What is a Purchase Order?
A purchase order (PO) is a document that a buyer gives to a supplier, indicating what goods or services the buyer wants to purchase. POs specify an agreed upon quantity and price of the goods. A PO includes all the specific terms of the purchase that the buyer is making as well as when the order is going to be fulfilled.
A PO also serves as an internal document of what has been ordered and notifies a vendor that a customer wants to place an order. If a business is ever unsure about the price they are paying for goods from a supplier, they can always check the purchase order.
A purchase order is considered a legally binding document between both the seller and buyer only once the seller has accepted the terms by signing the document, or otherwise agreeing to accept in writing, or providing the ordered goods.
Purchase Orders Vs. Invoices Vs. Purchase Agreements
Purchase orders differ from invoices in who generates them. A buyer generates a purchase order in order to get what they need from the supplier. The supplier in turn creates an invoice to show how much the buyer owes them. A purchase order is the contract part of a sale, whereas the invoice is the confirmation of the sale.
Meanwhile, a purchase agreement typically involves complex, high-risk transactions (e.g. real estate), whereas a purchase order typically involves simpler purchases or repeated purchases of the same goods (e.g. office supplies).
In addition, unlike a purchase order, a purchase agreement is drafted, reviewed, and negotiated, and then signed (and is effective upon signature). The agreement will have all the information that a PO would have, but it is usually a bit longer and more detailed.
Why Do You Need Purchase Orders?
Some companies might feel like purchase orders are an unnecessary step in their process. This is especially true for smaller businesses because they feel like they already have good relationships with their current vendors. But as a company grows, the need for purchase orders also grows.
Processes for ordering become more complicated and require more people to use their time and resources to sort out the details. This leaves a lot of room for mistakes, which can result in a loss of income for the company or inventory overspend. If a business deals with purchases that don’t have a PO attached to them, it can be hard to figure out where it came from and what the terms of sale are.
Purchase orders provide an audit trail and also give companies peace of mind because they are legally binding. Once a purchase order has been signed, vendors don’t have to worry about whether the buyer is going to fulfill their end of the deal.
The Process of Creating a Purchase Order
Step 1: Create a purchase requisition
This is a document that keeps track of what is being ordered, and it must be approved by a manager before the PO is made.
Step 2: Create the purchase order
Once it is agreed upon which goods are needed, the PO is created. It should contain:
- Shipping info
- The buyer and sellers’ name
- Any discounts
- Item numbers
- Quantity
- Purchase order number
POs can be transmitted through paper or electronically. For the former, a purchase order is physically sent to the supplier, who then manually transcribes the order into an enterprise resource planning (ERP) system. It is more common for businesses to transmit POs through Electronic Data Interchange (EDI).
EDI refers to the computer-to-computer exchange of documents, which is more efficient and more accurate. When transmitting POs through EDI, the order is sent electronically and automatically placed within the supplier’s ERP or material requirements planning (MRP) system.
Step 3: The seller accepts or rejects the purchase order
There will be a line for the seller to sign off approval at the bottom of a purchase order. It’s common for businesses today to use electronic POs and thus, eSignatures. Prior to signing, the seller maintains the right to reject the document if they feel that the terms aren’t fair. After the PO is signed, it becomes legally binding for the buyer and seller.
Step 4: Fulfill the purchase order
The PO will remain open until the order has been received and will only be closed after all the goods have been delivered.
What is Three-Way Matching in the PO Process and Why is it Important?
A three-way match is an important technique used often in the PO process. This method ensures that only valid and accurate vendor invoices are recorded and paid.
The three-way match includes the following:
- Company purchase order: What the company had ordered and at what cost
- Company receiving report: What the company received
- Vendor invoice: What the vendor billed the company
When the details on all three of these documents match, then and only then will the invoice be entered into the AP account and scheduled for payment.
Three-way matching is used to mitigate the acceptance of fraudulent invoices. For example, one person will prepare the company’s purchase orders while another prepares the company’s receiving reports. A third person should compare each PO, receiving report, and vendor invoice.
However, the three-way match method is not always a viable option. Occasionally, vendor invoices do not have purchase orders or receiving reports. For example, a company doesn’t often issue a purchase order for electricity, as it will be billed based on usage rather than a pre-established amount. The same is true for water, telephone, and natural gas payments.
The three-way matching process is important and helpful, but it can be extraordinarily time-consuming. The process can cause delays in payments that annoy suppliers while compromising the company’s ability to take advantage of early payment discounts.
How to Budget for Purchase Orders
Before creating a purchase order, a business should analyze its projected supply and demand. Businesses don’t want to fill out a purchase order for more than they can reasonably sell because this can result in excess costs or inventory. Once a business can accurately predict the amount of inventory it needs on a monthly basis, it can craft purchase orders for a reasonable amount of inventory within its budget.
Tip: Designate certain people as approvers who maintain your business’s budget and keep it in the green. If someone goes over the budget, make sure they know that they are only to purchase what is needed immediately for the company.
Offering Volume Discounts
Sometimes when a business submits a purchase order from the same vendor multiple times, a business may be able to get a volume discount. This means that if a business purchases a large enough amount, the supplier might reduce the price. If a vendor agrees upon a volume discount, make sure it is explicitly stated on the purchase order.
How to Automate the Purchase Order Process
Is your business making POs with Word docs or PDFs and storing them on a cloud storage service? Relying on such manual purchase order processes can require regular maintenance and organization, slowing down business significantly.
With an automated system, your team can store, search, and organize all documents in one place, and it’s easier to turn purchase orders into invoices.
Creating a Purchase Order Template
If you’re new to the world of purchase orders and need a good place to start, we can help! Check out our free purchase order template to instantly create your first purchase order on us.
How Settle Can Help
Settle's purchasing feature gives you access to end-to-end support that can take the load off your plate. You can store and update all your purchasing, bill, and payment data on our intuitive all-in-one platform, save time by creating POs within minutes and emailing them to vendors automatically, and prevent fraud and overspending by using our side-by-side comparison to 3-way match between POs, receipts, and bills. See how easy it is to use Settle for POs by giving it a spin for yourself - get started with unlimited free POs.
Sources:
- https://corporatefinanceinstitute.com/resources/knowledge/other/purchase-order/
- https://www.ownr.co/blog/purchase-order-po/
- https://vendorcentric.com/single-post/when-does-it-make-sense-to-use-a-purchase-order/
- https://www.legalzoom.com/articles/purchase-order-vs-purchase-agreement
