Complete Guide to Purchase Orders & PO Systems
At some point, a business will have to purchase products or services from another company. This can be anything from raw materials needed for production, supplies for office work, or services needed to run the business. Many small businesses typically start out with verbal agreements to conduct these transactions. But at some point, companies are going to ask for more official documentation in the form of purchase orders.
A purchase order (PO) is a legally binding contract or document sent by a business to procure the products and services of a seller or supplier. From a financial perspective, using purchase order documents allow businesses to keep track of and control spending. On the inventory side of things, purchase order systems play a crucial role in monitoring the influx of goods such as raw materials and supplies.
What Information Does a Purchase Order Carry?
A standard purchase order document will generally include the following information-
- Type of item(s) or service(s) being purchased
- Quantity of items purchased
- Unit price and total price of items or services ordered
- Delivery date and location
- Company billing address
- Payment terms (e.g., upon delivery, in installments)
- Supply chain management
- Expense management
- Tracking PO processing costs
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4 Types of Purchase Orders
While the purpose of the purchase order remains constant, there are 4 main types of purchase orders depending on the occasion.
1. Standard purchase orders
This is the most commonly used type of purchase order and is utilized when the buyer (the business) knows all of the details pertaining to the purchase. The business must be able to identify the item or service they require as well as the quantity, delivery timeframe, and payment terms.
2. Planned purchase orders
These purchase orders are based on estimations of future business needs and are submitted in advance. In order to create a planned purchase order, the buyer must be clear on what item or service they require, the price, and the payment terms. However, the quantity is based on an estimated figure and the delivery timeframe is unconfirmed.
3. Blanket purchase orders
These purchase orders are used when businesses place multiple orders at once in order to attain or negotiate a discounted price. The blanket purchase orders are most commonly used when placing bulk orders.
4. Contract purchase orders
This is the most formal variation of the purchase order and provides the most legal protection for all parties involved. In this situation, the business and vendor agree to a contract, which details the purchase term condition before the purchase order is created.
How Does a Purchase Order Work?
Different companies often have different ways of processing purchase orders. For example, according to a report by CAPS Research, the responsibility of approving purchase orders can fall on the supply management team (84%), the budget owner (54%), or the finance department (21%). A small percentage of companies (8%) don't even have a chain of responsibility for purchase order approvals.
Still, most organizations follow the same lifecycle when creating and managing purchase orders.
The requisition stage involves identifying a business need that can be fulfilled by purchasing goods or services. For companies with dedicated procurement departments, this step typically involves acquiring quotes from multiple suppliers and negotiating prices.
The second step involves the approval of the purchase order. As mentioned earlier, this process ultimately depends on the company's structure and methods. Research by Coupa shows that PO approval requests are typically approved by individual department managers (34%), a dedicated procurement manager(s) (31%), or some combination of the two (27%).
3. PO processing
This stage is where the actual creation of the purchase order happens. Depending on the business's adoption of technology, POs can be created and sent to suppliers manually, semi-manually, or on a fully-automated basis. Most small businesses start out manually with paper-based purchase order forms. However, this quickly becomes inefficient as the business grows. In contrast, automated procurement software creates and sends POs automatically to the supplier's preferred platform.
At this stage, the supplier acknowledges receiving your request by agreeing to the terms of your purchase order. However, there are unforeseen circumstances that leave suppliers with no choice but to ask for new terms. When this happens, the PO can be changed through a change order process.
5. PO change order
Both the buyer or supplier may initiate a change order process. On the supplier side, a change order can happen due to incorrect pricing, stockouts, discontinued items, or disagreements over the items in the purchase order. On the other hand, buyers typically request a change order due to an incorrect unit of measure (UOM) being used in the purchase order.
Best Practices for Handling Purchase Orders
While the purchase order process sounds simple enough, human errors can still occur. Therefore, it's important to follow best practices for managing PO's.
- Invest in technology - Technology adoption is something businesses of all sizes struggle with. At the enterprise level, for example, only a third of procurement leaders have adopted modern technologies such as collaboration networks and predictive analytics, according to a study by Deloitte. Still, baby steps are better than inaction. Consider investing in the best purchase order management system you can afford.
- Order in bulk - Buying in bulk is a tried and proven tactic to leverage economies of scale. When done right, it allows businesses to reduce the cost per unit of their purchase. However, the catch is having to spend more money upfront. Consider doing this only if your business is stable enough.
- Be timely - Time is money. Make a habit of processing and sending purchase orders in a timely fashion. The sooner suppliers get your purchase orders, the sooner they can begin processing the purchase. On a separate, but related note, automated purchase order systems allow purchasing teams to save time by eliminating routine tasks, such as manually filling out forms and sending POs via email.
- Get employees involved - Rather than silo the procurement process in one team or department, consider introducing a purchase order management system that allows employees to send purchase requests for the supplies they need at work. Apart from empowering them, giving teams access to the procurement process provides them more insight into the flow and cost of operating the business.
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Common Purchase Order Management Mistakes
Oftentimes, it's easier to know what not to do than what to do. Just as there are best practices when it comes to purchase order management, there are also common mistakes worth keeping in mind.
Not comparing suppliers - As a business uses certain suppliers more frequently, its procurement team will come to depend on these companies out of convenience. But what often happens is that the team forgets to check what deals other suppliers may have. This can be a costly mistake when purchase orders involve large sums of money. Always remember to check and compare prices, rates, and deals between suppliers.
Ignoring suppliers' suggestions - Suppliers are likely to know their products better than you do. Don't ignore any advice they might give about things like handling, storing, and even saving money when buying their products.
When it comes to service providers, it's a good idea for procurement teams to listen to their recommendations about which services match the company's immediate needs. They can compare this with their own research. Bottom line? It never hurts to listen to suppliers.
Not negotiating prices - Supplier prices are rarely if ever, set in stone. Even if a supplier's quoted price stays fixed, failing to negotiate means robbing the company of an opportunity to save money. Remember, buyers and sellers ultimately want the same thing. Just as buyers want to spend as little as possible, suppliers also want to save money by retaining customers. In fact, increasing customer retention rates by just 5% can increase profits by up to 95%.
Procurement agents can convince suppliers to tinker with prices by communicating a willingness to be a long-term customer.
Not being dynamic - To remain competitive, businesses must anticipate what the market could look like in both the near and far future. This might mean looking at emerging suppliers with innovative solutions or preparing for the next technological disruption.
For example, according to Deloitte, 33% of procurement leaders believe their digital procurement strategies will allow them to achieve their objectives and drive value. For the average business, this represents a clue of the direction procurement processes are going.
Isolating procurement teams - Creating a procurement team is one thing, but completely isolating them from the rest of the company is another. Procurement is a collaborative effort that covers the entire business - more so if the purchase involves supplies or services vital to the work being done by multiple teams.
Procurement agents need to engage managers or departments to understand their needs and find out how and why the items or services being ordered benefit them.
Are Purchase Orders Only for Large Businesses?
As you grow your business, your suppliers, dealers, and vendors will eventually want something more official than handshakes and informal arrangements. Unspoken agreements might seem convenient at first, but what happens during a dispute, an issue about payment, or disagreements about performance and quality standards?
This is where purchase orders come in. They not only convey information to suppliers, but they also serve as legal documentation for both parties. And any business, regardless of its size or number of locations, will eventually need a system for recording all of its past and future purchase orders.
Automated Purchase Order Systems to the Rescue
Research by CAPS shows that 96% of companies now use enterprise resource planning (ERP) software to create standard purchase orders. In contrast, only 17% of companies still use a paper-based manual purchase order system.
Perhaps most interesting is that nearly half (47%) of companies that rely on ERP software now report using automated systems to create POs. Here are a few reasons why these businesses are going this route.
Lower processing costs per purchase order - Every minute an employee spends creating a purchase order manually is time they could have spent on more important and strategic tasks. And the more complex a purchase order is, the more time and people are needed to write up, review, and send the document to suppliers.
For example, in the engineering and construction sector, the average processing cost of a purchase order is $1,226. Automated purchase order systems solve this problem by eliminating tedious and repetitive tasks, allowing procurement agents to focus on other work.
Higher levels of productivity - Manual purchase order systems also introduce wastage along the supply chain. The risk of human error, for one, can mean spending more time cleaning up messes with change orders, which, in turn, results in time and money wasted. Software fixes this problem with accurate data entry and automated sending of POs to suppliers.
Lower risk of fraud - Procurement fraud is a problem that costs government agencies and institutions hundreds of millions of dollars each year. In the UK, the country's National Health Service lost more than $300 million in 20152016 to procurement and contracting fraud.
For businesses, the risk of fraud stems from weaknesses in purchasing controls, which can introduce cash leakage and billing schemes that let unscrupulous individuals siphon cash out over extended periods of time. A secure purchase order system plugs these weaknesses by tracking suspicious activity, such as sudden increases in purchases, POs with vague descriptions of items, or POs written out to new vendors with little to no background information.
Granular visibility - While paper-based purchasing systems leave a trail of forms and documents that procurement teams can follow, going through these files will naturally take time. This means that businesses with manual purchase order processes often have limited visibility of their company spend.
With automated purchase order systems, procurement teams can drill down to the line item level of their POs. This allows businesses to detect trends in spending and plan budgets more efficiently while increasing the accuracy of the purchasing process.
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