What is a Purchase Order?
Purchase orders are the single most effective tool that a business has to keep track of large and complex purchases.
Most small businesses buy stuff by just placing an order, making payment, and waiting for the thing to arrive.
But as your business grows in size and complexity, you’ll need a formalized system that makes sure purchases are ordered, budgeted for, and fulfilled properly. That’s where purchase orders come in.
A purchase order is a document sent from a purchaser to a vendor to confirm a specific purchase of goods or services. But one little document can go a long way in clearing up the logistical confusion of a growing business.
How are purchase orders different from an invoice?
A purchase order is issued by the buyer, who wants to make sure they got exactly what they ordered, while an invoice is issued by the vendor, who wants to make sure they get paid.
Purchase orders are sent by the buyer to the vendor first, and they outline exactly what the order should contain and when it should arrive. It’ll include things like quantity of items, detailed descriptions of the items, the price, date of purchase, and payment information.
A vendor sends an invoice only after they have approved the purchase.
That invoice will usually mention the reference number included on the original purchase order, so that finance can make sure the information on both forms is the same.
How are purchase orders different from sales orders?
Purchase orders are used to officially confirm purchases, and are sent by the purchaser to the vendor.
Sales orders, on the other hand, are sent by vendors to purchasers in order to confirm a sale before the order has been fulfilled.
Why do companies use purchase orders?
When most small businesses start out, they forego purchase orders in favor of a more informal purchasing process.
But as companies grow and their purchases become more complex, detailed, and urgent, a simple cash-for-goods purchasing system will lead to confusion.
Here are four of the most common reasons why companies use purchase orders.
1. They give you legal protection
Let’s say your startup ordered ten ergonomic chairs from a vendor, paid for them, but then on delivery day only nine chairs arrived at your office. Who’s to blame?
If you and your vendor disagree and you don’t have a purchase order—which is a legally binding contract—you can end up in a legally tricky position. Without a paper trail, it can sometimes be difficult to definitively prove what went wrong in a purchase.
Purchase orders get around that ambiguity by bringing both parties together in a mutually-binding contract. Once a vendor receives and approves a purchase order, you’re both legally bound to your end of the deal.
(Note: simply sending a purchase order to a vendor isn’t enough for it to take effect. The document only becomes legally binding once the vendor “acknowledges” the purchase order by signing it.)
2. They make orders easier to track
Purchase orders help you better account for all of the goods and services your company has ordered, keep tabs how you’re paying for them, and track when they’re arriving.
From an operations standpoint, you can track orders more confidently knowing that your supplier is contractually bound to deliver them at a specific time and date. From an accounting perspective, you can budget confidently knowing that you have a contractually-enforced purchase price.
3. They help you avoid audit problems
If you happen to get audited, you’ll thank your former self for creating purchase orders. Why? Purchase orders remove a lot of stress from the auditing process by providing auditors with a conclusive paper trail and an easy way to cross-check invoices and packing slips.
Without purchase orders, prepare for a long, painful process of poring over invoices, receipts and emails with vendors.
4. They make life easier for your vendors
If your vendor is used to receiving purchase orders, you’ll get your shipment faster if you send them one. With everything they need to know in one place, there will be no back and forth and no miscommunication.
How do purchase orders work?
The steps involved in issuing a purchase order can be a bit complicated. Here’s a breakdown of a typical transaction involving a purchasing order from the perspective of a purchaser:
- First, the person or department responsible for purchasing at your company is notified by management that a purchase needs to be made. Some companies do this by issuing a purchase requisition form.
- If the purchaser approves the order, they fill out a purchase order detailing exactly what the purchase is.
- The purchase order is then sent to the vendor, who decides whether they can and want to fulfil the order. Once they approve the purchase order, it becomes legally binding.
- The purchaser sends payment for the order (or does so at an agreed-upon later date, which is specified on the purchase order.)
- The vendor delivers the order along with an invoice. The purchaser’s finance department then compares this invoice to the purchase order to make sure that the two documents agree with each other.
Here’s an example of a purchase order
Your purchase order doesn’t have to look exactly like this. But it should include these elements.
The elements included in this example are:
- Purchase order number
- Purchase order date
- Vendor name and address
- Buyer name and address
- Delivery date
- Shipping method
- Shipping terms
- Item name
- Item description and technical information
- Item quantity
- Item unit cost
- Line total
- Total price
- Payment information
Purchase orders are standardized across the entire company and contain, at the very least, information about: the purchaser and vendor (names, addresses), the order itself (product description, technical specs, price, quantity), and payment information (due date, form of payment).
These days, most companies who issue purchase orders do so electronically using accounting software.
If your accounting solution doesn’t have that option, Shopify has an excellent purchase order template.
When do I not need a purchase order?
Making large, important purchases without purchase orders is usually a bad idea. But there are some exceptions to the rule.
Certain regular, recurring purchases relating to the day-to-day operations of a business—including heat, electricity and gas payments, monthly subscriptions to services, memberships, etc.—are usually billed for monthly and do not require a purchase order.
Any internal expense reimbursements—for travel, educational materials, supplies, entertainment, etc.—are tracked using their own form, usually called a reimbursement request.
You need to know the total cost of a purchase ahead of time to fill out a purchase order. That means purchases that have an unknown future total cost—advertising costs and legal expenses, for example—can’t be purchased using a purchase order (a simple invoice will do for these.)
For the sake of efficiency and simplicity, companies will also often set a lower cost threshold for issuing a purchase order. For example, your company might decide that it is most efficient if all orders smaller than $500 don’t use a purchase order.
Have more accounting questions? We’ve got you covered on our Small Business Syllabus, with over 100 in-depth small business finance articles.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.