Analyzing Purchasing Performance Using Activity Based Costing

Author(s):

Michael F. Pohlen, Ph.D., C.P.M.
Michael F. Pohlen, Ph.D., C.P.M., Associate Professor, University of Delaware, Newark, DE 19716 302/831-1777.
Scott K. Jones, Ph.D.
Scott K. Jones, Ph.D., Associate Professor, University of Delaware, Newark, DE 19716 302/831-6515.

80th Annual International Conference Proceedings - 1995 - Anaheim, California

Abstract. This paper presents a methodology for using Activity Based Management (ABM) to improve the contribution that the Purchasing function makes to its organization. The basis of ABM is an Activity Based Costing(ABC) analysis of the purchasing activities in the organization. A case study of purchasing costs in a large financial institution is used as an example. The focus of an ABC analysis is on distinguishing between those activities which add value to a purchase order and those which do not. Attempts must be made to eliminate those costs which do not add value or, at least, to reduce their cost.

Introduction. There is a minor revolution taking place within the purchasing function of most businesses. Top management is beginning to look critically at the cost of the purchasing department and question the justification for these activities. Paradoxically, at the same time, the same top management is expecting "better purchasing" as a contribution to more effective materials management. As purchasing managers begin to respond to these seemingly contradictory, yet real, challenges, they are beginning to realize that traditional methods of cost and performance accounting do not provide useful answers to their questions. They are asking questions such as the following. "How much does it really cost to process a Purchase Order?" "What would be saved by automating some purchasing activities?" "Who or what is really responsible for driving up purchasing costs in this company?"

This paper presents a methodology for answering these questions about purchasing costs and, by example, demonstrates how this methodology was used at a large multinational financial institution. The results of the study are presented.

The ABC Process. Figure 1 shows a brief flow diagram of the process for using Activity Based Costing. PLEASE NOTE: FIGURE ONE HAS BEEN DELETED FROM THIS TEXT. FOR A COMPLETE COPY OF THIS ARTICLE, PLEASE CALL THE NAPM INFORMATION CENTER.

The key task for purchasing management is to decide on how to group activities into "pools" which reflect the bases which actually drive up purchasing costs. Traditionally, the volume of purchasing activities has been thought of as the major cost driver, i.e., purchasing costs go up as do the number of purchase orders, or lines per purchase order. The calculations are something like what follows.

Total Annual Cost for The Purchasing Department / Total Annual Number of Purchase Orders or Lines
= Cost per Purchase Order or Line

Where: Total Annual Cost = Salaries + Fringes + Supplies + Fixed Costs

While this method of identifying purchasing costs may be easy to use, with the usual accounting information available, it provides little value to the purchasing manager under pressure to reduce or explain purchasing costs. Reorganizing the equation states that ...

Total Cost = Cost per PO x Total Number of PO's

The only advice given by this method, i.e., using volume as a driver, is that total purchasing department costs can be reduced by reducing the volume of purchases made ... a suggestion likely to be unpopular with higher management or by reducing the cost of processing a purchase order. Unfortunately, the equation does not suggest how that reduction should be made. The usual conclusion has been to use some combination of reduction in personnel and use of computer technology ... and hope.

Cost Drivers. There are any number of drivers which affect costs. The experience of companies which use ABC has shown that there are a large number of drivers which directly affect costs. These depend on the organization, its technology, its competitive environment, and its products. For example, a company which introduces dozens or even hundreds of new products each year might discover that the cost of purchasing is much less related to PO volume than it is new product introductions. The strategy for reducing purchasing costs might in this situation focus on improved relationships with engineering. A company which modifies its product line to customer specification might reach a similar conclusion.

Conversely, a purchasing manager might discover (as many have) that purchasing costs are related to the number of suppliers rather than the volume of purchasing activity. A program to reduce the supplier base might have very beneficial results.

Complexity. In the bank study, an initial analysis revealed (to no one's surprise) that there was a great variety in the types of purchase requisitions submitted to the purchasing department. Orders to replenish standard stationery items were intermingled with orders for complex equipment, new items, and RUSH items. While, therefore, variety of orders was determined to be an important cost driver, a meaningful measure was needed to use in an ABC analysis. For this purpose, order complexity was determined to be a major cost driver for purchasing costs and was defined in the context of activity based costing to be the number of separate activities or transaction processing events that are needed to generate the order up to and including the actual disbursement of cash to pay the invoice. Table 1 presents a list of the individual activities and transactions, grouped into cost pools, that were identified as driving purchase order complexity. The asterisk (*) identifies those activities whose cost is likely to be reduced through purchasing automation. PLEASE NOTE: TABLE 1 HAS BEEN DELETED FROM THIS TEXT. FOR A COMPLETE COPY OF THIS ARTICLE, PLEASE CONTACT THE NAPM INFORMATION CENTER.

The rates per minute assigned to each of these activities and transactions is also shown prior to automation. The asterisk indicates those activities whose cost is likely to be substantially reduced by automation. The time required for each of these activities for the ten purchases (A through J) was then multiplied by the respective rate per minute to determine the cost of each activity and then summed for the grouped pools and for each complete purchase. These costs are shown in Table 2, both by dollar amount and by percentages. For very simple purchase orders, many of these transactions do not occur and hence no cost is accumulated. PLEASE NOTE: TABLE 2 HAS BEEN DELETED FROM THIS TEXT. FOR A COMPLETE COPY OF THIS ARTICLE, PLEASE CONTACT THE NAPM INFORMATION CENTER.

Table 3 compares per purchase order and annual purchase order cost before and after automation for the ten (A through J) purchase orders. These orders are roughly sequenced in increasing amount of order complexity. As shown, the role of automation was to eliminate the clerical burden associated with certain transactions. Refer again back to Table 1 to identify those activities which were judged to be likely to be substantially reduced by automation and indicated by an asterisk. Note that these are common to all purchase orders. The costs of purchase orders of low complexity are substantially reduced (as much as 56%) in some cases). The effect of automation on cost is much less for complex purchases, and the resulting savings amount to perhaps as little as 10%. The main reason is that the labor intensive activities, such as negotiating, reviewing bids, and capital budget approval, are characteristic of complex purchases and these activities are not affected to any significant amount by automation. PLEASE NOTE: TABLE 3 HAS BEEN DELETED FROM THIS TEXT. FOR A COMPLETE COPY, PLEASE CONTACT THE NAPM INFORMATION CENTER.

Figure 2 captures these effects by plotting purchase order costs before and after automation verses order complexity. Except for the most basic order, the cost savings realized by automation remain almost constant at $10 per purchase order. PLEASE NOTE: FIGURE 2 HAS BEEN DELETED FROM THIS TEXT. FOR A COMPLETE COPY OF THIS ARTICLE, PLEASE CONTACT THE NAPM INFORMATION CENTER.

Conclusions. By far the most important finding of the study is an understanding of how purchasing costs are affected by automation. It has been shown that automation in the purchasing function has the greatest impact on clerical activities, such as filling out forms, transmitting forms and recording and verifying their receipt, and many of the activities related to payment to suppliers. It is also demonstrated that these costs are relatively constant for all orders are equally relatively unaffected by order complexity, where complexity is measured by the number of individual activities associated with an individual order.

Once these routine and largely clerical activities are automated and the burden of their costs eliminated, purchasing managers must look to the more complex cost pools and activities to reduce purchasing costs and thereby improve purchasing productivity. Included in these non-routine costs are research, negotiation, bid analysis, contract review, and all the approvals often associated with more complex purchases.

A two-pronged attack is recommended. First, the approval process itself should be studied. Threshold levels requiring approval can be compared to the costs of the approval and adjusted accordingly. The design of the information system which provides backup data needed for an approval could be enhanced, i.e., when an approval for a P.O. is presented on a manager's screen, the necessary budgetary data could be available at the same time.

Second, emphasis is needed on improving the skills of purchasing professionals in those activities which contribute to purchase order complexity and cost. Examples are negotiations (costs saved by better preparation), contract review (costs saved by increased knowledge of contract issues), and supplier identification and research (costs saved by more strategic and longer-range purchasing activity).

Finally, it must be recognized that some costs associated with purchasing are not under control or influence of the actual Purchasing Department. Both Purchasing and higher management need to recognize this and begin to look more systematically at total purchasing costs, wherever the cost may be incurred.

REFERENCES
Brown, Diane, "Purchasing Skills of the 21st Century," NAPM Insights, November, 1993, 20-21.

Ellram, Lisa, "Total Cost of Ownership: Elements and Implementation." International Journal of Purchasing and Materials Management 29,4 (Fall, 1993): 2-11.

Shearer, Andy, "Know Your Total Procurement Costs," NAPM Insights, May 1992, 6-7.

Turney, Peter B. B., Common Cents: How to Succeed with Activity-Based Costing. Hillsboro, OR: Cost Technology, 1991.


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