Direct Material Procurement Life Cycle Guide - Part 2Business | June 10, 2022 | By
Welcome to part 2 of the 2-part series blog on Direct Material Procurement LifeCycle. In case you missed part 1, it is available here. The objective of this handbook is to help the audience understand the life cycle of the procurement process in the context of a product manufacturing company, particularly relating to their direct materials. In part 1, we saw the criticality of sourcing in the procurement lifecycle and how it aligns with the new product development process of the product life cycle. In part 2, we will cover the role of procurement in the production phase of the product life cycle. The procurement technology industry reference to this phase is Procure-to-Pay. At the end of this handbook, you will also be able to appreciate the difference between source-to-contract vs. procure-to-pay.
At the end of the Product Development process, when the parts have been sourced and the final contract is signed off with the supplier, the ownership of the parts is usually transferred to a part of the organization that manages the production. In well-established and large organizations, a team of purchasing specialists is responsible for releasing purchase orders based on contracts or Blanket Agreements created by the Sourcing organization. These purchasing specialists are usually part of the supply chain function within the company. One might have guessed by now that:
- In small companies, sourcing for suppliers during development and purchasing/ procuring during production may be handled by the same person.
- In large companies, purchasing specialists involved in releasing the purchase orders based on the production schedules/requirements using an existing contract do not work on sourcing and creating final contracts.
Creating a production plan is a high-stakes activity as it ensures the functioning of the company smoothly and ensures there are no disruptions to the revenue stream and that there is no loss in efficiency in trying to meet the daily, weekly, and monthly delivery targets from the factories. This requires an understanding of the company’s internal processes, warehouse operations, manufacturing capabilities, speed & quality of production, labor, other changes within the factory such as new product introductions or machinery changes, and a handle on the logistics feeding into the factory warehouse (inbound logistics), ability to view the bigger picture of the supplier landscape, at the same time being able to zoom-in to specific supplier situations and have a grip on the logistics of delivering whole goods to their final destination (outbound logistics). Disruption or changes in any of these areas create ripples that finally end up in the company missing product delivery on time, at a higher cost, or with poor quality.
The production plan starts with what is called demand forecasting using sales projections, historic requirements, seasonal adjustments, current trade & economic factors, and the market anticipation of the new products. The production plan is a schedule of products to be built daily; established companies maintain this plan anywhere from 90 days to 180 days, with some forecasts maintained up to 12 months, at any given time.
The schedule would have the product IDs and the quantities against each product ID on a calendar. The number of product IDs may vary anywhere from a handful of items to a few hundred (technically, the same product with two different colors would have two unique IDs). The variations of the same product are referred to as ‘types’ or ‘variants’.
Material Requirements Planning (MRP):
Take, for example, two-color variants of the same product like we just mentioned and consider a specific part that comes from a particular supplier, the production team would require that the parts are received in two different colors and in the right quantities so they can be produced. The suppliers would be required to be informed at the right time so they could plan and make batches of color1 before switching to color2 within their factory.
Otherwise, the production team would have to switch for every piece or add separate painting booths, either of which may drive up the cost of the item. Or in other cases, the supplier may simply need a few weeks to arrange for the raw materials from a different continent altogether. So, the SCM in the buyer’s organization converts their production plan/schedule into requirements for every part within their product. This schedule is then shared with the suppliers as a forecast for 90/180/360 days. The buyers confirm this schedule regularly within this period and there is a 30-90 day (depending on the supplier and item) firm order period where the quantities are locked-in and POs are released. This entire process of converting production plans to supplier orders is called Material Requirements Planning or MRP.
Releasing the Purchase Orders to the suppliers based on this plan is called Production Procurement or Purchasing.
The production in a factory is like a flywheel that keeps rotating. In this case, the flywheel goes through a continuous cycle of
- Sales Projection
- Demand Forecasting
- Production Planning (PP)
- Material Requirements Planning (MRP)
- Supplier Schedules
- Purchase Orders
- Material Receipts
- Supplier Invoices
- Supplier Payments
- Wholegoods (Product) Production
- Wholegoods Shipment
This cycle is explained clearly in the Production phase of the life cycle shown on the right-hand side of the life cycle diagram.
This phase of the procurement life cycle is referred to as Procure-to-Pay in many contexts; captured between steps 5 through 9 above.
It’s a given that companies have to place resources optimally in every step of production to ensure the cost of making the product (Direct Material Cost or Total Manufacturing Cost) does not exceed the pricing potential. Over time, the total cost of manufacturing has been under tremendous pressure due to rising costs of raw materials, energy, labor, and environmental and regulatory compliance, just to point out a few. The point is that companies must manage all aspects of production costs. That means there is no room for errors when creating production plans, sharing schedules with the suppliers, placing orders, processing receipt of items, and processing payments. And definitely, no room for added costs if the suppliers send items of poor quality or documents inconsistent with actual deliveries. To build efficiencies, companies now share the production schedules through online portals so there is no back-and-forth over emails on schedules, costs, quantities, etc. Also, for quick processing of materials received, companies ask the suppliers to communicate the shipment details in advance (Advance Shipment Notice – ASN).
Advanced Shipment Notice (ASN)
To maintain visibility of parts arrival so that production is not disturbed due to missing parts, the buyers and SCM specialists in companies regularly communicate with the suppliers. And when the parts arrive in the factories, especially when 1000s of items are received on a daily basis, including small batches of multiple parts for new product development, the buyer organizations expect prompt processing of the consignments. For this reason, companies require suppliers to notify them of their consignments in advance using a document called ‘Advance Shipment Notice’ or ‘ASN’. The document captures information regarding the parts (part numbers) in the consignment, the purchase orders against which the parts were made, quantities shipped, the commercial invoice for the shipment, and the vessel/carrier information. That means, when someone receives a consignment, they can bring up all the necessary documents to compare and accept/decline the consignment received.
Receiving materials along with advance notices enables staff at the receiving location to process the items faster and communicate across the company much more efficiently. The document that communicates internally is called Goods Receipt Note (GRN). In some systems, this document is also referred to as Goods Receipt Voucher (GRV). However, when there are hundreds, if not thousands, of large receipts in a day, any kind of processing of the consignment beyond just receiving is next to impossible at the warehouse.
So, the warehouse staff usually receive and hold the consignments for further checking in terms of actual quantities concerning the invoice and packaging. It may be surprising how often, even in highly mature markets, there are discrepancies between the invoice amount and the actual receipt—the actual quantities in the shipment are either higher or lower than the invoice and packaging documents. Another frequent concern when receiving materials from the suppliers is the poor quality of items within the shipment – sometimes the quality engineers at the receiving station reject the items and tag them for return to the suppliers. Just like we explained about cost a short while ago, processing poor quality items adds a significant cost to the company. So there are several ways in which the companies penalize suppliers for shipping poor quality items. Penalties for delayed deliveries and quality issues are captured in the supplier contracts/blanket agreements.
Invoice Processing & Accounts Payable (AP)
As mentioned earlier, vendors/suppliers need to be paid when they deliver on their promises. What is payable to the suppliers is simply referred to as ‘Payable’ or ‘Accounts Payable’. The promise was what was discussed during the sourcing process and finally captured by the Purchase Orders or Contracts. When in the middle of production, there are hundreds or thousands of deliveries from the suppliers at the company’s warehouse. Technically, every delivery would have its shipment information, invoice, and quality checks. Apart from the parts received for production, the companies also receive invoices for hundreds of services they employ to keep the businesses running. Making timely payments to the suppliers requires the processing of every invoice – processing of invoice means reading every piece of information and matching it with the actual documents like the Purchase Order (PO) for the requirements, cost, etc. and checking the actual goods received from the supplier at the warehouse (Goods Receipt Note – GRN) to ensure the payment requested is against the actual quantities received and finally factoring in all the rejections. This way of matching the details when processing the invoices is called a 3-way match or a 4-way match depending on how many pieces of information are checked. Once done, the information is then shared with the accounting department for releasing the payment to the suppliers. (Why are there discrepancies? We will park that discussion; for now, let’s note that every invoice has to go through this process). The part of the organization that handles these payables and accounts for the
Several companies offering software in procurement claim expertise in procure-to-pay process and procurement domain, but simply enable scanning of the invoices and stage them for the buyers to complete a 3-way match. As we can see, there is so much beyond just invoice processing in the procurement life cycle for direct materials.
In conclusion, during the Procure-to-Pay phase, the procurement organization supports the companies in keeping their revenue stream live. A good job during the Source-to-Contract ensures the Procure-to-Pay runs smoothly. However, by now we realize that no amount of precaution can help in avoiding errors/exceptions. So maintaining a healthy supplier relationship, keeping a tab on their performances and costs, and periodic strategy reviews, followed by strategic (re)sourcing from existing suppliers to new/alternate suppliers for the parts are all part of the procurement lifecycle.
Supplier Relationship Management:
We have been discussing all along how the procurement organization works with the vendors/suppliers for the success of the product and how every item/part that is put on a product is critical for the cost and quality of the product. Needless to say, a healthy supplier partnership is critical for the success of a company. It was evident during the times of pandemic and supply chain disruptions how companies with a healthy and highly proactive supplier network thrived while others learned painful lessons in terms of missed deliveries and product availability in the market. And for obvious reasons, the responsibility for maintaining this relationship falls with the procurement organization, of course with management sponsorship. This part of the procurement lifecycle is referred to as Supplier Relationship Management.
Supplier relationship management begins with the registration of the supplier as an approved partner in the company’s records. During the registration process, companies ask for a variety of information regarding the incorporation of the supplier’s company, management details, financial information, capital investments, manufacturing capabilities, quality system and environmental certifications, competency, and personnel skill upgrade programs. The supplier is added as a partner after a detailed review of all such information, customer references, and on-site visits by the procurement and supplier quality staff. The addition of suppliers also includes early contracts between the supplier and the company to ensure the protection of proprietary information and intellectual properties of both parties (Non-Disclosure Agreements – NDA).
The suppliers are then invited to participate in the RFQ process and start supplying parts after winning the bids during the sourcing events. As they start delivering the items, the procurement organization keeps track of their performance in terms of percentage On-Time delivery, percentage acceptable in quality, etc.
Supplier Relationship Management also includes communicating and keeping track of the supplier schedules, orders, changes in orders if any, sharing a status on the goods received quality checks, processing of invoices received, and payment status. Very importantly, this includes a continuous sharing of supplier performance data and working with them to improve their performance over time.
Now, after looking at the complete procurement life-cycle, it is clear how the source-to-contract and procure-to-pay phases drive each other. A significant part of this is also monitoring the health, risks, and exceptions on a daily basis. So, even after a product is launched in the market and the supply chain is fully set up, the procurement team is busy with sourcing for the existing parts (parts that are already in production, with assigned suppliers). The advantage here is that the product is already in the market and the team does not have to work on all the parts simultaneously. But the flip-side is that it becomes a very expensive failure when, during production (procure-to-pay), a supplier fails and the overall business is at risk and the procurement team has to find another supplier almost immediately. As mentioned before, the risk is on multiple factors like cost, delivery, quality, reliability, competitor engagement, high dependence and lack of fail-safe, etc. Other macro economic and global factors that nudge the procurement teams to revisit their strategies include global and local commodity rates, economic inflations, cost of fuel (driving the cost of delivery), socioeconomic shifts, geopolitical issues, etc.
The part of the procurement organization that is involved in this part of the lifecycle is referred to as the Strategic Sourcing group. They continuously look for risks and take actions appropriate for every situation. Two critical actions apart from putting out fires are to prevent future situations by fine-tuning their supplier strategy & proactively resourcing parts from an existing, high-risk supplier to a better supplier. In some cases, the supplier that is providing a part may be a top-rated supplier but the risk may be due to logistics, deep technical dependence, or simply the supplier’s capacity.
As shown in the procurement life cycle diagram, strategic sourcing is a continuous process that runs during the production phase and in parallel with the procure to pay. The steps involved in strategic sourcing are exactly the same as in production sourcing:
RFQ -> Quotes -> Supplier Selection -> Standard PO -> PPAP -> Blanket Agreement
There would be limited or no design iterations as the product has already been through this during the development process.
While we are discussing strategic sourcing at the end of this handbook, it is critical to note that strategic sourcing is the force behind the success of the direct material procurement process.
We hope the handbook has been useful to you in understanding the direct material procurement process and the steps involved in the procurement life cycle of direct materials. We also hope that procurement professionals involved in the purchasing of goods and services in non-manufacturing industries were able to relate to their current activities and appreciate the differences, and the deep impact of the process on the success of a product and the company manufacturing the product. We also understand that there is scope to improve this handbook by expanding on several smaller terms/concepts mentioned throughout the text; we shall continue to add those and improve the relevance of this guide.