Table Of ContentThis book is the fourth volume in a new international book series
FRONTIERS OF OPERATIONAL RESEARCH
AND APPLIED SYSTEMS ANALYSIS
General Editor: Rolfe Tomlinson
The series is aimed at helping practitioners to broaden their subject base and to advise
managers and specialists in related areas of important new developments in the field.
The scope of the books will be broad and their authorship international. The subject
is interpreted widely to include any scientific, applied, interdisciplinary and
systems-oriented approach to the study of real-life decision problems.
Rolfe Tomlinson is Professor of Systems and Operational Research at the School of
Industrial and Business Studies at the University of Warwick, and is President of the
European Association of OR Societies. He was for many years the Director of
Operational Research at the National Coal Board and was then Area Chairman for
Management and Technology at the International Institute for Applied Systems
Analysis. The series reflects his deep belief that scientific systems-oriented research
can be of direct practical use over a much wider range of topics than at present, but
only if the work is problem-oriented and seen as a collaborative effort with the problem
owner.
Volume 1
EDEN, C, JONES, S. AND SIMS, D.
Messing about in Problems: An Informal Structured Approach to their Identification
and Management
Volume 2
TOMLINSON, R. and KISS, I.
Rethinking the Process of Operational Research and Applied Systems Analysis
Volume 3
STAHL, I.
Operational Gaming: An International Approach
A Related Journal
JOURNAL OF THE OPERATIONAL RESEARCH SOCIETY*
Published on behalf of the Operational Research Society Limited, London
Editor: Peter Amiry, Department of Engineering Production, University of Birmingham,
P.O. Box 363, Birmingham B15 2TT, England
This journal publishes contributions on any matter relevant to the theory, practice,
history, or methodology of Operational Research or the affairs of the Society. It is
aimed at applications in any field and encourages the submission of accounts of good,
practical case studies illustrating OR in action; of reviews of the state of development
of fields of knowledge relevant to OR; and of controversial articles on methodology,
technique or professional policy.
* Free specimen copy sent on request.
R aw M a t e r i a ls P u r c h a s i ng
An Operational Research Approach
by
B R I AN G. K I N G S M AN
University of Lancaster, U.K.
PERGAMON PRESS
OXFORD · NEW YORK · TORONTO · SYDNEY · PARIS · FRANKFURT
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FEDERAL REPUBLIC Pergamon Press GmbH, Hammerweg 6,
OF GERMANY D-6242 Kronberg-Taunus, Federal Republic of Germany
Copyright ©1985 B.G. Kingsman.
All Rights Reserved. No part of this publication may be
reproduced, stored in a retrieval system or transmitted in
any form or by any means: electronic, electrostatic,
magnetic tape, mechanical, photocopying, recording or
otherwise, without permission in writing from the
publishers.
First edition 1985
Library of Congress Cataloging in Publication Data
Kingsman, Brian G.
Raw materials purchasing.
(Frontiers of operational research and applied systems
analysis; v. 4)
Bibliography: p.
1. Raw materials—Purchasing—Decision making.
2. Industrial procurement—Decision making.
3. Commodity exchanges. I. Title. II. Series.
HF1051.K56 1984 658.7'2 84-6479
British Library Cataloguing in Publication Data
Kingsman, Brian G.
Raw materials purchasing.—(Frontiers of operational
research and applied systems analysis; 4)
1. Raw materials—Purchasing
2. Operations research
I. Title II. Series
658.7'2'072 HF1051
ISBN 0-08-029976-8 (Hardcover)
ISBN 0-08-029975-X (Flexicover)
Printed in Great Britain by A. Wheaton & Co. Ltd., Exeter
To Margaret Karl and Claire,
whose value, unlike prices,
was never uncertain
Editor's Preface
This fourth volume in the Series "Frontiers of Operational Research and
Applied Systems Analysis" covers a topic of major commercial importance.
Indeed, in the face of continuing uncertainty in world markets, there can be
few topics which are more critical than the purchasing of raw materials.
Because of the uncertainties involved, the field is very much one in which
'expert' dealers, operating by experience and hunch, hold court. At first
sight the opportunities for 'rational' analysis would seem minimal; yet here,
as in other unexpected areas of commercial management, analysis has
proved not only to be useful but highly profitable. No-one has done more in
this field than Dr Kingsman with his colleagues at the University of
Lancaster.
Much of the merit of this book lies in the fact that it is based on a series of
practical studies. It is replete with illustration and sound advice for the
practitioner, at the same time as providing technical information for the
respective analyst. Thus, not only has the author broken through to new
frontiers in the field, he has provided both a map and a manual to those
coming after him who would wish to profit from this newly discovered
territory.
ROLFE TOMLINSON
General Editor
vii
Preface
The importance of the general purchasing function to a company's
well-being has often not been sufficiently appreciated in the past. Surveys
have shown that on average over half of the final product cost is made up of
bought-in supplies and materials. A good or bad purchasing policy will thus
have a significant effect on a company's performance. The goods bought by
the purchasing function divide naturally into two classes, manufactured
and semi-manufactured items, and secondly raw materials. The major
characteristic of the first class is that usually the prices paid are the result of
negotiations between the buyer and his suppliers and that prices are kept
constant for an appreciable time into the future. The major characteristic
of most raw materials purchased is that the prices are not preset by the
individual buyer and seller and that the prices are continuously changing,
from day-to-day and even from minute-to-minute in some cases. The prices
are determined by a market of all buyers and sellers worldwide. Individual
buyers and sellers generally have little direct influence by themselves on
the prices quoted by the market at particular times. The problem of
purchasing raw materials whose prices are continually changing is one
faced by many companies in countries all over the world.
The term 'commodities' is often used to describe such materials.
However, this term is often only interpreted as referring to those materials
whose prices are determined through international commodity exchanges
in public trading sessions. Many other materials have fluctuating prices,
but are bought on the basis of telephone conversations between buyers and
sellers since no open central commodity exchange exists. Furthermore,
many economists use the term to describe anything that is bought and sold.
Because of all these ambiguities the term raw materials will generally be
used in this book. Because the limited published work in this area has
considered only those materials traded on international commodity ex-
changes the problem is usually called the commodity purchasing decision
problem. Although this label will be used frequently it should always be
remembered that it refers to the purchasing of any material whose price is
continually fluctuating over time whether bought through international
commodity exchanges or more informal arrangements.
viii
Preface ix
It is probable that more than half of the items bought on a worldwide
basis by the purchasing function of companies are raw materials as that
term is used here. There are large variations of course between one
company and another. The extreme cases where the purchasing costs make
up 75% or more of the final product cost tend to be where most of the
purchasing is for raw materials, for example animal feeds and the
nonferrous metal industries. Indeed some manufactured products are 'raw
materials' in the sense that the term is used here, for example copper cable,
copper tubing, electric light plugs, etc., since their prices to customers will
vary as the price of copper varies.
Much work has been carried out and published on various aspects of the
problems of purchasing manufactured and semi-manufactured items.
However it is surprising that so little published work has considered the
problem of purchasing raw materials in any real depth, in view of the
everpresent possibility of large losses or great gains arising from the
uncertain large fluctuations in future prices. This book is an attempt to
remedy that deficiency. It is based on many man years of research and
consultancy by the author and his colleagues. The book contains an
analysis of the commodity purchasing problem from an operational
research viewpoint. The underlying structure of the problem is identified
and discussed. Models for the component parts are then developed to
provide decision making policies. These are illustrated via numerous case
studies to show both the problem situations that occur and the potential
improvements that might be made. In general the case studies described
are ones carried out by the author or where he has had some personal
involvement.
The book is mainly written for operational research practitioners who
are involved in studies in the purchasing area or are contemplating such
studies in co-operation with the buyers and for purchasing managers who
are responsible for buying raw materials. The book is aimed at this dual
audience since success in improving purchasing performance will only
come from the purchasing management and the management scientist
working hand-in-hand on a joint study. Because of this approach the
mathematical and statistical aspects have, wherever possible, been put into
appendices to each chapter. A nontechnical explanation is given where this
is not appropriate. It is recommended that those readers without a good
statistical knowledge should jump over the technical appendices, at least
on a first reading. Several case studies which illustrate the application of
the methods discussed to particular aspects of the problem have been
included. Since the book is mainly aimed at those directly involved with the
raw material purchasing problem, the case studies are described in some
detail so as to give better guidance on what such studies entail and how to
cover the various problems and difficulties that arise in practice.
RMP-A*
χ Preface
It is hoped that the book will also be of interest generally to operational
research practitioners and theorists, particularly to students on OR
courses, as an example of operational research methodology applied to a
currently neglected but very significant new problem area. Many parts of
the book should be of interest and use to economists, particularly those
concerned with the trading of materials between countries and with
international commodity agreements. Any researcher studying speculative
time series should also find much of relevance to his work. Many parts of
the book are of interest to students taking management courses, particular-
ly those leading to a purchasing management qualification, since it
highlights an important area of management activities currently somewhat
neglected.
I would like to record my appreciation of the help of a number of my
colleagues at Lancaster, both in the preparation of this book and in the
research leading up to it. Professor Alan Mercer first aroused and then
encouraged my interest in this area. Colin Jex worked jointly with me on the
copper buying study described in Chapter 12. Dr Steve Taylor, firstly as a
research student and then as a colleague, developed the new general model
for daily commodity price movements presented in the appendix to Chapter
2. He also produced for me several of the figures and tables of Chapter 2.
Brian Parker provided many useful comments and suggestions on the first
draft, as did Professor Rolfe Tomlinson, the editor of this series. Dr Rui
Guimaraes, of Oporto University, whilst a research student at Lancaster,
co-operated in some of the work on maize price forecasting. I also owe a debt
of gratitude to many Masters students on the Lancaster courses, who worked
with me over the years in applying the ideas presented in this book on their
practical projects, only a subset of which have been included. Finally, but
not least, my thanks to Margaret Threlfal and my wife, Margaret, who
between them typed and retyped the manuscript. Because of the decision to
preserve anonymity it is not possible to mention the many purchasing
personnel who co-operated in the research in the companies of the case
studies described. I record my thanks to them for the help they gave to the
research.
Summary
The opening chapter introduces the problems that companies and
purchasing managers have in coping with the commodity purchasing
problem. To provide an appropriate background to the purchasing
situation, a brief description is given of the different types of market in
which raw materials are bought and sold and in which their continually
changing prices are generated. The type of price movements that occur and
the sheer size of the price fluctuations that can exist are illustrated for
several materials in Chapter 2. The 'conventional wisdom' among many
researchers is that raw material prices follow a random walk. This means
that the price movements are entirely random with no systematic
components or causes. If this were so then an immediate consequence is
that there is little point in trying to determine improved purchasing policies
since the attempt is bound to fail. Chapter 2 concludes with a brief
description of some recent research which establishes conclusively that the
random walk model is an inadequate approximation to the underlying
process generating daily commodity prices. Systematic trends can and do
exist and persist for moderate periods of time.
The various components and stages in the purchasing decision can best
be seen by examining practical examples in some detail. This will also show
to what extent a common structure exists in the purchasing decision
problem. Four examples of actual buying situations are described and
discussed in detail in Chapter 3. The materials and the practical detail in
each example are taken from real life situations. However, for reasons of
commercial confidentiality, the names of the companies used in the
examples and the later case studies are fictitious. Each problem is
described together with the constraints placed on the buyer's freedom of
action by company policy. The general way in which buyers and their
companies have organised themselves to cope with their purchasing
problems is also described.
These buying examples all show that the commodity purchasing decision
contains five major stages. The first stage is to determine what are the
future consumption usages for each material that the buyer needs to
purchase. If there are alternative grades of each material or alternative
materials which are partially substitutable for each other then this stage
XV
xvi Summary
contains very complex decision problems indeed. The second stage is to
batch consumption requirements into delivery order quantities to be
placed with the supplier, specifying size and delivery date. One important
conclusion determined for this stage is that classical Statistical Inventory
Control methods are inappropriate for purchasing raw materials, because
of the way pricing, supply and delivery of the materials is organised. A
Materials Planning Requirements approach must be used. A company
needs to forecast the future demands for its final products and produce a
schedule of the demands it will meet in each future period. Parts explosion
or other methods can then be used to give the raw material requirements
for each future time period. The third stage is the determination of the
absolute limits on the freedom of action allowed to the buyers. Discussion
of this problem leads to the concept of the 'Strategic Buying Period', the
period of time over which any future period's requirements may be
purchased, and maximum and minimum values for the 'Purchase and Stock
Cover', the total amount of material held by the company at any time
either in stock or as forward contract orders. Fixed values are determined
for these factors which depend on the company's general ability to make
good forecasts of prices over differing future time periods, the company's
overall strategic policies on capital investment in raw material stocks and
its attitude to the risks of occasional large losses relative to expected
overall net gains compared to a back-to-back buying policy. The fourth
stage is the determination of the 'Active Buying Period' or 'Purchase and
Stock Cover'. This is the value the buyer uses in practice and is buying
performance related rather than concerned with company strategy. It
depends upon whether the buyer feels able to make confident forecasts of
future prices in all the varying situations that can occur in the market. If
not then a single constant value for the active buying period should be used
for all time. If successful price forecasts can be made then it can be an
adaptive value, sometimes leading to buying requirements for several
months ahead over the next 3 or 4 weeks whilst at other times buying only
to cover current requirements. An adaptive buying period requires the
development of a medium-term econometric/behavioural price forecasting
model which 'explains' why particular price movements have occurred and
enables reversals of an existing trend to be anticipated in advance. The
final fifth stage is the tactical day-to-day buying problem, to decide on each
particular day or at which particular price offer, within the limits imposed
by the early stages, a purchase or purchases for each delivery order should
be made. The tactical buying problem manifests itself as one of two basic
forms; the continuous supply and continuous usage situation with material
being required for usage at every buying opportunity, mainly relevant to
the metals, or that of buying a known amount of material before a known
or specified deadline, mainly applicable to the agricultural materials. Both
