THE QUESTION WE WERE WORKING ON

Suppose that annual sales are £50, with variable materials costs equal to 60% of sales and
‘internal’ costs of £15m. Profit is therefore £m [50 – (30+ 15)] = £5m. Now, what will happen
when?
a) Sales volumes rise by 5%; or alternatively
b) Materials costs fall by 5%.
Solution: (a) (b)
£m £m £m £m
Sales 52.5 50
Materials costs 31.5 28.5
Internal costs 15 15
Total costs 46.5 43.5
Net Profit 6.0 6.5

NB: The profit increase achieved by increasing sales volume is not as great as that achieved by
reducing costs.

PURCHASING CONTRIBUTION TO PROFITABILITY

In fact, the purchasing department caught the attention of management when the latter
recognized the importance of the former’s role and contribution to profitability through cost
cutting. It is an undeniable fact that the greatest scope for savings lies in the area of greatest
expenditure. And in most organizations, particularly in the manufacturing firms, their greatest
expenditure lies in the bought-out materials, components etc. In fact, an analysis of
organizational expenditure indicates that materials cost constitutes about 65% - 75% of the total
organizational cost or expenditure.

There is the need therefore, to manage this (expenditure) efficiently and effectively through the
supply chain management. Take a critical look at the worked example below to realize the
important role purchasing can play in the profit making of the organisation.

Question: An organization has total sales of 10m. Its profit is 20% of the sales. The organization
spends 60% of the turn over on bought-out goods and services. The organisation was able to
save 10% on materials cost. What would be the effect to its purchasing efficiency or otherwise?

Solution:
Turnover = ¢10,000,000

Expenditure on mat. = ¢6,000,000 (i.e. 60% of 10,000,000)

Profit = ¢2,000,000 (i.e. 20% of 10,000,000)

Savings on materials = ¢600,000 (i.e. 10% of 6,000,000)

Therefore total profit = ¢2,000,000 + 600,000 = ¢2,600,000

OR

20% profit of 10,000,000 = ¢2,000,000

10% savings on 6,000,000 = ¢6,000,000

Therefore total profit = ¢2,600,000

NB: Supposing there was no savings on materials cost and the profit ratio (percentage in profit)
is unchanged. To what extend sales has to increase in order to achieve the same additional profit
margin of $600,000?

Solution

¢10,000,000 = ¢2,000,000
? = ¢600,000

→ ¢ 10,000,000 X ¢600,000
¢2,000,000 =¢3,000,000

OR
3,000,000
10,000,000 X 100 =30%

This means that for the organization to achieve additional profit of ¢600,000 it has to increase
sales (turnover) by 30% or total turnover of 13 million i.e. additional ¢3,000,000.

From the above, one can infer that 10% savings on purchase is equivalent to a 30% increase in
sales. However, it is less difficult to cut cost by 10% than to increase sale by 30%. This is
known as the “profit leverage effect”.

The means by which purchasing can contribute to the profitability of the organization (cutting
down cost and waste and adding to value) may include the following:
What Is Purchasing Management?
Purchasing management can be summed up to a dedicated position created within a corporation
to manage the acquisition of goods and services.

Company X will not accept any gifts from potential vendors of any size or amount.
Company Y will always obtain three closed bids before making a purchase.
Company Z will always receive all proposals in a RFP or RFQ format (companies use RFP and
RFQ for formalizing the bidding process from potential vendors) as dictated by the offer, in
writing and delivered in a specific format and venue.
Company XY will only make purchases through a purchase order (PO) process established by
the corporate controller.

Establish purchasing
objectives

Identify, evaluate and

Purchasing research select strategies

Prepare detailed plans

Implement plans

Evaluate outcomes