Purchasing Objectives and Its Impact On Profitability

For any function to be successful, it must establish clear and measurable objectives, and work diligently to achieve them. Purchasing, as one of the caretaker of the largest share of the company’s revenue inflow, is no exception. As a Controller, I organize and syncronize the accountants, Purchasing peoples, Internal Auditors and controlling each manager of the departement. I can see when they perform over or under the whole company’s expectation obviously.

To maximize its contribution to the company’s overall performance, purchasing must establish the following two overarching objectives:

1. Assure economic supply through the procurement of goods, supplies and services to keep the company in operation.
2. Contribute to profits by efficiently controlling the total cost to the operation.

Consider: While many business people think of the first function only, it is through the smart handling of the second point (after the first is assured) that defines the difference between an average and a world class purchasing organization.

In addition to the above overarching objectives, some specific purchasing objectives include:

1. To get the best buy—suitable quality at minimum cost
2. To pay reasonably low prices, negotiating and executing all company commitments
3. To develop satisfactory sources of supply and maintain good relationships with them
4. To secure optimal supplier performance, sometimes by seeking process improvements across boundaries between trading partners
5. To locate new and better materials and products
6. To keep inventories throughout the supply chain as low as is consistent with company needs
7. To carry out programs to continually reduce total cost of purchases
8. To develop effective controls and procedures
9. To keep acquisition costs at the minimum compatible with optimal performance

This list is far from all-inclusive; other objectives will become evident to the alert purchasing manager based on the specific nature of the procurement activity involved. Furthermore, although the above list is largely conceptual, it is important in practice that specific objectives be quantified to the maximum practical extent.

A company will have stated objectives, but the individual manager must interpret what company officials actually say and do. For example: chief executive financial officers (CFOs), backed by the law of the land, will usually stress their responsibility to the stockholders. But the company’s objectives are usually composites of many decisions, resulting in various cross-functional compromises. So in actual practice the CFO’s goal is to balance the objectives of a fair return on investment to stockholders, stable and satisfying employment for employees, satisfaction of customers and the community, and so forth.

In setting procurement’s functional objectives, the Purchasing Manager must be aware of the CFO’s (and accordingly, the company’s) objectives, and ensure consistency in constructing the specific objectives for the purchasing department. With increased focus on meeting customer needs more effectively, many enterprises have begun to evaluate the results of the entire supply chain in satisfying these needs. This has given rise to the concept of competition between supply chains rather than merely between companies. Consequently, the importance of supplier contributions to enterprise results has further increased expectations of the supply management organization.

Purchasing’s Impact On Profitability

It is clear that since purchasing is responsible for controlling a dominant share of the company’s revenue dollars, it directly impacts profitability and the financial success of the overall business enterprise. As a purchasing people, simply maintaining adequate sources of supply is not enough. Making sure that suppliers are the “right” suppliers, selling at the “right” price—and then seeing that they keep serving well, are important activities.

Let’s look at purchasing’s impact on profitability. For easier understanding let’s assume the purchasing profit ratio is based on an average company with a 7 percent profit before tax. A $1 reduction in the cost of purchased goods produces a profit of $1, or a 1-1 ratio, whereas it takes $14 of sales to produce the same amount of profit! A dollar saved in purchasing equals the profit from $14 of sales: so, the profit leverage of the material cost reduction dollar is 14 times that of the sales dollar. The purchasing profit ratio can be computed for any company by dividing its annual sales volume by profit before tax.

Questions & Considerations: Purchasing claims to be a profit-productive profession. Fine! But, where’s the profit? As an example, a broom previously costing $8 is now bought for $7.00. A dollar is saved. We can agree on that, but where is that saved dollar? It’s not itemized on the profit and loss statement, balance sheet, or “where-got-where-gone” cash flow comparison. Unfortunately, traditional accounting systems don’t always take into account purchasing’s contribution.

So, again, where is the dollar savings? We know the savings for buying brooms has to be in the budget of the using department, but the issue isn’t solely about the budget for brooms. In 2002, the gross domestic product (GDP) for the U.S. was $10.45 trillion. That year the collective spending of about $6 trillion by American buyers means that during any working day, over $25 billion was spent throughout the U.S and the real question is, “How well was that money spent?”

Let’s look at purchasing’s impact on profit in further detail. Let’s assume the profit ratio depicts a typical performance for a healthy $20 million sales company. Purchases, in this case 53% of sales, are equal to $10.6 million, and are part of company costs. Next let say  starting with a 2.5% savings reduces purchases to $10.3 million, which causes a chain reaction as it flows through the cost accounting system; first by reducing total cost that increases profit, and then profit margin, and ultimately return-on-investment (ROI).

The return on invested capital for the company has increased from 10.5 to 13.6, which is a 28% improvement because of purchasing’s profit contribution. In addition, lower material prices will reduce inventory value, or assets. So, the final result is an even higher investment turnover than shown. This is a measure of purchasing’s effect on the total company results.

Note: The management of successful companies is very aware of such performance measurement results.

Here is an interesting exercise. To prove the strong impact of good or bad buying on any specific company, fill in a blank ROI chart using the company’s performance as stated in the annual report. Then simply add 2% (or a figure you judge appropriate) to the cost of purchases and compute the new ROI compared to the original numbers. Also, drop the purchases by 2% and note the change in ROI. A 2% change in purchasing expenditures swings the return on invested capital dramatically! This is a clear example of purchasing’s leverage on profitability.

Although the impact of purchasing on a company’s profit is great, it is not easily achieved! It takes a skillful team of buyers under a competent manager who understands scientific purchasing techniques and methods. In marginal companies, the difference between operating at a profit or a loss may lie in the efficiency of the purchasing function.

If this purchasing function can make money, it can also lose money by poor performance that can reduce profits; so, purchasing is an heir to a profit-producing responsibility. The purchasing manager is key in the ability to influence company profit and thereby affect ROI.

Hmm… okay, I planned to not discusse it further, but I know there is one question left in your head (What Make Purchasing People Successful?), Okay… read on….

What Make Purchasing People Successful?

Two qualities are especially important—the ability to motivate and encourage others to perform, and the ability to find alternative solutions when under pressure. Flexibility, the ability to quickly shift mental gears, is key, as purchasing often occurs at a hectic pace beset by a variety of problems. Examples of purchasing duties are: cost studies, supplier negotiations, and “fire-fighting” to overcome quality or delivery problems as they arise.

Question: Purchasing is a demanding job, requiring a dedication and commitment to serving the company’s best interests over the long run. How do you measure up?

The competent purchasing people will:

1. Handle his or her share of the departmental workload.
2. Perform work quickly and accurately.
3. Accept that periodic assignment changes are sometimes required in a dynamic business environment.
4. Accept some overtime work, with or without extra pay.
5. Offer workable ideas for improving purchasing systems.
6. Seek to continually improve process effectiveness.
7. Know supplier capabilities and limitations.
8. Foster long-term supplier relationships.
9. Recognize that the suppliers’ success reflects on his or her individual performance.
10. Keep up with market and technology developments.
11. Stay abreast of his or her company’s products and services.
12. Continue to add to personal knowledge of the job.
13. Work within procedures and guidelines of the department.
14. Maintain the highest personal ethical standards.
15. Justify sourcing decisions based on total cost and the best interest of the company.
16. Know how to tactfully challenge specifications and delivery dates that affect the ability to assure supply.
17. Accept constructive criticism without becoming overly defensive.
18. Pitch in to help other buyers during times where workloads become strained.
19. Let the supervisor know when workload can be increased.
20. Reasonably enjoy his or her work.
21. Remain loyal to the supervisor, the department and the company!

The purchasing people should be firm and decisive, yet, when necessary, eloquent in pleading a case for special treatment. It’s all in the daily job; the individual that can’t make swift transitions will be unhappy as a purchasing people. Purchasing’s role will continually shift as supply and demand forces change. Scarcity of materials will cycle again. Higher prices are needed at times, to reduce consumption as the world’s resources are being deplete

Source:

http://accounting-financial-tax.com/2008/12/purchasing-objectives-its-impact-on-profitability/