What is Purchasing Cycle?
The purchasing cycle refers to the process that a company or individual goes through when making a purchase.
Purchasing is the formal process of buying products and services. The process of purchasing can vary from one organization to another. However, there are some common key steps that are followed by all organizations.
Table of Content
- 1 What is Purchasing Cycle?
- 2 Purchasing Cycle Steps
- 3 Purchase Agreement for Standard Purchase Orders
- 4 Types of Purchase Agreements
- 5 Blanket Purchase Order
Purchasing Cycle Steps
To make purchasing effective, most organizations follow a purchasing cycle or process. A purchasing cycle is a step-by-step approach to an effective purchasing function.
Let us now discuss the purchasing cycle steps:
Identifying the Need
It refers to the first step of the purchasing cycle in which the requirements of materials are determined by the user department. These requirements are determined by taking into consideration the purchase requisitions and BOMs, which were discussed in the previous chapter.
Specifying the Need
It involves determining the exact quantity of materials to be purchased for production. Different departments of an organization need to define their requirements in the purchase requisition form. The approved PR reaches the purchasing department for making the purchase.
If there is any error or unclear description in a requisition form, the purchasing department does not make any changes to it, rather the department sends the form back to the respective department for clarification.
Selecting a Source
It refers to one of the most important steps of the purchasing cycle. The quality of materials depends on the source from where they are procured. Therefore, the purchasing department is responsible for selecting the right source for procuring materials.
To do so, the department maintains a list of reputed suppliers. The purchase department also selects a supplier by inviting tenders through advertisements.
Determining the Price
As discussed earlier, the purchasing department is responsible for procuring the optimum-quality materials at the lowest price. Therefore, it is important for the purchasing department to analyze its budget, perform market research and determine the best price for procuring materials.
The purchase department generally uses three ways for determining the best price of materials, which are:
- Vendor catalog: It is a list of different materials along with their prices and quantity, available from different vendors. The department only needs to check the current list to determine the best price of materials.
- Negotiation: It involves bargaining with the supplier to reach the best price for materials.
- Tendering: It refers to a method mostly used by government organizations in which the buyer sets a price for materials and the supplier needs to bid for receiving the purchase order from the buyer.
Placing a Purchase Order
A purchase order is a legal contract that specifies the entire agreement between the purchasing department and the supplier. It defines the agreed price, terms and conditions, and specifications of materials to be purchased. The purchase order helps in preventing any misunderstanding between the two parties.
Acknowledging the Order
After the order placement, it has to be acknowledged by the supplier. Acknowledgement is all about getting confirmation from the supplier about the timely delivery of materials. Without acknowledgement, the order will remain only “an offer to purchase” with no legal standing.
Once the supplier issues acknowledgement, it becomes a purchase contract and the same needs to be noted in the purchasing system.
Following up and expediting
It ensures that the items are delivered by the supplier on time. No special expediting procedure is required in the following conditions:
- Good production planning
- Less engineering alterations
- Efficient inventory control
- Proper purchase order
- Appropriate supplier
Checking the Invoice and Approving the Payment
This is the last step of the purchasing cycle wherein the invoice is verified by matching it with the purchase order and GRN. This is called three-way matching. If there is no mismatch between the materials ordered and received, payment is made to the supplier.
In certain cases, the invoice needs to be matched only with the purchase order. This is called 2-way matching, and it is applicable in cases where GRN is not raised. For example, in the case of blanket purchase orders, GRN is not raised.
As discussed, the purchasing cycle is applicable to any standard purchase order. However, all purchases do not go through such elaborated stages. Owing to the nature of repetitive purchases of the same materials, organizations have invented new methods that simplify the purchasing cycle and integrate it with the inventory management process.
In this chapter, you will study some important purchasing methods in detail.
Purchase Agreement for Standard Purchase Orders
The Chartered Institute of Procurement and Supply (CIPS) defines a purchase order (PO) as a document issued by a buyer to his/her supplier that defines what is needed, in what quantity, when performance is required, and on what terms, including price and payment terms.
The issue of a purchase order is a prerequisite in many payment systems for the payment of invoices. A sample format of the purchase order was shown in the previous chapter.
It is important to understand that manufacturing organizations producing the same set of finished products require similar sets of materials and components for each and every production schedule.
Given that the manufacturing plant and the nature of production methods do not change, the required raw materials and component parts for manufacturing any particular finished product would not vary with every production plan. Only the quantity of raw materials and components may change depending on the customer demand forecasts and production plans.
Similarly, procurement of standard inventory items that are required on a day-to-day basis usually involves the same set of suppliers who have already been approved (through a supplier selection process) by the organization for sourcing its inventory requirements from them.
Therefore, organizations are not required to identify a new supplier every time an inventory procurement requirement is raised, owing to the repetitive nature of the requirement.
To fulfill their standard, repetitive purchase requirements, organizations enter into long-term purchase agreements with suppliers. These purchase agreements envisage a long-term partnership with suppliers in terms of procurement commitment from the buyer organization.
Different types of organizations like manufacturing, service, software, etc. use different types of purchase agreements depending on the nature of their procurement needs.
Types of Purchase Agreements
CIPS classifies purchase agreements into the following two categories:
Framework contracts are legal contracts where the buyer commits upfront that it will purchase a specified quantity of items in a given period. For example, a manufacturing organization may enter into a framework contract with an electric utility for the off-take of a specified amount of electricity during a given period.
Similarly, a pharmaceutical company might forecast that it requires a particular amount of chemicals to be used as raw materials in its batch production processes at any given period. Though the company might be certain of its requirements, it may not need to purchase the entire quantity at once.
Instead, it can enter into a contract wherein it commits to purchase the entire quantity from the same supplier over a specified period. This helps fix both the price and the supplier at the best possible terms for the entire production period. Such a contract is called a framework contract.
A framework agreement is not a legal contract but only an agreement to buy an unspecified quantity over a particular period of time.
For example, an automobile major like General Motors knows that it would require sourcing anti-braking systems from a supplier like Robert Bosch, over a period of time. But General Motors does not want to enter into a framework contract that specifies that it will purchase a specific quantity from Robert Bosch during a particular period.
In that case, it can enter into a framework agreement with Robert Bosch wherein it only commits (or firms up its intention) to purchase anti-braking systems over a period at given terms and conditions including the price.
So, a framework agreement need not specify any quantity nor carry a legal commitment to purchase a fixed quantity. It may not even specify delivery dates or the shipment location. Most manufacturing organizations enter into framework agreements due to their flexible nature.
Standard purchase orders are similar to framework agreements as they do not have a legal contract but only an offer to purchase. A purchase order becomes a contract only after the supplier accepts it by acknowledging the same and committing to supply products/services as per the terms mentioned in the purchase order.
Blanket Purchase Order
The term ‘blanket purchase order’ is used differently in the context of different organizations and ERP modules. The APICS (Association for Purchasing and Inventory Control Specialists) dictionary defines a blanket purchase order as a long-term commitment to a supplier for material against which short-term releases will be generated to satisfy requirements.
The CIPS definition says blanket purchase orders are purchase orders placed on suppliers that cover a range of products or a time period that commits to a volume of one product.
In CIPS terminology, a blanket purchase order is a form of framework agreement. CIPS defines a blanket purchase order as an agreement between buyer and seller whereby certain goods will be purchased at prices established or agreed to by way of a formula over a period of time.
In other words, it is an agreement with the supplier where the buyer commits to purchase the items over a specified period. It may or may not specify an indicative quantity.
A blanket purchase order is generally meant for a particular item or a group of items required to be ordered repetitively from a single supplier. It is basically an open order effective for a specified period, say, for one year. It eliminates the need for issuing a separate purchase order whenever there is a need for materials.
The buyer will enter into a blanket purchase order through due negotiations after which ordering of any item covered by the blanket purchase order only requires a release order. Through this mechanism, the order and receipt of materials as per the production schedule become a routine matter between the buyer and the supplier.
Most purchases in the organization covering routine standard items happen only through blanket purchase orders. Standard purchase orders are used only for one-off purchases from new suppliers.
When a blanket purchase order for an item is negotiated, the buyer and the supplier evaluate the anticipated demand for the item over a period of time. The two parties then agree to the terms and conditions including price, quantity, discounts, specifications, quality, and delivery lead times.
For a purchase to be made by the blanket purchase order, individual purchase orders and GRNs are not raised. The blanket purchase order reduces transaction processing costs which can have a significant positive impact on the total acquisition costs of materials.
Features of Blanket Purchase Order
The salient features of a blanket purchase order are summarised below:
- A blanket purchase order is a type of long-term purchase order and is the most preferred and widely adopted method for all repetitive and standard purchases.
- A blanket purchase order covers a procurement commitment to a supplier for specific products at an agreed-upon price for a specified period.
- A blanket purchase order eliminates the need of issuing a purchase order every time there is a requirement for the material.
- To manage routine and standard inventory items, buyers enter into blanket agreements that enable the shipment of items through release orders obviating the need to go through an elaborate purchasing cycle.
- A blanket purchase order is based on negotiated terms and conditions including price, quantity, discounts, and projected demand over a period. It leaves the delivery date and the ship-to location open.
- Release orders are issued against blanket purchase orders as and when material requirements are identified in the MRP system.
- On shipment, the supplier raises the invoice for payment.
- No GRN is raised for shipments based on blanket purchase orders
- Two-way matching is done while making payment for shipments on the basis of blanket purchase orders.
- Total invoices raised against a blanket purchase order cannot go beyond the limit set for blanket purchase orders.
Release Orders and System-generated Purchase Orders
Release orders (also called material purchase releases) are authorizations issued to suppliers to make shipments as and when required as per the blanket purchase order agreement.
A copy of material purchase releases is also sent to purchasing, accounts payables, and store departments. Release orders specify the current quantity to be shipped, delivery date, and ship-to location. These orders are based on material requirements identified by the MRP system. These orders raised by the MRP system are based on the BOM associated with the finished product.
For example, for a desktop PC, there is a demand for 1,000 finished products, that is 1,000 PCs. To cater to this demand, release orders derived from BOM, for components or parts to be replenished will require the shipment of 1,000 monitors, 1000 keyboards, 1000 mouses, 1,000 hard disks, etc (assuming these are externally sourced from suppliers).
In an ERP system, automatic release orders for each of these components will be directly issued to the suppliers as per the respective blanket purchase order details. Such release orders are called system-generated purchase orders/release orders. In the real world, most purchases happen only through such automatic system-generated release orders.
In such release orders, in the first few weeks (or days depending on lead time), the material requirement indicated will be the actual shipments required as per the delivery date specified, while the requirement stated for the subsequent period will be the quantity forecast for the period.
It is also practiced by many supply chain-driven manufacturing organizations to share material requirement forecasts with their suppliers. This would help the supplier plan supply requirements in advance.
Open-end orders are similar to blanket purchase orders. However, they allow for the inclusion/deletion of additional items over a period of time. Such orders are useful for procuring MRO and production support items discussed in the previous chapter.
Usually, these items are of low cost, high volume, and large in number. The required items can also change and can be unpredictable. Open-end orders allow the convenience of modifying standard blanket purchase orders. The period of the order could be up to one year or till renewal.