This project intends to figure out the procurement strategy adopted by most of the food companies. We would look into the ways of commodity procurement strategies that is 1) the spot market strategy 2) forward purchasing mechanism. In addition, this project would look into the specific product constraints, company constraints and service constrain which can affect the procurement decisions. Also it would focus on the importance of technology and its affect on the whole purchasing and supply chain strategy.
Purchasing in Food Industry
Due to the growing food industry, the competition amongst the food manufactures has increased. The biggest reason of this increasing competition is because of the new retail formats and globalization.
Now retailers have high bargaining power With the bargaining power shifting towards and in favor of retailers it has put in a lot of pressure on manufacturers to increase service level while reducing costs. The service level, quality, and price expectations from retail customers and end consumers are high and continue to rise, which puts in a challenging situation for the manufactures to keep the prices stable or even reduce it. Purchasing, if managed effectively, offers opportunities for better cost control while improving service levels.
Manufacturers have started concentrating on developing effective purchasing strategies to remain competitive in today’s market. An effective purchasing strategy is “one that fits the needs of the business and strives for consistency between the firm’s internal capabilities and the competitive advantage being sought, as defined in the overall business strategy”.
Since an average manufacturer spends “55 cents out of every dollar of revenues on goods and services,” the impact of an effective procurement strategy on company performance is easily observed. Furthermore, companies have increased the use of outsourcing considerably over the last decade, thereby increasing the need for procured materials and services.
Commodity and Non-commodity goods
Commodity goods are the raw materials and agricultural products such as wheat, corn, and rice. They must meet minimum quality standards to be classified in a certain grade or standard category of that commodity. Conversely, non-commodity goods are highly differentiated, branded, and have value-added characteristics.
Procuring commodity is a complex process that is caused due to many factors. If we consider food commodities buyers face not only the risk of inadequate supply but also the price risk inherent in seasonal and potentially volatile commodity markets. For example, seasonality and the need for buying products globally extends the lead-time between when the purchasing commitment could be made and when the actual product is needed/used. This extended lead-time increases price risk but also increases the need for assurance of supply. Perishability and quality add risk components as well. The timing of commodity purchases can have a significant influence on unit costs for a firm. Therefore, commodity procurement is one of the main areas which should be focused by the companies in order to improve profit, service, and/or quality and to withstand pressures to reduce price.
The most basic function of a food manufacturer’s commodity-procurement department is to maintain commodity supply in order to meet production demands. Managing supply risk is an essential element of this function and is critical to successful supply management. The commodity-procurement department’s second function is cost minimization. Commodity buyers accomplish these two functions by developing an optimal procurement strategy for each commodity depending on a variety of factors such as volume needs, associated risk, and potential costs. The two primary categories of commodity-procurement strategies are (1) spot-market (i.e., cash) transactions, and (2) forward purchasing mechanisms.
The spot market is the traditional commodity-procurement instrument, where buyers purchase the commodity in a predefined, general quality category on the cash market, immediately take possession, and have no direct contact with the supplier. Spot markets “offer products at essentially negligible lead-time,” but this flexibility often comes at a higher price and incurs greater price uncertainty. In food manufacturing, this strategy is employed as a simple replenishment strategy-e.g., when inventory drops below a pre-determined threshold level, a repurchase order is generated and carried out in the spot market.
Why is Spot market used?
it does not involve sophisticated tactics or market analysis, but merely involves monitoring current supply and reordering .
Spot-market purchases also minimize inventory costs, since no storage is needed if the purchase is tightly coordinated with production needs.
Furthermore, the spot market is an applicable tool when there is little price movement, and hence little risk of price fluctuation, or when price movement cannot be predicted, limiting the ability to minimize price risk through other strategic means.
Disadvantages of using spot market strategy:
Risk of the demand-supply matching
Reduces the opportunities to purchase commodities at lower prices
Forward Purchasing Mechanisms
Commodity-procurement instruments are sometimes used by firms to secure commodities needed for future production. These can be categorized as forward purchasing mechanisms, including forward buys and forward contracting. Each requires the buyer to project future quantity requirements. Firms also may reduce price risk by hedging spot-market purchases in the futures market.
A forward buy is a natural extension of spot-market procurement. Manufacturers purchase and take possession of a commodity in advance of manufacturing needs when spot-market prices are favorable. For example, suppose a commodity price is forecasted to increase. If storage costs for that period are less than the forecasted price increase, a forward buy lowers per-unit commodity cost. However, price risk is inherent in a forward buy since the commodity price may not move as predicted after the forward purchase.
Another forward purchasing instrument used by manufacturers is a forward contract with a supplier that specifies delivery of a commodity at a certain future date. Such contracts typically stipulate all of the transaction’s details, including the quantity to be traded, the quality of the commodity, delivery time and place, and price determination. Forward contracts offer the opportunity to procure commodities with the desired qualities for future processing without holding physical inventory and with little or no required payment in advance of delivery. A disadvantage of forward contracts is the possibility that the supplier fails to deliver either the desired quality or quantity. However, the likelihood of contract default is small and legal recourse is available.
Following characteristics are important in commodity-procurement decisions: market efficiency, perishability, seasonality, storage requirements, and commodity cost share, budget constraints, cooperative involvement, limited supply, price risk, storage availability, traceability, and volume.
The characteristics described above can be divided into three broad categories:
Product constraints are those characteristics that derive either from the physical characteristics of the commodity itself or from the economics of the commodities market.
Company constraints are those characteristics which are created by financial, managerial, or organizational characteristics of the firm.
Service constraints are related to the manufacturer’s relationships with buyers of the finished good as well as with purchasers of the commodity.
Figure 1 illustrates the three commodity categories and the factors that affect decisions in each category.
Characteristics derived from product constraints include market efficiency, perishability, seasonality, storage requirements, and the commodity cost share in the final product.
Market efficiency refers to the speed at which commodity markets react to and incorporate new information into market prices. Good information guides efficient production and allocation decisions. A market with a high degree of market efficiency reacts very quickly to new information. Forward purchasing mechanisms are less likely to be implemented in more efficient markets, since a commodity-procurement department would have limited ability to “beat” the market. In less efficient markets, a commodity-procurement department may hold an asymmetric information advantage and may execute a forward purchasing mechanism, such as a forward buy or a forward contract, before the market is able to react.
Perishability refers to the length of time before the commodity decays or spoils and can no longer be used in production. A high degree of perishability refers to a commodity with a relatively short shelf-life before spoilage and thus a higher associated transaction cost. Since companies move away from open markets when transaction costs are high. it is unlikely a manufacturer will use the spot market for highly perishable commodities. High perishability also discourages a standard forward buy that requires the buyer to secure storage. When commodities are highly perishable, it is likely that the manufacturer will develop forward contracts with a supplier to ensure fresh supply is delivered when needed to minimize risk.
Seasonality is the degree to which historic price swings (highs and lows) occur across growing seasons. A high degree of seasonality implies a strong and predictable pattern for the commodity’s prices within a year. Seasonality in prices can stem from growing patterns on the supply side and seasonality in demand patterns. When purchasing highly seasonal commodities, it is likely that manufacturers will use forward purchasing mechanisms, such as a forward buy, to obtain large volumes of commodities when prices are low and hold product in inventory.
Storage requirements of a commodity focus on the physical environment needed to preserve the commodity’s quality (e.g., refrigeration). High storage requirements imply higher storage costs, so commodities with high storage requirements are less likely to be purchased with forward purchasing mechanisms, such as a forward buy. When a manufacturer cannot accommodate special storage requirements, taking possession of inventory in advance of production needs may not be practical. Furthermore, relatively higher storage costs may eliminate any financial gains generally available from a standard forward buy. Thus the tradeoff between reductions in unit price and increases in storage costs must be considered, and is likely to favor a spot market strategy or a forward contract where delivery is taken close to the time of production.
The commodity cost share in the final product is determined by the contribution of the commodity to overall final product cost. When commodity cost share is high, it is expected that manufacturers will use forward purchasing mechanisms to minimize price risk and ensure profit margins. Forward purchasing mechanisms also allow a manufacturer to set a stable final product price, avoiding radical price fluctuations for the final good.
Company constraints are those characteristics that arise from the distinct characteristics or policies of the purchasing firm. Some company constraints stem from financial characteristics of the firm, while others are rooted in the firm’s managerial and organizational characteristics (e.g., policies, marketing strategies). The nature and size of markets in which the firm participates also play a role in creating company constraints. Budget constraints, cooperative involvement, limited supply, price risk, sales-forecast accuracy, storage availability, and volume are all company constraints.
Budget constraints refer to the degree to which the budget for the commodity-procurement department is limited. In a strict budget environment, manufacturers are expected to be involved in fewer forward buys. Forward buys are expensive to execute in the short run since the manufacturer has to pay for the commodity before it is needed in production (Kingsman 1985). Furthermore, when budget constraints are high, it is expected that commodity-procurement departments focus more on cost avoidance or cost reduction. When budget constraints are more relaxed, the commodity-procurement department can focus more on profit or revenue generation as measured against price risk.
Cooperative/common involvement refers to a situation where more than one entity is involved in the procurement decision. The most common form is a farmer cooperative-owned plant that buys commodities from its members. Common involvement can also occur when multiple manufacturers form a buying cooperative. Commodities procured under a common-involvement process are more likely to be purchased through a forward price mechanism. Nearly all of these cooperative involvements have some form of contract that commits the parties involved to a given quantity of a commodity. In this sense, the manufacturer is committed to a future purchase, and thus will want to hedge price risk via forward purchasing mechanisms.
When a limited supply exists at a specific quality level, it is more likely that forward purchasing mechanisms will be used. The primary benefit is the minimization of supply risk so that production can continue as planned and final product supply is not affected. Price risk refers to volatility of the commodity price over time. Volatility is measured in percentage terms and annualized to evaluate the historical volatility of a commodity. Higher volatility implies higher price risk. If the commodity price is relatively volatile, it is expected that a manufacturer will implement a risk-management instrument in the form of a forward purchasing mechanism, such as a forward buy. Without an advanced price mechanism there is a risk of paying a significantly higher price on the spot market. If there is little price risk, the spot market is generally sufficient.
Nearly all manufacturers base their procurement volumes for input supplies, at least to some extent, on the sales-forecast accuracy of final product. Sales-forecast accuracy refers to the degree to which forecast sales mirror actual sales. It is expected that higher a degree of sales-forecast accuracy will lead to a higher likelihood of manufacturer use of forward purchasing mechanisms. Greater accuracy minimizes volume risk, so a manufacturer can be more aggressive and focus on minimizing price risk.
Storage availability is the amount of physical space available for commodity storage. It is hypothesized that manufacturers with relatively high storage availability are more likely to participate in forward buying activities since ample space is available for storing the procured commodity (Kingsman 1985). Manufacturers with a relatively low amount of storage availability are limited to purchasing activities that do not require taking possession of the commodity in advance of production, such as spot markets or forward contracts.
Volume is the amount of a commodity needed within a given time frame to fulfill manufacturing requirements. It is expected that a manufacturer would seek a forward purchasing mechanism for high-volume commodities to avoid the risk of stock outs. When manufacturers lack sufficient levels of high-volume commodities, it delays production and incurs significant cost (Kingsman 1985). For low-volume commodities, it is more likely that a manufacturer will buy the commodity on the spot market in order to save storage costs.
Service issues affect commodity-procurement departments in two ways. First, service can equate to the service that the manufacturers’ customers (e.g., generally retailers) demand. Second, service can equate to the requirements that the manufacturer sets for its suppliers, including supplier service level and traceability. The first service constraint affects the manufacturer as the seller of a finished good, while the second service standard affects the manufacturer as a buyer of a commodity product. Each of these constraints is discussed below.
While most special promotions are based at the retail level, the end result is an increase in production quantities for the manufacturer-translating into an increase in the volume of the required commodity. Special promotions also put price pressure on commodity-procurement departments. If the final product is discounted at retail, the base commodity must be purchased at a lower price in order to maintain profit margins. Based on pre-test interviews, it was apparent that this is a key characteristic, particularly in highly price-competitive markets. A special promotion is expected to encourage a manufacturer to investigate forward purchasing mechanisms. Two reasons for more-advanced purchasing include the need to ensure sufficient supply exists to produce the desired amount of final product forecasted for the special promotion; and the need to protect profit margin needed to make the promotion worthwhile and successful for both the manufacturer and retail customer.
Supplier service level refers to services available from a commodity provider, and can range from providing market forecasts to on-time delivery. Monczka and Trent (1995) list the service level of a supplier as one of the top five concerns of procurement. Commodities with a high service-level requirement are more likely to be purchased through forward purchasing activities. A high service level implies that a relationship generally exists between the two parties and more information is shared, allowing for forward purchasing activities to be executed. It may indicate a higher level of trust and cooperation between the two parties. Thus manufacturers are more willing to listen to supplier ideas with respect to forward purchasing opportunities. Also, suppliers are more likely to work closely with manufacturers and assist in activities (e.g., cost-reduction programs) to ensure preferred-supplier status. Finally, since a spot market implies that no relationship exists between buyers and sellers, this procurement strategy will not be as beneficial when a high level of service is required.
Traceability refers to the ability to trace the source of a commodity and other pertinent product information such as where and how the commodity was grown (e.g., what herbicides were used on the field). A high degree of traceability refers to a commodity that can be completely traced back to its origins and where many details about the production environment of the commodity are known. When a high degree of traceability is required, a forward purchasing mechanism, such as a forward contract, is more likely to be used. While traceability is typically considered a differentiating trait, it is also true that the line between commodity and differentiated product becomes blurred when traceability is applied to commodity agriculture. In fact, it is the implementation of traceability that transforms an agricultural commodity into a differentiated product. We include it here as an important characteristic that may guide how some food manufacturers make commodity-procurement choices. As traceability is integrated into a commodity or is expected from a supplier, the transaction costs of maintaining traceability increase, moving a manufacturer away from the spot market where commodities do not have traceability attributes.
Importance of Technology in the whole Purchasing and Supply chain strategy
Cite This Work
To export a reference to this article please select a referencing stye below: