Develop Specifications and Initiate Sourcing, Pricing, and TCO Analysis

Develop Specifications and Initiate Sourcing, Pricing, and TCO Analysis


  • ·        Develop Specifications – Normally, a performance specification is developed by the team. A performance specification describes the desired performance together with the required engineering features. If another type of specification is determined to be appropriate, one or more qualified potential suppliers may become involved in the process of developing the specification.


One of the advantages of formally establishing a sourcing team is the fact that more cooperative action usually is generated in attacking the procurement. This can be extremely useful in the development of the equipment specifications. Quality/cost trade-offs are best addressed by a team. When specifications are nearing completion and requests for proposals are to be issued, a good supply management professional should function in the role of an informal auditor. Although technical requirements predominate, the supply management professional should make every effort to see that specifications are written as functionally as possible. Most equipment users are biased toward or against specific types of equipment. Every effort should be made to exclude personal biases from the specifications. The nature of many equipment requirements limits the number of possible suppliers. This number should not be reduced further by arbitrarily excluding certain potential suppliers on the grounds of personal prejudice. After development of the appropriate specification, sourcing, pricing, and negotiations are accomplished.


  • ·        Sourcing – The sourcing of equipment suppliers involves the quantitative and qualitative analyses. Briefly, the first step in equipment sourcing is the development of a request for proposal. Once proposals are received, they are evaluated for responsiveness. The supplier or suppliers that appear to be most attractive are identified. Some suppliers are more qualified in the “soft”, or qualitative, area than are others. The degree of qualification should be considered carefully by the team in deciding which machine to buy. The team must determine the level of a supplier’s technical, production, and commercial capabilities. The team also must assess the supplier’s capability and willingness to provide any engineering service required during the installation and start-up of the new equipment. This is an extremely important financial consideration when complex expensive equipment such as steam turbines and numerically controlled machine tools is involved. Closely related to this factor is the necessity of training operators. What service is the supplier willing to provide in this area? The reliability of a supplier in standing behind its guarantees is another important consideration. A combination of the supplier’s history of satisfactory performance and financial viability must be addressed. Once the equipment is installed, unexpected problems beyond the purchasing firm’s control sometimes add significantly to the total cost of a machine. Finally, what is the supplier’s policy on providing spares and replacement parts? When the purchased machine is superseded by a new model, what will be the availability of obsolete parts? The policy of one pump manufacturer, fore example, is to produce a small stock of replacement parts for obsolete equipment once every six months. The semiannual production policy of this manufacturer, combined with its low inventory levels, forces some customers to carry unreasonably large stocks of major replacement parts. The other costly alternative for the customer is to risk occasional breakdowns, which may leave a machine out of service as long as three or four months, waiting for the next run of parts. In practice, unfortunately, such considerations frequently play a minor role in the initial selection of equipment suppliers, only to assume major proportions at a later date. It is the responsibility of the supply management department to evaluate potential suppliers in light of these qualitative factors and to bring significant considerations before the evaluating group.


  • ·        Develop Updated Acquisition Cost and TCO Estimates – When proposals are received, a supply management professional tabulates them and makes the necessary calculations so that they can be interpreted on a comparative basis by the team responsible for the final recommendation. Because administration and control of such activities are clearly related to the capital budgeting function, the finance department frequently assumes responsibility for conducting a total profitability study. The authors’ view, however, is that once management has selected the types of analyses to be used, the supply management department can perform the analyses more easily and effectively. Those analyses are a logical extension of the supply management department’s proposal and analysis activities. Clearly, the supply management professional is familiar with any proposal complications. Through his or her involvement  in the preceding technical discussions, that professional also should understand any technical problems involved in developing estimates for maintenance and operating costs. Consequently, an individual with a good understanding of the total cost situation ma effectively prepare, interpret, and present the complete package of price, cost, and profitability  data for the group’s consideration.


The team now has considerable information to update its TCO estimate, including all likely acquisition costs and data on actual operating characteristics. As a result, a reasonably accurate TCO estimate can be developed. One of the most challenging issues confronting the team responsible for the selection of an expensive item of equipment is the possible conflict between the budget authorization and the total cost of ownership. The budget focuses on “now” costs; the total cost of ownership addresses both now and likely future costs.


  • ·        Meet Budget and TCO Objectives – The team now ensures that the updated acquisition and TCO estimates are at or below its objectives. If they exceed either objective, the project is returned to the objectives phase for revision.


  • ·        Top Management Approval – If significant funds are involved, once the project satisfies budgetary and total cost considerations, it should be forwarded for top management’s review and approval.


  • ·        Negotiation – Once appropriate approvals have been receives, the team proceeds to negotiate all the terms and conditions on a contract with the most attractive potential supplier. During negotiations, the negotiating team may explore the advantages of leasing.


  • ·        Leasing Equipment – In addition to the possibility of purchasing new or used equipment to satisfy a firm’s requirements, an equipment customer has a third alternative: leasing the equipment. In recent years, leasing has become a big business. It is now a $190 billion industry whose volume of business has doubled in the last five years. Approximately 20 percent of the new office and industrial equipment used on American business today is leased. Generally accepted reasons underlying this trend appear to be the heavy demand for capital in most firms, the costs of capital, and the increased flexibility that can be negotiated in the contract.  


  • o       Types of Leases – If one looks at leases in terms of the basic purposes for which they are used, most fall into one of two categories: operating leases and financial leases.


  • ·        Operating Leases – As the name implies, an operating lease is used by most firms as a vehicle to facilitate business operations. The focus typically is on operating convenience and flexibility. Frequently, a firm has a temporary need for equipment that will be used in the office or on a special production or maintenance job. The firm requires the use of the asset but is not interested in ownership and the risks and responsibilities that accompany it. Equipment obtained by means of an operating lease may fit the firms’ need well. Most operating leases are short term, for a fixed period of time that’s considerably less than the life of the equipment being leased. In many instances, an operating lease is used when the customer firm wants the freedom of being able to avail itself of new and unexpected technology.


  • ·        Financial Leases – A financial lease in most cases is used for a very different purpose. When operating equipment is obtained by means of a financial lease, the primary motivation is to obtain financial leverage and related longer-term financial benefits. Relatively speaking, a financial lease is a long-term lease that usually covers a period just a bit shorter than the approximate life of the equipment being leased. Many financial leases are not cancelable. Several prices argue that such leases distort the firm’s financial reports by reducing debt, which might otherwise be required to finance major purchases. Additionally, assets will be understated, resulting in a lower asset base in calculating he firm’s return on assets.  


  • ·        Factors Favoring Leasing


  • o       Operating and Managerial Convenience – While there are different types of leasing organizations, most industrial leasing firms are called full-service lessors. This means that the leasing organization owns the equipment, has its own continuing source of financing, and is prepared to assume all the responsibilities of ownership for the lessee. Hence, the lessee has full use of the equipment and can concentrate on its regular business operations without having to worry about maintenance, special service, and other administrative tasks associated with equipment ownership. This can be a major benefit in the case of complex equipment that requires highly specialized technical support.


  • o       Operating Flexibility – With relatively short-term leases for selected pieces of operating equipment, a lessee is not locked into long-term commitments resulting from large capital investments. The lessee can maintain maximum flexibility in its operations to respond to changing business conditions and the subsequent production requirements. It can use a leasing arrangement to meet temporary operating needs with relative ease, and in the same manner it can test new equipment before making a longer-term purchasing decision.


  • o       Obsolescence Protection – Leasing substantially reduces the risk of equipment obsolescence. In many businesses, particularly those which use high-tech equipment, some machines become technologically obsolete in a very short period. In leasing things such as data processing equipment, for example, an arrangement usually can be made with the lessor to replace or upgrade the old equipment. This can be an extremely important consideration in a highly competitive industry.


  • o       Financial Leverage – A major advantage of leasing expensive equipment stems from the fact that a leasing decision typically replaces a large capital outlay with much smaller regularly timed payments. This frees working capital for use in meeting expanded operating costs or investment in other segments of the business operation. Leasing equipment reduces the up-front start-up cost for new businesses.  Viewing the lease strictly as a financing mechanism provides a cash flow advantage over a conventional bank loan financing arrangement. Most equipment leases can be stretched over a longer payment period, reducing the relative size of the monthly payments.  In the United States, the Financial Accounting Standards Board (FASB) requires that all financial leases be capitalized. This means that the present value of all the lease payments must be shown as part of the firm’s debt


  • ·        Income Tax Considerations – If a lease fulfills the Internal Revenue Service’s requirements for a “true lease” from an accounting point of view lease payments are recorded as operating expenses. As long as lease payments exceed the value of allowable depreciation (if the asset were owned), an additional tax shield is provided for the lessee. Comparatively speaking, the amount of taxable income is reduced by the difference between the lease expense payments and allowable depreciation expenses. Therefore, if a lessee plans to obtain this tax benefit, it is important to compare the proposed lease payments with the corresponding allowable figures (if the asset were owned) over the life of the lease to ensure that the anticipated positive relationship actually exists.