An efficient purchase order (PO) system can also give employees and finance teams keep tabs on pending and future purchases before any additional money is committed or spent.
In this blog, we explain what purchase orders are, how they work, and how to create an efficient PO system that works perfectly for your needs.
Table of Contents
- What is a Purchase Order?
- How do Purchase Orders Work?
- What Does a Purchase Order Contain?
- What Do Purchase Orders Look Like?
- Purchase Order vs Invoice: What’s the difference?
- Is a Purchase Order a Contract?
- The Benefits of Using Electronic Purchase Orders
- The Pros and Cons of Using Purchase Orders
- Should You Use Purchase Orders in Your Business?
It seems logical to start this guide off by answering a simple question: what is a purchase order? Here’s what you need to know.
Purchase orders (POs) are documents sent from a buyer to a supplier with a request for an order. Each PO will outline the specifics of a purchase request, including an order description, quantity of items, and the agreed-upon price and payment terms. They also identify the purchase order (PO) number.
When a seller – like a supplier or a vendor – accepts a purchase order, a legally binding contract is formed between the two parties.
Although purchase orders add a few extra steps to the purchasing process, they help to ensure a smooth transaction between the buyer and the seller. They also help reduce the risk of fulfilling an incomplete or incorrect order. In short, these documents are an opportunity for the buyer to clearly and explicitly communicate their request to the seller.
Also, if the buyer refuses payment upon delivery of a good or service, the seller is protected; the PO acts as a binding contract between both parties.
Lastly, some commercial lenders will use purchase orders as a reference to provide financial assistance to an organization.
In order to streamline the purchase of resources a company needs to do business, a PO needs to follow a strict step-by-step procedure known as the purchase order process.
In this section, we’ll explain who and what is involved in this process within an organization.
The purchase order process is the journey a PO takes from creation through to closure and everything in between. Depending on the nature of a company (size, industry, human resources, organizational structure, the goods and services it is acquiring, etc), the purchase order process can also be modified to include additional necessary steps like quality checks, budget approval, contractual approval, and more.
Here are the steps in the purchase order process:
- Create a PO
- Approve a PO
- Send a PO to the vendor
- PO Received (Binding Contract)
- Receipt of Goods or Services
- 3-Way Matching
- Authorize and Arrange Payment
- PO Closure
Let’s break these steps down in detail.
1. PO creation
When a company (i.e. the buyer) decides to buy a product or service, it creates a purchase order that details what is being requested from the seller, along with pricing and payment terms.
2. PO approval
Before a PO can be sent, it needs to be approved. A company’s approval process will dictate who, within the company, is required to approve a PO before it is sent to the supplier.Modern companies tend to facilitate this step by requiring (and approving) purchase requisition first. This process eliminates the need for PO approval, and streamlines the process for the purchasing team.
3. PO sent to a vendor
Once approved, the PO is sent to the seller. For software companies that buy online, this step might seem redundant. However, POs also serves as an internal document that streamlines reconciliation for the accounting team once the invoice is received. So while it isn’t mandatory to send the PO to the vendor, it’s still good practice to keep it for internal purposes.
4. PO received [binding contract]
The vendor/seller receives the order. Once the vendor tells the company that it can fill the order, the purchase order becomes a binding contract. E-procurement tools like Procurify offer to send POs through an online procurement system, which makes it easier to track that emails with POs were both sent by the company and received by the vendor.
5. Receipt of goods or services
The seller ships the order, attaching the PO number to the packing list. This helps the buyer know which order has arrived.
The seller also invoices for the order, making sure to include the PO number to the invoice.
7. Three-Way matching
The company uses 3-way matching to confirm that the PO number and order details (quantities and prices of the goods and services ordered) match up on the Purchase Order, Invoice, and Packing Slip.
8. Authorize and arrange payment
Provided everything checks out and the company is happy with the order, the company approves the invoice and arranges payment to the seller (as per the agreed-upon payment terms).
9. Purchase order closure
When the above steps are completed, mark the PO as closed.
The buyer is responsible for creating and issuing a purchase order. In larger companies, a procurement or purchasing department will typically issue the purchase order. In smaller companies, the business owner, operations manager, or financial manager may issue the purchase order.
It’s also important to note that the role of creating and issuing a purchase order can be designated to a central purchaser for a specific team. For example, in a software company, an office manager can create purchase orders.
Ultimately, who issues the purchase order comes down to how a company decides to set up its purchasing process.
One or several people can approve purchase orders depending on the purchasing process that’s in place. In larger companies that have defined purchasing processes, purchase order approvals are typically structured around locations and departments, with specific dollar thresholds attached.
For example, if a digital marketing manager in a software company is requesting a new ad budget, the purchase order approval routing could include a marketing director and a CFO (or another role in charge of the company budget).
In smaller companies, CFO or CEO could be the final approval for any kind of spend, which can result in approval bottlenecks.
Generally speaking, here’s what a purchase order contains:
- Product(s) or service(s) being purchased
- Quantity purchased
- Specific brand names, SKUs, or model numbers
- Price per unit
- Delivery date
- Delivery location
- Company billing address
- Agreed payment terms (e.g. on delivery, in 30 days, etc.)
These items can be a strict requirement or an option, depending on a company’s procurement and purchasing workflows. In addition, purchase orders can be customized to suit the needs of a business, so this list is not exhaustive.
With e-procurement software like Procurify, you can add account codes in the requisition phase. Adding this information will streamline the reconciliation process and make it easier to transfer information to your accounting system.
Companies typically have a standardized PO document with stock information to ensure consistency.
If you’re new to using POs, you might be wondering: how are they different from an invoice? Well, these documents are created by different team members and oftentimes, different departments.
Buyers create the PO and send them to vendors. In turn, this prompts the vendor to accept the PO and send an invoice back to the buyer.
It’s common for the PO and the invoice to contain similar details. The invoice generally references the PO number, along with an invoice number, to confirm that both documents contain the same information and correspond to each other.
Here’s a handy table that explains the key differences between purchase orders and invoices:
|Who creates it?||Buyers are responsible for creating POs.||Vendors are responsible for creating invoices.|
|When to send?||Must approve and send to the vendor prior to purchase, or kept for internal record.||Create and send an invoice once payment has been received.|
|What information does it contain?||– Details of what’s being purchased (products/services, and the requested quantities)
– SKUs, model numbers, and brand names of each item
– Delivery date
– Delivery location
– Billing address
– Payment terms
|– PO number
– Invoice number
– Itemized breakdown of the order with the cost
Here’s an example to help you understand how to use a PO and an invoice in the purchasing process:
David is an IT Manager at a software company. He needs to purchase some laptops for new hires. So he creates a PO that outlines the quantity and specific requirements of what’s needed (number of laptops, laptop models, etc.).
The company responsible for selling the laptops receives the PO. Once they confirm they are able to supply the laptops with the required specifications, they fulfill the order. The laptops are shipped with a delivery date and an invoice is sent back to David, the purchaser.
When the laptops are received, David verifies the delivery.
Sarah, the company’s accounting manager, will then perform a 3-way match once the invoice is received. Provided everything matches up, Sarah can submit the invoice for approval and then pays the seller.
Once complete, it’s important to mark the PO as closed and the invoice as paid.
Yes, when accepted by a vendor, a purchase order is a legally binding contract.
Vendors “accept” a purchase order by telling the buyer that they can fulfill the order. Vendors can “reject” a purchase order by telling the buyer that the order cannot be completed.
Alternatively, if Request for Quotation (RFQ) is part of the process, the vendor can simply not accept the RFQ to indicate that they cannot fulfill the order.
If you’re using paper-based POs, you’re creating more work for yourself than you need to. And you’re opening yourself up to a range of potential errors that can easily be avoided by switching to electronic POs.
E-procurement platforms like Procurify can streamline company purchasing and provide greater transparency into every stage of the purchasing process.
Here are the benefits of switching to an electronic purchase order system and e-procurement software:
1. POs are centralized
All company POs are created and managed in the same online platform. Teams and managers get full visibility into what stages the POs are at, in real-time. Because e-procurement software lives in the cloud, POs are stored securely, yet remain accessible from any location at all times.
2. Speed up the PO approval process
Approving team members are notified immediately when a purchase request is submitted in the system. With a paper-based system, approvals can be dragged out and cause unnecessary bottlenecks.
3. Better visibility into the budget
Purchasers and procurement managers know what’s coming down the spend pipeline. Pending but not-yet-approved purchases are known and taken into account before additional spending is approved.
4. Avoid unnecessary expenditure and fraud
Because they offer better approval systems and automated 3-way matching, e-procurement platforms can reduce the chances of your company paying for things that haven’t been received. They also make it easier for teams to spot fraudulent invoices prior to payment.
5. Efficient record-keeping, less room for an administrative error
Good record-keeping is essential for purchasing and procurement. It’s easy to lose, damage, or accidentally destroy paper-based records. It’s often hard to spot duplicate requests, purchases, invoices, or missing transactions — all of which can cost your company time and money. Using paper also requires an efficient and regularly updated filing system which consumes space and man-hours in order to work effectively.
All of these problems are eliminated with digital records. And when POs are stored and managed in the cloud, more than one person in the finance team can have easy access to all the POs, not just the person on whose desk the paper PO lives.
Less paperwork means a better carbon footprint for your company.
POs are important because they can help companies:
- Avoid duplicate orders
- Avoid surprise invoices
- Track incoming orders
- Catch unexpected pricing increases
- Improve financial and inventory accuracy
- Comply with auditing requirements
- Get better with budgeting, as funds must always be available before a PO is approved
- Improve (and even speed up) delivery times, as POs help to schedule delivery for whenever the buyer needs it
- Ensure clear communication with vendors
- Act as legally binding documentation
However, it’s important to assess your company’s specific needs before introducing a purchase order system as there’s an administrative downside to using POs.
The drawbacks of using POs include:
- POs create additional paperwork, which can be annoying for smaller purchases and time-consuming for smaller teams
- Although they don’t act as a legal contract between the vendor and the supplier, credit cards can replace POs to help with record keeping and documenting purchases. (Keep in mind, if a company does use credit cards for purchasing, POs can facilitate the credit card reconciliation process for the accounting team.)
Using purchase order forms can help a company shift its spend culture from a reactive state to a proactive state. So should you use purchase orders in your business or not?
To answer this question and create an approach to purchasing that works for your company, you’ll need to take a step back and observe how your organization is currently handling purchasing.
POs give you insight into your company spending. They help team members make purchases efficiently and streamline the purchasing process. They also help accounting teams reconcile spending.
Here’s what you should assess before you integrate a purchase order system in your company.
Purchase requisitions: helpful or not?
Assuming your organization doesn’t currently use purchase orders, it is also likely that you’re not managing the requests your team members make when they want to purchase something. Most organizations simply allow their employees to email a manager their request and then have that person make the necessary purchases.
An informal purchasing approval process probably isn’t an issue if your company is small and employee spending isn’t exceeding your budget. But as your company grows and more employees start purchasing goods and services, the need to have tighter control on company spending will arise. This is where purchase requisitions will come in handy.
Requisitions are a purchase order request your employees make for materials or items they need to do their job. The approval or denial of a PO happens when an employee sends the request to their manager, or directly to the procurement team.
By formalizing the process of requesting to purchase something, you can eliminate excessive and unnecessary expenditures and get your company spending under control.
Keep in mind, introducing purchase requisitions is that it adds yet another step in the purchasing process. So consider if the benefits outweigh this drawback before moving forward.
If getting your budgets under control is a priority for your company, you should know that adding PO requests creates two important benefits—the ability to manage a budget for employee spending and the opportunity to take advantage of volume discounts on large orders.
As employees begin to draft purchase requisitions, you’ll be able to create an average monthly spend and track what your employees are purchasing. This means you can start analyzing how they use supplies and identify opportunities for savings. An approver will be the person managing the budget. If employees go over budget, the approver may not approve all the purchase requisitions that are not immediately necessary.
Is there a chance that bulk purchasing could get you better discounts from vendors? If so, POs and purchase requisitions are likely going to be helpful.
Once your employees begin submitting purchase requisitions, the approver can also easily identify purchasing patterns. The approver can then submit bulk orders and request discounts to vendors. If the requests is digital, it can significantly reduce processing time because employees can add frequently requested items to a catalog from the best supplier at the best price.
Is purchasing getting out of control? Do you have clear, transparent insight into who’s buying what, and which vendors you should be buying from? Can you access real-time financials that tell you how much you (and your employees) can spend on purchases at any given moment in time?
Your answers to these questions will provide clues on whether you need a purchase order system in your business.
If the answer is yes, then we’ve got good news: creating a purchase order process is likely as simple as contacting suppliers and informing them that from now on you’ll be submitting a PO before sending payment for goods. The supplier will likely be happy about this because it will significantly help both parties.
The purchaser will complete a PO and send it off to the vendor once the approver has a request to fulfil. The vendor, if necessary, will communicate any concerns or issues with the purchase, otherwise, they will ship the product and invoice once payment is received.
Introducing a PO process is even easier for you, your employees, and your vendors when you use e-procurement software.
Many organizations avoid using purchase orders because they don’t want to deal with extra paperwork or slow their existing processes down. But unless your business is small and makes just a few purchases from a handful of vendors each month, you’re probably not leveraging the many benefits that a purchase order system can bring to your company and its bottom line.
A PO provides a legal document and concrete instructions for the vendor, as well as a concrete audit trail that can be used as a point of reference for when things go wrong.