, touch and give to others. Written document relating to a contract is not a contract, but it is an evidence or proof of the contract, which states the details of the contract. A contract may be made by words spoken or written. So far as the legal effects are concerned, there is no difference between a written contract and an oral contract, i.e., a contract made by words of mouth. Oral contracts are as much binding as the written contracts, but written contracts are more preferable because it becomes very difficult to prove the oral evidence or the facts stated orally. A written contract makes all prior oral

294 Outline of Materials and Purchasing Management evidence meaningless. Thus the purchasing executive/buyer cannot legally rely on the oral statements concerning materials performance, warranty etc. made by the supplier. He can rely on such statements only if they form a part of the written document of the contract. It means that when a contract is reduced to writing by the supplier, the purchasing executive/ buyer should carefully examine it and see that the terms fixed by them orally have been included in the written evidence or not, because the court considers that when a contract is reduced to writing and the parties to it have agreed to the written facts, all prior oral evidence becomes meaningless.

In some cases, in addition to the contract being in writing, it has to be registered and stamped. Writing and registration facilitate the proving of facts and prevent fraud or mischief on the part of parties. Such written agreements can be made enforceable by law, e.g., Documents relating to the transfer or sale of immovable property must be in writing and have to be registered. While signing the written document of the contract, the purchasing executive should specifically mention that he is signing the same in his capacity as an agent of his firm. All the relevant data terms and conditions of the contract should appear in the document above the agent's Signature, so that no party can add anything in the document, in writing and legal complications may not arise in future. It means that to avoid legal complications that may arise in future and to prevent any of the parties to the contract from adding anything in writing in the contract, no space should be kept between the written matters and the signature of the parties.

3. LAW OF AGENCY General: The modern business has become so complex that it is not possible for any man to transact all his business by himself. He cannot personally attend to all the matters in which it is necessary for him to be brought into legal relations with others. He has to depend on the services of others, if he wants to run his business efficiently and smoothly. The persons who provide services are called agents. Today most of the business units use the services of other parties, who are called agents. Agent: A person, who has capacity to contract, may enter into a contract with another: (i) either by himself or (ii) through another person. When he acts through another person, he is said to be acting through an 'agent.' When A.(the purchasing executive), on behalf of his firm, enters into a contract with B for the purchase of goods, the firm is said to be acting through an agent (here A). Here the firm uses the services of A in doing business with B. A is another person, who enters into a contract with B on behalf of his firm. He is acting, here, as an agent. Now a person on whose behalf an agent acts with the third party is called the 'principal.' Here the firm of which A is the purchasing executive, is the principal for A because the firm has employed him to act with the third party. An agent is the connecting link between the principal and the third party. He brings his principal into contractual relation with the third party. In the above example A is the connecting link between the firm and B. The law relating to agency defines the relationship between an agent and a prinCipal. As per the law relating to agency "An 'agent' is a person employed to do any act for another or to represent another in dealing with a third person." The person for whom such act is done, or who is so represented, is called the 'Principal.' A purchasing executive acts as an agent for his firm. He provides his services to the firm. An efficient purchasing agent procures materials and services of right quality, in right quantity, at right time, at right place, at right price from the right sources of supply. He does this with the help of the staff of his department. His efficiency helps a lot to his firm in running the business smoothly and profitably.

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Rules of an Agency There are two important rules of an agency: (1)

(2)

Whatever a person can do personally, he can do through an agent. But when the act to be performed is of perional. nature or is annexed to a public office, this is not possible, e.g., A has appointed B as his agent. A and C contract to marry each other. Now here 'B' cannot marry 'C on behalf of 'A', even though he has been appointed as an agent by 'A.' 'B' can purchase goods on behalf of 'A.' He who does an act through another, does so by himself. It means that he who does an act through another can be held responsible for the act of another through whom he has done the act. In other words, the acts of the agent are considered the acts of the principal and the principal becomes responsible for the acts of his agent provided the agent acts within the authority given to him, e.g., 'P', the agent, purchases goods, from 'R', on behalf of his principal '0.' '0' becomes responsible to pay the amount to 'R' for the goods purchased by 'P.'

Essentials of Relationship of Agency The following are the essential elements of the relationship of Agency: (1) Agreement between the Principal and the Agent: Agency depends on agreement but not necessarily on a contract. It means that consideration is not necessary for the creation of an agency. If the principal agrees to be represented by the agent, the contract of agency comes into existence. If the principal has agreed to be represented by an agent, it is a sufficient determinant to support the contract of an agency. Any person, who is competent to contract, may appoint an agent, but it is not necessary that the agent should have a contractual capacity. It means that any person may become an agent. Even a minor or a person of unsound mind may be an agent. But it is in the interest of the principal that the agent should be competent to contract. If the agent is not competent to contract, the principal becomes liable to the third party for the acts of such person. But the principal cannot sue the agent in the court of law, if the agent is not competent to contract. (2) Intention of the agent to work on behalf of the principal: Any person competent to contract may employ an agent, i.e., any person who is of the age of majority according to the law to which he is subject, and who is of sound mind, may employ an agent. The agent must be ready to act as an agent on behalf of the principal. It is in the interest of the principal that the agent should have the contractual capacity. The agent can be held responsible by the principal in case he acts beyond the authority given, only if the agent is competent to 'contract.' Suppose 'A' wants to appoint 'B' as an agent. The contract of agency comes into existence, only if 'A' & 'B' agree to the conditions of agency. Further, 'B' must be ready to act on behalf of 'A.' It is necessary that 'A' must be competent to contract. Consideration is not necessary. Moreover, 'B' may not be competent to contract. It is advantageous on the part of 'A' to appoint a competent person as an agent to make him legally liable for certain acts.

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Creation of Agency The relationship of agency may be created : (i) by express agreement or (ii) by implied agreement or (iii) by ratification. (i) Agency by Express Agreement: When an agent is appointed by written agreement or by word of mouth, it is called an agency by express agreement. When an agent acts within the limit of the authority given by the principal, he can hold the principal responsible for the acts done by him within the limit of his authority. In other words the principal becomes responsible for the acts done by his agent, if the agent has acted within the limit of his authority. It is in the interest of the principal to have the agreement of agency in writing. Whether the agent has acted beyond the limit or within the limit can be decided or proved if the written agreement exists. If it is proved, on the basis of written agreement, that the agent has acted beyond the limit of his authority, he can be sued by the principal. (ii) Agency by Implied Agreement: Such an agreement arises from conduct, situation or relationship of parties and can be known from the circumstances of the case. Agency by implied agreement comes into existence when the principal conducts himself towards the agent, or the third party in such a way as if he has agreed to the appointment of that person as agent. Agency by implied agreement includes the following types of agencies: (a) Agency by estoppel: Where a person by his conduct, or by words spoken or written, leads wilfully other person to believe that a certain person is his agent, he is estopped from denying, subsequently the fact of agency, e.g., 'L' tells 'M' in the presence of 'N' that he (L) is 'N,s agent. 'N' does not object to the statement of 'L.' By not objecting the statement of 'L'. 'N, leads 'M' to believe that 'L' is an agent of 'N.' Now 'M' supplies goods to 'L'. Here 'M' is responsible to pay for the goods to 'N.' In the same way, when an agent has, without authority, done acts or incurred obligations to third persons on behalf of his principal, the principal is bound by such acts or obligations, if he has by his words or conduct induced such third persons to believe that such acts and obligations were within the scope of the agent's authority. (b) Agency by holding out: It is the branch of agency by estoppel. Here is a prior affirmative act on the part of the principal is required to establish an agency subsequently. If the principal has given other persons to suppose that acts of the agent are done with his authority, then he is bound by the acts of the agent, e.g., A sends his agent B to buy certain goods from C on credit for him. Later, he pays for the goods. On another occasion, he again sends B to buy goods. But this time he pays sufficient cash to B for the purchase of goods. B misappropriates the amount and purchases goods on credit from C. After sometimes, B runs away. Here, A is bound to pay C. In other words, C can recover the amount from A. (c) Agency by necessity: The circumstances may arise where law confers the authority on a person to act as an agent for another without requiring consent of that person. Such agency is called 'agency by necessity.' It arises in the following cases: (1) Agent Exceeding his Authority in an Emergency: When an agent exceeds his authority in an emergency the agency by necessity arises provided the agent: is not in a position to communicate with the principal, has taken all reasonable and necessary steps to protect the interest of the principal, and has acted bona fide.

297 Here the principal becomes liable for the acts of the agent, e.g., C of Kolkata has consigned goods to A of Ahmedabad and has informed A to send the same to B of MumbaL Now, taking into account the condition of the goods received, A assumes that the goods may get spoiled in transit, if he sends the same to B of Mumbai. Therefore, A sells the goods in Ahmedabad. Here his intention shows that he wants to protect the interests of C. It becomes necessary for A to exceed the authority. (2) A Person Entrusted with Another's Property: An agency by necessity also arises when a person is entrusted with some property of another, which he has to protect or preserve. The person who is entrusted with the property has no express authority to do the act necessary to preserve it but out of necessity he has to do the act necessary to preserve it. Thus his authority to do the act necessary to preserve the property of another person entrusted to him is implied, e.g., the carrier of the goods takes necessary steps for the safety of the goods carried by them. Here it acts as an agent of the owner of the goods. It becomes the agent of necessity of the owner of the goods. (iii) Agency by Ratification: A person may act on behalf of another without his knowledge or consent. Now the other person may (Le., the principal) subsequently either accept the act of the agent, or reject it. If he (Le., the principal) accepts the act of the agent done without his consent, he is said to have ratified that act, e.g., A acts as an agent of B without the consent of or authority from B. If B accepts the act of A, done without his consent, subsequently, he is said to have ratified that act and B becomes responsible for the acts done by A. Suppose A purchases goods for B, without his consent. B receives the goods and sells the same to C. Here B's conduct implies that he has ratified the act of A. Here agency comes into existence by ratification. The agency comes into existence from the date of the act of the agent and not from the date of ratification. So far as the ratification is concerned, the following points should be kept in mind: (a) The agent must contract as agent at the time of the contract on behalf of a principal. If an agent acts in his own name, the act cannot be ratified afterwards. (b) The prinCipal may ratify the contract, only if he was in existence at the time of the contract. (c) The prinCipal must be competent to contract both at the time of the contract and at the time of ratification. (d) Ratification must be done within a reasonable time of the act purported to be ratified and must be communicated. (e) Ratification of the lawful act is only legal. (f) The person, who has to ratify the act of another, must have full knowledge of the facts of the case. (g) The principal can ratify only those acts, which he is capable of doing. (h) Ratification should not put a third party to damages. (i) Ratification has got retrospective effect. It relat.es back to the date of the act of the agent. (Iv) Agency by Operation of Law: In some cases an agency arises by operation of law, e.g., a partner is the agent of the firm for the purpose of the business of the firm. The firm is bound by the act of a partner done by him to carry out the business of the firm. In this way, the promoters become agents by operation of law, when a company is formed. Legal Aspects of Purchasing

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AUTHORITY AND RESPONSIBILITY IN AGENCY General: A purchasing executive acts as an agent on behalf of his company, which employs him. He does not act on his own. He brings the principal into contractual relationship with a third party. Now for smooth, effective and efficient working, the purchasing executive must have necessary authority. To bind the principal, it is necessary for him to act within the limit of authority given to him. The authority given to an agent may be express or implied. When the principal gives him authority in writing giving complete details of the work assigned to him, it is called an express authority. An authority given by words spoken is also an express authority. Express authority describes the rights and duties related to the work assigned. It is advisable on the part of the principal as well as the agent to have the authority documents in writing, so that in case of dispute, solution may become easy. When an agent is given express authority to do a particular job, implied authority to do every lawful thing, which is necessary or customary to complete the job, assigned to an agent, e.g., A has authorised B to collect his debtors. B can take legal actions to recover the debt. But the implied authority and the express authority given to an agent must not be contradictory, e.g., if the salesman has been authorised to take orders only and has no power to grant discount or to fix credit period, he cannot guarantee or agree with the purchaser so far as the terms of discount and credit are concerned. If he does so, it can be said that he has acted beyond the limit of authority given to him. The amount of authority given to the purchasing executives varies among various business units. Therefore, it is very difficult for any supplier dealing with such purchasing executives/agents to know about the authority of a particular agent given to him by his principal. The supplier can know about the authority of a particular agent by contacting his principal only, which is not an easy task. An agent is required to act within the limit of the authority given to him by his principal, but sometimes the agent exceeds his authority. In such circumstances the principal cannot be held liable for the act of the agent. Therefore it is very very necessary for the supplier to know about the agent's authority, so that he can be held responsible for the acts of the agent. It is well and good, if the purchasing executive/ agent clearly informs the supplier about his authority. Sometimes, the principal approves of the act done by or assurances given by his agent afterwards, even after knowing that the agent has exceeded his authority. By approving of the act of the agent subsequently, the principal binds himself for the act done by the agent. If the supplier has no knowledge about the actual authority of the purchasing executive/agent and deals with the agent in good faith believing that the agent has the apparent authority to act in that way, the principal can be held liable by him for the acts of the agent even though the agent may have exceeded his authority. Even after knowing that the purchasing executive/ agent is acting beyond the limit of his authority, if the supplier deals with him the principal and his agent (purchasing executive) cannot be held legally liable, by the supplier for the act of the purchasing executive/agent. In most of the cases the purchasing executive has also to deal with the suppliers through their agents. Therefore, the purchasing executive should also know about the authority of the suppliers' agents, so that while dealing with any of the supplier's agent, he can determine whether the agent acts according to the authority given to him or not. Suppliers can be contacted directly to verify the authority of their agents or the agents can be asked to produce necessary documents relating to the creation of agency to prove their authority. By examining the documents, the purchasing executive can know whether the agency actually exists or not and further to what extent the supplier can be held responsible for the act of his agent.

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Duties of an Agent The purchasing executive acts as an agent of his firm. He should perform his duties with -great efficiency and honesty in the interest of his principal. He must have full knowledge of his duties to his principal, when he acts as an agent. The duties to be performed by the purchasing executive/agent are as follows: (1) He must carry out the work undertaken according to directions given by the principal. He must have a clear idea about his authority. If he does not act according to the directions given by his principal, he personally becomes liable for any loss arising out of such an act, but has to give the amount of profit to the principal, arising of such an act. Therefore, he must know what can be done and what cannot be done. (2) He must carry out the work with reasonable care, skill and diligence. (3) He must render proper accounts to the principal. (4) He should communicate with the principal in cases of difficulty. He can obtain necessary instructions by communicating with the principal. (5) He must not deal on his own account. If he does so without the knowledge of his principal, the principal may repudiate the transaction, if dealing is disadvantageous to him or may claim from the agent any benefit which may have resulted to him from the transaction. (6) He must pay to his principal all sums received on his account. He can deduct the reasonable amount of expenses incurred by him for performing the duties as an agent. (7) He must protect and preserve the interests of the principal in case of his death or insolvency. He should take all the reasonable steps for the same. (8) He must not use information obtained in the course of the agency against the principal. If he does so and the principal suffers a loss, he is bound to compensate the principal. (9) He must not make secret profit or take secret advantages from the agency. He must act faithfully. (10) He must not set up his own title or the title of a third party to the goods which he receives from the principal as an agent. (11) He must not put himself in a position where his interest and duty conflict. He has to act in the interest of the principal only. (12) He must not delegate authority. It means that only he must do the work which he has undertaken to do. Legally, he cannot employ another person to perform acts which he has undertaken to perform, expressly or impliedly.

Rights of an Agent An agent has the following rights against his principal: (1) He may retain, out of any sums received on account of the principal in the business of an agency, all money due to himself in respect of advances made or expenses properly incurred by him in conducting such business, and also such remuneration as may be payable to him for acting as an agent. (2) He has a right to receive an agreed remuneration or reasonable remuneration, if there is no agreement.

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(3)

(4)

(5) (6)

He has a right to retain goods, papers and other property of the principal received by him, until the amount due to himself for commission, disbursements, and services in respect of the same has been paid or accounted for to him. He has a right to be indemnified against the consequences of all lawful acts done by him in exercise of authority conferred on him, or injury caused by principal's neglect. He has a right to be compensated for injuries sustained by him by neglect or want of skill on the part of the principal. If the agent has bought goods for his principal on his (agent) personal liability, he has a right of stoppage in transit against the principal, in respect of the money which he has paid or is liable to pay. This right is also available to him, when he is personally liable to the principal for the price of the goods sold and the buyer becomes insolvent.

Personal Liability of an Agent Generally an agent acts on behalf of his principal, and therefore only the principal can be held liable for the fact of his agent. But in the following cases an agent becomes personally liable : (1) If a person while entering into a contract with an agent expressly stipulates that he would be personally liable in case of breach of contract, and the agent agrees to it, the agent becomes personally liable. Thus, when the contract expressly provides, the agent becomes personally liable. The purchasing executive, while entering into a contract with a supplier, on behalf of his principal, should see that such type of condition exists in the contract or not. (2) When the agent acts on behalf of a foreign principal for purchase or sale of goods, the agent is personally liable. (3) When the agent acts for an undisclosed principal, he becomes personally liable. (4) When the agent acts for an incompetent principal, e.g., where the principal is a minor or is of unsound mind, the agent becomes personally liable, because incompetent person cannot be sued in the court of law. (5) When the agent enters into a contract in his own name without disclosing the fact that he is acting as an agent, he becomes personally liable. (6) Where an agent acts for a principal not in existence, it is considered that the agent has acted on his own and is held pe'rsonally liable, e.g., when promoters of the company enter into contracts with third parties before incorporation of the company, (the principal) they become personally liable for the acts done by him. (7) When a person acts as if he is an agent of the alleged principal but without the authority of the alleged principal or he exceeds his authority, he becomes personally liable for breach of warranty. (8) Where an agent receives money from a third party by mistake or fraud, he is personally liable to the third party for the money received. If he has paid money to the party by mistake or fraud, he can sue the third party in the court of law to recover the amount paid by him. (9) When an agent has an interest in the subject matter of the contract entered into by him with the third party, he can be sued to the extent of his interest in the subject matter.

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(10) Where there is a trade usage or a custom making the agent personally liable, he (the agent) becomes personally liable. It is in the interest of a purchasing executive to know in what circumstances he can be held personally liable. Therefore, the study of above-mentioned pOints becomes important for any purchasing executive, if any purchasing executive wants to be on safer side.

Duties of the Principal Generally, the duties of the principal towards his agent are the rights of the agent against his principal. The rights of the agent against the principal have been discussed earlier. The duties of the principal towards his agent are as under: (1) To indemnify the agent against the consequences of all lawful acts done by him in exercise of authority conferred upon him. (2) To indemnify the agent against the consequences of act done in good faith. (3) To indemnify the agent for injury caused by principal's neglect. (4) To pay the agent the commission or any other remuneration agreed upon.

Rights of the Principal The duties of an agent towards his principal are indirectly the rights of the principal. The rights of the principal are as under: (1) To recover damages caused by lack of requisite skill, care or diligence on the part of the agent. (2) To obtain an account of secret profits, and recover them and resist a claim for remuneration where such a profit is made out of the agency. (3) To resist the agent's claim for indemnity against liability incurred, where the agent has acted as a principal and not as an agent.

4. CONTRACT OF SALE OF GOODS (The Sale of Goods Act, 1930) General: The sale of goods is most common to all commercial contracts, and knowledge of its main principles is of great importance to the purchasing executive/materials manager, because he is connected with the purchase of goods. All the general legal principles of all the contracts have been discussed earlier in this chapter under Section 2. 'Law of contract' is applicable to the contract of sale of goods also. A contract of sale of goods is a contract whereby the seller transfers or agrees to transfer the property in goods to the buyer for a price. Where under a contract of sale, the right of ownership in the goods is transferred from the seller to the buyer, the contract is called a sale, but where the transfer of the right of ownership in goods is to take place at a future time or subject to some condition thereafter to be fulfilled, the contract is called an agreement to sell. An agreement to sell becomes a sale when the time allowed for acceptance or otherwise elapses or the condition, subject to which the right of ownership in goods is to be transferred, is fulfilled. The contract of sale is made by the ordinary method of offer to buy or sell goods, for a price, by one party and its acceptance to sell or buy goods respectively by the other party. It may be made in writing or by word of mouth. An offer to sell goods for a price becomes binding only when the buyer accepts it on the terms and conditions on which it is

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made and he intimates to the seller his acceptance. Any change in terms and conditions amount to rejection of the original offer. In other words, it becomes a counter offer. However, a buyer's request to the seller to modify the terms of offer, if possible, does not make the contract void. The contract of sale may provide for the immediate delivery of the goods or immediate payment of price (or both), or for the delivery or payment by instalments or, that the delivery or payment (or both) shall be postponed. Sometimes orders are placed on 'telephones.' In order to make the telephonic order binding a formal purchase order should follow. For the completion of the performance of the contract of sale, the seller has to deliver the goods to the buyer and the buyer has to take the delivery of the goods and to pay the price as per the terms of the contract of sale. In case of contract of sale also, a proposal cannot be revoked once the acceptance is put in a course of transmission to the proposer and the acceptance cannot be revoked once the communication of the acceptance comes to the knowledge of the proposer, i.e., a proposal can be revoked by the proposer before it reaches to the party, to whom the proposal has been made and an acceptance can be revoked by the other party accepting the proposal, before acceptance reaches the proposer. Suppose X proposes to sell an item to Y by a letter sent by post. Now Y accepts the proposal by a letter sent by post. Here X can revoke his proposal at any time before Y posts his letter of acceptance but not afterwards. In this way Y can revoke his acceptance at any time before his letter reaches to X but not afterwards. However, the person, who gives time to another to accept or reject an offer, is not bound to wait till the time expires. The price is an essential element in the contract of sale of goods. It may be fixed in whatever manner, but the buyer must pay the price to the seller. Price is the consideration in a contract of sale of goods. Generally, it is fixed at the time of the contract of sale and is expressed in money.

Conditions, Warranties and Guarantee A condition is a stipulation which is essential for the main purpose of the contract, the breach of which will make the contract liable to be rejected. A warranty is also a stipulation, but it is only of collateral nature to the main purpose of the contract, the breach of which gives rise to claims for damages but does not cause it to be rejected and hence the goods cannot be rejected. A guarantee is something which the promiser undertakes to be answerable to the promisee for the debt, default etc. of another person, whose primary liability to the promisee himself exists or is contemplated. Therefore, it is an additional and conditional contract. Conditions and warranties may be express or implied. Express are those which are agreed upon between the parties at the time of the contract. Express warranties refer to the product's capacity, performance etc. When a buyer relies on such warranties, the seller can be held liable for such warranties. They may arise from the statements in catalogues, in advertisements, on brochures or labels. There is no need to make a warranty in any formal sense. Statements in letters, conversations or any other type of communication will suffice. Express warranties can be phrased in more detailed terms than ordinarily is possible by implication. They are more routinely filed or noted with papers relating to the particular transaction and therefore they are more easily proved and are more reliable. But it is somewhat difficult to formulate and negotiate these warranties. It takes time, effort and requires skill.

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303 Implied conditions and warranties are those implied by law, unless parties stipulate to the contrary. Express warranties nullifies an implied warranty to the extent that it conflicts with the implied warranty. There are two implied warranties in the contract of sale, which are as under: (1) Implied warranty of quiet possession: There is an implied warranty that the buyer shall have and enjoy quiet possession of the goods. It means that the seller's title to the goods sold is not defective and if the buyer has to suffer the damages due to the seller's defective title to sell, the buyer can claim damages from the seller.

(2) Implied warranty of freedom from encumbrances: There is another warranty that the goods are not subject to any charge or right in favour of a third party. If the buyer has to suffer due to existence of any charge or encumbrance on the goods bought, the buyer can claim damages for the breach of this warranty. Implied conditions in the contract of sale are as under: (a) Condition as to title: In a contract of sale there is an implied condition on the part of the seller that (i) in the case of a sale, the seller has a right to sell the goods and (ii) in the case of an agreement to sale, the seller will have a right to sell the goods at the time when the property is to pass. It means that the seller must have a legal authority to sell the goods, e.g., A has a car, which does not belong to him. As A has no title to the car, he has no right to sell that car. If anybody purchases the car from A, the title does not pass to the purchaser because the seller has legally no title to it. The title to the car remains with the original car owner. (b) Sale by description: When the goods are sold by description, there is an implied condition that the goods shall correspond with the description. Tangible goods must be of fair average quality as per the goods contract description. Goods must be adequately containerised, packed and labelled as per the agreement. It means that goods must be such which can be passed without objection as per the contract description. If A supplies 1,200 kg groundnut oil in 75 tins of 16 kg each instead of 300 tins of 4 kg each to 8, the buyer (8) can reject the goods on the ground that A has not supplied the goods as per the description given in the contract. The seller should supply the goods as per the description. (c) Sale by sample: In contract of sale by sample there is an implied condition (i) that the bulk shall correspond with the sample in quality (ii) that the buyer shall have a reasonable opportunity of comparing the bulk with the sample (iii) that the goods shall be free from any defect, rendering them unmerchantable. Here the seller is responsible for the latent defects only and not for the visible or discoverable mistakes. (d) Sale of description as well as by sample: In case of such type of sale, the implied condition is that the goods shall correspond both with the sample and with the description. The goods must conform to the promises or affirmatives of fact made on the container or label, if any. (e) Condition as to quality or fitness: Where the buyer informs the seller well in advance that he needs goods for a particular purpose or the fact has been mentioned in the contract itself, and the buyer relies on the skill and judgment of the seller for the selection of such goods, there is implied condition that the goods are reasonably fit for that purpose. If the purpose is not stated or mentioned, it may be ascertained from the nature or description of the goods purchased. Generally, goods must be fit for ordinary purposes for which such goods are to be used. (f) Condition as to merchantability: Where the goods are bought by description from a seller who deals in goods of that description, there is an implied condition that the goods

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are of merchantable quality. This means that goods should be such as are reasonably saleable under the description by which they are known in the market at their full value. Goods must be such which can be accepted without objection in the trade as per the contract description, e.g., a pen that will not write, cannot bo regarded as merchantable under such name. Goods must not be defective. (g) Condition as to wholesomeness: In case of eatables and provisions (food articles, drinks etc.) there is an implied condition that the goods shall be wholesome. It means that the goods shall be conducive to health and shall not be harmful. (h) Condition implied by custom: An implied condition as to quality or fitness for a particular purpose maybe annexed by the usage of trade in the locality concerned. The parties to the contract of sale can do modify or exclude the implied conditions and warranties. To resolve the dispute on implied warranty or condition, the court considers the knowledge and conduct of the buyer and the seller and also the specific conditions surrounding a transaction. If a buyer acts in good faith and has no knowledge of condition contrary to an implied warranty, the seller is held liable.

Legal Aspects regarding Payment of Price According to the Indian Sale of Goods Act, stipulations regarding time of payment are not necessary. Delay in payment does not make the contract without consideration. But if the contract provides for the delivery of goods by instalments and each instalment is to be paid for on the delivery, then failure to pay for anyone instalment is adequate for the seller to repudiate the contract. Here the time of payment for each instalment is of the essence of the contract. In determining, whether the time" was of the essence of the contract, the court will consider the intention of the buyer and the seller as stated in the contract as well as in the course of dealing between the parties or usage, surrounding circumstances, equitable considerations etc. However, when the specific time is fixed, it is treated to be of essence and the responsibility of proving that it is not so lies with one who asserts so. The Indian Sale of Goods Act states: "Unless a different intention appears from the terms of the contract, stipulations to the time of payment are not deemed to be of the essence of the contract of sale. Whether any other stipulation as to time is of the essence of the contract or not, depends on the terms of the contract." However, the price in a contract of sale is an essential part of the contract. It is the consideration for the transfer of ownership in the goods from the seller to the buyer. It may be fixed at the time of contract or afterwards in any manner, but the buyer has to pay the price. If it is not fixed, the buyer has to pay a reasonable price of the goods to the seller. So far as the payment of price is concerned, one has to consider three aspects:

payment10f Price

Time

Mode

I

I

Time of payment, i.e., When to pay

Mode of payment, i.e., How to pay

I Place

I Place of payment, i.e., Where to pay

So far as the time of payment is concerned, the amount should be paid when it falls due or within the reasonable time. The buyer has no right to delay the payment, until a

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demand is made. As regards the place of payment, it should be at the seller's place, unless otherwise specified. In the purchase order, the mode of payment should also be clearly spelt out, e.g., discount, credit period, despatch terms etc. The mode of payment is important. It the buyer comply with the mode of payment, suggested in the contract, he is safe even if the amount is stolen or does not reach the seller.

Performance of the Contract of Sale of Goods So far as the seller is concerned, it means the delivery of the goods to the buyer and so far as the buyer is concerned, it means the acceptance of the delivery of goods and payment for them, in accordance with the terms of contract of sale. Now from the seller's point of view, the delivery of the goods includes (i) transfer of ownership of goods (ii) transfer of possession of the goods and (iii) the passing of the risk from the seller to the buyer. Now the ownership in the goods is transferred to the buyer in the following ways: (i) In case of specific goods the ownership passes to the buyer at the time when the parties intend it to pass, i.e., as per the terms of the contract and if nothing is mentioned in it then at the time when the contract is made. But if the goods are not in a deliverable state, then it passes to the buyer when the goods are put in a deliverable state. (ii) In case of future goods the ownership passes to the buyer, when the goods are actually ascertained. (iii) When the goods are delivered to the buyer on approval or "On sale or return" or other similar terms, the ownership in the goods passes to the buyer when the buyer signifies his approval or acceptance to the seller or if he does not signify his approval or acceptance to the seller but retains the goods, beyond the time fixed for the return of goods or if no time has been fixed, beyond a reasonable time. If the buyer does not signify his approval but starts using the goods, it amounts to his acceptance. Now it is the general rule that risk follows the ownerShip. It means that if the goods are destroyed, or damaged or lost by accident, the owner of the goods at the time of loss will have to bear the loss. If the loss has resulted from the action of the third party, only the owner has a right to take actions against that party. So far as the delivery of goods is concerned the seller must deliver the goods in the quantity as contracted for, i.e., neither more nor less. He must deliver the goods at fixed time. If the time is not stated, then within the reasonable time. It is to be noted that the seller is not legally bound to deliver the goods until the buyer applies for delivery. If the place of delivery is not specified in the contract, the buyer has to take the delivery of the goods from the seller's place of business or factory or warehouse. Now the cost of goods includes cost of loading and unloading of goods, cost of transportation, insurance, demurrage, delivery to a carrier, packaging, delivery at destination, customs duty, octroi etc. Goods may be lost or damaged in transit. Now who should bear the above expenses or losses? It all depends on the terms of delivery. If nothing is mentioned in terms of the contract about the above-mentioned factors the buyer has to bear the expenses and losses. Even if the buyer has authorised the seller to send/ship the goods, he remains responsible for paying the cost of transportation and also for the loss or damage in transit. If the terms of delivery and payment are specifically mentioned in the contract, the responsibility can be fixed. Generally the following terms are found in the contracts:

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(1) C.!.F.: It means 'Cost, Insurance and Freight.' In a contract of sale with such term, the seller has to deliver the goods at buyer's place and the seller has to bear the freight as well as insurance charges relating to the goods sent. Here the legal title to the goods passes from the seller to the buyer, when the carrier delivers the goods at the buyer's place of business or buyer's godown or factory. In case of loss of goods or damage to the goods in transit, whoever is the owner can claim and recover the amount from the insurer. In such type of contract the price of the goods quoted includes (i) the price of the goods (ii) the cost of insurance and (iii) the freight up to the buyer's place or destination. This term is generally found in the contract of sale in case of foreign trade. In case of foreign trade the name of the port of destination is always given with C.LF. term, e.g., C.LF. Aden. Suppose A of Ahmedabad agrees to sell 200 units of goods at Rs. 500 per unit, C.LF. Mombasa, he becomes responsible for the following: (i) he has to prepare the invoice for the goods sold, (ii) he has to arrange for the shipment of goods, (iii) he has to make arrangement in such a way, so that the goods will be delivered at port Mom basa, (iv) he has to arrange for transportation of goods from Ahmedabad to the port of shipment, (v) he has to arrange for the insurance as required and (vi) he has to send the relevant documents - bill of lading, insurance policy, invoice, certificate of origin etc. - to the buyer so that he can take the delivery of the goods, when they reach Mombasa. However, the cost of unloading and import duty at Mombasa port is to be paid by the buyer (importer). (2) C & F (Cost and Freight): Under this term the seller has to deliver the goods at buyer's place or destination and has to bear the freight charges. Here, the supplier does not take any risk for the loss of, or damage to, the goods in transit. It is the buyer's responsibility to insure the goods, if he wants to protect himself against loss of goods in transit. This term is also generally used in foreign trade. (3) F.O.B. (with the name of the port of shipment, i.e., shipping point); Here the seller is responsible for the delivery of the goods at the port of shipment. His responsibility ends when he delivers the goods to the ship at the port of shipment. He has to bear the expenses for transportation of goods from his place of business to the port of shipment. The possession, ownership and risk are transferred to the buyer at the time of delivery of goods to the ship at the port of shipment. The buyer has to pay the freight charges directly to the carrier and in case of damage in transit, the buyer has to make the claim for damages and to negotiate with the carrier. This term, is used when the purchases are made in a big lot and freight charges are substantial. Generally, the buyer names the ship to which goods are to be delivered. By doing this, the buyer can control in-bound shipments and can control freight charges also. Sometimes, the buyer authorises the seller to select the ship. Suppose P of Pune agrees to sell the goods F.O.B. Mumbai to A of Aden. Here P has to put the goods on board a ship at Mumbai at his own expenses. Once the goods are put on board the ship, they are at the risk of the buyer (A). All the subsequent expenses are to be borne by A. (4) F.O.R. (with the name of the station): F.O.A. means "Free On Rail." This term is used in internal trade when the goods are sent by trains. When the name of the station is mentioned, the supplier becomes responsible to deliver the goods at the named station. If D of Delhi agrees to sell the goods to G of Kolkata - F.O.R. Kolkata, D has to bear the

Legal Aspects of Purchasing 307 freight charges. Now the goods may be sent at the owner's risk or the railway's risk. In the latter case, whoever is the owner at the time of loss can claim and recover the amount from the Railway authorities. The ownership and the risk in the goods are transferred to 'G' in the above case, when the goods are delivered to him at Kolkata railway station.

Purchaser's Legal Rights (1) Right to have delivery as per contract: The purchaser has a right to have delivery of the goods as per contract. The supplier must deliver the goods strictly according to the terms of the contract. The purchaser cannot be held responsible, if he rejects the goods, in case of delivery of wrong quantity or quality. (2) Right to inspect the goods: Purchaser has a right to inspect the goods before paying for them, if he has not inspected the goods before purchasing the same to determine whether they conform to contract specifications, i.e., the terms of the contract. If the method, place or time of inspection forms a part of the terms of the contract, then the inspection is to be done as per the agreement. If the time is not stated, the purchaser can inspect the goods within reasonable time after the receipt of the goods. The decision regarding 'reasonable time' depends on the business practices prevailing at that time. The expenses of inspection are to be borne by the supplier, if the goods are found to be nonconforming. (3) Right to reject non-conforming goods: A purchaser has a right to reject the goods, which do not conform with the terms of the contract i.e., the purchaser can reject the goods which are not satisfactory or do not meet specifications. However, he can accept the nonconforming goods subject to correction or price adjustment. If it is possible to separate the damaged or substandard lot from the whole lot purchased, the purchaser can accept the goods in part and reject in part. If the purchaser wants to reject the whole lot or a part of it, he must inform the seller within the reasonable period. If the purchaser does not raise objection or does not inform or fails to inform the seller of his rejection within a reasonable period, it is considered that he has accepted the goods and he becomes liable for the materials purchased. Goods once accepted cannot be rejected subsequently on discovery of defects. Therefore, it is advisable for the purchaser to make complete inspection. Before rejecting the goods, the purchaser must inspect the goods completely and must clearly state the reason for rejection. Moreover, he must be able to justify the rejection because if he fails to prove the defects, he becomes liable to the seller for the goods. If it is not possible to discover the defect by ordinary process of inspection, the purchaser has a right to claim damages, only if he informs the supplier of the problems as soon as he finds out the defect. If he has bought the goods on seller's assurances about its quality etc., he can reject the goods which do not conform with the agreed terms. But after receiving the goods, if he starts using the goods, resulting in substantial changes in the conditions of the goods, he cannot reject the goods. He can only claim the damages. It should be noted that unless otherwise agreed upon, the purchaser is legally under no obligation to return the rejected goods, when the rejection relates to non-conforming goods. When the buyer fails to recover a defect by 'mistake', he can subsequently claim for the damages. (4) Right to sue for damages for breach of warranty: We have discussed earlier in this chapter that a warranty may be express or implied. Where there is a breach of warranty by the supplier and the buyer has to suffer damages by the supplier on account of breach,

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the buyer has a right to sue the supplier for damages arising out of the breach of warranty - either express or implied. (5) Right to receive expenses relating to the rejected goods: The purchaser has a right to receive the expenses incurred in connection with rejected goods. But it is necessary for him to hold the rejected goods for seller's disposition and should dispose of or return the goods as per the reasonable instructions of the supplier. (6) Right to cancel the order and to sue for damages: The purchaser can cancel the order (i) if the supplier does not deliver the goods by delivery date agreed upon in the contract or (ii) the supplier refuses or neglects to deliver the goods to the purchaser. The purchaser can claim and recover the damages, if he actually suffers on account of breach of the contract. If the supplier does not deliver the goods by delivery date, which are readily available, and the purchaser subsequently purchases the goods from other suppliers, the purchaser can recover the damages to the extent of difference between the contract price and the price paid to the new suppliers. Fixation of damage becomes very difficult when the purchaser fails to get the materials from any other source. Suppose, A accepts an order from B to supply detergent powder at Rs. 4 per kg. and subsequently A refuses to deliver or fails to deliver the goods. If B purchases the same type of materials from another supplier at Rs. 6 per kg., he can collect damages at Rs. 2 per kg. from A. Procedure to determine the costs and damages in case of cancellation of contract by either party (Le., supplier or purchaser) can be incorporated in the contract document itself at the time of drafting the terms and conditions of the contract. Specific damage payments can also be stated, e.g., the commencement of production is delayed by the late delivery of the machine A, the purchaser may suffer heavy losses. Sometimes late delivery causes as much damage to the purchaser as no delivery. Therefore, in such type of contracts a liquidated damage clause is included. Here it is stated that damage of Rs .... per day will be paid to the purchaser for the late delivery. However, both the parties should agree fully over the clause. Such type of provisions minimise the possibility of misunderstanding and chances of litigation in case of breach of the contract. (7) Right to sue for price and interest if any: If the purchaser has paid the price in advance, but the supplier does not deliver the goods or refuses to deliver the goods subsequently, the purchaser can also recover the amount paid. Moreover, the purchaser can claim interest on the amount of price. (8) Right to protect one's own (Purchaser's) organisation: The purchaser has a right to protect his organisation by adding a special patent infringement clause in the purchase order. When the buyer purchases as per his own speCifications this does not apply. But sometimes large-scale purchasers give financial and technical assistance to the suppliers for development of new products and materials. In such cases it is advantageous for the purchaser to include such clause in the purchase order, covering the patent rights for inventions discovered by a supplier while executing his purchase contract. (9) Right to claim damages or to reject the goods in case of sale by samples: The sale by samples is advantageous to the purchaser. It can be proved very easily with the help of samples that the goods are not as per the specifications or are not fit for the use as stated in the purchaser'S order. But the purchaser must be able to establish existence of the sample and prove that the sample is of the contract standard. Here, the preservation of sample for future inspection becomes extremely necessary. When a supplier sells the goods on the basis of sample, he implies that the sample is representative of the total quantity to be sold.

Legal Aspects of Purchasing 309 (10) Right to claim damages in case of sale by description: While drafting the purchase order, description of the goods to be ordered is given. Description must be given to make the purchase orders complete and clear in their specifications. This can be done by mentioning the end use, tolerance, finish etc., referring to rational and international specifications and the tests which the items have to pass. When the manufacturer manufactures the items with full knowledge of their uses and if the items prove to be unfit, the purchaser has a right to claim damages. In a contract for the sale of specific items under patent, there is no implied condition as to the fitness of the item for a specific use.

(11) Right to return the goods purchased 'On approval': The purchaser can return the whole lot including conforming goods at the cost and risk of the supplier within reasonable period, if he does not want to accept the same. If he does not take decision within the reasonable period allowed by the supplier or if the purchaser starts using the goods it is considered as his acceptance and he becomes liable to pay for the same. In the same way, when the purchaser purchases goods on "Sale or return" or "Consignment" basis, he can return the goods, if he does not want to accept the same. But he must inform the supplier about his rejection within the reasonable period. Here, the purchaser has to bear the expenses for return of the goods. If the purchaser fails to return the goods within a reasonable period, he becomes liable to pay for the same. (12) Right to reject the goods delivered in wrong quantity: The purchaser has a right to reject the goods if the delivery is defective. When the supplier delivers the goods in less quantity than contracted for or in excess of the quantity contracted for or the goods contracted for have been mixed with other goods, the delivery is treated as a defective delivery or the delivery of wrong quantity, e.g., A contracts with B for the purchase of 100 tons of sugar of 'B' grade, if (i) B supplies 125 tons of sugar of 'B' grade or (ii) he supplies 75 tons of sugar of 'B' grade or (iii) he supplies 80 tons of sugar of 'B' grade and 20 tons of sugar of . C' grade. It is considered in all the above three cases, as a delivery of wrong quantity. A has the following options in the above cases. In the first case, A can accept 100 tons of sugar of 'B' grade and reject 25 tons of sugar or he can reject the whole lot of 125 tons. In the second case, he can accept 75 tons of sugar or he can reject the whole lot. In the third case, he can accept 80 tons of sugar of 'B' grade and reject 20 tons of sugar of 'C' grade or he can reject the whole lot. In the same way he can also reject the goods if they are delivered by instalments, unless otherwise agreed. (13) Right, in case of cancellation of contract by the supplier before due date: Where the supplier cancels the contract before the date of delivery, the purchaser may either treat the contract as substituting and wait till the date of delivery, or he may treat the contract as rescinded and sue for damages for the breach.

Duties and Liabilities of the Purchaser (1)

(2)

To take delivery of, and pay for, the goods: When the supplier delivers the goods, it is the duty of the buyer to accept the goods and pay for them, in accordance with the terms of the contract of sale. To apply for the delivery: Apart from any express contract, the supplier of the goods is not bound to deliver the goods until the buyer applies for delivery, and therefore, it is the duty of the buyer to apply for the delivery of goods.

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(3)

(4)

(5)

(6)

(7) (8)

(9)

To reject the non-conforming goods within reasonable periodn-o inform the supplier of rejection of goods within reasonable period: If the purchaser wants to reject the non-conforming goods, he must inform the supplier within a reasonable period. If he fails to do so, it is considered that he has accepted the goods and he becomes liable to pay for the goods. Goods once accepted cannot be rejected subsequently on discovery of defects afterwards. To state clearly the reasons for rejection: Before rejecting the goods, the purchaser must inspect the goods completely and he must state clearly the reasons for rejection. He must be able to justify the rejection, because if he fails to prove the defects, he becomes liable to pay for the goods. If he fails to inspect the goods within a reasonable time and fails to determine whether they conform to contract conditions, he is deemed to have waived his right to inspect the goods. To take decision for approval of the goods or otherwise within the time limit allowed: When the goods are purchased on approval, the purchaser must take the decision about the approval of the goods or otherwise within the time limit allowed by the supplier. If he fails to take any decision or starts using the goods, it is considered as his acceptance and he becomes liable to pay for the same. In case of goods purchased on "sale or return" or "consignment" basis, also, he must inform the supplier about his acceptance or rejection within reasonable period and must return the goods at his own cost. To hold the rejected goods on behalf of the supplier: When the purchaser rejects the goods, it becomes his duty to hold the goods for supplier's disposition and to dispose of or to return the goods as per the reasonable instructions of the supplier. To preserve the sample of the goods: When the goods are purchased on the basis of a sample, the purchaser must preserve the sample for future inspection. To take the risk of deterioration of goods: To take the risk of deterioration of goods during the transit rests with the buyer provided it is not abnormal, even though the supplier might have agreed to deliver the goods at his own risk at a place other than where they are sold. Liability of purchaser for cancellation of an order or for refusal to take delivery of goods: When the purchaser cancels an order before the supplier is obligated to supply the goods or when the supplier is ready and willing to deliver the goods and requests the purchaser to take delivery or when the supplier delivers the goods and the purchaser does not take or refuses to take the delivery of goods, the supplier can hold the purchaser liable for any damage suffered by him. If as a result of cancellation of an order or refusal to take delivery of goods, the supplier is left with the goods, which are not saleable now, the purchaser becomes liable for the supplier's cost prior to cancellation or refusal plus reasonable profit on the contract. The purchaser is also liable for a reasonable charge for care and custody of the goods left with the supplier. If as a result of cancellation of order or refusal to take delivery, the supplier is left .with the materials in process which are saleable, the purchaser is usually held liable for the difference between the proportionate contract value and the market value of the materials in process. Moreover, when the delivery date is not stated in the purchase order, it becomes very very difficult for the purchaser to

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cancel the contract for the non-delivery of the goods, by the supplier, within a reasonable time. (10) Liability for the use of patented articles : Only the patent-holder can manufacture, sell or use the patented articles for specified number of years. If a purchaser manufactures, sells or uses the patented articles during the period of patent protection without patent-holder's permission, he is held guilty of patent infringement and can be sued for damages by the patent-holder. In most of the cases the purchaser does not know whether the supplier is selling the patented articles with or without the permission of the patent-holder. Even if the purchaser buys such materials from the supplier without the knowledge of infringement of patent-holders' rights by the supplier, he is held guilty, if he uses the articles. Therefore, to protect against such unintentional violations and to avoid litigation against himself as well as his company, a protective clause should be included in the purchase order. This clause states that the supplier will indemnify the purchaser for all expenses and damages, resulting from patent infringement. Here also patent-holder can take legal actions against the purchaser for patent infringement, but the properly framed clause stated in the contract becomes helpful to the purchaser. In such a case the supplier has defended the purchaser and the purchaser can recover from the supplier, the damages or losses resulting from the patent infringement. It is to be noted that when the manufacturer has patented the complete machine and not the individual parts, the purchaser of the machine (i.e., the owner) can replace or can make any part of the machine, when it is needed, without the permission of the patent-holder. But if the manufacturer has patented the different parts of the machine, the purchaser cannot replace or make any part of the machine, without the permission of the patent-holder. Only the patent-holder and if he permits the other party than that party can rebuild the machine. • (11) Liability for purchase of goods at discriminatory price: The purchaser can ask for legitimate price concessions, e.g., trade discount etc., which are justifiable. But, if knowingly he purchases the goods at discriminatory price, he violates the law. (12) Liability in case of a mistake: When a supplier makes honest mistake which the purchaser knows or should know, the contract is void, e.g., if the supplier quotes Rs. 94 for a particular item instead of Rs. 945 and the purchaser accepts the offer knowingly that there is a mistake on the part of the supplier, the contract is void. Even if the buyer does not know the mistake, he is expected to recognise such type of mistake. But if the supplier quotes Rs. 930 for a particular item instead of Rs. 945 and the buyer accepts the offer without the knowledge of the mistake, the contract is valid as the mistake is not such which can affect the agreement materially.

Rights of an Unpaid Supplier When a supplier is not paid the price for the goods purchased from him, he becomes an unpaid supplier. Unpaid supplier has been given some rights against the goods sold as well as against the purchaser personally. The knowledge of the rights given to unpaid supplier is very important for any purchasing executive because this knowledge makes him more careful in dealing with the supplier so as to avoid litigation against the company or himself. He has the following rights:

312

(1)

(2)

(3)

(4)

(5) (6)

(7)

Outline of Materials and Purchasing Management Right of lien : He has a right to retain the possession of the goods until payment of the price. This right can be exercised only if the goods are in his possession.

Right of stoppage in transit: He has a right of stopping the goods while they are in transit, resuming possession of the goods as long as they are in the course of transit. This right is available when the purchaser becomes insolvent and the goods are in transit. Right of resale: He can re-sale the goods, if he is not paid the price. He can do this only if he is in possession of the goods. Where the goods are of a perishable nature, the supplier exercises this right for non-payment of price. Right to sue for price: Where the supplier has delivered the goods to the purchaser and the purchaser refuses to pay for the goods, the supplier can sue the purchaser personally for the price of the goods. Right to sue for interest: The supplier can also recover interest on the price from the purchaser for the period of late payment. Right to sue for damages for non-acceptance: Where the supplier is ready and willing to deliver the goods and informs the purchaser to take delivery or he delivers the goods but the purchaser does not take or refuses to take the delivery of goods, the supplier can sue the purchaser for the damages or losses suffered by him and for the expenses incurred by him as a result of wrongful refusal. Right to cancel the contract before due date: Where the purchaser cancels the contract before the date of delivery, the supplier can also treat the contract as cancelled and can sue for the damages for breach.

Special Contracts Sometimes a purchasing executive places a contract where a rate is agreed upon and the quantities to be supplied from time to time are left to be intimated by periodical releases. Here the buyer does not commit himself to lift any minimum quantity. Such contracts are deemed to be standing offers and acceptance is that the buyer recognises the standing offer for a stated period. But as soon as release order is issued, the contract becomes binding for that quantity. The supplier may, if he wants, withdraw his offer with reference to any future period. This is however not possible if the tender and its acceptance were intended by the buyer and the supplier is to be contracted, involving obligation on both sides during that period. Frequently orders are given, stipulating specific quantities to be lifted during the period, with clauses of some variation in quantity or period during which it is to be lifted. This is a binding contract e{lforceable for the supply of entire quantity of goods contemplated in the contract. There is another type of contract where the purchaser is not bound to purchase any specific quantity. He commits to buy and pay for goods as needed by him, in a stipulated period. This is a binding contract.

Works Contract These types of contracts pertain to the supply and fixing of materials for immovable property, such as buildings etc. Here, the contract is not divisible. From the viewpoint of a purchasing executive, large savings can result by way of reduction in sales tax through

Legal Aspects of Purchasing 313 resorting to a works contract. A guarantee to the contract is something which the promisor undertakes to be answerable for debts, default etc. of another person. It is an additional and conditional contract.

5. NEGOTIABLE INSTRUMENTS (NEGOTIABLE INSTRUMENTS ACT, 1881) In commercial transactions and monetary dealings, certain ciocuments are generally used. These documents are known as 'negotiable instruments.' These documents include promissory notes, bills of exchange (also Hundi bill of exchange in a vernacular language) and cheques. A negotiable instrument is transferable from one person to another by mere delivery, if it is payable to the bearer or by indorsement and delivery, if it is payable to the order. Every instrument is payable otherwise than 'on demand' is entitled to three days of grace. Payment must be made according to the terms and conditions of the instrument and the payment should be made in good faith, without negligence and under bona fide ci rcumstances. If a person obtains an instrument by unlawful means (by theft, by fraud, etc.), he does not acquire a title to the instrument as against the rightful owner and he cannot enforce payment on it against any party thereto or cannot recover anything. If he obtains payment on it, he is liable to the true owner. A negotiable instrument may be dishonoured by non-acceptance or by non-payment. When it is dishonoured, the party liable to pay becomes bound to pay compensation to the holder or indorsee. The compensation payable includes the principal amount, interest due on the principal amount and all proper expenses for noting, protesting or for exchange.

6. CARRIAGE OF GOODS General: Generally all the commercial transactions relating to the goods result in the carriage of goods from one place to another within a country or from one country to another, i.e., across international borders. Goods may be carried by land, sea or air. The persons who carry goods, whether by land, sea or air are known as carriers. Carriers may be common or private. Common carriers undertake for hire to transport from one place to another, either by land, sea or air, the goods of anyone wishing to employ them. A private carrier carries the goods for selected persons only and not for everybody. A common carrier is responsible for safe delivery of the goods. He is bound to make good to the consigner the loss or damage to the goods in the course of carriage. Carriage by Rail: The railway administration is bound to carry the goods of every person who is willing to pay the freight and comply with other requirements. The goods may be carried at owner's risk rate or at railway risk rate. In case of the owner's risk rate, the railway administration is liable only when it is proved that any loss, deterioration or nondelivery of goods arose from negligence or wilful misconduct on the part of the railway administration or its employees. In case of the railway risk rate, the railway administration has to prove that the loss, deterioration or destruction was not due to the negligence or misconduct on the part of its employees. Thus the railway administration can be sued for damages and losses resulting only from its negligence or misconduct of its employees in the course of their employment. Carriage by Sea: A contract to carry goods by sea is called the contract of affreightment. In case of a charter party form of contract an entire ship or a part of it is hired. Here the ship owner agrees to place the entire ship or a part of it, at the disposal of

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a sender of the goods for the carriage of the goods. In case of a bill of lading form of contract, the goods are carried in general ship, which is ready and willing to carry the goods of any person, who intends to use it for the carriage of goods. In both these contracts the ship owner undertakes the responsibility of carrying the goods of a consigner safely and securely to the destination for consideration called freight. A bill of lading is a document of title to the goods and it acknowledges receipt of goods which are delivered to a general ship for carriage. Carriage by Air: Goods carried by air must be covered by an air consignment note. The consignor of the goods is required to make out and hand over the note to every carrier of goods. The consignor has a right to require the carrier to accept the document. The carrior must sign the acceptance of the goods. The air consignment note is the proof of the receipt of the goods. The carrier is liable for the destruction or loss of, or damage to, any goods and also for the delay in the carriage of goods. When a person, responsible for taking delivery of the goods, gives receipt to the carrier without complaint, it is considered that the goods have been delivered in good conditions and in accordance with the document of carriage. In the carriage of goods, the liability of the carrier is limited to a sum of 250 francs (French francs) per kilogram.

7. ARBITRATION General: Arbitration is the method of settling disputes between two or more persons through an independent and impartial third person, instead of going to the court for the same. Arbitration is advantageous for the following reasons: (1) The procedure is simple. (2) It saves time. (3) It saves expenses. Litigation is too much expensive. (4) Delay and uncertainty involved in appeals is avoided, because the award is final. (5) As the proceedings are held privately, the publicity is avoided. (6) In case of matter of technical nature, technically qualified person may be appointed as an arbitrator. (7) Facts and figures presented remain confidential. But the arbitrator may be incompetent or biased and the injustice may result from the informality of the procedure.

The arbitration agreement is also a contract and therefore the parties must be competent to contract so that they can be bound by the award of the arbitrator. The arbitration agreement is the written agreement to submit present or future differences to arbitration. A person who is appointed to determine differences and disputes between two or more parties is called an arbitrator. He is appointed with the mutual consent of the parties and is an extra-judicial tribunal whose decision is binding on the parties. The appOintment of a person as an arbitrator is complete only when such a person has accepted the reference and consented to act. Arbitration in the field of Materials Management is used for settling the dispute between purchasers and suppliers due to its advantages mentioned in the foregoing paragraph. The purchaser must inc!lude an arbitration clause and the supplier should agree to it to take the advantages of arbitration. When such clause is there in the contract, the court will not entertain any suit1mless the arbitration process has been exhausted. Arbitrators have similar powers as courts and their award is binding and enforceable on the parties.

Powers of the Arbitrator or Umpire The arbitrator or umpire shall, unless a different intention is expressed in the agreement, have power to (i) administer oath to the parties and witnesses appearing, (ii) state a special case for opinion of the court, (iii) make the award conditional or as an alternative, (iv) correct in the award any clerical mistake or error ariSing from any accidental

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slip or omission, (v) administer to any party the arbitration such interrogatories as may, in the opinion of the arbitrator or umpires, be necessary.

Duties of Arbitrators (i)

(ii) (iii) (iv) (v) (vi) (vii)

After receiving the notice of appointment, the arbitrators should see that the appointment is in order. He must also satisfy himself that the dispute which he deals with are within the terms of submission so that this award may not be vitiated for want of jurisdiction. He must, with all reasonable dispatch, enter on the reference and make an award. He must act judicially and impartially. He must have no interest direct or remote in the subject matter of the dispute between the parties. He must not misconduct himself on the proceedings in any way. He must give a final award on all matters referred to him unless he is empowered to make several awards. He must not exceed his authority and must act within the scope of the arbitration agreement.

Award The award is the decision of the arbitrator. It must be made in writing and must be in such a form and expressed in such a language as the arbitrators think fit. But it must be clear, certain in meaning, possible and reasonable. It must be dated and signed by the arbitrator. The award can be modified by the arbitrator if (i) there is a clerical mistake in the award, (ii) when the award is remitted to him for reconsideration. It can be modified by the court (i) where it appears that a part of the award is upon a matter not referred to arbitration, (ii) where the award is imperfect or contains any obvious error and (iii) where the award contains any clerical mistake. An award can be set aside by the court on one or more of the following grounds: (1) Arbitrator has misconducted himself or the proceedings. (2) The award has been made after the issue of an order by court superseding the arbitration or after the proceedings have become invalid. (3) The award has been improperly procured or is otherwise invalid. Parties to an arbitration agreement are given an option of proceedings without the intervention of the court or under the supervision of the court where there is no suit pending. Sometimes, the parties to a suit which is pending before a court may decide to settle it by arbitration. Here they may apply to the court for an order of reference. The court shall then refer the matter in deference to the arbitrator appointed in such manner as may have been agreed upon between the parties.

000

CIiAPTER 2} Transportation and Traffic Management Traffic function is a specialized phase of purchasing dealing with such matters as selection of the mode of shipping, routing of incoming shipments, rate schedules and claims. In any business concern, there are problems regarding incoming and outgoing shipments. It is the former that is of primary interest to the purchasing department. The purchaser must have goods available at the place they are needed, at the time they are needed and at the lowest possible cost. Traffic management is obviously related to the manner in which these responsibilities are met. The incorrect choice of carrier or route can delay a shipment and add to the transportation as well as production costs. Traffic function, thus, includes transportation which constitutes about 10 to 20% of the final selling price of the goods. Traffic and transportation are of particular importance to purchasing personnel due to the following reasons: (1) It has been accepted as a function of that department. Nevertheless, some large companies do have a separate traffic department which is responsible for problems related to the purchase of transportation services, including the selection of mode of transport and of carrier, negotiation of rates, tracing and expediting of shipments, filing and negotiation of claims for lost or damaged shipments and audit of freight bills. (2) Every order placed includes transportation services. A vendor's quotation has a little significance until transportation charges are added to arrive at a delivered price. (3) In the typical manufacturing concerns, transportation services are the third greatest expenditure. Only purchased materials and labour are more important.

Basic Responsibilities of the Traffic Manager As stated above, sometimes a separate traffic department is established to relieve the purchaser from the stresses and strains of the job. The traffic matters of greatest concern to purchasing incfude: (i) Negotiation of rates. (ii) Selection of mode of transport and carrier. (318)

Transportation and Traffic Management (iii) Audit of freight bills.

(iv) (v)

Tracing and expediting of shipments. Filing and negotiation of claims for lost or damaged shipments.

(vi)

Minimize transportation costs.

317

Traffic is intimately involved in purchasing management and physical distribution even in companies where there are no organizational ties linking traffic with other purchasing activities. The reason being that the choice of a carrier automatically influences inventory levels. Speedy transportation permits less inventory than is required for slower more erratic modes. The traffic function is also intimately linked with the problems of warehouse and plant location. In simple cases, the location must be easily accessible to low cost transportation; in more complex cases, inventory investment, transportation costs and other variables combine to determine optimum location. The typical traffic department also has a number of miscellaneous functions including the handling of all passenger reservations for employees travelling on company business and the moving of household effects of employees transferred from one company plant to another. Sometimes, he is also responsible for the operations of all company-owned vehicles; even if he is not, he should always be consulted prior to their purchasing. Further, traffic is concerned with packaging material because the weight of the tare has direct relationship with the transportation costs. However, traffic usually is concerned with both inbound and outbound shipments of materials and finished products. It becomes involved with charter carriers or companyowned vehicles. Normally, most of their dealings are with various common carriers including rail, roads, trucks, pipelines and water carriers.

Negotiation of Rates The factors determining freight rates and the flexibility of rates are some of the least understood areas of transportation and traffic management. Generally, they are unaware of the fact that proper planning and the knowledge of basic principles on which the rates are established can decrease the transportation costs. A general tendency is to view it as a mesh of tedious facts that cannot be influenced by the individual firm. The basic principles underlying the determination of transportation rates are quite simple and such principles if applied in practice can lead to a considerable reduction in the transportation costs. The principles are as follows: (1) The value of the product: The higher the value of the product the higher is the transportation rate. So the rate of transporting gold can be much higher than that of cheaper goods like iron, coal or steel etc. (2) Density: The density of a product is related to the ability of a carrier to obtain complete loads. So, the denser the product is, the easier it is to completely load a carrying vehicle and consequently lower the transportation rate. For instance, the shipment of clothes would be cheaper to transport. (3) Packaging requirements: The greater the requirements, the higher the rates. (4) Space required: If the commodity is a bulky one, requiring more space and weighing less, the transportation rates are higher as they are based on space required for such items. That is the reason why transportation of cotton bales is a bit more costly. (5) Volume of traffic moved: Quality discounts are universally applied. The full load truck would prove to be extremely cheap in comparison to retail or quarter load or half load.

318

Outline of Materials and Purchasing Management (6) The place to which the goods are to be transported: If the goods are to be transported to a small city or town from where there is no likelihood of getting return shipment, the rates are naturally higher.

(7) Special services required: Special services such as special connection and stopover privileges will increase the costs. (8) Competition: It may be of two types: (a) (b)

Internodal: e.g., railroads versus trucks. Intra-industry: i.e., number of truck lines, i.e., Jaipur Golden versus R.R. Transport. Over and above, the rates may depend on the demand and supply of the carriers also. If there is a rush for the up-trip, the freight rates for up-trip will decrease as there would be a glut of carriers over that point or place. To cut short, established freight rates reflect many variables, in fact more than one at a time, and so charges will vary with the relative importance of the above considerations.

Carrier Alternatives The carriers can be stratified into three classes: (1) Common carriers. (2) Contract carriers. (3) Private carriers. The preponderance of freight is shipped by common carriers. They provide service either for all commodities or for specified types of commodities. A contract carrier is an independent contractor who operates under individual contracts. He usually provides specialized service for selected commodities to a limited number of shippers. The private carrier provides transportation for his own commodities in company-owned or leased vehicle.

Free-on-board Terms The abbreviation F.O.B. indicates the point of origin from which freight charges are calculated. It has both economic and legal significance to buyers, carriers and shippers because it determines who pays the freight charges and also who has the legal title to the good in question. However, F.O.B. alone does not convey any sense until and unless a phrase is added to indicate the point at which the goods are free on board; such as F.O.B. consignor's place or F.O.B. destination. It is at the F.O.B. pOint where title changes hands and from which the transportation charges accrue to either buyer or shipper. For a shipment proceeding F.O.B. shipping pOint, title passes to the buyer at the shipping point. Therefore, the carrier sets as the agent of the buyer who is responsible for damage, freight claims and other complications that may arise during shipment, and-paying freight charges. For a shipment made F.O.B. destination, these responsibilities fall upon the seller until it reaches the destination. If no qualifying phrase is added, the term F.O.B. is generally understood to be at the point of origin of the shipment. Tho following can be of material use in determining who is responsible under various F.O.B. terms. The seller, the Enfield India Limited, is assumed to be located in Chennai and the buyer Pragati Automobiles, Mumbai.

Transportation and Traffic Management

319

I. F.O.B. named point of origin (i.e., F.O.B. the Enfield India Limited, Chennai, through Jaipur Golden Transport Service). A.

Seller has to (1} Place goods on or in cars or vehicles. Secure the receipt from the carrier. (2) (3) Be responsible for loss and damage until the goods have been placed in or on cars or vehicles, at the point of origin, Le., ChennaL

B.

Buyer has to (1) Provide for the movement of goods after they are on board. Pay all freight charges to destination, Le., bear transportation costs for bringing (2) the goods home. (3) Be responsible for loss or damage or for filing claims with carrier for loss or damage to shipment while in transit. Pay any demurrage and storage charge. (4) II. F.O.B. named point of origin with transportation charges allowed to destination (Le., F.O.B. Enfield India Limited, Chennai, Freight allowed via Jaipur Golden Transport Service).

A.

Seller has to (1) Place goods on or in cars or vehicles. Secure receipt for the goods. (2) (3) Pay transportation charges from the point of origin to destination. Be responsible for loss or damage until goods have been placed in or on cars (4) or vehicles at the point of origin.

B.

Buyer has to (1) Provide for the movement of goods after they are on board. (2) Be responsible for loss or damage or for filing claims with carrier for loss or damage to shipment while in transit. (3) Pay any demurrage and storage charges.

C.

Title passes to buyer when shipment is turned over to carrier. III. F.O.B. named destination (Le., F.O.B. Pragati Automobiles, Mumbai, via Jaipur Golden Transport Service). A.

Seller has to (1) Place goods on or in cars or vehicles. Secure receipt for the goods. (2) Pay all transportation charges until goods have reached the destination. (3) (4) Be responsible for loss or damage to shipment while in transit.

B.

Buyer has to (1) Provide for any movement of the goods after their arrival at named destination. (2) Be responsible for any loss or damage incurred after arrival of goods at named destination. Pay any demurrage and storage charges. (3)

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Outline of Materials and Purchasing Management

C.

Title remains with seller until the shipment is delivered to the buyer IV, F.O.B. a place which has been mutually agreed upon at the time of contract for certain types of costs, octroi etc. (Le., F.O.B. Enfield Warehouse, Ranoli, via Jaipur Golden Transport Service). . >

A.

Seller has to (1) Place goods on or in cars or vehicles. (2) Secure receipt for the goods. (3) Pay all transportation charges until goods have reached that particular place. (4) Be responsible for loss or damage or for filing claims with carrier until the goods have reached that particular place.

B.

Buyer has to (1) Provide for any movement of the goods after their arrival at named destination. (2) Be responsible for any loss or damage incurred after arrival of goods at named destination. (3) Pay any demurrage and storage charges.

C.

Title remains with seller until the shipment is delivered to the buyer.

Picking the Carrier Many alternatives are left open for the suppliers. Amongst them, however, the railroads are the most frequently utilised common carriers. Trucks are ranking second in respect of tonnage handled. Transportation through pipeline (in case of crude oil) is yet another way open to the Supplier. However, there is a wide difference so far as the freight rates are concerned. Trucks are more expensive than railways whereas pipelines are the cheapest. The reason for such difference is obvious - the rate per quintal-km for all commodities is not the same. A trucker who hauls a ton of household goods for one km may get about a 100 times as much as a pipeline gets for moving the same quantity of crude oil for the same distance. A company should buy transportation services just as it buys any other commodity on the basis of quality, price and service. It should select that carrier which provides prompt delivery with a minimum of loss or damaged shipments, co-operate readily in tracing and rerouting shipments, make a minimum of errors in invoicing and so on. These are some of the criteria which a company should consider while selecting amongst like types of carriers which charge identical rates, when the market structure is perfectly competitive. The transportation buyer must also select among various types of transportation service. His two fundamental norms should be price charged and service rendered. For most of the time, it is true that carriers that give speedy service charge relatively higher rates whereas those charging the lowest tariffs usually provide the slowest service. For example, shipment over water is the cheapest and normally the slowest way to ship any commodity - particularly in specialized bulk carriers that transport oil, coal, grain etc. Pipeline is the lowest-cost overland mode of transportation - so cheap that in certain foreign countries even coal is pulverized and mixed into slurry so as to pump it through special pipelines. However, it is not possible to transport all kinds of materials through pipelines so, shippers have to choose among a variety of higher cost, but usually faster, carriers.

Transportation and Traffic Management 321 Rail Freight: Railway freight charges are, for most of the time, lower than that of its

substitutes such as air freight, truck freight etc. Sometimes they are competitive with ship rates also. However, they are rarely cheaper than pipeline rates. For most of the commodities rail shipment - particularly in wagonload quantities is the cheapest possible mode of overland shipment. However, if the quantity is less than wagon load, sometimes it is better to ship it by truck. Air Shipment: In the wake of the introduction of supersonic jets and boeing airplanes, the real costs have reduced to a considerable extent. Since the end of World War II, physical volume of airshipment has increased at least by 50 times, although total tonnage is still a small fraction of that carried by rail or truck. The only factor that has tempered growth is the fact that air tariffs are still two to ten times higher than those charged by railroads and truck lines. The growth of air shipments is due to the perishability of certain commodities needed for production. Naturally such commodities need to be transported as quickly as possible, almost regardless of the cost. The other reasons for this growth are as follows: Firstly, the increased knowledge of the air tariffs which are obviously not as high as they appear. In ordinary cases, extremely fragile items would require heavy packaging if shipped by overland carriers, which is not needed in airshipments. Such saving would recoup the extra-freight rates. Secondly, the damages and losses are relatively less if the supplier chooses to ship by air. Thirdly, it permits the buyer to carry lower inventories. As it is speedier than other alternatives, the buyer can get the goods at a short notice and so he has not to invest very large sums in inventory. As a consequence, it also saves inventory carrying costs, storage costs, etc. Sea Transport: Unlike airshipment, it is usually the cheapest and slowest mode of transportation. So the shippers of bulky, relatively inexpensive raw materials try to ship by water or pipelines whenever possible in order to keep transportation costs at a minimum. This is the recoil why most of the chemicals, aluminium, steel and power-plants are located at deep-water parts or on inland water ways in order to reduce the cost of inbound raw materials. Water shipment is slow, but the rates always are low. Maritime Frauds: The rising incidence of maritime fraud has assumed frightening proportions, as more and more shippers, shipowners, insurance companies and banks fall prey. Between 1975 and 1980, reported losses directly related to various forms of maritime fraud all over the world touched the staggering figure of us $650 million. International Maritime Bureau (1MB), London plays a key role in combating such frauds. A large majority of frauds remain unreported. The bulk of maritime fraud cases can be classified into four major categories : 1. Scuttling or sinking of ships, 2. The illegal manipulation of shipping documents, 3. Ship deviation and subsequent theft of cargo, 4. Fraud related to chartering of vessels. The increased volume of traffic at ports provided an opportunity for dishonest operators to land their cargoes elsewhere and if possible sell them off to other parties. Capt. J. Abhyankar, Assistant Director, 1MB appeals to the trading community in India to check the records of their trading partners abroad, shipping companies, ship brokers and chartering agents before entering into an export or import contract. The depression in the world's freight markets give a fillip to maritime frauds' Buyer beware' is the principle in all deals. Exporters and importers are cautioned to keep away from unknown carriers or characters even if they offer lower rates. Insurance companies also should not give cover

322 Outline of Materials and Purchasing Management to vessels of doubtful origin and character. The government by suitable legislation should control and regulate maritime trade. Inland Water Transport (IWT) System: An apex body, the Inland Water Transport Authority has been formed at the central level to monitor and develop this mode of transport in various states. The Indian Farmers Fertiliser Corporation Ltd. (IFFCO) has decided to use the National Waterway I (Haldia-Calcutta-Allahabad) for the transportation of heavy equipment for its new fertiliser plant coming up at Alona, U.P. We have operators like Urmila & Co. and the calcutta-based central Inland Water Transport Corporation (CIWTC) in this field. IWT has been neglected in India. In the us, IWT accounts for 10 per cent of the total cargo handling, and in Europe it is very much in vogue. IWT is fuel-efficient and less capital intensive mode of transport. The government had declared non Haldia-Varanasi stretch to be the first national waterway. IWT henceforth world playa supplementary role to the rial and road-transport system., To lend speed to IWT, mechanised fuel efficient barges will be necessary. Brahmaputra is likely to be the second waterway. There is definitely room for growth. Transportation by Trucks: It has gained tremendous importance in the present times. Though almost same rules and regulations as rail and water carriers apply to this medium, there are certain differences that should be observed if one is to manage truck traffic to the best advantage. The purchaser should keep abreast of the concurrent transportation rates of various companies. Such rates are constantly fluctuating as they are based on the demand and supply for the carriers. If there is rush for booking carriers from Anand to Delhi, the rates would naturally shoot up. At the same time, the rates for the return journey would either remain same or would go down, again depending on the demand for such carriers. The rates for the down-trip are generally lower because there is a glut of such carriers. Therefore, purchaser should take maximum advantage of such ups and downs. The purchaser should select a limited number of responsible carriers for handling his truck shipments because too many carriers cause congestion and chaos at his plant. Transport: Towards an Optimal Inter-modal Mix: One of the most important issues in transport policy planning revolves round the choice of optimal inter-modal mix. Obviously, the optimality implies minimisation of economic costs or maximisation of economic benefits form the society's point of view to carry a given amount of freight and passenger traffic. Unfortunately, there has been no enthusiastic attempt to study systematically and from time to time the most preferred inter-modal mix for India. Recently, however, National Transport Policy (NTP) committee has examined the issue elaborately and recommended the optimal inter-modal mix for the country. With air and water transport carrying a very small proportion of the country's freight and passenger traffic, the choice of inter-moda I mix restricts to the determination of the relative shares of rail and road transport in the total traffic flow. So far as freight traffic is concerned, the NTP committee has recommended a 72% share for rail and 28% share for road against prevent shares of 67% and 33%. As for passenger traffic, the existing rail: road ratio of 40:60 has been allowed to continue The monthly average of several thousand containers being handled in Mumbai port for Indian Dock is being used as container terminal gives an idea of the growth of containerization in the last decade. There may be some truth in the claim that the whole concept of containerization is a lUXUry that India can ill afford at the moment. But at the same time, one must admit that there is no escape from containerization and its technological adyancement. Containerization also requires special facilities at ports like high capacity cranes and fork-lifts, fractors and trailors for the movement of container and adequate

Transportation and Traffic Management 323 facilities of rail and road to convey them from ports to the inland centres. Mumbai port has done a good job in handling containers despite the several limitations under which it has been functioning. Routing Incoming Shipments: The buyer may direct the carrier to use a particular route if he so wishes. Simple logic behind this is that there are almost always two or more possible routes for an interstate shipment. Secondly, the purchaser may have arrangements with particular carriers under which the carriers buy the company's product in return for being given favourable consideration on the routing of incoming shipments. Again, the company may prefer a particular carrier because in the past it has given it the best service between the pOints involved. Further the need for routing may arise from the fact that more often than not, the originating carrier, left to his own devices, carries you on his own lines. This may not be the fastest routing, but it gives the originating carrier maximum revenue. However, routing the incoming shipments is not always favoured. Sometimes, a purchaser may do better if he does not insist on his right to route the shipment and permits the seller to select the route. If there are carrier shortages, the best interests of the purchaser may be served if he permits the vendor to use his own judgment in selecting a carrier. At the time the material is ready for shipment, the vendor is in a better position to know which of the carriers are available. Furthermore, the vendor is more likely to be familiar with unfavourable traffic conditions such as floods, accidents, labour difficulties etc., which make it inadvisable to use a particular route at a time. However, companies with professional traffic managers are found to give their carriers precise routing for each shipment. In most cases, responsibility rests with the firm that is purchasing the materials rather than the supplier. The routing becomes a standard part of the purchase order and supplier's traffic department follows its customer's instructions. Tracing: The supplier's traffic department may trace shipments for its customers. Typically the buyer follows up with the supplier's sales department to determine why a particular shipment has not yet been received. The sales department may then discover that the item has been shipped. It might give the appropriate bill of lading or waybill number to the buyer so as to enable his traffic department to trace the shipment, or else the seller may do the tracing for the customer. Thus tracing is a traffic function that is resorted to after the shipment has had sufficient time to reach its destination but has not arrived. Whatsoever, it is not synonymous with expediting. Expediting commences at the time of placing an order. Part of it consists of selecting the most direct route in view of prevailing traffic conditions. Also, to expedite a shipment, the carrier has to be informed in advance that a particular shipment is urgently needed. Finally a shipment may be expedited by keeping in touch with the representatives of the carrier to make sure that the purchaser is being given the best possible service. It should be obvious that to expedite or trace all or nearly all shipments lessens the effectiveness of expediting and tracing. Carriers soon get to know habitual tracers and their requests for tracing receive little attention. Truck Shipments: Tracing truck shipments (either TL, i.e., truck load, or LTL, i.e., less than truck load) is quite simple. The information required for traCing a truck load shipment is the truck number and whether it is moving direct to the final destination or is to be delivered to an intermediate line. LTL shipments can be traced by getting the information regarding the date of shipment, the number of packages and pieces, weight of the shipment, way bill number (equivalent to invoice), the truck number and to what transfer pOint the car was directed.

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Other Shipments: Since express companies do not keep records of transfers of shipments from one truck to another, or from one depot to another, there is no possibility of tracing express shipments. Airlines operate in the same manner as trucking companies in tracing shipments. So it is possible for them to tell a shipper the location of his shipments between points of origin and shipment.

Damage Claims In ordinary course of transit, the goods are shuffled back and forth a good deal. And so there is a good deal of damage. Even if the shipper is reimbursed in full, damaged shipments cause production delays and the processing of claims is huge burden on the typical firm's traffic department. For such damages, both the parties are at fault. The shipment would certainly not have been damaged if it had been handled with sufficient care. At the same time it can be argued out that there would not have been any damage had the merchandise been packed more carefully in costlier containers. Traffic departments spend a great deal of time investigating damaged shipments and making claims against carriers. They also work with their own company's packaging engineers and others on ways to reduce damages. Shippers are becoming increasingly conscious of the simple truth that they are losers on damaged shipment even if they are reimbursed in full by carriers . .The procedure for claiming damages is fairly straightforward. The shipper presents the carrier with a claim, bill of lading, the paid freight bill and a copy of the supplier's invoice or other evidence that establishes the value of the damaged merchandise. Naturally carriers must include an allowance for damage claims in their tariffs and it is to everyone's benefit to help minimize such claims.

Cost Reduction Opportunities Rate structures can be compared with the constitution. It is so complex that there always exists a loophole. So one of the functions of the purchaser is to save his company's funds by finding out such loopholes that permit shipments to be made at lower tariffs and also by stopping errors that carriers make in computing charges. Audit of freight bills can help a lot in this respect. Sometimes, large amounts can be saved with the help of systematic examination of freight bills because there is a separate rate for each commodity and each point of origin and destination. Thus, a traffic department in large corporation may be working with so many rates and so errors are likely to creep in. Therefore, a purchaser's job will be to find out such errors and take maximum advantage of such errors for curtailing the transportion costs.

Cost Effective Transportation (1) (2) (3) (4)

Trend movement in transportation costs must be periodically assessed vis-a-vis current arrangements. Periodic review should also be made on ownership of carriers, leasing of carriers, containerization and ware-hoUSing. There should be a periodic audit of freight bills, preferably by independent auditors. Containerization and groupage should be considered to save on freight.

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(5)

(6) (7)

325

Choice of correct shipping lines in a competitive freight market may result in substantial savings in freight. Non-conference vessels have a lower freight tariff than conference vessels. Consolidation in air-traffic should be tried. OR techniques may be employed wherever possible.

Cost Effectiveness in Transportation The transport being the mainstay of the present market mechanism, any cost saving on this account will contribute substantially towards the reduction of ultimate material costs. The following check-list is very useful to probe our effectiveness. Area Packaging

The Capital Outlay

Carrier selection

Routing

Consolidation

Speciality goods Freight Bill Audits

Check-List Is it possible to change the packaging and classify the material into a lower rated class? Can we employ efficient carts (manually driven) for short and intermediary distances? Can we improve cart-designs? Do we know how our goods are classified and to which classification they are subjected to for freight calculation? Will it be possible to choose the route and the transport carrier which has adequate load on return trip? Can we consolidate in one lOad a large variety of compounds expected from .the same vendor or close-by vendors? Can we have fruitful negotiations on this count? Do you audit the freight bills carefully for Hamali, statistical charge, service charge and many similar items? Do you particularly pay attention to demurrage charges? (even though the material is cleared before or within · a designated free period) Is it possible to make with the carrier on 'average demurrage agreement'?

Auditing Freight Bills As explained above, auditing freight charges may reveal the overcharges paid off to the carriers. They must be recovered so as to reduce the transportation costs. In fact, such auditing, should be a continuous process rather than an ad-hoc one.

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In fact, ninety-nine per cent of the bills are correct but the discrepancy lies in the rest one per cent. Such discrepancy should be avoided.

Charter Truck Switching on private chartered trucks from common carriers has been a sure-fire cost reduction technique for many traffic departments. Firstly, because common carriers charge rates much higher than their true cost for some shipments in order to offset losses on other shipments. Secondly, the charter rates are not regulated by the competition prevailing in the market. The traffic manager should route their trucks in such a way that they expend a maximum amount of time travelling with pay loads. One way to do this is to use the trucks to pick up materials from suppliers after they have made deliveries to customers in the same area.

New Guidelines It is befitting that being the industrial nerve centre of India, Maharashtra has taken the lead by passing legislation to ensure safe transport of hazardous goods. It stipulates that the primary responsibility for safe transportation of hazardous chemicals lies with the company which produces or handles such chemicals and loads them for road transportation. The new guidelines which have been incorporated as "additional permit conditions" are to be fulfilled for obtaining a transport licence. Every public or private carrier transporting hazardous chemicals will now have to satisfy the following conditions: • Special labels pictorially representing the hazardous chemical should be displayed on the vehicle. • Drivers of such vehicles should carry "instructions in writing" which will include firstaid treatment dealing with fire, motor accidents, spillage, etc. These instructions must be written in English, Hindi, and Marathi. • A summary of these instructions in the form of a card called "Transport Emergency Card" (Tremcard) should be ~arried by the driver in his cabin. The Chemical Industries Association, UK has developed Tremcards in respect of some 400 hazardous substances. These can be adapted to suit Indian conditions. A treamcard contains details regarding the type of cargo, nature of hazards, emergency action, the protective devices, spillage control, first-aid, etc. The tremcard is a handy (A4 size) and informative document which is carried during transit.

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Safety Code for Transportation What measures should be taken to prevent or minimise the chances of accidents and their consequences to life and property? To discuss this issue, the Loss Prevention Association of India (LPA) and Indian Chemical Manufacturers Association (ICMA) organised a national seminar on 'Safety in Road Transportation of Hazardous Material' at Mumbai on 7th February, 1986. Attended by nearly 350 delegates, the seminar had a two-fold objective. •

to create an awareness on a subject hitherto neglected by providing a forum where professionals from the chemical industry, road transport sector, concerned government departments and safety organisations could exchange views. • to discuss the implications of the new legislation on the subject introduced by the Maharashtra state government, and examine the feasibility of extending it to cover other states in the country. According to the National Transport Policy Committee report, the total traffic of chemicals and drugs is projected to grow from 4.61 million tonnes in 1982-83 to 11.47 million tonnes by 2001. Petroleum products traffic is expected to grow from 20.47 million tonnes in 1982-83 to 48.80 million tonnes by the year 2001. This means a substantial proportion of chemicals and petroleum products will have to move by road in the foreseeable future. Overall, the government's Road Development Plan for India: 1981-2001', forecasts the ratio of freight traffic by road to go up from 40 per cent in 1980-81 to 60 per cent by the turn of the century. Thus there is no scope for any further complacence in this vital aspect of environmental safety. It was suggested by the speakers that there should be a uniform code in the country for safety, the drivers should be trained properly, the agencies involved must take coordinated action, there should be proper vehicle certification and there should be proper road development. An important outcome of the seminar was that it brought the problem into sharp focus and made some useful recommendations such as : • enactment of comprehensive national legislation. • setting up of transportation safety boards for investigating and analysing accidents and providing research and training support on a continuous basis. • evolving safety standards on driver training and vehicle deSign, testing and maintenance. • identification and grouping of hazard prone zones in the country and preparation of transit emergency plans, where different agencies begin to share common problems and find common solutions. An issue which is equally important, but not deliberated upon at the seminar, is making the man-on-the-street aware of his problems. Eventually, all transit catastrophes affect the community. A sustained mass communication campaign needs to be organised to inform the public on the elementary principles of hazard information systems. They should, over a period of time, generally learn to recognise the significance of hazardous labels and pictorial marking on vehicles, cautionary warnings, and be clear about their role in an emergency. A good safety record is worth shouting about and one hopes that there will be no dispute over the basic principle that public safety is non-negotiable.

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Roads In India, we have grievously neglected our roads. For a nation of our size, our roads are less than meagre in length. The roads we have are poorly built and badly maintained. The National Highway System is our primary roads grid, and is the direct responsibility of the Centre. It constitutes a mere 2% of our total road length but is made to carry more than 30% of the country's road traffic. Nearly a third of the National Highway System, including some of the most heavily traversed segments, consists of single-lane strips -- an invitation to head-on collisions. Not that the authorities are unaware of all this. Every successive Five Year Plan document gives a more and more graphic account of the state of our roads. Not to be outdone, the Seventh Plan, which was published in October last year, also points out that the entire grid suffers from serious deficiencies and that "there is a growing mismatch between traffic needs and available infrastructure, thus resulting in severe capacity constraints, delay, congestion, fuel wastage and higher vehicle-operating costs. It has been estimated that fuel wastage due to bad road alone costs the country nearly Rs. 500 crores a year, the loss due to extra wear and tear of tyres, spare parts and other components being many times larger." We must realise that roads take time to build and that we have decades of this neglect to catch up on. Each year of delay compounds the cost of the backlog -- an inescapable penalty for operating in an inflationary environment. Government has now invited the private sector to participate in road-building activity. This timely initiative is in line with the growing worldwide interest in toll-financing of roads, bridges, bypasses and the like and deserves a constructive response from our private sector. The Telco chairman also suggests the setting up of a Road Fund to finance construction of high quality roads and for upgradation and maintenance of existing roads - with the National Highways getting the highest priority. The quality of new roads and of repairs to the existing roads be certified by an autonomous professional authority. The National Highways Authority has since then been set up The Golden Quadrilateral Project has commenced to link India from top to bottom and from west to east. There is much progress in highway building activity.

National Transportation Planning and Research Centre (NATPAC), Thiruvantpuram The institute is committed to research into all aspects of transportation by an diSCiplinary team and using a systems approach. The research is applied and field-oriented. The chief thrust areas are rural, regional and urban transportation, traffic engineering and management, road safety, economic feasibility studies and environment and energy. The institute has built up a good rapport with users' associations. The basic principle followed is that traffic science should ultimately consider human beings in the design and not inanimate objects i.e. vehicles. We should not plan on the western vehicle movement models but for the movement of people as a whole. Sometimes a non-transportation solution like reducing the total distance travelled in urban areas is needed to a transportation problem. The Institute planned the traffic for 1982 Asiad.

Transportation Institutions National Transportation Planning and Research Centre (NATPAC) with headquarters at Thiruvantpuram and another office at Delhi is a unique institution with a cyclopaedic

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perspective on transportation. The approach of this organisation is not the car-oriented western model. It is oriented towards human beings also. NATPAC's studies on rural roads further establish its relevance to the Indian context. It has used OR models to solve several vexing problems. NATPAC was commissioned to study the transportation of marine products throughout the country. It also did transportation and traffic planning for Asiad Games 1982. It has also worked on road safety and computed an Accident Risk India (ARI) for Indian states. Other institutions doing related work are: Central Aid Research Institute, the Institute of Road Transport, the Indian Road Congress, and ORG.

Tighter Scheduling When a shipper controls his own fleet, he can more easily regulate relative priorities of various shipments. Sometimes, he also can offer prompter service to customers or reduce his in-transit inventories.

Packaging and Materials Handling An easy way to curtail the costs is to equip the carrier with special racks or other materials handling devices. The most obvious example is that of Campa-cola company. It had its own fleet of trucks, well equipped with such materials handling devices. Modern Bakeries has also adopted this system.

Goodwill and Convenience A company-owned truck with the company name and trademark painted on its sides is a rolling advertisement. Secondly, it creates a favourable impression if the delivery is made by company truck instead of common-carriers.

Classification Charge Sometimes, if the shipper is successful in "persuading the carrier to accept a new classification for the item, he can possibly reduce the costs. The only thing he has to do is to convince the carrier that his product is unique and should get a lower rate because it either costs lets to ship or is worth less than other products in the same rate class.

Reducing Demurrage Charges Demurrage charges are penalties assessed by carriers on cars or vassels held by company for a consignor or consignee beyond a stipulated free time provided for loading and unloading. Normally, one day's free time is 'permitted before demurrage charges are levied. However, in railways only five hours are allowed as free time for the wagon-load shipments. It is calculated on per hour per qUintal basis whereas wharfage, which is the penalty for the goods which occupy space in the godowns, is calculated on per day per kg basis. In many cases, purchaser can reduce demurrage charges substantially by carefully scheduling shipments so that unloading facilities are never overtaxed. Sometimes it pays to incur extra demurrage charges than to have an unloading crew work at premium rates or during peak production periods rather than to invest in the additional storage space that would be required to eliminate it.

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330

APPENDIX Safety in Transportation The transport of hazardous materials is governed by Petroleum Rules, 1976, Chapter III, parts I - V framed by the Government of India. The products are classified based on flash pOints as follows : - Flash point below 23°C (73° F) Class A - Dangerous Petroleum Class B - Non-dangerous Petroleum - Flash pOint above 23°C (73° F) but below 65° (149° F) Heavy Petroleum Flash point above 65°C (149° F) Class C but below 93°C (199° F) - Flash point above 93°C (199° F) Class D - Excluding Petroleum The hazards presented by the transport of chemicals are : (a) fire; (b) explosion; (c) toxic release and the events which can give rise to these hazards are: (a) container failure; (b) accident impact; (c) loading/unloading operations. For carriage of dangerous and non-dangerous petroleum products the rules stipulate safety features such as earthing to avoid generation of static charges P and V valves for tank compartments, emergency vents, spark arrestors on fuel exhaust systems and emergency shut off valves for individual compartments. Compressed gases transportation in similarly governed by Gas Cylinder Rules, 1940, and the Classification is as follows : Critical

Example

Temp.oC

Permanent Gases Liquefiable gases High pt. Low pressure

(1)

-10 -10 to 70 > 70

Air, Hydrogen, Methane Ethane Ethylene Ammonia, Butane, Chlorine, Propane, Sulphur Dioxide

Where the gases show tendency to polymerise (Butadine, Ethylene oxide) with resultant release of heat and pressure tankers have to be properly insulated. (2) Crews should be trained on product hazards and in preserving product integrity to avoid contamination. (3) Design of road tankers should be scientific with proper material of construction and due emphasis should be placed on following aspects: (a) Reference temperature. (b) Minimum well thickness. (c) Test pressure. (d) Filling ratio. (e) Safety valves'. (f) Other fittings and attachments. Tanks may be built with dedicated systems to eliminate the need for changing the lines which is major source of product contamination. Specialised lining and engineering modifications should also be tried wherever feasible.

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APPENDIX

The Containerisation Revolution The introduction of containerisation in the transport of general cargo internationally in the late fifties has revolutionalised transportation systems all over the world. The concept of containerisation is based on an intermodal box or container which can be handled interchangeably on ship, Struck and rail, world-wide. First introduced in the US in 1956 by Sea-Land Industries Investment Inc. - currently in the largest container ship company in the world - containerisation has caught on rapidly. From 48 ships which were amenable to containerisation in 1959, the number of containerised vessels rose to 1,500 in 1980, while the number of containers in use increased from 5,000 to 2 million units during the same period. Indeed, so dramatic has been the growth of containerisation that today more than 75% of the world's cargo that can be containerised is being shipped through containers. Containers are available mainly in three sizes - 20 ft, 35 ft and 40 ft - and vary in height from 8 ft to 9 ft 6 in. They are made of steel, aluminium, wood or stainless steel although steel is the most popular construction material and about 65% of containers in use today are made of steel. There are many different types of containers including tank containers for bulk liquids, dry bulk containers for dry cargo, "reefer" or refrigerated containers for perishable commodities and specially designed containers for such high value durables as automobiles. Containerisation has replaced the old port-to-port service rendered by shipping companies with the concept and reality of a total transportation service. "Today all over the world there is the concept of door-to-door service in the general cargo trade," says Dilip De chairman and managing director of the Mumbai-based Ranadip Shipping and Transport Co. Pvt. Ltd., the agent in north India for Sea-Land and has a 15% share of the 1,50,000 strong container trade ex-Bombay. Major advantage: Apart from facilitating door-to-door service, containerisation also facilitates the movement and safety of cargo in transit due to limited handling. One of its major advantages however, is that it helps to lower packaging costs and this ultimately reduces unit freight rates. Comments De, "In the case of garments which are to be exported, for instance, these can be hung (using hangers) in the containers and on reaching their destination can be transported straightway to the point of sale without having to be unwrapped or ironed." This is a considerable saving taking into account that labour charges in western countries are extremely high. Given these numerous advantages, exporters and importers in several parts of the world including India have opted for containerisation in a big way. The number of containers handled at Indian ports during 1983-84 was 2.33 lakhs and their number is growing at an annual rate of around 10%. However, despite the growing preference for containerisation and the fact that almost 85% of Indian exports and 50% of imports can be containerised, Indian shipping companies have been slow to take to it. There are several reasons for this. Firstly, containerisation is a capital-intensive business with substantial fixed cost outlays. Therefore not only does it call for large investments, but also for efficient assets utilisation to make the venture profitable. This in turn would require an efficient sales and marketing network which most Indian shipping companies do not possess. Secondly, there is also the tremendous disadvantage of ill equipped ports and a dearth of stockyard ports and a dearth of stockyard capacity to store containers. And

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finally, the transportation infrastructure in the country is woefully deficient. Indian roads do not permit axle loads of more than 10 tonnes while a fully loaded container on a two axled trailer weighs about 12 tonnes. Thus both Indian shipping companies and the Union government will have to take urgent remedial measures if India is not to miss the containerisation bus. Sometimes cost-wise it is also effective to use alternative transportation modes, or at times expediency demands it. For example, if crude oil is to be transported to Mathura refinery from the Bombay High, they can load a tanker vessel from Indira Dock and navigate it to Wadiar port in Gujarat from where it can be on its way to Mathura refinery by land.

000

CIiAPTER 24 Logistics Management Logistics Logistics is the term brought from military science. In corporate circles, it means the management of all in-bound materials and out-bound products. It is an attempt to optimise utilisation of transport services and warehousing and distribution capabilities. Logistics is now considered to be a profit centre. It has become more complex because freights and other costs to move goods from and to far-flung markets have escalated too much in recent years. Moreover the length of distribution channel as also increased. In-bound traffic moves are managed by materials department and out-bound traffic moves by the marketing department : Logistics represents a systems approach to the traffic problem. Logistics managers are basically responsible for providing safe and cost-effective transport services. Logistics management is a comprehensive term which covers organization, planning control and execution of goods flow from development and purchasing, through production and distribution to the final customer in order to satisfy the requirements of the market optimising cost and capital. Logistics management is primarily divided into three segments - Logistics control, LogistiCS operation and LogistiCS distribution. As we already know, materials constitute a valuable resource. Sixty per cent of the organization's operating money is tied up to materials. Therefore, as we have already observed, we shall have to focus on raw materials and finished products to make an organization cost effective and profitable. Previously, the departments handling materials operated independently, e.g., Stores, Purchase, Dispatch, Production Planning and Control and so on. These were later integrated to become integrated materials management. However, the complexities emerged. It was necessary to streamline manufacturing time required, reduce manufacturing lead time (MLT) maintain minimum stock and make quick distribution. All these need integration so as to satisfy customers at minimum cost and minimum capital usage. That gave rise to logistiCS management. It brought in precision, reliability and lower costs.

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Outline of Materials and Purchasing Management

Let us consider the Activity Pipe Line of a modern company. Order - Driven Activities

Forecast Driven Activities _ _ _ _ _ _ _----. ..

I

Forecasting

I

Financel Technical Segment

i

Production Planningl Material Planning

Materials Procurement

Incoming Inspection

Warehousing Receipts Issues

Production

J

~

Warehousing JphYSical Finished DistribuGoods tion

Order Intake

t Logistics Control Line

Fig. 24.1 Activity Pipe Line Logistics control activities constitute a greater part of activity pipe line. Let us put logistics activities in the form of a table.

Activities

Cluster of Activities Logistics Control

Long-range Planning (LRP) Policy making Demand processing Order processing Purchase planning Master Production Schedule (MPS) Import Planning

Logistics Operations

Short-term planning (STP) Purchasing Dispatching Production control Materials control Incoming Goods/Storage Issue of materials Finished goods Spares

Logistics Distribution

I Control Quality

Storage Packing Handling Transportation

Logistics Management

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Logistics performance is measured by monitoring stock periodically, ensuring quality, supplier delivery performance and quality performance indicator (QPI). We have to also focus on manufacturing lead time (MLT). Performance indicator records the percentage of all products manufactured within the fixed target given by the management: Total Number of Units Complete in the Month within Date Total Number of Units Completed in the Month If all the products in a factory are completed within target days, the actual MLT of each product should be recorded.

Functions of a Logistics Manager Logistics managers are typically in charge of the entire distribution function, the prime components of which are : (a) ensure cost-effective distribution of company products. (b) analyse computer-based MIS reports flowing from distribution decision application in force for the last eighteen months and recommend revisions in decision logic consistent with dynamic changes in market, distribution facilities, company product priorities etc. (c) consistently search and recommend alternate packaging-cum-transportation modalities so as to convert business opportunities from uneconomical to economical propositions (d) negotiate and monitor contracts with transporters consistent with protection of company's interests through insurance and other appropriate means and optimum cost. evaluate need for increase/decrease in stock points and implement changes through (e) appropriate modifications to computerised model. (f) monitor inventory levels at various points and suggest system improvements for optimizing. (g) coordinate product arrival from different sources of supply to terminal locations. The Logistics manager is expected to have considerable experience of moving men and/or materials, flowing from multiple sources to multiple destinations and is required to have precision in coordination of time and mode of transportation. Logistics people are retained these days by consumer goods companies, especially food products companies like biscuits and oil, ad agencies (print and slide co-ordination), shipping companies, airlines, and travel agencies. The formal background of operations research and computers or management science helps a logistics manager.

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CIiAPTER 2~ Government as a Purchaser 1. GENERAL Generally, it is believed that the government purchasing is totally different from the industrial purchasing. But it is not so. The basic principles of materials management are same in both the cases. Both - the government purchasing as well as the industrial purchasing - are concerned with the right purchasing, i.e., purchasing, the right quality of materials at right price, in right quantity, at right time from the right source of supply. Efficient procurement is the main objective in both the cases. In both the cases efforts are made to purchase wisely at the competitive rates, to keep inventories at minimum level, to develop reliable sources of supply and to hire and train competent personnel. Therefore, industry as well as government require the services of competent and motivated, materials managers to fulfil their objectives. They employ such expert personnel who understand thoroughly and employ profitably the fundamental concept of purchasing as well as management for successful purchasing and efficient administration. The materials manager in a private sector unit works to maximise the profit of his firm, while the materials manager in a government department or unit works to get maximum value from taxpayer's money. In both the cases the materials manager works hard to derive the maximum benefit from every rupee spent for materials. However, in purchasing the government has to give due weightage to some special considerations, e.g., development of domestic industries for rapid industrialisation of the nation, development of small-scale industries to create employment opportunities for millions of unemployed, development of a co-operative sector to help the small-scale producers, especially in the agricultural sector. Private sector units see their self-interest only, while purchasing the goods. Therefore, the government generally favours local manufacturers or suppliers, small-scale manufacturers and co-operative-organisations for purchasing the goods, in the interest of the national development. In special circumstances only, it purchases from sources outside the country, e.g., when the materials are not available in the country. Sometimes the government gives subsidy to the domestic manufacturers to promote industrialisation in the country. It also levies heavy import duty on the imported materials. This type of protection to domestic industries results in keeping their efficiency at low level, because these manufacturers have not to compete with outsiders for their existence. They are paid for their inefficiency, by way of subsidy. Government purchasing has to take social as well as economic factors into account. For this reason the government purchasing (336)

Government as a Purchaser 337 officials have to purchase the goods from certain manufacturers or from local manufacturers or from certain places even though the better goods are available at competitive rates; elsewhere.

2. DIFFERENCE BETWEEN GOVERNMENT PURCHASING AND INDUSTRIAL PURCHASING Even though the same basic principles of materials management are applicable to government purchasing as well as to industrial purchasing the points of difference between them are there, which can be mentioned as under: (1) Government purchases including many types of items from pencils and paper to supersonic aircraft, submarines and space vehicles involving extensive research and development. As per one estimate, in the U.S.A., roughly 75% of government purchasing by value is for sophisticated and complicated major weapons and space systems, and 25% is for civilian type commodities. State Governments, Municipalities, Statutory Corporations, Public Sector units etc. generally purchase civilian type commodities. However, the largest single expenditure of State Governments and Municipalities (including Municipal Corporations) is for construction contracts. Industrial purchasing includes purchases of raw materials, and spare parts generally and to some extent machinery and other fixed assets. Thus, government purchasing officials have to deal with many types of items. Moreover, government departments and units use various latest techniques for efficient purchasing and inventory control, e.g., value analysis, cost analysis, statistical quality control, EDP, PERT etc. Therefore government purchasing officials become more skilled and exper.t in materials management as compared to the purchasing officials in industrial - units. However, some of the big industrial houses also use latest techniques for materials management and employ intelligent and expert personnel in materials management department. (2) Sometimes government has to purchase from small sector or co-operative sector or has to purchase from local/domestic sources of supply as a part of meeting social bbligation and for national development. Purchasing executives in the industries are free to use their intelligence and technical knowledge for efficient purchasing. (3) Government as well as industrial purchasing officials have to work within the limits of the budgets. But if the large quantity of materials is available at unexpectedly very very favourable terms the purchasing executive of an industry can obtain more funds to purchase the materials. It means that the funds of the business units can be diverted towards more advantageous uses as and when chances arise. This is not possible in case of government purchasing, because government purchasing executives have to operate within the limits fixed by a legislative body well in advance. Budgets are approved by state legislature, so far as the budgets of the states are concerned and by the Parliament, so far as the central budgets are concerned. Municipal councillors of a certain municipality approve the budget of that municipality. So far as the other government or semi-government bodies, corporations etc. are concerned, they have their own authorities who approve their budgets. Standards for maintaining inventories are also fixed and sometimes kinds of materials to be purchased are also specified by the authorities, who have authority to approve the budgets. This is all done to control and make efficient use of public funds.

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Outline of Materials and Purchasing Management Changes in budgets can be made only by legislative bodies. Sometimes it becomes impossible to make changes in budgets once they are approved, due to various reasons. Rigid auditing process and predetermined budgetary limits force the government purchasing officials to act as per the budgetary limits, whatever may be the outcome. Moreover, to meet the increase in expenditure, limitless borrowing and taxing the people is not possible for the government. Therefore to limit the expenses, sometimes government (state or central) purchasing officials purchase cheaper materials irrespective of their quality, so that the expenses may not exceed budgetary limits. But this practice of purchasing results in increased operating costs, decreased efficiency and high cost of production. But so far as the industrial purchasing is concerned some flexibility is there. Funds of the business units can be diverted towards more advantageous activities. Budgetary control exists in business units also, but rules there are not hard and fast or rigid. If the business unit is short of funds and chances of getting materials at very favourable terms arise, arrangement is made to provide the funds from outside sources. (4) Government purchasing officials enjoy less freedom of action and discretion than purchasing officials in private business units. Government purchasing officials cannot act freely, because they have to follow the procedure laid down by various laws and regulations and have to purchase as per the prescribed standard specifications. Such procedures and specifications and also various rules and regulations are framed with good objectives. Central and State Governments' purchases are financed from taxpayers' money and therefore to avoid misappropriation and misuse of taxpayers' money, i.e., to avoid wasteful use of the amount is the first objective. Now at the local level, State level or central level, those businessmen who have given financial support to the ruling party bring pressure on the party at various levels to get the business from various departments and various units at the concerned level. Now the various regulations framed and procedures laid down protect to some extent the government purchasing officials from political pressures. But procedures, rules and regulations framed and various legislations passed with good objectives limit the freedom of government purchasing officials and increase the cost of purchasing.

So far as the industrial purchasing executives are concerned they have more freedom of action and discretion. (5) In case of industrial purchasing, the suppliers supply the materials strictly as per their speCifications, because they know that if they do not supply the right quality, they will lose their business. Industrial purchasers will divert their business to more reliable suppliers. But when the same suppliers deal with government they act otherwise, because they know that it is very difficult for the government to prove that the materials supplied are of inferior quality and the government is not going to take legal actions in most of the cases. Moreover, unless and until the name of the supplier is deregistered from the list of approved suppliers, he can continue to deal with government. Sometimes, the suppliers find out ways to get the materials approved by government purchasing officials. (6) In purchasing by tender method various departments of, state and central governments, other government undertakings, local bodies, e.g., Irrigation departments and Public Works departments of various state governments, State Electricity Boards, District Panchayats, Taluka Panchayats, Municipal Corporations, Post and Telegraph department, Indian Railways, Defence department, Steel plants etc. take too much time in purchasing and therefore they have to maintain inventory at high level. But industrial units in private sector have not to' maintain this much stock, because of flexibility and speed in purchasing. It is not necessary for them to follow a lengthy procedure of tender method for purchasing.

Government as a Purchaser

339 (7) In government purchasing, the paper work is much more as compared to industrial purchasing. Tenders contain so many pages, because detail specifications are given at a length. (8) So far as the tender method of purchasing is concerned, information relating to prices quoted by various tenderers do not remain a secret matter. Therefore many suppliers, who do not want to reveal their customers or competitors the prices quoted by them to government, do not prefer to deal with government. When they want to deal with government, they quote somewhat higher prices than normally they would have quoted to industrial purchasers. Thus government loses the benefit of lower prices, which the industrial puchasers can get. (9) Sometimes marginal suppliers offer to supply .goods to government. They quote very low price. After they enter into contracts with government departments or other government or semi-government organisations, they try to find, out loopholes in terms, conditions, specifications etc. of the contracts. If they become successful in dOing this, they take full advantage of the situation to minimise their losses or to maximise their profits. This is not possible in industrial purchasing. (10) Government generally maintains high inventory, in various departments and other units, of even common items also, which, are readily available locally, because they use public money. Private industrial units try to maintain the inventory at the minimum level, because they want to reduce or minimise the inventory keeping costs, so that their production costs may remain at low level. (11) Sometimes government departments or various corporations, created by various laws, are allowed to purchase or import goods for redistribution amongst the actual users. Due to their monopolistic position, they make huge profits on such transactions. Industrial purchasers have nothing to do with such type of practices. (12) Government purchasing is generally affected by political appointments to key posts in various departments or other units, i.e., the post of a chairman, managing director, executive director, purchasing executive etc. Efficiency can be increased or can be maintained at the same level as before, only if competent persons are-appointed and retained. Sometimes efficient/competent persons are appOinted or are found on the top positions, but due to limited period allowed to them to work on that position, they do not take full interest in their jobs. They know that they will not be there after 3 to 5 years or even before that period. Therefore, they do not take risk and also they do not want to be unpopular. These factors make them less efficient. Moreover, change in party in power or changes in ministers or their portfolios at central or state level may result in transfer or early retirement of efficiently working officers or office-bearers for no reasons. Thus when the existence of such officers or office-bearers depends upon the good wishes of political leaders, they work as per their wishes for their own interest, which results in gross inefficiency. Sometimes retired military officials or retired civil servants or defeated politicans or other party workers are appOinted on key posts, who may not be qualified or may not be fully qualified so far as the duties and responsibilities of the posts given to them are concerned. Such persons generally do not serve as efficient purchasing executives. Industrial purchasing executive appOintments are not made as stated above. Fully qualified, intelligent and experienced hands are found as purchasing managers in various industrial/manufacturing units. Questions of transfer or early retirement does not arise. They take decisions in the best interest of the units in which they work, without any pressure from the top level. Thus they are the masters, of their work and they can take decisions freely.

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Outline of Materials and Purchasing Management (13) In a private sector industrial unit the ownerfs isfare very much interested in the profitable existence of the unit. Now efficient purchasing plays an important role in ensuring profitable existence of the unit. Therefore, the purchasing executives of private sector units are generally found working hard to achieve the goal of profitable existence. In case of government unit, nobody is interested so much in the profitable existence or even existence of the unit. It is so because, in case of government unit, profitability and existence has generally no relation. The big losses generated in government units are financed from the taxpayers' money. It is said by government officials and ministers that government uses public funds, wisely (whatever may be the outcome) even though public funds may not have been used wisely. Big losses year by year and the existence of public sector units has no relation. When the working of public units or government departments is criticised on the basis of losses incurred, government officials, ministers, political magnets and pro-government persons argue that government units and departments work for the service to the people and not for the profit. Profit is not the criteria. That is why government executives do not care for efficiency.

3. METHODS OF PURCHASING The following methods are in use for government purchasing, depending upon the type of goods, quantity to be purchased and other considerations, e.g., social and economic factors, maintenance of secrecy (particularly for defence purchases) etc. (a) Tender Method - (Advertised bidding method). (b) Negotiation Method - (Negotiated purchase method). (c) Purchases through D.G.S. & D. - (Director General of Supplies & Disposal).

(a) Tender Method Most of the purchases by central and state government departments, corporations and other units of central and state governments, panchayats and other government agencies are made through this method. Tenders are invited through advertisements in newspapers or, by posting the invitations inviting tenders in public places. Record of each and every government purchase is to be kept ready for inspection and scrutiny by interested parties. It is necessary to maintain full and complete records to defend the actions taken against any challenge. When the quantity to be purchased and the amount of purchase is very small, this method becomes uneconomical because it is an expensive method. Expenses on advertisements and on long time consuming procedure to be followed make the method uneconomical for small purchases. In case of purchase of certain products also, e.g., standard products, patented products, sophisticated items etc. This method is not used. Tender method of purchasing is considered highly effective and is used under the following circumstances: (1) When there are many qualified parties, e.g., bidders, interested in supplying the materials or doing the contract work. Tenders are invited for the selection of the best supplier out of many interested. If only limited number of suppliers show the interest, this method'does not serve the purpose. (2) Purchases through this method take very long time. Therefore this method can be used only when sufficient time is there before the materials are required. Materials cannot be purchased at very short notice through this method.

Government as a Purchaser

341

(3)

Highly detailed specifications are required to make purchases through this method. Therefore, the method can be used where detailed specifications for the materials to be purchased or work to be done are clear and ready before the advertisement is given. Due to this reason, the method is used for the purchase of such commodities, the standards for which have already been fixed and for the construction contracts Iwhere detailed ''specifications are a mu~. / i

(4)

It is used where the terms and conditions of purchase are clear and such that would be beneficial to government and result in efficient purchasing.

The method is used when the purchase is important enoug~, to be worth advertising, e.g., when the amount involved in purchasing is large. This method is used, because it gives the purchaser opportunities for selection Qf the best source of supply, and when the amount involved is large, the best'selection helps in reducing the cost of purchasing to a great extent. It is so because in tender method large number of suppliers submit tenders, which increases the chances of good selection. Procedure in Tender Method: Under this method detailed specifications of the items to be purchased are important. Once the specifications are available, the whole procedure becomes mechanical. The purchasing executives / buyers act as a machine. It is not necessary for them to use their talents or imagination, because here the source of supply is automatically selected. The following procedure is followed for purchasing materials ~ (1) Central or state government department or other government unit or agency or panchayat which wants to purchase materials must get the budget for purchases to be made approved by a competent authority and detailed specifications of the materials required must be drawn up. (2) Invitations for submission of tenders, i.e., tender notices are prepared. These notices contain various details, e.g., due date for submission of tenders, date and time of opening the tenders, place from where tender papers may be available, tender fee, earnest money deposit description and quantity of the materials to be purchased etc. The tender notices are sent to all - the registered suppliers/contractors or pasted in public places. Generally, the tender notices are advertised in newspapers. (3) Blank tender copies are given to the interested bidders on payment of necessary tender fee or sent by post also to the bidders, if it is demanded by post. But for this service bidders shall have to pay extra charge over and above the tender fee. (4) The interested bidders submit the tenders, duly filled in and signed, with necessary deposit before due date, which is always mentioned in the advertisement. All the r:'ecessary details must be given in the tender. Tender fee and amount of deposit vary in different cases depending upon the value of the contracts, purchasing agency etc. (5) At specified place and time, tenders are opened in presence of the bidders, who have submitted the tenders before due date. Generally, a tender once submitted, cannot be withdrawn by a party who has submitted the same. If a tender of a particular party is passed but that party does not want to accept the work or refuses to accept the work for which he is a low bidder, his deposit is forfeited. Details of various tenders are kept open in abstract form for public (5)

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Outline of Materials and Purchasing Management

inspection, so that the parties submitting the tenders can know where they stand. (6) The tenders received are evaluated by materials manager/purchasing executive/ authorised officer. The tenders which are not complete in every respect or which do not conform to specifications are rejected. Where tenders are invited from registered parties only, the tenders received from unregistered parties (dealers or manufacturers or contractors) are also rejected. Tenders received without earnest money deposit are not considered complete in all respect, hence these tenders are also rejected. After weeding out all the disqualified tenders, the responsible officer of the purchasing agency makes the selection of generally the low bidders. The work is awarded to that party, who is found reasonable and more advantageous to the purchasing agency. (7) The party, whose tender has been passed, is required to work as per the terms of the contract. He must supply the materials as per the detailed specifications. If the party fails to supply the materials as per the contract, the purchasing agency has right to terminate the contract and can purchase the same from other suppliers even at a higher price. The original party who has failed to supply the materials as per the agreement can be sued by the purchasing agency for any losses sustained by the purchasing agency to the extent of the difference in the value of purchases at original price and at new price. Supplier can also be sued for the losses sustained by the purchasing agency on account of late delivery. Merits and Limitations: This method of purchasing ensures reasonable impartiality in government purchasing, because the whole process of purchasing in this method is mechanical. The source of supply is selected automatically. Generally, the party, whose tender is low, gets an order from government purchasing official. But it does not mean that, the party whose tender is the lowest, always gets the work, because there are other factors or considerations except price which are also taken into account while making an award. The party, who is capable of doing the work satisfactorily 'and who agrees to accept all the terms and conditions of the tender (which are more beneficial to government agency), is awarded the work.' Even though, the method is highly effective for economic purchasing by government agencies and it ensures impartiality in purchasing, it has some limitations, which can be explained as under: . (1) Generally the work is awarded automatically to that party, whose tender is the lowest. Such party may not be reliable or fully qualified to do the job. Giving contract to inefficient or irresponsible or unqualified party means taxing the people because the difference between normal costs and high costs resulting from inefficiency, is to be met from the public funds created out of tax payers' money. Awarding certain percentage of work to small sector units or co-operative societies or certain class of the society, e.g., scheduled caste etc., sometimes results in heavy costs or work remains incomplete. In case of such type of reservations, efficiency becomes secondary matter. Politicians and unscrupluous government officers are not ready to understand this fact. They do not accept also. In case of private business units, not the lowest bidder but more reliable and responsible, more experienced and qualified bidder is awarded the work. Price is not the only criterion for private sector units.

Government as a Purchaser

(2)

(3)

(4)

(5)

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Government purchasing official tries to get tenders from maximum number of parties and therefore sometimes the last date fixed for submission of tender is also extended. In some cases, it becomes necessary to evaluate several hundred tenders, which is not an easy task. The purchasing executive of a private firm invites tenders from limited number of parties. If he is satisfied that adequate competition exists amongst the limited number of parties, who have already submitted the tenders, he does not invite tenders from the other qualified suppliers. This method is time-consuming and very costly. Tender notices are prepared and they are advertised in newspapers. Blank tenders are distributed or sent by post to those who pay necessary charges or fees. One week to four weeks are given for submission of tenders. This time is also, sometimes, extended. Tenders are opened. They are evaluated and then final decision is taken. Newspaper advertisements and printing of blank tender forms costs too much to purchasing agency. Blank tender form together with detailed specification of the work to be awarded, sometimes, runs into several pages. Therefore, its printing may cost too much. When tender method of purchasing is used by government agency, many parties submit tenders. The prices quoted and other details given by various parties are presented in abstract form for public inspection. As the quotations do not remain a matter of secret, the various parties, who submit tenders, quote comparatively higher prices as compared to the prices quoted in dealing with private firms. Thus, even though, there may be many bidders, the price quoted by the lowest bidder may not be the lowest price actually. Possibility of it being a high price is there. Private firms do not reveal the details of prices quoted by various bidders and therefore they get the benefit of lower quotations. This method of purchasing makes it necessary to have detailed specifications of the materials to be purchased. If something is lacking in the detailed specifications and the party submitting tender is able to find it out successfully, he quotes the lower price and if he is awarded the work he will deliver the goods as per the defective speCifications. It will be very difficult for government agency to hold the supplier liable because the supplier has the knowledge of the defect in specifications. In case of dealing with private firms, informal relations play an important part. Here the supplier knows that the dissatisfied purchasing executive/materials manager/buyer, even if he may not sue him for defective materials or work, he will surely divert his business to other supplier. Therefore, the supplier does not give to government anything more than contracted for, while the same supplier may give to private firm something more as an incentive even if the firm may not have asked for the same. Some of the government departments and other agencies maintain the list of registered suppliers. Sometimes, tenders are invited from these suppliers only. Sometimes pre-tender conferences of the parties, who intend to submit tenders, are also held, before the last date for submission of tenders, to explain certain details of the work to be done.

(b) Negotiation Method Under this method of purchasing, the purchasing officers get some freedom in taking decisions. They are free to use their own intelligence and imagination to some extent in

344 Outline of Materials and Purchasing Management decision making. Where it is not possible or not practicable to purchase materials through tender method or where it is felt that the purchases through tender method would not be beneficial to government, purchasing by negotiation is allowed, e.g., patent owner or his licensee only can supply the patented item and therefore tender method becomes useless for purchasing such items. Generally, every government department (central or state), municipalities, corporations and other government agencies have authority to purchase certain items by negotiation. Negotiated purchases are allowed in certain circumstances which can be mentioned as under: (1) When small purchases of any kind of materials or services, are to be made, i.e., when the amount involved in a transaction relating to the purchase is very small. (2) When the government has declared emergency. In case of emergency, decisions are to be taken quickly. It is not possible in tender method. (3) When the purchases are to be made from abroad, e.g., Oil purchases from various middle east countries are negotiated by the Government of India. Food and fertilisers purchases from the world markets are also negotiated by Government of India. (4) Where the services of professionals or experts or educational institutions are required. (5) When the standard products (products of a particular brand) of particular manufacturer are to be purchased, the tender method becomes useless because only the manufacturer of that product can supply the same at the lowest rate. In case of the purchase of technical equipments and sophisticated items which (6) requires big investment and where the suppliers are limited, the tender method does not serve any purpose. Here negotiations with limited number of suppliers for purchasing proves to be the best method. In case of military purchases secrecy is very important. Therefore, major part (7) of the military purchases is negotiated. More over, the design, price etc. of the most complicated and sophisticated latest weapons cannot be known in advance and therefore they can be purchased by negotiation method only. Under this method offers are invited from the selected suppliers. After examining the offers, the purchasing officer can negotiate with any of them, whom he considers a good offerer. Now "to negotiate" means ''to deal successfully with." The purchasing officer/materials manager has to deal successfully with the' selected supplier. The purchasing officer may ask for changes in the design, reduction in prices quoted etc. and may explain about the expected performance from the products required. The details of various offers are not revealed and the details of an offer from one party are not given to another party, i.e., the details of various offers remain secret. Sometimes, the selected offerer is asked to submit or he can submit a new offer as the result of negotiations with the purchasing officer. Negotiation may be there on even the smallest purchase. Procedure for purchasing is not so much lengthy or time-consuming as compared to the tender method. Moreover, the purchasing officer has not to follow the rigid rules, regulations and procedure as it is so in tender method. But in case of purchase of latest technical and sophisticated weapons (which requires the use of high level technology) by defence department or in case of purchase of items with complicated technology, by other departments, only the purchasing officer does not take decision'. Various committees of

Government as a Purchaser

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expert of the concerned department consider the proposal from the technical, financial and defence (in case of defence department only) view point. These committees first meet separately and finally they meet together for arriving at the final decision. The purchasing officer may not accept the lowest offer. He can negotiate with more than one supplier who have sent offers. It does not mean that purchases under this method are made at unreasonable prices. On the contrary, the purchasing agency may get the materials at a comparatively cheaper rate, because the purchasing officer is free not to accept the lowest offer and is free to negotiate with one or more offerers for more favourable purchase terms, e.g., Air Force wants to purchase a supersonic fighter plane with certain performance specification. Suppose the purchasing officer has received three offers from three different companies. Prices quoted by them are different. One company has quoted Rs. 8 crores, another Rs. 10 crores and the third Rs. 11 crores. The purchasing officer can accept the bid of that company, which has quoted Rs. 8 crores. But he may discuss with all the three companies and may ask them to revise the original offers if possible. If he succeeds, he may procure the fighter plane at less than Rs. 8 crores from the highest bidder also with whom he has negotiated. It is to be noted that in case of purchase of sophisticated items (items with latest complicated technology), where designs are unknown, government has to take decision considering technical and managerial competence and reliability of the supplier and not the price. In such cases neither the suppliers nor the government department really knows what the item is supposed to cost. The actual cost may turn out to be greatly in excess of the originally estimated cost. When the government tries to buy something which does not exist, the question of quoting the price for something which has never been made before becomes very difficult for the bidders. Here the competing suppliers try to quote the lowest possible price. They underestimate the costs when keen competition prevails. Where the design has not been finalised, the lowest quotation helps the supplier in getting the contract and afterwards, the same supplier becomes successful in increasing the prices than originally quoted and recover the losses, that may arise from the lowest quotation. When the specifications are not clear or are not well defined, the supplier succeeds in getting higher prices than, originally quoted, by reasonable representation regarding the technical problem, special type of design, and other characteristics of the products supplied. It does not mean that government is always cheated in purchasing. To avoid malpractices detailed and elaborate specifications have come into existerice. As and when loopholes are found in government specifications by the manufacturers who supply materials or equipments at very low prices than others have quoted, government takes steps to close these loopholes. Specifications may be of two types : Design specifications and Performance specifications. In case of equipments and defence weapons where the design differs from manufacturer to manufacturer, government prescribes performance specification. Moreover, in case of items like electronic weapons of tomorrow, where experiments are going on to make them more effective and where designs are not ready or have not been finalised yet, decisions are taken on the basis of practicability of the proposed design, proposed performance of the products, experience of the supplier or manufacturer in the field, reliability of the supplier or manufacturer etc. In, case of items like Trucks, Tractors, Cars, Scooters etc., each manufacturer has its own design which cannot be changed easily. Here only performance of the product is considered while selecting the supplier. When the product is very complex and particular manufacturer has much more experience of manufacturing that product, no other supplier will be able to compete with him even if highly detailed specifications for this product are provided to all the suppliers including the experienced one. The cost of production in manufacturing company with long

346 Outline of Materials and Purchasing Management experience would be much less than other manufacturers and therefore only he can supply the items at the lowest price. As a result of negotiation, government will be able to procure the item at the lowest possible rate. In such circumstances tender method may prove harmful, e.g., suppose X company supplies a complex machine Y at Rs. 10 lakhs. Government invites tenders for the purchase of machine Y. Other supplier with less experience or with no experience may quote Rs. 15 lakhs for machinery because their cost of production may be high. Now X company's cost of production is much less. Here, it can quote Rs. 12 lakhs and can get the order (as it is the lowest bidder) if tender method is used. In negotiation method of purchasing, the purchasing officer knows that who is more reliable and experienced supplier, He selects such supplier and negotiates price with such supplier. So that even if X company has quoted Rs. 12 lakhs for machine Y the purchasing officer can procure the item at much less price by negotiating with X company. Under this method the purchasing officer has not to follow the rigid rules and regulations and also lengthy procedure, as it is so in tender method. Moreover, under this method, it is not necessary for him to accept the lowest bid only. He can negotiate with other bidders also and can give order to other party, whose bid was not the lowest. Thus the purchasing officer can give a contract to the most favoured parties. As no details are published or given to other suppliers, as to why only a particular party has been selected, it becomes easier for him to take such decisions, in which his personal interest is best served. Thus chances of favouritism and corruption are there. Other factors may also influence the decisions. When the designs of different suppliers are not the same, the products of any of them can be ordered in the name of good performance. Here pressure from politicians including ministers play an important role. The supplier most favoured by them is selected. Sometimes, small scale industries, or business! manufacturing units of a particular undeveloped or underdeveloped region are given contracts as a policy matter for the development of small-scale units to generate more employment opportunities or to develop particular region. When the question of region arises, the elected politicians from that particular area try to influence the decisions of purchasing officers, so that the manufacturers situated in their area may get the contracts.

(c) Purchases through the Directorate General of Supplies & Disposals (D G S & D) General: Instead of independent purchasing by different government departments and other different government agencies, if the purchasing is centralised, it will prove more beneficial to all the purchasing agencies. In absence of centralised purchasing, each department and other government agencies would be purchasing different types of materials and services at different prices. Here the total cost of purchasing, inspection, inventory carrying, storekeeping etc. would be much more. Centralised purchasing with standardisation of materials may cut the cost of purchasing to a great extent. To serve the purpose the Government of India has established the Central Purchase Organisation in the name of the Directorate General of Supplies and Disposals (0 G S & D) under the Ministry of Supply and Rehabilitation. It comprises the following main wings: (1) Supplies wing (2) Inspection wing (3) Disposals wing. DGS&D purchases stores right from brooms to the heavier! equipments on behalf of all Ministries of Government of India and their attached and subordinate offices and also those of State Governments, local bodies, quasi-public bodies like Municipalities, District Boards, statutory corporations and public sector undertakings, which may desire to avail

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themselves of its services. Certain excepted categories of stores like foodstuffs, lethal stores, coal, wooden furniture etc. are not purchased by this organisation. Apart from purchasing stores, it undertakes inspection and clearance of stores imported against DGS & 0 and Supply Mission contracts as well as by other Government Departments, State Governments etc. and arranges disposal of surplus stores declared by Central Government Departments other than Railways. DGS & 0 has its regional supply offices at Kolkata, Mumbai, Kanpur and Chennai with headquarters at New Delhi. There is a separate Directorate of supplies at Mumbai for textile items only. Jute purchases are centralised in the Kolkata office. There are several inspection offices with sub-centres at different places. Inspection offices at Jamshedpur and Burnpur together with their sub-offices are concerned with metallurgy only. A Chief Controller of Accounts is stationed in New Delhi with Regional offices in Kolkata, Mumbai, and Chennai. Full particulars of Inspection and Payment offices are given in the respective tenders and contracts.

Organization of DGS & D The organization is headed by the Director General, assisted by one Additional Director General and five Dy. Director Generals. DGS & 0 has separate wings for supplies, inspection, progress and disposals. The supply wing is the mainstay of the organization with eleven directorates at headquarters and five regional directorates in other parts of the country. The grouping of purchase directorates has been done so as to ensure that homogeneous groups of items are dealt with at one place as far as possible, e.g., Jute purchases are centraiised at Kolkata office. Centralised items are handled by the directorate at the headquarters only. The planning; and development division helps to make the procurement process a success by rationalising speCifications, and drawing a comprehensive· programme for receipts and booking of indents of common user items. The 0 & M branch assists the supply wing in devising; procedures, systems and effective control measures to maintain optimum efficiency. The statistical branch maintains up-to-date statistics of the requirements and publishes the Annual Report as well as Directory of Govt. Purchases. The inspection wing under the charge of the Dy. Director General (Inspection) ensures that goods are purchased and supplied as per specifications required by the users. The working, responsibility etc. have been discussed in detail under the head "Inspection wing" later on in this chapter. The progress wing under the charge of a Dy. Director General is responsible for progressing all contracts placed by 0 G S & D. It keeps a close watch on the supply position after the placement of contract and finds out through the .field officers the cause for delay in supply. The wing has been divided into three branches, i.e., Defence, Railway, and General. The field officers work vigorously on behalf of the indentors for timely supply of the goods ordered. For this purpose periodical meetings are held, so ~hat issues like coverage of indents, supply position of contracts and obtacles which may cause delay in supplies. The disposal wing is responsible for the disposal of stores, deClared surplus by vari('us government depar:tments. Surplus stores worth around Rs. 50 crores are dispose-=: of annually by 0 G S&D. The details of the working of this wing have been given under the head "Disposal of Stores" later on in this chapter.

348

Outline of Materials and Purchasing Management A Directorate of Complaints and Public Relations has also been set up to assist the trade in their business with D G S & D, considering the importance of public relations in a large organization like DGS & D. Its functions are given below: (1) It guides trade in all procedural and contractual matters, pertaining to DGS & D. (2) It informs the trade representatives of the actual position in respect of particular outstanding cases, by due dates, through a system of position slips. (3) It attends complaints of delay or inaction on the part of purchase department. It helps in the release of payment against bills by the Controller of Accounts, (4) wherever necessary. Many publications, e.g., (I) DGS&D and the Prices, (il) Keep Your Date, (iiI) Consequences of Cancellation, (iv) How to sell to D G S & D, (v) Standardisation & Quality Control, (vi) Contract Manual, (vii) Conditions of Contract, (viii) Role of Central Purchasing in the devevelopment of small-scale industries, (ix) Let us help ourselves, (x) Make the Best of the Rate Contract, (XI) Import Substitution, (xiI) Pamphlet for the Guidance of Indenting Departments, (xiiI) Instructions to Contractors for preparation and submission of Bills, (xiv) Quarterly list of Stores on Rate!Running Contract Concluded! Extended by DGS & D, (xv) Instructions for Guidance of Rate Contract Holding Firms Regarding Rate Contracts, (xvi) Instructions for Guidance of Direct Demanding Officers Regarding Rate Contracts, (xvii) Annual Directory of Government Purchases etc. have been brought out. Moreover, the organization has a contract officer, legal adviser, liaison cell with main identors such as railways and defence, cost accounts branch and a deputy secretary for internal and finance matters. A Purchase Advisory Council under the chairmanship of the Ministry of Supply and Rehabilitation with representatives from the trade, industry and indentors is also there, which advises the DGS & D on procurement policy and procedures, so as to make the organisation effective and responsive to the socio-economic changes in the country. D G S & D works in collaboration with the Director General of Technical Development to locate indigenous sources of manufacture. Firm efforts of D G S & D have resulted in reduction of the percentage of imported stores in relation to total purchases from 41.1 % during the first plan period to merely 3.7% during 1976-77. In respect of imported spare parts and components for maintenance of earth moving and construction equipments, D G S & D has succeeded in locating and bringing out on rate contracts about 15,000 items of indigenous spares and components. In respect of non-sophisticated items, D G S & D advises the users to use alternative items which are available indigenously and which can prove to be the best substitute.

Registration of Suppliers (1)

D G S & D maintains a Register of Suppliers of various stores in order to facilitate procurement: (I) There are many items required by D G S & D for which advertised tenders are not issued and enquiries are addressed only to registered suppliers, (il) Even where advertised. demands are issued, intimations of demands are sent to registered firms, (iiI) Normally DGS&D places rate.and running contracts on registered firms only, (iv) 80% of the quantity against urgent demands is procured through registered firms, (v) These firms are not normally required to

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submit any security deposit which is required from unregistered firms, (VI) The list of registered suppliers of DGS&D is utilised by various other Central Govt. Departments, State Governments and public sector undertakings, which may waive the requirements of security deposit from such firms. No supplier is registered unless it is verified that he has got necessary technical know-how and he is manufacturing the stores to relevant standard specification, so that the same can be objectively tested at an independent laboratory. DGS & D assists, encourages and insists upon the suppliers to maintain the standards in manufacture and quality control techniques. Moreover, after the orders are placed, all supplies are tested consignmentwise and only those conforming to the standard specifications are accepted. During the process of inspection the manufacturers are also given technical 'advise, wherever necessary, for improvement in quality control. Thus great importance is given to standards and quality control in purchasing the supplies. ' (2)

All firms which are manufacturers/stockists of imported stores, sole distributors of Indian manufacturers and agents of overseas suppliers can apply for registration with D G S & D.

(3)

Small-scale units can apply for registration either to DGS & D or to the National Small-scale Industries Corporation, Okhla, New Delhi, under their 'Single Point Registration Scheme' which has come into existence with effect from July, 1976. Firms which are found eligible and registered under the scheme are treated as registered with DGS&D and are entitled to all benefits of DGS&D registration programme.

(4)

Application forms for registration are given from DGD&D offices in New Delhi / Kolkata/Chennai/Mumbai/Kanpur against payment. The application is to be submitted with a Treasury challan. All applications are to be completed with documents as per instructions given in the forms. It is necessary to send documents like memorandum of association, articles of association, current Income Tax clearance certificate, annual profit and loss account, name of bankers, performance of suppliers, etc. along with the application for proper processing, D G S & D arranges to inspect the premises of the firms and decides about their registration or otherwise on the basis of the technical assessment.

(5)

(6)

(7)

(8) (9)

Initial registration is granted provisionally for one year and if their performance during the year is found satisfactory, it is confirmed for three years. Therefore, it is the responsibility of the firm to apply for renewal of registration at least 4 months in advance of the expiry of their current registration. All registered firms are expected to participate in the tender enquiries issued by 0 G S & D and Regional Offices and to submit competitive offers, secure and execute the orders satisfactorily. They are also expected to abide by the general terms and conditions of purchase laid down in D G S & D - 68 (revised). They are also required to submit annually the income tax clearance certificates, trading and profit and loss accounts etc. All changes in constitution, addresses, names and constituents may be duly reported to D G S & D for proper incorporation in the records. Firms can contact the Public Relations Officer of DGS & D or its Regional Offices for any further assistance in seeking registration and can discuss their problems with Dy. Director (Registration), D G S & 0, New Delhi.

350

" Outline of Materials and Purchasing Management (10) . Normally, applications for registration are decided within 3 to 4 months. In case of any inordinate delay, firms may approach any of the 0 G S & 0 officers direct for any expeditions decision. Registration with 0 G S & 0 facilitates the firms securing orders from 0 G S & 0 as from other Central Government Departments, Public Sector Undertakings, etc.

Registration with 0 G S & 0 raises the firm's standing in business not only with Government departments but also with foreign firms and establishments.

Purchase Procedures Tender Method (competitive bidding method) is used to purchase the stores, to give equal opportunity to all eligible parties to participate in tenders and to ensure that all the offers received are treated in an equitable manner. The "General conditions of contract governing contracts placed by the Central Purchase Organisation of the GOI (OGS and 0-28) states clearly the principles of tendering. The general modes of purchases are (a) Open tenders, (b) Limited tenders, (c) Single tender and (d) Negotiations. The purchase policy of the Government is oriented towards encouraging the growth of small-scale units by giving them price preference and by reserving certain items for exclusive purchases from them. More and more items are added from time to time under the reserved list. Price preference up to a maximum of 15% is given to small-scale units over the lowest quotation offered by large-scale units where large-scale and small-scale units compete. The volume of purchases made from small-scale units has been steadily increasing. The particulars of open tender enquiries floated by 0 G S & 0 and its Regional Offices are published in the Indian Trade Journal. These are also exhibited on the Notice Boards in the 0 G S & 0 and the Regional offices. Details of tenders meant for opening in the next few weeks are furnished in the form of a weekly bulletin, by 0 G S & 0 and copies of this bulletin are supplied to all Directors of Industries and other recognised Trade Associations for giving wide publicity to the Trade for participation in 0 G S & 0 purchases. Tender sets are also available for sale in these offices. Registered suppliers are entitled to supply tender sets in case of limited tenders, free of charge. Additional or duplicate copy of tender forms and the accompanying schedule are provided on request at 50% of the • original price of tender forms. Cost of drawings and specifications is charged extra. The latest hour for receipt and opening of tenders is indicated in the schedule to tender. Hand delivered tenders are to be put in the tender box provided for the purpose, not later than the time and date specified in the schedule to invitation to tender. Tender boxes are cleared twice daily at 10 a.m. and 1 p.m. All tenderers are required to abide by the time table in their own interest as tenders not submitted within the scheduled date and time are likely to be ignored. TendeYenquiry consists of four parts: (a) Invitation to tender (b) Schedule to tender (c) Forwarding letter to be signed and returned by tenderer (d) A slip indicating details of the tender No. etc. to be pasted by the tenderer on the inner cover containing tender form. Tender enquiry clauses should be read carefully and correctly answered. The essential ones are item No., Description of stores, prices, terms of delivery, schedule of delivery, conformity to specification and so on. The tender enquiry also lists out the authorities from whom the necessary specifications and drawings can obtained.

Government as a Purchaser 351 Tenderer or his authorised representative can be present at the time of opening of the tender. Telegraphic or letter quotations from registered firms may be considered provided they are complete in all respects with regard to price, specification, delivery, and other particulars essential for taking purchase decisions, subject to the condition that they are confirmed within three days in the prescribed tender forms.

Unregistered firms have to furnish security deposit by the date mentioned in the contracts for due performance. This could be in the form of cash, money order, bank deposit receipt, fixed deposit receipt or demand draft of any of the Nationalised Bank or any other forms as may be detailed in the tender enquiries. D G S & D has decreased its dependence on 'Open tenders' and it depends more on limited tenders and negotiations to make the procedure less time-consuming. Tender enquiries are sent to limited number of suppliers only, who have supplied stores in the past satisfactorily. Many Government departments, public procurement agencies and other bulk purchasers invite tenders for supply of certain goods and services. These agencies also invite tenders for disposal of their surplus stocks. Tender method of purchasing is not free from limitations. While submitting a tender or bidding at an auction, certain suppliers or buyers, as the case may be, join hands with a view to eliminating competition inter se, or to exclude other competitors. The tenderers may also agree that the tender will be submitted by only one or a few of them. Moreover, the agreement may provide for quoting such rates and terms as would make the offer of only the pre-decided tenderer acceptable. These practices are referred to as "Collusive tendering." Three major difficulties stand in the way of 'controlling collusive tendering: (1) It is difficult to detect secret collusive practices. (2) It is difficult to distinguish be'tween a collusive tendering arrangement and a more subtle form of concerted action in the form of prior consultation. Collection of necessary evidence for action under the relevant regulatory law is (3) almost impossible. The remedy lies in the close co-operation and collaboration between procurement officers on the one hand and the law enforcing agencies on the other. Procurement officers should provide details of an identical tender or any other sign of collusion among tenderers.

Collusive Tendering in India The Monopolies Inquiry Commission discovered several cases of collusive tendering. For instance, all the cable manufacturers quoted the same prices to the Director General of Supplies and Disposals. The tenders for lamps received by the Director General of Supplies and Disposals from members of the Electric Lamp Manufacturers' Association of India were in identical terms. Furthermore the tenders received from the Indian lamp Manufacturers' Association quoted one and the same price.

Regulatory Provisions in India The statutory provisions for prohibition of collusive tendering in India are contained in the Monopolies and Restrictive Trade Practices Act, 1969 (the MRTP Act). Under the scheme of MRTP Act, collusive tendering may amount to a restrictive trade practice, if it has or may have the effect of preventing, distorting or restricting competitions in any manner and, in particular, if it tends to obstruct the flow of capital or

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Outline of Materials and Purchasing Management

resources into the stream of production, or to bring about manipulation of prices, or conditions of delivery or to affect the flow of supplies in the market relating to goods or services in such manner as to impose on the consumers unjustified costs or restrictions. After-making an inquiry, if the Commission is of the opinion that the practice is prejudicial to the public interest, it can direct the party-concerned to discontinue the practice and not to repeat the same. The Commission can also declare the relevant agreement as void, in respect of the restrictive trade practices, or order modifications of the agreement in the specified manner.

Types of Contracts, their Finalisation etc. DGS & D purchases stores on the basis of various types of contracts depending upon the circumstances of each case. The following types of contracts are concluded: (1) Fixed Quantity Contracts: This is usually termed as "Acceptance of Tender." In such type of contract, the firm is required to supply a specific number or quantity of stores at a price and terms of delivery agreed upon. (2) Rate Contracts: This is a contract for the supply of stores at specified rates during the period covered by the contract. No quantities are mentioned in the contract and the contractor is bound to accept any order which may be placed on him during the currency of the contract at the rates specified therein. The Rate Contracts cover a large variety of items of common use required by various departments of the Government. These contracts are operated by placing supply orders by DGS & D and/or Direct Demanding Officers. Here the user is assured of a steady flow of supply as and when he needs the stores. He is not required to maintain large stocks of various items and thus he can save money and the requirement of storage space is minimised. (3}Running Contracts: This type of contract is meant for the supply of specific quantity of stores with a plus minus tolerance indicated at specified prices generally during a year. In terms of the conditions governing these contracts the purchaser has the right" to vary the quantity ordered (usually 25 per cent) over or below the approximate quantity mentioned in the contract. User departments are advised to plan such requirements in advance and bulk indents are received according to predetermined schedules. The Running Contracts provide that any of these users may demand his requirements at any time or at specified period during the currency of the contract whether direct from the firm or through DGS & D. Although the prices of such contracts are fixed, in certain cases variable prices are incorporated based on established rates of raw material, etc. In such type of contracts, the suppliers are assured of a reasonably large demand, spread over a fairly long period. Therefore, the suppliers can derive benefits from comparatively more economic planning of their production programmes. (4) Price Agreement: Price agreement is entered into with a firm for making supplies of certain stores during a given period at agreed rates specifying the monthly rate of supply to serve as standing offer to the purchaser for meeting any requirements of that store on an ad-hoc basis during that period. As soon as a contract is received by the suppliers, the latter should immediately go through the contract clauses and return the acknowledgement (from contractor, in the form sent with contracts) duly signed to the office issuing the contract. Unsuccessful tenderers are informed individually. The supplier is required to pay security deposit in cash or by any of the acceptable forms like

Government as a Purchaser

353 bank guarantee, fixed deposit receipt, etc. as indicated in the general conditions of contract (DGS&D - 28) by the due date indicated in the contract. Delivery is the essence of contract. The suppliers have to deliver stores on time as stipulated in the contract. They should follow the following guidelines: (i) to supply stores as per delivery date specified in the contract, (ii) to ensure quality of stores contracted, (iii) to keep the Purchase Officer informed of the progress in supplies, (iv) to keep in touch with the Inspector for ensuring timely inspection of stores and (v) to approach Purchase/Progress Officer for any assistance required. If the supplier feels that he is not able to supply stores as per delivery date indicated in the contract, he should apply to the supply officer for extension in delivery date giving full reasons for his inability to supply as per the contract. Such requests should be made well ahead of the expiry of the delivery date to enable the purchase officer to arrive at a decision in time. Such requests are considered on merits. The requests should be made only if absolutely necessay because delays in supplies cause inconvenience and at times loss to the users. Besides regularisation of such extension at the completion of the contracts invariably cause delays in payment. The suppliers should therefore in their own interest indicate a realistic date in their offers and having accepted them adhere to it in procuring supplies. DGS&D rates high a supplier who always keep his date. If the contract is placed for a fixed quantity and at a fixed rate and is supplied within the delivery date specified in the contract, its finalisation is not required and the payments are effected straightaway without any difficulty. In respect of the following cases, the finalisation of the contracts are required before final payment is made to the suppliers: (i) If it is a fixed price contract, but suppliers have not been made within due date, and if the supplier has already obtained extension of delivery date, he will have to apply to D G S & D after the completion of supplies to finalise the delivery date by giving reasons for delays. D G S & D considers such requests on merits and finalises the delivery date with or without levy of liquidated damages depending upon the merits of the case. (ii) In case the contract prices are variable, the supplier will have to submit documents as laid down in the contract to enable DGS&D to finalise the prices so that the supplier may get the remaining payment due to him. For this purpose, it would be in the interest of the supplier to send all documents specified in the contract relating to the basis of price variation, sales tax, excise duty, customs duty, exchange rate or any other documents that the contract requires him to produce for the purpose. Such requests are normally attended to promptly, but in the event of any delay in the finalisation of such cases, the supplier can write directly to the Directorate of Complaints and Public Relations or to the Director General (S&D) for prompt settlement of his case.

Terms of Payment Payment against contracts placed by DGS&D and its Regional offices have been decentralised and excepting the contracts of the following nature, the payments are made by the respective Controller of Accounts according to the location of suppliers. This arrangement has been made to ensure early payment to the suppliers so that their capital may not be blocked up. Major portion of their payment is made to the suppliers immediately

354 Outline of Materials and Purchasing Management on completion of supplies as a result of such arrangement. The regions to be with each Controller of Accounts are as follows: (i) Controller of Accounts, New Delhi - Punjab, Haryana, Rajasthan, U.P., M.P., H.P., J & K and Delhi. (ii) Controller of Accounts, Kolkata - Bengal, Assam, Orissa, Bihar, Meghalaya, Arunachal Pradesh and Mizoram. (iii) Controller of Accounts, Chennai - A.P., Tamil Nadu, Kerala, Karnataka and Pondicherry. (iv) Controller of Accounts, Mumbai - Maharashtra, Gujarat and Goa. Payment against contracts is made as under: (A) Contracts covered by general conditions of contracts form No. DGS&D-68 (Revised) : Ninety-five per cent on proof of inspection and despatch and balance 5% after receipt of stores in good conditions subject to a maximum limit of 90 days. (B) In case of CIF Contracts - 90% on the strength of shipping documents and certificate to be issued by DGS&D, Port Shipping Officers, and balance 10% on receipt of stores in good condition. (C) Where Inspectors also act as interim consignees or where inspection is carried on by the consignee himself at destination and in all cases of local delivery, 100% payment supported by inspection certificates and consignee receipt certificate. (D) Rate/Running Contracts - 98% on proof of inspection and despatch and balance 2% on receipt of stores by consignee. (E) Different payment terms are available for contracts for plant and machinery, contracts for sea and river crafts and so on. Full details are available in the general conditions of contract (DGS&D-28). Bills should be prepared in the standard will form DGS&D - 135 in quadruplicate. These, duly supported by documents, should be submitted to the Controller of Accounts indicated in the contracts. Detailed instructions on the preparation and submission of bills are contained in the special publication No. DGS&D-204 (i.e., Instructions to contractors for preparation and submission of bills) which can be had on request. If the bills are properly prepared as per the instructions, prompt payments are facilitated.

Inspection Wing The Inspection Wing of DGS&D ensures that the goods purchased and supplied are as per specifications required by the users. The Headquarters of the Inspection Wing are located in the DGS&D office at New Delhi. Besides, there are Directors of Inspections located at New Delhi, Mumbai, Kolkata, Chennai, Jamshedpur, Burnpur and Tokyo. In addition 35 sub-centres are also there located at various places in India as stated earlier in this chapter. The task of the Inspection Wing starts, with the inspection of facilities for supply available with the suppliers. A representative of the Inspection Wing visits the premises of the supplier who apply for "registration or any un-registered firms which submits a quotation against any tender issued by DGS&D. The representative of the inspectorate examines the plants and machinery equipments available with the supplier, technical skill employed,

Government as a Purchaser 355 testing facilities, etc. In case such facilities are considered adequate for the manufacture and supply of the items offered by the firm, he recommends their case to DGS & D suitably.

After the placement of the orders, the Director of Inspection concerned deputes his representative to visit the premises of that supplier as and when called upon to do so and reports on the progress of supplies, examines the quality of the products produced, vis-avis the specifications mentioned in the contract by testing in the department's laboratories or by sending the samples to National Test Houses at Kolkata, Mumbai, Chennai and Delhi. On receipt of a satisfactory report, the goods are released after proper scrutiny and the inspection notes issued to enable the supplier to despatch, the goods and obtain 95/98/ 100% payment as the case may be. The Inspection Wing not only inspects the goods and examines its quality, but also advises the suppliers to improve upon its quality in case any shortcomings are found. He assists the suppliers by giving technical advice with a view to improving the quality of the products. The Inspection Wing not only inspects the goods ordered by DGS & D but also by other organisations like Railways. In these cases too, the Inspectorate ensures that the goods of the right quality are produced and supplied to the users. The Metallurgical Inspectorate of Inspection Wing at Jamshedpur and Burnpur render a special facility to all manufacturers including private parties by providing them facilities of quality control for the metals and metallurgical products. This can be availed of by any supplier on payments.

Disposal of Stores While the main task of DGS & D is to arrange for the supply of stores to the Central Government Departments, it also functions as the disposal agency for the stores rendered surplus in various Government Departments. Bulk of these disposal stores are declared by the Defence Services, Posts and Telegraphs, Mints, etc. DGS & D arranges the disposal of stores either by auctions or by tenders. The auction and tender programmes are regularly advertised in the leading newspapers every month. Any party interested in procuring these stores could partiCipate in these tenders and auctions on the basis of the terms and conditions laid down. Normally, auctions are conducted by auctioneers duly appointed for the purpose who could be contacted for any further details regarding the availability, quantities, terms and conditions, etc. Similarly, the terms and conditions for sale-by tenders are enumerated in the tender documents which can be had from the Headquarters of DGS & D at New Delhi as well as from various Regional offices at Mumbai, Kolkata, Chennai and Kanpur. The stores can be inspected in either case two days before the opening of tenders or the holding of the auctions .. The stores generally put up for auction comprise surplus vehicles, machinery and equipment, spare parts, semi-manufactures of ferrous and non-ferrous metals, zinc draws, steel cuttings, used gunny bags, containers of various sizes and various other types of scrap materials.

4. CONCLUSION Thus this Central Purchasing Organization of the Government of India, with the diversified services as a procuring agency for Inspection, as a clearing agent for imported stores etc. has played an important role in the development of Indian Industries and in import substitution along with procurement and disposal of store for Government Departments

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Outline of Materials and Purchasing Management

and other agencies. The span of its activities have increased and has yet to playa major role for the development of small-scale industries as a part of Government policy. The Estimate Committee has observed in its 121 st Report that "The organization has stood the test of time and has shouldered the responsibility, cast on it in regard to the maintenance of supply lines in the country having due regard to the development of Indian Industries both in times of peace and war and according to the exigencies of the situation resulting from emergencies from time to time."

000

CItAPTER 26 Materials Management as a Profession In majority of Indian industries today, materials is recognised as a vital function and has been given the necessary status at the corporate level and plant level. The function which was formerly subordinated, either to production or finance is now a separate functional area staffed with specialists. All related materials functions like procurement, traffic and transportation, inventory and stores, materials research and planning are put in charge of a Materials Manager - the function has been integrated. The materials manager now reports directly to top management. This is a trend towards professionalization. In order to make any practice a profession, it should satisfy four benchmarks of a profession. Organized body of knowledge as evidenced by books and periodicals and the (1 ) research carried out. Learning of the body of knowledge through academic institutions. (2) Growth of consultancy and professional organizations. (3) Code of Ethics to govern the profession. (4) On all the above counts, materials can be considered to be a professional practice. There is a plethora of literature available, though we need some more Indian journals and books by Indian authors with models suited to Indian conditions. Materials management is being taught at P.G. level in all major management institutes. Besides we have courses from Management Associations and Productivity Councils. Materials consultancy has become an important activity for many engineering and management consultancy firms. All India Materials Management Association has been established and runs a correspondence and regular course in Materials Management which has recently been recognised by Government of India. The materials people have started observing a code of conduct too, though they so far, it seems, have not been able to dispel the impression on public mind that a purchase manager's job is to make fast buck by striking a surreptitious deal with the vendor.

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Outline of Materials and Purchasing Management

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Suggestions The following suggestions will accelerate the trend towards greater professionalization : (1) More research efforts are necessary to develop inventory models and storekeeping systems for Indian conditions. (2) More efforts are necessary to develop vendor relations, to the extent of helping the vendor from concept to commissioning of a supply of right quality and in right quantity by offering him all assistance to do so. (3) It is necessary to have more literature on materials functions, mostly the Directories (General and Specific). (4) This function is. expected to have more say in purchase decisions which are shared by materials executives now with other functionaries. (5) All India Institute of Materials Management with a regular programme and short-term MDPs is a need of the hour. The regular MBA programmes with one or two papers on Materials cannot cope with the growing complexions in this profession. (6) It is necessary to consider materials as a managerial activity needing planning, organizing, staffing, directing and controlling; rather than as a technical activity only limited to product knowledge. Conceptual skills and analytical skills therefore must be developed in materials functionaries. (7) Cases of materials, therefore, in Indian situations must be developed. (8) Materials should not be view