Making The Purchase

The major objectives in making the purchase are:

1. To obtain a fair and reasonable price.

2. To negotiate the terms of sale and determine type of purchasing contract.

3. To motivate the supplier to meet all obligations.

4. To develop a solid relationship with competent suppliers.

Fair and Reasonable Price

Cost analysis and Value Analysis, are two methods for obtaining the information with which to negotiate a good price. Competitive bidding and an investigation of published price lists, where available, are two other ways for assuring that the price you arrive at will be a fair and reasonable one. In competitive bidding, it is important, however, not to accept the lowest price, unless it is clear that the vendor will be able to deliver and make a reasonable profit on the sale.

It is rarely to your advantage to accept an exceptionally low price from an inexperienced vendor, or one which is the result of an error.

Competitive bidding is appropriate in situations where:

the bids are easy to obtain (through a phone call or simple letter)

the value of the purchase is large enough to justify the expense to obtain and evaluate bids

the specifications of the item or service to be purchased are simple and clear to both the buyer and seller

there are an adequate number of sellers in the market who wish to bid on the contract and are willing to price competitively to get it

there is sufficient time to utilize this method of purchasing

Negotiating Terms of Sale

To run your business efficiently you must have reliable and prompt delivery. Furthermore, you want to keep the lowest inventory possible while keeping enough stock on hand to satisfy customer needs. You also would like to sell as many units of a new shipment as possible, before you have to pay for it. When negotiating a purchase, therefore, you want to obtain:

prompt delivery
split shipments
as much time as possible, after delivery, to pay the bill (dating of invoices)
cash discounts
lowest possible freight costs

Obviously, you cannot expect to get everything from your supplier all the time and still be considered a desirable customer. Therefore, you must use judgment on how hard you want to push.

Split shipments are important only when there are quantity discounts; if the vendor grants such split shipments to other customers then there is no reason why you should not get them too.

The same is true of "dating" of invoices, a practice in which, at least at certain times of the year, some suppliers will permit you to buy and accept delivery but pay as much as 60 to 120 days after receipt of the merchandise.

Cash discounts usually are shown on vendor invoices. Sometimes, however, they have to be requested. These discounts can be 1 or 2 percent off the total order if you pay in full within 10 days. While 1% may seem unimportant, a 2% discount does represent a small saving. Besides, paying promptly may create better relations with vendors and may lead to better credit ratings. This, in turn, can lead to better deals with suppliers.

Freight costs can be an important item, especially if purchased components are either bulky or heavy. Sometimes a good buyer can get the vendor to absorb freight costs or, if that is not possible, obtain special freight arrangements in which the supplier routes and schedules shipments in such a way that shipping costs are minimized.

Sometimes, if you do not ask for it, the representative may not tell you that split shipments or dating or cash discounts can be granted. It is up to you, therefore, to bargain for them.

Reciprocal Buying. One type of negotiation which deserves special mention is reciprocal buying. Reciprocal buying is simply the practice of giving preference to suppliers who are also customers. Since it is rare that a customer can also be a supplier, reciprocal buying is not a widespread practice.

Obviously in those situations where it is possible, it can be good business to buy from companies that are also customers if all factors of service, quality and price are equal, since this practice strengthens the relationship and turns a customer into an even better one.

Unfortunately, reciprocity is not used only when quality price and service are equal. If either party is less than a highly desirable supplier, problems can develop.

Furthermore, although reciprocity is not against the law by itself, it could develop into conspiracy and commercial bribery, which are illegal. In the case of large corporations, it may be a violation of the anti-trust laws.

Reciprocity, for all these reasons, should be approached with caution. If you are in a situation where it can be important, it would be wise not to use your customer as a sole source of supply for the product or service involved.

Determination of Purchasing Contract Type

The type of purchasing contract selected for any given order always affects the purchase price of the order. It is, therefore, important to consider different contract types.

There are two basic types of contract: Fixed price contracts and cost type contracts.

Fixed price contracts

Firm fixed price contract is a type of contract which is most preferred by all buyers and perhaps most frequently used in small businesses. Whenever a fair and reasonable price can be determined, a fixed price contract is desirable to use. Such a contract provides the vendor with a maximum incentive to produce efficiently and all financial risks are borne entirely by the vendor.

Fixed price contract with an escalation clause is often used for contracts involving purchases upwards of $200,000 and a long production period. The escalation clause allows for an upward or downward change in price as a result of changes in either material prices or labor rates. This type of contract is often used in construction industries.

Fixed price contract with redetermination is often selected in situations where the amounts of labor and/or material (as well as prices in some cases) are difficult to estimate because changes in specifications or other requirements are likely to occur. In such uncertainty, a firm fixed price contract would be impractical but a fixed price can still be useful since it establishes a mutually agreed-upon base which covers the bulk of the purchase and establishes a formula for calculating fair prices for the expected changes from the basic package.

Fixed price incentive contract is another variation of the fixed price agreement. It provides for a target price, and a cost plus profit formula. The agreement usually specifies a higher profit for the vendor if savings below the target price can be achieved. Sometimes this is coupled with a penalty which applies if the formula would bring a price equal to, or exceeding a ceiling figure. Sometimes this ceiling is higher than the target and sometimes it is the same.

Cost Type Contracts

Cost type contracts are used when it is impossible to contract on any of the variations of a fixed price discussed above. The major difference between a fixed price and a cost type contract is that under a cost type contract, the buyer assumes almost all the financial risks. The seller is usually guaranteed all costs up to a predetermined amount as well as a fee. A seller, therefore, has no real incentive to keep costs or prices down. Cost type contracts have the additional disadvantage that they may require thorough auditing.

Cost plus percentage of cost contract is the most undesirable of all of these types of contracts. It is often used in many private firms, mostly in the construction industry. This type of contract tends to inflate costs since higher costs will bring greater profit to the supplier.

Cost plus fixed fee contract provides that the supplier be paid for all allowable costs plus a fixed fee which is either a percentage of the estimated cost or a lump sum.

Cost plus incentive fee contract is basically the same as the fixed price incentive contract except that the supplier usually is paid for all costs and the fee varies depending on the relationship between actual costs and budget.

Cost sharing contracts are often used in situations in which the supplier can benefit if the product being developed for the buyer can later be used with other customers. Under such conditions, the buyer and seller often agree to split the costs.

Cost without fee contracts also exist. They are usually only use with non-profit institutions where work such as research is done without a fee except that which is necessary to recover overhead costs. Some government supported consulting organizations and colleges may provide services on this basis.

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