Purchase Orders – Introduction to Fundamentals
Purchase orders are requests to a seller to provide a certain product or service. Purchase orders are a business tool to control both physical and financial outcomes related to operational activities. For publicly traded entities, they are required as a function of internal controls to minimize fraud. With small business, purchase orders are used to comply with budgets, document project work and provide management with the corresponding physical and financial status of the company. Purchase orders have many advantages, but don’t kid yourself, there is one disadvantage, they are a lot of work to keep track of them and ensure performance in accordance with the original intention. In effect, it costs money via administration to track them properly. Thus for small operations, purchase orders are not necessary.
This article is an introduction to purchase orders and their fundamental operational processes. It starts by explaining the purpose of purchase orders and continues by explaining how they work. In addition, this article will finish up with a set of parameters that warrant implementing purchase orders in your business. Other articles on this site cover purchase orders in more detail including proper bookkeeping of purchase orders.
Purpose of Purchase Orders
The primary use of purchase orders is to comply with budgets, i.e. limits for respective functions. Similar to how governments encumber funds to purchase products or services to perform their legal duties, private enterprises use purchase orders to comply with budgeted amounts associated with their respective functions. As an example, the company’s budget may limit office supplies to a certain maximum sum. Purchase orders are used by the office staff to buy the necessary supplies or technology to fulfill their respective purpose. A purchase order can not be issued for an amount that exceeds the respective budget amount authorized for that particular function. In effect, its a financial control to reign in free spending by the company’s employees.
A secondary use of purchase orders, most commonly found with larger organizations, is that purchases are restricted to authorized sellers. Basically, a well designed system will not allow a purchase order to be issued to unapproved vendor. This has tremendous value to a company as approved vendors often have to comply with several standards including:
- Product Quality
- Contracted Amounts
- Financial Relationship Terms
- Time and Method of Delivery Compliance
A tertiary purpose is for compliance, mostly with government contracts. Purchase orders create another layer of documentation to trace decisions made and who authorized the respective transaction. Purchase orders are instrumental with ensuring contracts are done in accordance with the terms outlined in the contract. Many government contracts, especially those for building structures or infrastructure mandate certain materials or sourcing for the contract. Often the contracts set the standards for subcontractors etc.; thus, purchase orders are used to fulfill the documentation necessary to prove the contractor is in compliance with the agreement.
The final purpose is really designed for the controller of the company’s finances. When a purchase order is issued, it informs the financial officer that in the near future, funds will be needed to pay for the item or service pending. This is instrumental for cash flow purposes and tracking of cash. The following section explains how this works.
Purchase Orders Process
Purchase orders add another layer of documentation to the accounting process and of course the physical process. Once the system is installed and set-up, the process can begin. Purchase orders follow a four step process as follows:
- An authorized employee prepares the buying document, the actual purchase order. This order basically states what is requested, the dollar amount expected for the item’s cost and of course the particular seller. Again, during set-up, sellers are pre-authorized in the system.
- The purchase order is approved by the accounting department and is issued an authorization number. This basically means the accounting department confirms that the item requested can be financially paid for because it is within the budget or has approval by a higher authority such as the upper management team/owner.
- The purchase order is forwarded to the seller and the seller delivers the product or service for receipt by the purchase order issuer.
- Once delivered, the seller sends a bill with the corresponding purchase authorization number and the accounting department codes the purchase order as complete and in turn creates an accounts payable for the amount purchased. This takes the dollar amount of the purchase order and turns it into a current liability, i.e. an amount due to the vendor.
As for the accounting system, purchase orders are loaded into an account that is non-posting to the trial balance. This means, the account keeps track of the dollar amount approved for spending and the amount outstanding. This is quite beneficial to the administrative management team as it lets them know how much to expect in the near future as bills from authorized vendors. Management’s is that the dollar amount in this account will be in the form of bills within 30 days. Thus, its value related to working capital management.
Once the item is delivered, the purchase order is closed and the process continues with existing and new purchase orders. Again, its an excellent system to work with budgets and prevent unauthorized spending.
Parameters to Implementing Purchase Orders
For really small business operations, purchase orders are not necessary and I advised against this as it adds another layer of documentation which actually does cost money. However, once the operation begins to generate sales greater than $5 Million per year, the management team should give purchase orders due consideration. The $5 Million tier is merely a suggested level, but if in doubt seek advice from your CPA. Other parameters to consider before implementing purchase orders include:
- The more homogeneous the product needed, the less need there is for purchase orders. For example, if you need water for your company (think of brewery or a car wash), why issue a purchase order for something that is readily available and already sold in the market at a competitive price. Other better examples include packaging material, food resources, auto parts, paint, building supplies, aggregate materials and so forth. One of the purposes of purchase orders is to comply with contract restrictions or ensure that the quality of the item purchased meets certain requirements. More generic items meet the quality level based on market conditions.
- If your total employee base is less than 10 employees, purchase orders are generally not a good idea. This is because the most common buyer in a small business operation is either the owner or the key man. Often, its someone who has been with the company a long time and is well aware of what to buy for supplies/parts. Purchase orders are better for a more complex employee hierarchy as this lets the management team know who authorized the purchase of a particular item.
- The accounting team must have the knowledge to not only understand purchase orders, but how they are processed and addressed for financial purposes. Do not implement this type of a system when the bookkeeper has no knowledge or experience with purchase orders.
- Purchase orders work really well with project driven operations. It benefits the project manager to understand what has been committed to the respective project and of course the timing of delivery. The more project intensive businesses thrive with purchase orders, this includes contractors, engineers, road (infrastructure) contractors and government contractors.
- Purchase orders are best done with an accounting software that has this sub-routine within its functional abilities. Investigate your accounting software before implementing purchase orders.
Summary – Purchase Orders
Purchase orders are used as an additional mechanism in business to control expenses and ensure purchase of the proper product/service by an authorized vendor. As an accounting tool, it does require some sophistication by the accounting department and the software used. It is not a required process, nor recommended for small businesses as it does add another layer of paperwork to operations. With larger businesses, it is a necessary tool to prevent fraud and ensure compliance with budgets and contracts. ACT ON KNOWLEDGE.
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