The purchase of capital equipment and its commissioning involves a number of phases. A cross-functional team consisting of professionals ranging from operations, production, finance, plant engineering and procurement is involved at every phase of the procurement process.
Procurement has a primary role only in the evaluation phase. For the rest of the phases, procurement is expected to only provide support to the team involved in the project.
Table of Content
- 1 Procurement Process of Capital Equipment
- 1.1 Preparatory Phase
- 1.2 Evaluation Phase
- 1.3 Agreement Phase
- 1.4 Execution Phase
- 1.5 Sourcing and Supply Issues
Procurement Process of Capital Equipment
Figure shows phases involved in the procurement process:
The preparatory phase is the first phase in the procurement of capital equipment where all preparatory activities are performed. It further includes four steps as listed below:
Need Identification and Demand Assessment
In this step, the need for capital equipment purchase is identified. Normally, it is identified by the production department in the case of the replacement of existing machinery.
For expansion projects, other departments like plant or facilities, engineering, finance, and corporate strategy will also be involved. While replacement could be due to the expiry of the life term of existing machinery. expansion or new projects could be for increasing the plant capacity.
Once the need is identified, the detailed requirement specifications for the capital equipment are prepared and documented.
Specification of Requirements
Detailed requirement specifications could be in terms of standard specifications, such as size and capacity or it could be a tailor-made specification as per the need of the process. Specifications include not only technical requirements but also operating requirements.
The technical requirements provide the technical details of equipment while operating requirements focus on performance requirements.
Technical specifications can be pertaining to the capacity and technology involved, such as production capacity; but performance specifications would clearly say, for instance, the quantity of standard specified items per minute the equipment shall produce. It means that the scope of the requirements includes standard specifications, technical specifications, and operating and performance specifications.
In addition, the scope document also includes Service Level Agreement (SLA) document that is prepared after thorough discussion with the cross-functional teams.
Procurement Market Research
Based on the requirement, supplier market research is done to find out available suppliers, their product range, the estimated cost of equipment, and the alignment with the organization’s requirements.
A preliminary cost estimate can be arrived at based on procurement market research. If required, a Request for Information (RFI) may be issued to gather market intelligence.
Financial Evaluation and Investment Decision (Capital Budgeting)
Once a cost estimate is made, the investment evaluation will be carried out by the finance department. This involves projecting future revenues and future expenses arising out of machinery. Once profit or free cash flows for every year for the entire life duration are estimated, the cash stream is discounted at the cost of capital of the company to arrive at the present value (PV) of the investment.
If this PV is more than the Cost Estimate of the equipment, there exists a Net Present Value (NPV) greater than zero and the investment is considered worthy to be undertaken. This decision is part of the capital budgeting exercise of the financial management division.
An important point is that the cost estimate should involve all cost components representing the Total Cost of Ownership (TCO) of the equipment. The purchase cost of equipment could be a very small portion of the overall TCO.
Considering only the purchase cost could lead to a positive NPV and a wrong investment decision. There could be many costs involved in the operation of machinery during future years, which might be considered as part of the capital expenditure and might not find a place in cash streams projected for NPV-based investment evaluation.
The TCO calculation will also involve discounting future costs at the appropriate discount rate. However, capital costs considered as a part of the derivation of free cash flows of NPV calculation should not be double-counted. The output of the preparatory phase is the final decision on the purchase of capital equipment by the finance department and the go-ahead for the procurement department.
The evaluation phase is the second phase in the procurement of capital equipment where procurement activities start. It further includes five distinguished sub-phases, which are:
Issuing request for quotation or proposal (RFQ/ RFP)
Based on supplier market research done in the preparatory phase and detailed specifications documented, the procurement team will issue RFQs (or RFPs as the case may be) to the shortlisted vendors. The RFQ will specify detailed requirements that should be met by the supplier.
Some important requirements that are stated as part of the tender are:
- Detailed description and specifications of the equipment
- Scope of supply such as design, assembly, commissioning, trials, and test-runs required
- Requirements such as supply foundation/assembly drawings
- Performance capabilities of the machine in terms of metrics, such as cycle times, productivity, etc.
- Any requirements of sub-systems associated with the equipment
- Requirements of any standard and optional accessories to be supplied along with the main equipment by the vendor
- Availability of spares and maintenance parts from a vendor during the warranty period and thereafter for the entire life term
- Any training requirements for assembly, commissioning, operation, maintenance, etc.
- Aftersales service requirements
- Supply of technical literature such as operation manual, troubleshooting procedures, design, drawings, etc.
- Vendor specifications on environmental conditions required for operation
- Inspection and testing procedure of vendor for measuring process capability
- Packing specifications
- Delivery schedule including inspection, pilot run, and commissioning schedule
RFQs will seek both a technical quote and a commercial quote. The technical quote will specify how the supplier is proposing to meet the requirements specified by the buyer and the scope of supply.
The commercial quote will specify details about price and other trade and payment terms and conditions. These two quotes will be evaluated separately but only proposals that pass the technical qualification will be considered for commercial evaluation.
Therefore, it is necessary that commercial businesses should not come into the picture while evaluating vendors on a technical basis.
The RFQ may also seek the following from the vendor based on which the quotation is processed:
- A demonstration to show that the equipment meets performance requirements during the trial period immediately after commissioning.
- A performance bank guarantee for an amount not less than, say, 10% of the total value of the equipment valid for the period covering the delivery period and some subsequent stated specific period.
- Reliability and availability metrics like downtime, mean time between failures, etc. If the availability of the machine falls below the stated metric, the buyer may have the option to reject the machinery with a levy of penalty fees and seek replacement of the machine.
- Penalty clauses for late delivery and related risks
- Terms regarding buy-back of spares not consumed during initial years
- Minimum availability metrics applicable after the warranty period
Once the responses to RFQs are received, supplier evaluation will follow the process described in earlier chapters for production items, where several qualitative factors, such as the supplier’s financial strength, management quality, experience, etc., are mentioned as part of the evaluation framework.
Some important factors specific to the procurement of capital equipment to be considered while evaluating supplier tenders are:
- Estimated operation cost associated with the equipment
- Projected maintenance-related costs
- The total cost of ownership over the life of the equipment
- Quantity of spares and associated items to be procured along with the equipment
- Availability of support for erection and commissioning
- Availability of aftersales service
- Training of operators
Supplier evaluation will also involve calculating the TCO of each supplier and arriving at the overall qualitative rating for each supplier. Based on the TCO, the NPV applicable for each individual supplier can also be calculated.
Let us discuss the concept of the scoring model:
In the scoring model, NPV is plotted along the X-axis while the qualitative score of the supplier is plotted along the Y-axis.
Supplier A having a higher NPV and supplier score rating will be preferred compared to Supplier C. The company may also decide to invite all three suppliers, A, B, and C for negotiations.
Supplier Site Visits
An important component of the supplier evaluation process is the supplier site visits which are made to perform qualitative assessments for gauging the supplier and the technical capability of the supplier.
Based on these evaluations, a few suppliers might be shortlisted for further negotiations and the one(s) that best matches the requirements is/are selected.
The agreement phase is the third phase in the procurement of capital equipment where the supplier is finally selected and the order placement initiates. It further includes five distinguished sub-phases, which are:
Based on supplier evaluation and negotiations, a final decision will be taken about the selection of the supplier.
Contract drafting and issue of the purchase order (PO)
Once the supplier is selected, the contract drafting will be done. The contract for procurement of capital equipment will involve several provisions, which may not be part of normal standard terms and conditions of the procurement of inventory items.
Proper care needs to be taken while finalizing various clauses. Various sourcing and supply issues in this regard are discussed in this sub-phase.
Monitoring the Order
After the PO is issued and accepted by the supplier, the equipment may be delivered depending on the lead time involved. For equipment that is custom manufactured, the time required for delivery could be a lengthy one.
Constant monitoring and supervision by procurement professionals will be required to ensure that the project proceeds as per the stated milestones of the contract agreement.
Monitoring Delivery and Release
Once the item is ready, the dispatch and installation should follow the agreed transportation logistics arrangement and installation requirements. The dispatch and installation activity should be strictly monitored along with the concerned members of the other departments.
The role of procurement professionals will be one of ensuring compliance with the contract provisions all through the procurement process.
The execution phase is the last phase in the procurement of capital equipment, which starts after the equipment is delivered to the site. It further includes five steps which are:
Inspection and Testing
Before the equipment can become operational, it needs to be inspected and tested. This could involve inspection by a third-party agency or by the quality control department. In parallel, employees will be trained for operating the equipment.
If the equipment is found defect-free, it will be tested for operational and functional parameters.
A test operation is conducted to verify the equipment’s conformance to specifications.
Commissioning and Acceptance
An acceptance report is prepared to state the conformance of equipment to specification. A significant part of compliance with the procurement contract ends with the acceptance report.
Support for Maintenance, Repair, and Spare Parts
After the commissioning of the equipment for production operation, procurement needs to provide support for MRO-related provisions of the contract.
Divestment at the End of Life-term
At the end of the life term, equipment will need to be decommissioned from its service. This might involve the disposal of the item in the used market for achieving residual or scrap value.
Let us now focus on different issues that might arise during sourcing and searching for the supply of equipment.
Sourcing and Supply Issues
Some important sourcing and supply issues that need to be cautiously evaluated and considered beforehand while finalizing the contract with the supplier are listed as follows:
- The identification and vetting of suppliers itself could be a significant challenge in the case of capital equipment procurement depending on the nature of the machinery. This is unlike the procurement of raw material items.
Owing to the nature of the supplier market and possibly unique requirements of the buying organization, establishing proper cost estimates could be difficult as standard price analysis and cost analysis methods may not be applicable.
- Procurement of capital equipment may require import from international suppliers when domestic suppliers are absent. Customs clearance, sea shipment, freight forwarding, etc. can add on to the cost and increase lead times.
The import transaction has its own characteristics, including logistics and trade terms involved, all of which need to be considered in the procurement process in addition to other factors.
- The qualitative evaluation of the supplier needs to consider several other factors beyond normal analysis done in the case of procurement of raw materials.
The supplier’s technical, production, and commercial capabilities need to be analyzed in depth due to the high cost involved and the irrevocable one-off nature of the procurement of capital equipment.
- Apart from ensuring that the supplier’s product meets the unique requirements of the buying organization, the procurement contract for capital equipment should also focus on the supplier’s ability and willingness to offer any technical service required during the commissioning and operation of new equipment.
If required, the supplier should train the operating personnel of the buying organization.
- Though the contract will provide for the performance guarantee and warranties associated with equipment, the ability of the supplier to stand by these clauses when required should be carefully evaluated.
The past track record and the financial standing of the supplier should be properly weighed in the evaluation process.
- The costs of MRO-related items could be a significant part of overall TCO. The supplier’s policy in providing maintenance service, and availability of spare and replacement parts during the life term of the equipment should be carefully evaluated.
- Non-availability of spare parts could significantly increase downtime and associated opportunity costs, derailing the initial NPV valuation. Hence, the contract provisions should carefully address these issues.
- It is also possible that due to technological obsolescence, the supplier may later discontinue manufacturing and distribution of spare parts, which could adversely affect the usage of the equipment.
In some cases, the buying organization may be required to keep stock of spare parts for a significant period of the life term of the equipment which could increase inventory carrying costs, which may not have been accounted for in the TCO/NPV analysis.
Procurement should obtain assurance from the supplier for a continued supply of MRO items during the operative life of the equipment.
- Owing to the long acquisition phase, the payment for capital equipment cannot be made upfront. On the other hand, suppliers may not be willing to wait till the commissioning and acceptance of the equipment.
Hence, a staged payment mechanism is normally adopted. The supplier may receive a certain percentage of the purchase price with the order, another portion when the equipment is delivered and the balance amount after the equipment is commissioned and accepted.
Some suppliers may also be willing to provide supplier’s credit, which could extend up to a year but with cost implications. All these factors need to be considered while finalizing the contract.
However, the delay in installation and commissioning should be supported by Liquidated Damages (LD) clause in the PO and/or the contract.
- Procurement may also insist on retaining some percentage of the purchase price till the equipment proves its capability in the production environment. These factors should be properly taken into account during the negotiation phase.