IntroductionIn the previous lesson, we looked at how to build a supplier database and assess suppliers already on the books using measures such as OTIF and PPM. This lesson covers the step before that: how to choose among prospective suppliers, what matters in that choice and, first of all, whether to buy from an outside supplier or make the item in-house. Finally, we turn to ethics, because procurement makes more decisions about other people's money than any other part of a company.Sources of supplyThe first step is knowing where to look. The most common sources are:Manufacturers: they usually offer the best prices and technical support, but require larger minimum orders.Distributors and wholesalers: they buy from manufacturers and resell in smaller quantities with shorter lead times, at a price.Sales representatives: they sell on behalf of one or more manufacturers in a given region.Imports: they widen the pool of suppliers but bring exchange-rate exposure, import duties, long lead times and logistics risks.Potential suppliers can be found through the company's existing database, industry directories and associations, trade shows, online business-to-business procurement platforms and referrals from other customers.Before choosing a supplier, a company must make a strategic decision about how many suppliers to use for each item:Single sourcing: one supplier. This gives the company greater purchasing scale and a closer partnership, but leaves it dependent on that supplier if something goes wrong.Dual sourcing: two suppliers, usually a primary and a backup. This is the most common middle ground for important items.Multiple sourcing: several suppliers competing for orders. It works well for standardized items that are easy to source elsewhere (the leverage and non-critical items in the Kraljic matrix covered in the previous lesson).Factors that influence the choicePrice is the most visible factor, but it is rarely the only one or even the most important. The most common considerations are:Total cost, not just the quoted price (see below);Quality: compliance with specifications, quality management systems and certifications such as ISO 9001;Lead times and delivery reliability: how quickly the supplier promises to deliver and its record of keeping that promise;Technical expertise and production capacity: can the supplier handle today's volume and tomorrow's growth?Financial health: a supplier close to bankruptcy poses a supply risk;Location: this affects freight costs, lead times and transport risks;Flexibility: the ability to handle urgent orders and changes in volume;Service and technical support, warranties and after-sales support;Commercial terms: payment terms, price adjustments and minimum orders;Legal, social and environmental compliance: tax and labor compliance and environmental permits. Buying from a supplier that uses forced labor or engages in illegal deforestation exposes the buyer to legal and reputational risks.Total cost, not priceThe supplier with the lowest price may end up costing more. Add up every cost the choice entails: freight, inspection, defective parts, rework and extra inventory needed because of long lead times or unreliable deliveries. This is the total cost of ownership (TCO).For example, a factory uses 50.000 parts a year. Each defective part costs the factory the price of the part plus R$ 5,00 in rework.Cost per partSupplier XSupplier YPriceR$ 10,00R$ 10,60FreightR$ 0,80R$ 0,30Defect rate3%0,5%Expected cost of defects0,03 × (10,00 + 5,00) = R$ 0,450,005 × (10,60 + 5,00) = R$ 0,078Total cost per partR$ 11,25R$ 10,978Supplier Y's quoted price is 6% higher, but its total cost is R$ 0,272 lower per part: 0,272 × 50.000 = R$ 13.600 a year in savings.Supplier P charges R$ 20,00 per part, plus R$ 1,00 for freight, and has a 2% defect rate. Supplier Q charges R$ 20,50 with freight included and has a 0,5% defect rate. Each defective part costs its purchase price plus R$ 10,00 in rework. Which supplier has the lower total cost per part?Answer: Q, at R$ 20,65 versus R$ 21,60 for P — P costs 20,00 + 1,00 + 0,02 × (20,00 + 10,00) = 21,60; Q costs 20,50 + 0,005 × (20,50 + 10,00) = 20,6525, or about R$ 20,65. Choosing P based on its quoted price ignores freight and defects, which together add R$ 1,60 per part.The weighted decision matrixWhen several factors matter at once, the most common tool is a weighted decision matrix. The team chooses the criteria, assigns each a weight (adding up to 100%), scores each candidate from 0 to 10 on every criterion and calculates a weighted average. It is the same idea as the performance index from the previous lesson, but applied before a supplier is hired, using proposals, site visits and samples.Here is an example with three candidates:CriterionWeightAlfaBetaGamaTotal cost35%978Quality25%697Lead times and reliability20%789Financial health and risk10%685Flexibility and location10%869Weighted score100%7,457,707,75Gama's calculation: 0,35 × 8 + 0,25 × 7 + 0,20 × 9 + 0,10 × 5 + 0,10 × 9 = 2,80 + 1,75 + 1,80 + 0,50 + 0,90 = 7,75.On the scores alone, Gama narrowly wins. But two points matter. First, just 0,05 separates Gama and Beta, less than the uncertainty in the scores themselves. In practice, they are tied, so it is worth comparing the criteria one by one. Second, many companies set minimum requirements: for example, a financial health score of at least 6. Under that rule, Gama's score of 5 would eliminate it before the totals were calculated, leaving Beta as the choice. A high average cannot offset an unacceptable risk.With weights of 50% for cost, 30% for quality and 20% for lead time, supplier M scores 6, 9 and 8, while supplier N scores 9, 6 and 7. The company requires a minimum quality score of 7. Which supplier should it choose?Answer: M, because N does not meet the minimum quality score — N has the higher weighted score (0,5 × 9 + 0,3 × 6 + 0,2 × 7 = 7,70, versus 0,5 × 6 + 0,3 × 9 + 0,2 × 8 = 7,30 for M), but its quality score of 6 eliminates it before the scores are totaled. Calculating only the average would lead to choosing N.From candidate to approved supplierIn practice, selection follows a series of stages:Request for information (RFI): a questionnaire to learn about the candidates, including their size, customers, certifications and capacity.Request for quotation or proposal (RFQ or RFP): everyone receives the same specifications and terms so their offers can be compared.Site visit or audit at the finalists' facilities.Sample or pilot batch, tested by the quality and production teams.Approval: the supplier is added to the database as an active supplier and assessed using the measures covered in the previous lesson.Vertical and horizontal integrationBefore deciding whom to buy from, a company decides what to buy and what to make itself. That decision determines how much of the supply chain it controls.Vertical integration means handling in-house stages that could be outsourced: producing raw materials or components, or providing transportation. A classic example is Ford in the early 20th century. Its River Rouge plant in the United States took in iron ore at one end and turned out finished cars at the other. The company even established Fordlândia in Pará in 1928 to produce rubber for its own tires.Horizontal integration takes the opposite approach: a company focuses on what it does best, its core business, and obtains the rest from outside suppliers through outsourcing and partnerships. A well-known Brazilian example is Volkswagen's truck factory in Resende (RJ), which opened in 1996 under a modular consortium model. Suppliers assemble their own modules inside the factory, while the automaker coordinates the operation and oversees quality and the finished product.Vertical integrationHorizontal integrationAdvantagescontrol over quality and lead times; independence from suppliers; protection of proprietary technology; retention of the margin that would go to a supplierfocus on the core business; less investment in assets; greater flexibility to change volumes or technology; access to suppliers' scale and specializationDisadvantageshigh investment; an operation that is costly and hard to scale down; loss of the expertise of specialist suppliers; risk of being left with outdated technologydependence on suppliers; loss of control and technical know-how; the cost of coordinating many partners; risk of information leaksThe trend in recent decades has been toward horizontal integration, but there are limits. Supply disruptions, such as the chip shortage in 2021, have prompted several companies to bring their most critical items back in-house or source them closer to home.Make or buyThe make-or-buy decision applies vertical integration to individual items. It has both a quantitative and a qualitative side.The break-even pointMaking an item usually involves a fixed cost for machinery, tools, supervision and space, but a lower variable cost per unit than the purchase price. Buying avoids that fixed cost but means paying the full price for every unit. The quantity at which the two options cost the same is the break-even point.Cost of making = CF + cv × QCost of buying = p × QSetting the two equal and calling the break-even quantity Qe: Qe = CF ÷ (p − cv)For example, a company buys a part for R$ 18,00. Making it would involve annual fixed costs of R$ 180.000 (machine depreciation, tooling and an operator) and a variable cost of R$ 12,00 per unit (materials and energy).Qe = 180.000 / (18 − 12) = 180.000 / 6 = 30.000 units a year.Make or buy: the two cost lines intersect at 30 thousand unitsAnnual demandCost of makingCost of buyingBetter option25.000180.000 + 12 × 25.000 = R$ 480.00018 × 25.000 = R$ 450.000buy (savings of R$ 30.000)30.000R$ 540.000R$ 540.000either option40.000180.000 + 12 × 40.000 = R$ 660.00018 × 40.000 = R$ 720.000make (savings of R$ 60.000)Below the break-even point, fixed costs make buying cheaper. Above it, the R$ 6,00 saved on each unit covers the fixed costs and leaves a saving.Two qualifications matter. First, a fixed cost belongs in the calculation only if it is new: if the machine already exists and is idle, it will depreciate either way, so that depreciation should not count against making the item. Second, the comparison can include inventory costs. Gonçalves's book gives an example: a refrigerator factory buys 54.000 valves a year at R$ 18,00 each, in economic order quantities of 3.750. It considers making them instead, with capacity for 108.000 a year and a setup cost of R$ 144,00 per production run. Comparing the total cost of its purchasing policy (R$ 977.760 a year) with that of production at the economic production quantity (4.500 units per run), making the valves pays off only if the cost per valve is no more than R$ 18,04. The formulas appear in the lesson on economic order quantity.A company buys a part for R$ 10,00. Making it would require a new annual fixed cost of R$ 90.000 and a variable cost of R$ 7,00 per unit. It uses 20.000 parts a year. Which option is cheaper, and what is the break-even point?Answer: Buy; the break-even point is 30.000 units a year — Qe = 90.000 / (10 − 7) = 30.000. At 20.000 parts, buying costs R$ 200.000 and making costs 90.000 + 7 × 20.000 = R$ 230.000. The figure 12.857 comes from dividing 90.000 by the variable cost, 7, instead of by the difference between the purchase price and the variable cost.What the calculation leaves outThe calculation is a starting point, not the decision itself. Other factors matter:Reasons to make: the item is strategically important or uses technology the company wants to protect; there is no reliable supplier; the required quality is hard to obtain externally; the company has spare machine and labor capacity.Reasons to buy: the item is outside the company’s core business; the supplier has specialist expertise and economies of scale; demand is uncertain or low; the company needs the capital elsewhere; technology changes quickly, leaving the supplier to bear the risk of obsolescence.Ethics in procurementProcurement determines where a large share of a company’s money goes, making it especially vulnerable to conflicts of interest. Ethics in procurement is not a formality: a dishonest buyer can cost a company dearly by overpaying, accepting poorer quality or driving away good suppliers who realize the bidding process is rigged.The most common problemsGifts, perks and invitations: lunch, a trip or tickets to a game. The issue is not necessarily their value, but the sense of obligation they create.Conflicts of interest: the buyer, or a relative, owns a stake in a supplier or receives a commission from one.Information leaks: telling a supplier a competitor’s price so it can beat the bid.Favoritism: tailoring specifications to a single supplier or splitting a purchase into smaller orders to avoid higher-level approval.Bribery: money or another benefit in exchange for an order.How companies protect themselvesA code of conduct with a clear gifts policy (many companies set a maximum value and require every gift to be recorded).Conflict-of-interest declarations from buyers.Segregation of duties: the person requesting a purchase does not approve it; the person buying does not receive it; and the person receiving it does not pay for it.Approval thresholds based on value, with a minimum number of bids required.Rotation of buyers between purchasing categories.A whistleblower channel and periodic procurement audits.What the law saysIn Brazil, several laws directly affect procurement:Law 12.846/2013, known as the Anti-Corruption Law, holds the company (not just an individual) liable for acts against Brazilian or foreign public administrations, such as giving an improper benefit to a public official. Its implementing rules are set out in Decree 11.129/2022, which takes the existence of an effective compliance program into account when calculating fines. It is essential for companies that sell to the government (see the lessons on public procurement).The CLT, in art. 482, item a, lists dishonest conduct as grounds for dismissal for cause. A buyer taking a bribe from a supplier is one example.Agreeing on prices or dividing customers among competing suppliers (a cartel) violates competition law under Law 12.529/2011, enforced by CADE, and is also a crime under Law 8.137/1990. Buyers are often the first to spot the warning signs: bids with suspiciously similar prices, suppliers taking turns to win, or suppliers dropping out without explanation.One rule of thumb sums it up: if you would be uncomfortable seeing your decision reported in the newspaper, or explaining it to your boss and the supplier who lost, something is wrong with it.A buyer receives an invitation from a supplier bidding for a major contract to take an all-expenses-paid trip, described as a technical visit, though the itinerary includes no factory visit. What should the buyer do?Answer: Decline or report the invitation to management and follow the company’s gifts policy, because it creates a conflict of interest — a trip with no technical purpose, offered during a bidding process, creates a sense of obligation. A genuine technical visit paid for by the buying company and properly recorded would be different.ExercisesEasy1) What are the advantages and disadvantages of using a single source, two sources or multiple sources for an item? Give an example of an item for each approach.2) Why is the supplier with the lowest price not always the one with the lowest cost? Construct a total-cost example involving two suppliers.3) Explain the difference between vertical integration and outsourcing, and give an example of each.4) Name three situations that create a conflict of interest in procurement and one measure to prevent each.5) A company buys a part for R$ 8,00. Making it would entail a new annual fixed cost of R$ 40.000 and a variable cost of R$ 6,00 per unit. What is the break-even point?Hard6) Build a weighted decision matrix to choose among three suppliers of a product you know, including at least one disqualifying criterion.7) A part costs R$ 25,00 to buy. Making it would require a new annual fixed cost of R$ 120.000 and a variable cost of R$ 17,00. Calculate the break-even point and determine which option costs less at annual volumes of 12.000 and 20.000 parts.8) A factory uses 20.000 parts a year and is comparing two suppliers. Each defective part costs the factory the price of the part plus R$ 4,00 in rework, while holding a part in inventory costs 25% of its price per year.a) Supplier R: price R$ 15,00, shipping R$ 0,50 per part, 4% defect rate; its long and unpredictable lead times require 1.000 parts in safety stock.b) Supplier S: price R$ 15,80, shipping included, 1% defect rate; its short lead times require only 200 parts in safety stock.Calculate each supplier’s total annual cost (purchase price, shipping, defects and safety-stock holding costs). Which should the factory choose, and how much would it save per year?9) A company buys a part for R$ 30,00 and uses 12.000 a year. Making it would cost R$ 22,00 per unit in variable costs. The accounting department has assigned production a fixed cost of R$ 200.000 a year: R$ 120.000 in depreciation on a machine the company already owns and is not using, plus R$ 80.000 in new expenses (an operator and tooling).a) Calculate the break-even point using the R$ 200.000 fixed cost and state the resulting decision.b) Recalculate using only the relevant fixed cost. State the correct decision and the annual savings.c) Name two qualitative factors that could change that decision.10) A company assigns these weights: total cost 40%, quality 30%, lead time 20% and financial health 10%, with scores from 0 to 10. Its disqualifying criteria are a minimum quality score of 7 and a minimum financial-health score of 6. The candidates’ scores (cost, quality, lead time, financial health) are: K = 8, 6, 9, 8; L = 7, 8, 7, 7; M = 9, 7, 6, 5.a) Calculate each candidate’s weighted score.b) Which candidate would be chosen without the disqualifying criteria, and which should be chosen with them?c) What does the difference between L’s and M’s scores, without the disqualifying criteria, say about how confident the company can be in its choice?Answer Key1) Single sourcing: greater volume, a better price and a closer partnership, but the company becomes dependent on one supplier (example: a custom component made with dedicated tooling). Dual sourcing: one primary supplier and one backup; the company loses some economies of scale but has an alternative if the primary supplier fails (example: a food factory’s main packaging). Multiple sourcing: competition and the ability to switch suppliers easily, but less opportunity for close partnerships and smaller volumes for each supplier (example: office supplies or standard screws).2) Because the quoted price leaves out the costs a supplier choice can create: shipping, inspection, defective parts, rework and extra inventory needed to offset long or unreliable lead times. For example, supplier A charges R$ 50,00 plus R$ 3,00 for shipping and has a 2% defect rate; B charges R$ 52,00 including shipping and has a 0,5% defect rate. A defective part costs its price plus R$ 10,00. A: 50 + 3 + 0,02 × 60 = R$ 54,20. B: 52 + 0,005 × 62 = R$ 52,31. The supplier with the higher quoted price costs R$ 1,89 less per part overall.3) Vertical integration means performing in-house activities that could be bought from suppliers (example: Ford’s River Rouge complex and Fordlândia, which produced everything from steel to rubber). Outsourcing means focusing on the core business and buying the rest from outside suppliers (example: Volkswagen’s modular consortium in Resende, where suppliers assemble their modules inside the factory).4) Examples: accepting gifts or trips from a supplier bidding for a contract (a gifts policy with a maximum value and a recording requirement); a buyer or relative owning a stake in a supplier (a conflict-of-interest declaration and removal from the purchasing process); telling a supplier a competitor’s price (sealed bids, segregation of duties and audits); tailoring specifications to one supplier (review by another department and a minimum number of bids).5) Qe = 40.000 ÷ (8 − 6) = 40.000 ÷ 2 = 20.000 units per year. Below that volume, buy; above it, make.6) Answers will vary. One possible framework: total cost (40%), quality (30%), lead time (20%) and financial health (10%), each scored from 0 to 10; disqualifying criterion: a minimum quality score of 6. Calculate each candidate’s score as the sum of weight × score. Eliminate candidates that fail the minimum before adding up the scores, and compare the remaining candidates criterion by criterion if the scores are close.7) Qe = 120.000 ÷ (25 − 17) = 120.000 ÷ 8 = 15.000 parts per year.At 12.000 parts: buy = 25 × 12.000 = R$ 300.000; make = 120.000 + 17 × 12.000 = 120.000 + 204.000 = R$ 324.000. Buying costs R$ 24.000 less.At 20.000 parts: buy = 25 × 20.000 = R$ 500.000; make = 120.000 + 17 × 20.000 = 120.000 + 340.000 = R$ 460.000. Making costs R$ 40.000 less.8) Defect cost per part: R = 0,04 × (15,00 + 4,00) = R$ 0,76; S = 0,01 × (15,80 + 4,00) = R$ 0,198.Cost per part (price + shipping + defects): R = 15,00 + 0,50 + 0,76 = R$ 16,26; S = 15,80 + 0 + 0,198 = R$ 15,998.Annual cost: R = 16,26 × 20.000 = R$ 325.200; S = 15,998 × 20.000 = R$ 319.960.Safety-stock holding cost: R = 1.000 × 15,00 × 0,25 = R$ 3.750; S = 200 × 15,80 × 0,25 = R$ 790.Total annual cost: R = 325.200 + 3.750 = R$ 328.950; S = 319.960 + 790 = R$ 320.750. Choose S, which saves R$ 8.200 per year despite a quoted price that is R$ 0,80 higher per part.9) a) Difference per unit = 30 − 22 = R$ 8. Qe = 200.000 ÷ 8 = 25.000 parts. At a volume of 12.000, this calculation would suggest buying.b) The idle machine will depreciate regardless of the decision, so that cost is not relevant. Qe = 80.000 ÷ 8 = 10.000 parts. At 12.000: buy = 30 × 12.000 = R$ 360.000; make = 80.000 + 22 × 12.000 = 80.000 + 264.000 = R$ 344.000. The correct decision is to make the part, saving R$ 16.000 per year.c) For example: whether the part uses technology the company wants to protect or there is no reliable supplier (reasons to make); whether the idle machine could be sold or used more profitably elsewhere, or demand is uncertain (reasons to buy).10) a) K = 0,4 × 8 + 0,3 × 6 + 0,2 × 9 + 0,1 × 8 = 3,2 + 1,8 + 1,8 + 0,8 = 7,6; L = 0,4 × 7 + 0,3 × 8 + 0,2 × 7 + 0,1 × 7 = 2,8 + 2,4 + 1,4 + 0,7 = 7,3; M = 0,4 × 9 + 0,3 × 7 + 0,2 × 6 + 0,1 × 5 = 3,6 + 2,1 + 1,2 + 0,5 = 7,4.b) Without minimum-score requirements, K would win. With them, K is ruled out (quality score of 6, below 7) and M is ruled out (financial health score of 5, below 6): L is selected, despite having the lowest weighted score of the three.c) L and M are separated by 0,1, a difference smaller than the uncertainty in the scores themselves. It is effectively a tie, so the decision would require comparing the criteria one by one. The minimum-score requirements show that a high average cannot offset an unacceptable risk.
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