As a small business owner, ordering raw materials and tracking inventory may not be your favorite thing to do, but these tasks play an essential role in how a company operates. Purchase orders (POs) are crucial for a well-managed purchasing process, because they can help your business streamline the process of acquiring goods and services, take control of spending and develop a proactive spend culture that improves the bottom line. A structured PO system also allows you to keep tabs on pending and future purchases before any additional capital is spent or committed.
What a Purchase Order Is
A purchase order is a document sent by a buyer to a seller with a request for an order. It typically outlines the type and quantity of products being requested, a PO number and the agreed-upon price and payment terms. Once the supplier or vendor accepts the PO, a legally-binding contract is formed between the two parties.
While creating POs may seem like a tedious task, they help ensure smooth transactions between a buyer and seller. POs remove all ambiguity, which reduces the risk of incorrect or incomplete orders being fulfilled. And in case the buyer refuses to pay after delivery of goods or services, a PO protects the seller because of its legal nature.
In addition, commercial lenders sometimes use POs as a reference to provide financial aid to a company.
A PO usually contains:
- PO number
- Date of issue
- Date of delivery
- Delivery location
- Products or services needed and quantity of each
- Price for each product or service per unit
- Product details, such as brand names, model numbers and SKU numbers
- Business information, including company name, contact information, shipping and billing addresses
- Agreed upon payment terms, such as delivery in 30 days, payment upon delivery or a specific payment date
There are four main types of purchase orders:
- Standard POs: A standard PO is commonly used for infrequent, irregular or one-time procurements. It usually requires detailed specifications of the items for purchase, along with their pricing details, quantity and timeframes for delivery and payment.
- Planned POs: Similar to a standard PO, a planned PO is extremely comprehensive. A planned PO contains full details of the goods and services to be purchased along with their pricing details. While the dates for delivery and payment are included in a planned PO, these are considered to be tentative dates. Once a release against the planned PO is issued, the individual order is said to be placed.
- Blanket POs: This type of PO involves a buyer agreeing to purchase specific goods or services from a particular vendor or supplier, but without mentioning any specific quantity. A blanket PO also may or may not confirm pricing details for the order. This type of PO is often used for repetitive procurement of specific products or services from a seller, such as basic supplies and raw materials.
- Contract POs: A contract PO is formed in order to create an agreement and terms of supply between a buyer and a seller as the basis for an ongoing commercial relationship. It carries the vendor’s details and likely also delivery and payment terms. The items to be purchased are also not specified. To place an order, the purchaser can refer to the contract PO and generate a standard PO.
How A Purchase Order Works
The process for building a PO begins with its creation and ends when the goods or services are delivered. The process can be modified to include such additional steps as budget approval, quality checks, contractual approval and so on, depending on the nature of a business (the goods and services being acquired, industry, size, organizational structure and more).
Here are the nine typical steps in the PO process:
Step 1: Buyer Creates PO: When a purchaser decides to buy something, they create a PO that includes products or services being requested from the vendor, along with their pricing and payment terms.
Step 2: Buyer Approves PO: The PO must be approved before it can be released. The approval can be given manually by the person assigned to do so, or the business can facilitate the process of PO approval by requiring (and approving) purchase requisitions first in order to eliminate the need for PO approval and streamline the PO approval process for the procurement team. (Purchase requisition is a document used to inform the purchase officer or department of the decision to purchase so they can begin the process. It also helps the finance team coordinate its reporting strategy with the accounts team.)
Step 3: Buyer Sends PO to Vendor: After approval, the buyer sends the PO to the seller.
Step 4: Vendor Receives PO: Once the supplier receives the PO, they confirm to the buyer that they can fulfil the order, and the PO becomes a legally-binding contract.
Step 5: Vendor Ships Goods or Services: The seller ships the order and also attaches the PO number to the packing list, so that the purchaser can identify the order.
Step 6: Vendor Invoices the Buyer: The vendor invoices the buyer for the order, ensuring the PO number has been added to the invoice.
Step 7: Buyer Carries out Three-Way Matching: The three-way matching system uses three documents (PO, vendor invoice and receiving document or packing slip) to triple-check the order. The buyer uses the three-way matching process to confirm whether the PO number and order details match with the PO, invoice and packing slip. It also allows the buyer to correct mistakes or oversights.
Step 8: Buyer Authorizes, Makes Payment as Per Terms: As long as everything checks out and the buyer is satisfied with the order, they approve the invoice and arrange payment to the vendor (according to the agreed-upon terms of payment).
Step 9: Both Parties Close PO: Both parties mark the PO as closed.
Note: Buyers can also create special orders for recurring purchases or large shipments. A standing PO allows them to purchase the same items several times using the same PO number. A blanket PO, on the other hand, serves as an agreement between both the buyer and seller for multiple deliveries for a set price, over a defined time period.
The Pros and Cons of Using Purchase Orders
Here are four ways POs can help growing businesses:
1. POs provide legal protection: POs bring buyers and sellers together in a mutually-binding contract and serve as a legal document. Once the supplier receives and approves a PO, both parties are legally bound to honor the deal.
2. POs make orders easier to track and avoid duplication: POs help the purchaser efficiently account for all the goods and services their company has ordered, keep tabs on how they are paying for those orders and track their deliveries. The PO number, which is assigned to each PO, helps them easily track the orders they’ve placed, similar to how invoice numbers help manage invoices.
Additionally, when the purchase requests grow in volume, it can get extremely tough to determine the status of who ordered what, when and from whom. This can cause duplicate orders to reach the vendors. POs can help curb confusion by reducing duplicate orders, especially if software is used for PO management. PO management software creates a searchable record of every order, while providing complete clarity into spending for fewer errors.
3. POs help avoid audit issues: In case of an audit, POs serve as a conclusive audit trail and provide an easy way to cross-check invoices and packing slips for the auditors.
4. POs make life easier for suppliers: With a PO in place, the vendor is more likely to ship the goods faster and without any errors.
Now, check out a few cons of POs:
- Paperwork can get monotonous: Most buyers use a set template for issuing POs, which require only changing the date and order details. This process can get repetitive and tedious after a while.
- POs are not always practical for smaller orders: Businesses usually don’t issue POs for small purchases, and use credit cards instead. This is because POs can turn out to be expensive for small-volume orders and credit card statements can provide documentation for small orders. However, credit card statements do not include the same details offered by a PO.
Best Practices for Purchase Ordering
Every company has its own approach to procurement activities. However, these best practices can serve as a handy reference when outlining procedures for more specific purchasing scenarios. These guidelines can also be used to train new staff members in vendor management, selection and negotiation.
- Maintain a database of all vendors your company has ever ordered from. Accessible and clear records help streamline procurement activities, making it easier and faster to choose a vendor. A database also allows you to create POs much faster.
- Prepare budget-related expense restrictions by classifying the goods and services required for inventory stock management, separating purchases into such categories as office supplies, manufacturing equipment or other components. This helps improve cashflow tracking and set caps by expense category.
- Set up a purchase-approval system in order to prevent financial mismanagement and control costs. This can keep purchases from getting out of hand, especially if a duplicate order is placed.
- Have well-maintained records and documentation for auditing purposes. Records must be filed properly so that all documents pertaining to a PO are filed together correctly, providing a clear record of the transaction. Data security is crucial to avoid documentation being intentionally or unintentionally misplaced, altered, destroyed or deleted.
- POs should be checked for quality in order to reduce errors and ensure that all components of the POs have been accurately completed.
- Purchase ordering must have a clear cancellation process. In case of a cancelled PO, there should be proper communication, authorized by an approved signatory. Cancelled orders should be filed with the other documentation related to the order.
How a PO Is Different from an Invoice
A PO is issued by the buyer in order to ensure they get exactly what they ordered and on time. An invoice, on the other hand, is issued by the seller in order to make sure they get paid for the goods supplied.
The buyer sends a PO to the seller, outlining exactly what the order should contain and when it should be delivered. It includes such components as a detailed description of all items, quantity, prices and payment terms, among other details. And a vendor sends an invoice to the buyer once the buyer approves the purchase.
When creating an invoice, the supplier typically includes the PO number mentioned on the original PO, so that finance teams can match the information on both documents.