Purchasing: Pipeline to Corporate Profit
Raymond A. Clayton, C.P.M., A.P.P.
Raymond A. Clayton, C.P.M., A.P.P., Clayton Advisory Management Practice (C.A.M.P.), P.O. Box 145, Stanton,NJ 08885, 908-236-6823, (firstname.lastname@example.org)
85th Annual International Conference Proceedings - 2000
Abstract. This workshop will reflect on the continuous flow and processes of the business cycle, albeit, pipeline, and the nature of opportunities for the purchasing function to contribute value and profitability to it. These things will occur if 1) purchasing executives understand the corporate executives' perspectives on profit, e.g. finance, 2) purchasing is advantageously placed in the corporate structure, 3) purchasing is doing the right things (operating effectively), the right way (operating efficiently) and 4) purchasing sees itself as An information resource/highway .
Introduction. Mr. Volney Taylor, Chairman and CEO of Dun & Bradstreet Corporation addressed the 1997 NAPM International Conference and in his concluding remarks he said, "...and I'll talk to management (NAPM) about re-naming this organization. How does this grab you? National Association of PROFIT Management. Same acronym, truer emphasis!" During his presentation Mr. Taylor highlighted four things that purchasing should do:
- Focus on the bottom line -Translate savings and cost avoidances into profit and earning per share contributions, etc., i.e. speak finance.
- Predict and forecast - Be pro-active - not reactive.
- Take the broader view - internally and externally.
- Use and leverage information sources
Mr. Taylor's address sparked the development of a related course for NAPM. This workshop is an overview of that course.
Our first need is to visualize the continuous flow of business and its cycling - ergo, pipeline. Just as a picture puzzle makes little sense until all the pieces are in place the following shows business functions in sequence and suggests the motion and interconnection of policies, procedures, practices, and information (report, etc). It also implies the need for cross functional communication/feedback to achieve efficiency and effectiveness.
Creation Finance Personnel
Distribution Conversion Purchasing
The gasoline engine has many parts and is fueled by gasoline. Similarly, the corporate engine has many parts (functions) and it is fueled by money or finance. Executives deal with and speak about finance. Their vernacular seldom if ever uses the term, "purchasing". Purchasing people therefore, must learn to speak, "finance" without any expectation that corporate executives will ever learn to speak "purchasing".
Corporate executives are primarily concerned with the following questions:
- How do we obtain funds?
- How do we account for the funds?
- How will the funds be allocated?
- How can the necessary activities be controlled or managed?
- How much profit can be derived from such operations?
These questions lead naturally to the development of an accounting system which fundamentally is an organized/structured way of gathering data to be used to strategically and tactically manage and report about a business both externally and internally.
External accounting is usually referred to as financial accounting and for the most part is required by law. Internal accounting is usually referred to as management/managerial accounting and it is not required by law.
Financial Accounting is best exemplified by the corporate annual report. These reports encompass income statement reporting, a balance sheet, and a statement regarding cash flow.
Income statement reporting is usually presented in four (4) major categories. These are: 1) Revenue 9%, 2) Cost of Goods Sold 56%, 3) Operating expense 18%, 4) Other Revenue/Expenses netted 17%. The percentage figures are from NAPM data designed to suggest purchasing's impact upon the average U.S. manufacturing company. How does purchasing fit into such data especially since there is no direct reference to the function in the income statement or for that matter, the balance sheet and cash flow statements as well?
On the income statement Revenues generally reflect Gross Sales less Sales Returns, and Allowance/Discounts. If Sales Returns reflect poor quality, related purchasing activity would include supplier selection, certification, and evaluation; supplier feedback regarding specifications, standardization programs, value/engineering analysis and even contributions to make or buy decisions. Cost of Goods Sold is impacted significantly by purchase savings and cost avoidances which are the direct result of applying purchasing techniques and leveraging information/communications. The structure and processes of purchases will affect Operating Expenses, G&A and Other Expenses.
Purchasing impacts the Balance Sheet through volume purchase activities which affect inventory status. Inventory is an asset on the balance sheet but also represents funds which have been spent/committed that might have been used more beneficially elsewhere in corporate priorities.
Cash Flow statements show from what sources cash enters a business and where it goes. A significant element of cash flow is Supplier Payments. Purchasing dramatically impacts this entry via terms of payment, frequency of orders issues, order volume and the nature of contract terms and conditions. Financial Accounting is controlled by Generally Accepted Accounting Principles or GAAP.
Also, let's reflect upon the comments of Scott McNealy, chairman, Sun Micro systems, Inc as reprinted in a recent NAPM information brochure:
"...The right partnership can help influence gross margins, reduce cost and allow us to focus on our core competencies. That's why we put so much effort into purchasing and supplier management, since this important function is part of our success formula"
Other accounting elements include management accounting, and responsibility accounting and financial analysis. These activities are usually focused by master planning and budget and are what management desires each to be.
Management Accounting. The National Association of Accountants (N.A.A.) defines management accounting as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of financial information which is used by management to plan, evaluate, and control within an organization. If the process is used to develop cost information for inventory valuation and income determination it becomes cost accounting. If the process is used for planing, control, and decision making it becomes management accounting.
Barron's Accounting Handbook 2nd Edition suggests costs can be classified by:
- Management Function
- East of traceability
- Timing of charges against sales revenue
- Behavior in accordance with changes in activity
- Relevance to control and decision making
The question is, "How does your company classify costs?" "Understanding this helps the purchasing manager understand purchasing's contribution to the cash/profit flow within their corporate structure. Among the terms a purchasing executive should become familiar with are: cost allocation, activity based costing, cost behavioral analysis, cost-volume-profit (CVP) and break-even analysis.
Responsibility Accounting: This is also known as profitability accounting and sometimes as activity accounting. It focuses on organizational business units that have control over costs, revenues or investment funds. Each business unit will appear on an organization chart and will be managed by an identifiable someone who is responsible for results according to a Master Budget Plan the design of which is to lead to corporate profits. Responsibility accounting systems require the following to be effective:
- Well-defined organizational structure so as to identify responsible centers
- Well-defined standards for costs profits and investments
- Reports that reflect only the items directly controllable by the responsible manager.
Responsibility centers are classified by Cost, Profit, and Investment. A Cost Center is an organization responsible only for costs such as in manufacturing or production and has no control over sales or generating revenue. Variance Analysis based upon standard costs and flexible budgets is a tool used for this area. An important component of Variance Analysis is the purchase price of materials, e.g. purchasing. A Profit center is an organizational unit responsible for revenues and costs incurred. Contribution Margin is an example of an often used tool in profit center measurement. A Investment Center is an organizational unit responsible for revenue, cost and investment funds such as a corporate headquarters or a division of a decentralized organization. Key performance measures are Return on Investment ROI and Residual Income. ROI is frequently used by corporate executives and may well be used to determine executive bonus structure. A fundamental element of ROI is the Cost of Goods Sold which is the line where purchasing impacts the most.
Financial Statement Analysis is an evaluation of a company's past financial performance and its future potential. This is an executive thing and is of interest primarily to investors, creditors and therefore to executive management. But if purchasing understands its impact on the Income Statement e.g. cost of goods sold, it can begin to calculate its contribution to corporate profitability with regard to gross profit margin, profit margin, return on total assets and return on common equity. Also, purchasing can calculate its contribution to Market Value in the areas of earnings per share, price earnings ratio, and dividend payout. Corporate executives understand these things not cost savings and cost avoidance. Purchasing executives need to translate into "executive speak"!
Structuring Purchasing to Maximize Contributions to Corporate Profit
An appropriate structure and procedures - one that focuses/concentrates and facilitates purpose, communications, coordination and motivation of employee efforts - provides an effective and efficient highway for achieving corporate goals. It contributes immensely to minimizing Operating Expense, including G&A and other Expenses which on average represent 18% of Total expense.
The Business Cycle pipeline/flow chart was noted earlier. Let's revisit. It essentially depicts the functions of business and the sequence of functional motivation. In small business the functions may represent six hats on the same head (thereby making communications easier) while each such function appears on an organizational chart of large businesses. The functions in sequence are (1) Creation - idea, research, product development, (2) Finance, (3) Personnel, (4) Purchasing/Procurement, (5) Conversion - manufacturing/service quality and (6) Distribution (?). If the cycle/pipeline is not fed by (1) & (2) it drys up. If (3) - (6) are not done effectively/efficiently the cycle/pipeline business becomes less competitive and ultimately non-competitive and stops flowing, e.g. goes out of business.
The idea of continuous flow, (connection, linkage, chain of supply information is now easier to visualize and how purchasing fits becomes very important. Purchasing activities in any particular company might appear anywhere on what might by called a purchasing maturity curve which starts with infancy which is decentralized and clerical in nature and ranges to complete maturity which at world level would likely be centralized, composed of buying processionals devoted to strategic supply activities and truly responsible foe the largest share of corporate funds. The trip from infancy (basic purchasing) to adult or world class supply management may be characterized by four states: 1. Reactive Mode - purchasing activities, 2. Mechanical Mode - procurement activities, 3. Pro-active Mode - materials management activities, 4. Strategic Supply Mode and Enterprise Resource Planning (ERP).
Stage four takes a global corporate and industry view, integrates unit/functional strategy with corporate strategy, is centralized by authority, understands total corporate cost concepts and implementation, maximizes use of data, manages internal and external relationships and measures and searches for continuous improvement.
The key elements of structure that lead to and enhance Stage 4 are:
- Centralization of Responsibility
- Know what you are buying
- Uniform Policy Guidelines
- Internal - Requisitioners
- External - Supplier Relationship
- Long-range Materials Planning
- Centralizing Strategic Activities
- Cross-Functional Teaming
- New Product development/design
- Early supplier involvement
- General strategy development
Streamlining the Purchasing Process
Efficiency is doing things right which contributes to minimizing the purchasing function's contribution to overhead/indirect cost. Effectiveness is doing the right things which facilitates lowering the Cost of Goods Sold which we all now know is a dollar-for-dollar contribution to bottom line profit as well as impacting other financial management analysis tools such as Return On Investment (ROI), return on total assets, return on common equity, earnings per share, price earnings ratio and dividend payout.
Those areas to which purchasing can contribute prior to receiving a requisition include:
- New Product development,
- Purchase descriptions and specifications,
- Make or Buy/Outsourcing.
Items (1) and (2) reflect a blending of feedback from suppliers and purchasing's own catalog/file of information provided to research/design and manufacturing functions. Standardization is a natural for cross-functional teaming. It is also a natural for the impetus to come from purchasing because it is responsible for economic procurement and it is in the strategic position (structure) of interfacing with both internal users and external suppliers. Purchasing knows (or should) what is bought and in what quantities and at what cost all of which is key to defining the purchase items/area to be considered for a standardization program. The same information content makes a useful contribution to Make or Buy and Outsourcing decisions.
The requisition and the resulting purchase order/contract should be viewed and actually are the basis for purchasing's data base and classification of information. When properly cataloged and evaluated/analyzed they frame the windows of opportunity for purchasing to become a corporate strategic partner and impact upon such areas as pricing policy, cost analysis, sourcing, quality, supplier relations and partnering, negotiations, and the nature of agreements.
Continuing evaluation can also significantly impact the purchasing process by leading to improved procedures, order preparation, payments to suppliers, order (small) techniques and the application of computer based programs.
Purchasing as an Information Highway
Most purchasing functions posses all the information that is essential/necessary to be effective and efficient. Probably they have more information than they realize because they are too busy just buying "for today" and the full scope of their activities are seldom evaluated.
Too often purchasing data is not organized for retrieval. Enter the computer and data base development. Each byte item of information throughout the procurement process must be accessible on its own and in combination with all other bytes. An information/tracking system need to be designed to serve each buyer and each whole purchasing function so it Knows who it is buying for, what it is buying, how much and how frequently it buys, from whom it buys, how much it pays for what it buys, what mode of buying is most appropriate, what buying techniques and processes are most efficient and effective, the extent of cost savings/avoidances so such information can be converted into corporate profit and earnings per share contributions.
Picture an hour glass. The top represents internal input (requisition) to purchasing. Purchasing is at the waist of the hour glass. The bottom of the hour glass represents the world external to the corporation. The sand (info bytes) passes internally through purchasing (P.O.s & contracts) to the external world of suppliers, etc. In the past this was the complete transaction. Today however, the hour glass must be turned up-side-down over and over again so the external info is fed back through and by purchasing to benefit internal functions. Connect the repetitive turning of the hour glass with your picture of the pipeline and you have a simplified picture/vision of profit in motion.
Dobler, D.W., and G.N. Burt. Purchasing and Supply Management, 6th Edition. McGraw-Hill, 1996.
Siegel, J.G., Phd., CPA and J.K. Shim, Ph.D. Accounting Handbook, 2nd Edition. Barron's Educational Series, Inc., 1995.
Clayton, R.A., CPM. Purchasing: Pipeline to Corporate Profit. NAPM draft program, 1998.