Methods of purchasing vary according to the nature of the demand in the plant and the conditions in the market in which goods are to be bought. There are eight principal purchasing methods:
(a) Market purchasing
(b) Purchasing small items in groups
ADVERTISEMENTS:
(c) Speculative purchasing
(d) Purchasing for a specified future period
(e) Scheduled purchasing
(f) Purchasing strictly by requirement
ADVERTISEMENTS:
(g) Contract purchasing
(h) Hedging.
(a) Market Purchasing:
When purchases are made in accordance with the conditions of the market to take advantage of price fluctuations rather than to meet immediate needs or for a specified future period, the method is known as market purchasing.
image source: thefreshexchangeblog.com
ADVERTISEMENTS:
This method cannot be classed as speculative purchasing as long as it conforms to the production schedule and its possible changes, or to the demands of the plant or business. It is entirely possible to purchase wholly with reference to demand, and yet take reasonable advantage of market fluctuations.
This method is used by rail roads, public utilities, and some manufacturing corporations, which have definite construction or manufacturing programs mapped out for long periods ahead. By constant study of market statistics and factors that affect prices, an efficient purchasing department is able to forecast the trend of market price and how to buy to best advantage.
When its studies indicate that the price range is at a reasonably low point; and that the future trend will be toward higher levels, the purchasing department will purchase its requirements for a considerable period ahead.
If indications are that prices are reasonably close to the peak, and that the trend will be downward, a hand to mouth purchasing program is followed until prices have become stabilized at a lower level.
Market purchasing applies to the buying of coal, pig iron, and raw materials generally. The advantages of this method are:
1. Greater margin of profit on finished products, the price of which does not fluctuate as widely as that of the raw materials.
2. Lower purchase prices.
3. Consolidation of purchases of a given material into one transaction, with a saving in purchasing expense.
The disadvantages of this method are:
1. Liability to obsolescence in case of radical changes in specifications.
2. Possibility of error in judgment of market tendencies, which may mean large losses.
3. Higher inventories with consequent higher carrying charges and tying up of storage space.
When the price of the fabricated product fluctuates with the price of the raw materials of which it is composed, the fabricator often desires to transfer to speculators, who perform the service of risk-taking, the serviced of risk taking means the risk of the price change that occurs between the time of purchasing the raw materials and the time of selling the finished product.
This operation is known as ‘hedging’. To hedge, the fabricator sells the speculator “futures,” which are contracts to deliver raw materials in the future. At the same time, the fabricator buys the raw materials required for the order he is to fabricate. When the goods are finished, he satisfies his contract for futures at prevailing raw materials prices.
As the selling price of the fabricated goods fluctuates with the Price of the raw material of which it is composed, any gain or loss trough the raw materials’ transaction is offset by increase or decrease in the selling price of the finished product.
The speculator I assumes for the manufacturer the risk of price change during the period of fabrication. Examples of commodity prices which fluctuate with raw material prices are steel drums with steel sheet, cardboard containers with chip board or Kraft, and leather belting with hides.
Merits:
1. Greater margin of profit on finished product, the price of which does not fluctuate as widely as that of raw material.
2. Consolidation of purchases of a given material into one transaction, with a resulting saving in a purchasing expense.
3. Lower purchase prices.
Demerits:
1. Liability to obsolescence in case of radical changes in specifications.
2. Possibility of error in judgement of market tendencies which may mean large losses.
3. Higher inventories with consequent higher carrying charges and tying up of storage space.
(b) Purchasing Small Items in Groups:
The purchasing method in which small items are grouped and purchased from one dealer who agrees to sell them at a fixed percentage of profit above dealer’s cost, is proving worthwhile in many concerns. Agreements of this kind often provides for an audit of dealer cost by the buyer.
Every purchasing agent finds that he must buy hundreds of small items, so trivial in value that the cost of placing the orders often exceeds the value of the goods purchased. The problem is to handle such purchases as quickly and as inexpensively as possible, and this method is proving to be the solution in many cases.
Some purchasing agents after the completion of the blanket order or agreement to purchase all items in a group from a specific dealer dispense with purchase orders for such items, and forward a copy of the purchase requisition to the dealer.
A monthly statement showing an itemized list of the items furnished is submitted by the dealer to reduce invoice checking. The multitude of small orders which require the attention of the purchasing department, increase purchasing costs tremendously and every device should be utilized to reduce this clerical burden to a minimum.
(c) Speculative Purchasing:
Speculative purchasingbuying in excess of needs with the hope of selling the excess at a future date at a profit. The term is occasionally applied to an unusually large purchase made at a price which is low enough to warrant taking the gamble that the savings in price will be more than the cost of carrying the inventory.
It goes a step further than market purchasing, makes price trends in commodity markets the primary factor, and a fixed program of use as a basis for buying secondary. It does not base decisions on demand of the business itself, but on the possibility of market price savings.
In some industries, the cost of a single raw material alone is more than 50% of the total cost of production. The cost of cotton, for instance, outweighs all other elements of cost in producing cotton cloth.
Here, a saving of a few rupees on raw cotton offers a greater chance of profit than does any other activity of the business. In such a case, successful speculation is often a primary means of earning dividends.
Speculative purchasing is not, properly, a function of the purchasing department. It should be authorized only by direct action of top management. The purchasing agent should present the full facts including the hazards as well as the possible advantages, together with his conclusions as to the advisability of taking the gamble. For ordinary manufacturing, the method is to be discouraged. Its single advantage is the possibility of huge speculative profit. Its disadvantages include:
1. Endangering manufacturing schedules by waiting for profitable buying points.
2. Using large storage spaces.
3. Tying up large amount of capital.
4. Running the risk of obsolescence in case of radical change in specification.
(d) Purchasing for a Specified Future Period:
Purchase for a specified future period is standard practice for buying goods regularly used but not in great quantity, and on which price variations are negligible. Most supplies are bought by this method. The period for which the purchase is made be fixed by a production schedule, by the stores record of past use, or by a combination of both.
The savings to be gained by the purchase of a given quantity also affects the determination of the period, as does the cost of carrying the goods in inventory. It is important to note that no fixed Period should be set for all purchases. Rather, a separate and flexible period should be determined for each item.
(e) Scheduled Purchasing:
The schedule plan for purchasing materials which are used regularly in large quantities has been developed to reduce the investment in inventory; essentially, the plan consists of giving suppliers approximate estimates of purchase requirements over a period of time, thus enabling them to anticipate the receipt of orders and be prepared to fill them when they arrive.
Although minimum inventory is probably the most important objective in this plan, others sought are good quality, prompt delivery, and low price. Good quality can be obtained only by giving suppliers enough time to produce.
Prompt delivery can be better assured if the supplier can include the purchaser’s approximate materials requirements in his own production plans. Lower cost result from this opportunity to pre-plan production, because better methods and equipments can often be provided when the demand is known.
Whereas the schedule provided is not a contract, except in contract purchasing, there is often a gentleman’s agreement regarding, adjustments when unexpected changes in requirement place a burden on the seller.
(f) Purchasing Strictly By Requirement:
Purchasing by requirement means that no purchase is made until a need arises, and then only purchasing that quantity which is necessary to meet the need. This method applies principally to emergency requirements, or to goods used too infrequently that they should not be carried in stock.
It is essentially emergency buying and ordinarily makes the procurement of goods the important: requirement. The task of the purchasing department is to have vendor connections which can be depended upon to fill such orders promptly and without taking advantage of the situation.
(g) Contract Purchasing:
All purchasing is by contract, but the term contract purchasing is applied to that special type of contract which calls for deferred delivery over a period of time. Through this medium, advantage can be taken of low prices of materials which are in effect at the time of placing the order, while providing for the delivery of the materials to meet estimated future requirements.
Thus, the price advantage is obtained without adding unduly to inventory. When such contracts are possible, they should be negotiated for those raw materials that fluctuate widely in price. In some cases, the prices for spot purchases are more favourable, and market purchasing, even with the increase in inventory costs, may prove advantageous. Contract purchasing often provides the means of assuming a continuous flow of materials into the plant and where the production program is known, often becomes scheduled purchasing in contract form.
Contracts for contract purchasing specify the followings:
1. Terms of payment, generally on monthly basis, so that smallest possible amount of the company’s cash resources is tied up.
2. Ways of altering or negotiating or terminating the contract. Advantages of this method include:
(i) Sizeable discounts on a large quantity of goods supplied over a long period.
(ii) Less inventory cost as deliveries are phased as per production schedule requirements; and
(iii) Economy in labour and paper work or placing orders.
3. Length of contract (which is usually six months to one year).
4. Type or types of items covered by the contract.
5. The delivery time is fixed by economic order value to give maximum benefit to both vendor and purchaser.
6. The places of dispatch and delivery and mode of transportation.
7. Prices and discounts.
(h) Hedging:
Hedging is the process of entering simultaneously into two contracts of an opposite nature — one in the cash market, the other in the future market whose primary purpose is to protect operating profit margins. Essentially, it involves the transfer of price risk to a specialist in risk taking, i.e., the speculator.
Objectives of Hedging:
1. To transfer the price risk to someone else who can easily bear that is the speculator.
2. To minimise risk of adverse price fluctuations.
3. To protect the organisation from possible loss due to price fluctuations. It aims at price protection by finding two different commodity price series that move together closely.
4. To reach to an ideal situation of a zero less in transaction a business.
Features/Nature/Characteristics of Hedging: areas under:
1. Hedging protects organization’s margin of profit.
2. Hedging transfers the price risk to the speculator, who is considered to be a specialist in risk taking.
3. Hedging is a process of entering into simultaneous two contracts having two distinct purposes.
4. Hedging is theoretically possible but practically impossible.
5. In hedging two markets are involved — the cash market and the features’ market.