October 5, 2021

What is a Purchase Order and how does it work?

Naveen Shayan

LedgerMax specialist

Tracking inventories and procuring supplies may not be a small business owner’s favorite job; however, it’s undoubtedly vital for the success of a business. A purchase order, commonly known as a PO is essential to keep your business' operations smooth and systematized. They’re imperative for a well-coordinated purchasing procedure as they help a business take charge of its spending and update the procedure of purchasing products and services. In this blog, we will discuss what exactly a purchase order is, how it works, the difference between a purchase order and an invoice and above all how it benefits your small business.

What is a Purchase Order?

A purchase order (PO) is a document which a business issues to a vendor/supplier requesting certain products or services. Every PO consists of the particulars of the requested item/service, the required quantity, order description, the set price, delivery time and payment conditions. It is a lawfully binding agreement that bounds both the buyer and the seller to establish a smooth deal. The buyer can explicitly convey his requirements to the seller and the seller gets his payment on time as per the agreement. Moreover, POs also benefit the buyers and sellers in keeping up precise, comprehensive records for financial statements and auditing purposes.

How does a PO work?

Now that we have learned what a purchase order is, let’s get into the details of how it works. Here’s the step by step procedure:

  1. Check Item Requirement

The first step is that the purchaser/buyer identifies that a certain item or service is needed. He then sorts out the required quantity of that item and the estimated time for order delivery. For instance, if you’re a shoe making company and ordering shoe boxes from some vendor, you are first required to check how many shoe boxes are needed and by when they are needed.

  1. Draft a PO

Now after acquiring the details discussed in step one, the buyer has to draft the PO and send it to the vendor for approval. In order to keep the procedure smooth and prompt, it is important to indicate when you need the approval. Preferably, the vendor should respond on time giving the purchaser sufficient time to contact other vendors if required. Using the same example quoted above; after identifying the quantity of the shoe boxes required and the time within which they are needed, draft your PO as per those details and send it to the vendor.

  1. Send the PO to Vendor for Review

Now that the vendor has received the PO, he will confirm the request by checking the availability of the required item on his side. He will also confirm if he can deliver the item by the date mentioned by the purchaser. Looking at the shoe boxes example again; after receiving your PO, the vendor will check if he has the required number of boxes in stock and also, if he can deliver them as per the date mentioned and then confirm the availability to you.

  1. Vendor approves the PO

Now that the vendor has checked the availability of stock on his side and he is certain to deliver the required item by the date mentioned by the purchaser, he will approve the PO and send it back to the purchaser so as to make it a legal agreement between the two parties. For example, the shoe box vendor will send the approved copy of the PO to you for order confirmation.

  1. Fulfill the Order

After the approval from the purchaser, it becomes the responsibility of the vendor to deliver the required item or service on time as per the agreed terms. In the meanwhile, the vendor can also create an invoice mentioning the amount and send it to the purchaser. This invoice should again include the number of items delivered, their details and the amount payable. Using the same example; the shoe box vendor gets the approval from you and now becomes liable to deliver your required number of shoe boxes on time. The vendor will send you an invoice against this PO stating the PO number, quantity of the boxes and the amount due.

  1. Pay the Invoice

This is the concluding stage where the purchaser is required to pay the invoice as per the agreed upon amount.  Following the above mentioned example; after receiving the invoice, you’re obligated to pay the shoe box vendor as per the terms set earlier.

Difference between a Purchase Order and an Invoice

People, who are new to the business world, often get confused between POs and invoices; even though they serve different purposes. Here, we have created a comparison table to differentiate the two:

                                  

 

 Why are Purchase Orders Important?

Purchase orders are beneficial for both the purchaser and the vendor in many ways. With respect to the purchaser, a PO is convenient for keeping a check on the inventory and buying records. On the other hand, for the vendor, it serves in tracking inventory, frequent orders as well as order history. Above all, a purchase order legally bounds the purchaser to pay the vendor as per the payment terms set giving the vendor assurance and legal safety. Moreover, it also obligates the vendor to deliver the required item on time as per the rates and quality approved by the purchaser. With respect to small businesses, a purchase order is helpful in:

  • Rising organizational productivity
  • Building up information to assist in keeping track of the payments
  • Coping up smoothly with the business expenses
  • Cutting down the risks of duplicate order

Summing up, a purchase order is a fundamental aspect of keeping up complete and accurate financial records for your business. Many small businesses use Microsoft Word and Excel for making POs which can be good at the beginners’ level only. As a matter of fact, a good accounting software is indispensable for running your business operations smoothly because it not only saves the hassle of doing manual work but also digitalizes the entire process of sending POs with accurate PO numbers and information etc. and keeping all the purchase records intact. 

LEDGERMAX BLOG

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