How do purchase orders work?

If you’re new to running a business, you’ve probably put a lot of thought into the basic first steps: sourcing materials, arranging production, and then serving customers. One finer detail of those steps is building relationships with your suppliers. They’ll want to see that you know what you’re doing, and that you’re both speaking the same language.

That’s where Purchase Orders (POs) come in. They aren’t just a formality; they’re a proven way to clearly communicate your needs as a buyer. This helps you establish trust, as well as speeding up procurement in general.

This guide shows you how to use POs to best effect, making your procurement process efficient, helping you keep track of spending, and ultimately safeguarding profitability.

Here’s what we cover:

The purchase order process

Before you can understand how purchase orders work, it’s important to visualize where they fit in your day-to-day operations: POs are part of a step-by-step journey from recognizing a procurement need to finalizing payment. Here’s the general flow of this process:

Identifying the need

Recognizing when goods or services are required is where it all starts. This could be anything from having to restock inventory to hiring a freelancer. For example, you may need someone to redesign your website or develop a new software feature. Any time you need external resources to support your business, you’ll likely need a purchase order.

Anticipate your operational needs by regularly reviewing inventory levels, analyzing sales data, and forecasting demand. For example, if you notice a particular product is flying off the shelves, it’s time to order more before you run out. The need to restock inventory is one of the most common reasons for issuing POs because you need to be ready to meet customer demand.

Creating the purchase order

A standard purchase order, typically generated through dedicated software or your company’s own branded stationery, outlines the specifics of your order. This includes detailed item descriptions, the number of units required, prices, delivery dates, and payment terms. 

To avoid any confusion, your PO should be meticulously clear. Use specific item codes or SKUs to ensure you receive exactly what you need. Double-check the prices listed to match the rates you agreed with the supplier. A well-defined PO will help you avoid disputes if, for example, a supplier delivers late or demands payment earlier than agreed.

While standard purchase orders generally cover one-time transactions, there are variations to suit different operational styles, buyer-seller relationships or the frequency of purchases. For example:

• Standing purchase orders: are ideal for recurring orders of the same products. You can set up an agreement once, specifying the items, quantities, and prices. And you simply reference the same PO number for each subsequent order, eliminating the need to create a new one every time.
• Blanket purchase orders: are best suited for ongoing relationships where you anticipate multiple deliveries over a set period.  For instance, if you regularly order a specific component, a blanket PO allows you to lock in pricing and delivery schedules for a defined period, often with volume discounts or other incentives.

Sending the purchase order to the supplier

When you settled on your preferred suppliers, you likely also established which person in their organization is responsible for receiving POs. It could be a sales representative, or a dedicated order processing team, and should be easy to find if you use supply chain management software. Another vital part of the conversation with your suppliers is to decide the preferred means of sending the documentation.

You have several options for sending a PO. Email is the most common method, especially for smaller orders. Dedicated procurement software is one step ahead because it can distribute POs automatically, often with built-in tracking and confirmation features. And, if you or your supplier lack digital means, you can always deliver a physical copy.

Regardless of the method you choose, always request a confirmation of receipt. This helps prevent potential delays or misunderstandings. In many cases, when using electronic methods like email or dedicated software, the vendor will respond automatically with a confirmation. However, it’s still good practice to follow up proactively, especially for time-sensitive orders. All it takes is a phone call or email to check that they have everything they need to process your request.

PDF is one of the most popular formats for sending POs because it’s universally compatible—your supplier can probably view it no matter what operating system or software they use. PDFs also tend to retain their original formatting when shared to different organizations.

Supplier review and approval

Once the supplier receives your purchase order, they’ll review it to ensure they can fulfill the order as requested. In most cases, if the PO is clear and the supplier has the items in stock, they’ll accept it without any modifications. This means they agree to provide the goods or services exactly as you’ve outlined in the PO.

However, there might be situations where the supplier needs to suggest modifications. This could be due to factors like limited stock, or market conditions such as changes in pricing. If modifications are necessary, the supplier will typically contact you to discuss the proposed changes and reach a mutual agreement.

In some cases, the supplier might reject the PO altogether. This could be because they don’t carry the requested items, or can’t meet the delivery timeframe.

Order fulfillment

With the purchase order approved, the supplier can now kick off the order fulfillment process. This involves picking, packing and shipping the goods—or organizing manpower if it’s a case of providing services.

If the required items are readily available, and the supplier’s internal processes allow, they might begin the shipping process as soon as they approve the PO. This can help expedite delivery and reduce lead times.

However, more complex orders or customized items might require additional steps before shipping. You may have to wait for production, assembly, or quality checks, for example.

Always track your order by following up with the supplier. Regular communication allows you to address any potential delays proactively. In case of interruptions, you can explore alternative shipping options, adjust production schedules, or inform your customers about new delivery dates.

Receipt and inspection of goods or services

Upon receiving the goods, carefully inspect them to ensure they match the PO. Check for any damage, defects, or discrepancies in quantity. Verify that the items match the descriptions and specifications on the PO.

In the case of services rendered, this could mean reviewing deliverables, assessing the quality of work, and confirming that the service was performed on time and within budget.

If you spot any issues, document them immediately and notify the supplier. You may need to include photos or videos–whatever provides ample details of the discrepancies. Run these checks as soon as possible because the window for claiming compensation or requesting corrections is often limited. Many industries have specific regulations or guidelines that dictate timeframes for reporting discrepancies.

Invoice matching and payment

The carrier or delivery service that transported the goods will hand them over with a delivery receipt. This could be a physical document signed by you upon delivery, or a digital confirmation sent by email.

You now have three documents that should all confirm the same details of the transaction. So, after verifying the deliverables, compare the invoice with the PO and delivery receipt. This is known as a three-way match and is an essential step before you pay.

Matching gives you peace of mind–you’re vetting for fraud and errors while also ensuring the accuracy of your financial records.

How to create a purchase order

Now that you understand the “why” of issuing purchase orders, let’s run through the “how”. It’s a simple matter of having the necessary information available, arranging it, and issuing the document:

1. Gather the essential information

The key elements of a purchase order include:

• Buyer information e.g. your company name, address, contact details.
• Seller information such as the supplier’s company name, address, and contact details.
• PO number and date that acts as a unique identifier for the purchase order.
• Detailed list of items or services including descriptions, quantities, units of measure.
• Agreed prices and total amount which states the price per unit and the total cost of the order.
• Delivery and payment terms to include delivery date, shipping method, payment due date, and any applicable discounts.

2. Format the document

Purchase orders typically follow a standardized structure, similar to invoices. This is because both documents serve as formal records of a transaction and need to convey key information clearly and consistently. The typical format is as follows:

• Header. Contact information for both buyer and seller, PO number, and date.
• Body. A table listing products or services, quantities, unit prices, and line totals.
• Footer. Total amount due, payment terms, and an authorized signature.

Here’s what it looks like on paper:

“ACME Devices” Address:			Purchase Order #: Date:
Buyer Details Division: Address: (if different from HQ above) Contact:			Vendor name: Address: Contact:
		Item ID	Quantity	Price
	Item 1			$
	Item 2			$
	Item 3			$
			Order total	$
			Tax	$
			Packaging & Shipping	$
			TOTAL	$
	Shipping method:
	Delivery date:
	Payment terms:

This standardized format ensures that all necessary information is presented in a logical and easy-to-understand manner, reducing the risk of errors or misinterpretations.

3. Use software and tools

There are numerous software options that can simplify PO creation. Many types of accounting software have built-in PO templates, or you can invest in dedicated PO management systems. Both offer a pre-designed framework for your purchase orders, ensuring consistency and accuracy. They often include pre-filled fields for common information like your company details and standard terms and conditions, saving you time and effort.  In most cases you can customize the templates to match each order.

Other common features in these tools are automated workflows and tracking. Automated workflows coordinate the entire PO process, from creation and approval to delivery and payment. This reduces manual effort and minimizes the risk of errors. Tracking features provide real-time visibility into the status of your purchase orders, allowing you to monitor progress, flag potential delays, and adjust your procurement needs on the fly.

Furthermore, many PO software solutions integrate with other business systems like Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), and your banking system. This integration enables seamless data flow between different departments. For example, integration with your accounting system ensures that purchase orders are automatically reflected in your financial records, simplifying reconciliation and reporting.

Purchase order management

It’s not enough to have a good system for creating purchase orders; you need to actively track their progress, ensure timely fulfillment, and accurately match invoices to avoid discrepancies and potential financial losses.

The effects of proper PO management also go far beyond your procurement processes, benefiting both buyers and vendors. For example, buyers gain better inventory control and enhanced visibility into spending patterns. Sellers can streamline their order processing, leading to improved cash flow and better customer satisfaction.

And both parties get to enjoy improved efficiency, cost savings and reduced risk of errors or fraud.

Let’s look at the main elements of PO management:

Tracking and processing purchase orders

The beauty of dedicated PO management software is that you can configure it to track your purchase orders and alert you to key events or potential issues. For example, the software might:

• Send automatic notifications when a PO is approved, shipped, or if there’s a delay.
• Highlight discrepancies, flagging mismatches between the PO, delivery receipt, and invoice.
• Provide real-time dashboards, giving an instant overview of all your outstanding POs, their status, and any potential bottlenecks.

Matching invoices to purchase orders

Remember the three-way matching process to verify orders, deliveries, and invoices? Your PO management system can take care of that.

Here’s what it will compare across the three documents:

• Invoice number and date
• Item descriptions and quantities
• Prices and totals
• Delivery address and date

Legal aspects of purchase orders

While purchase orders primarily serve an operational function, they also carry legal weight. Understanding the legal implications of POs is crucial for protecting your business and ensuring compliance.

Is a purchase order legally binding?

Yes, once a supplier accepts a PO, it becomes a legally binding contract. This means both parties are obligated to fulfill the terms outlined in the document. For buyers, this means paying for the goods or services as agreed. For suppliers, it means delivering the goods or services according to the specifications and deadlines in the PO.

This doesn’t mean you need to hire a lawyer to draft your POs, but it is advisable to have a legal professional review your standard PO template to ensure it adequately protects your interests. This is particularly important if you are dealing with complex transactions, high-value orders, or international suppliers.

Ensuring compliance

Both buyers and suppliers have a responsibility to ensure compliance with the terms of a purchase order. Whether you’re on the buyer side or the seller side, these tips will help you stay in line:

• Maintain accurate records to keep thorough and organized records of all PO-related documents and communications.
• Adhere to agreed-upon terms and fulfill your obligations as outlined in the PO, whether it’s delivering goods on time or making payments promptly.
• Use clear language to avoid ambiguity in your POs. Use precise language and clearly define all terms and conditions.
• Seek legal advice when necessary. If you have any doubts or concerns about the legal implications of a PO, consult with a legal specialist.

Balance budgets and purchase orders to increase your profitability

POs are the blueprint for your procurement process. They facilitate transparency and efficiency, giving you better control over spending, and potentially improving your bottom line.

Aligning your POs with your budget starts with accurate forecasting. By projecting your needs and ensuring you have the necessary funds allocated, you create a strong foundation for balanced procurement.

Final thoughts

When you present a well-defined PO with clear terms and a firm commitment to purchase, suppliers are more likely to offer favorable pricing and terms. This demonstrates your professionalism and seriousness as a buyer, fostering stronger vendor relationships.

Those positive qualities are even more apparent if you use a seamless and automated  purchase order management software. It simplifies the process, reduces manual errors, and provides real-time insights into your procurement activities.