Summary: In this article, you’ll learn the definition of a purchase order, different types of purchase orders, how purchase orders differ from invoices, purchase order processes and how purchase orders work, and the basics of purchase order accounting
What is a purchase order?
In the worlds of manufacturing and retail, purchase orders are the beginning of the inventory process. In the simplest of terms, a purchase order (PO) is a document sent from a buyer to an external seller outlining the proposed quantity, type, and price of desired goods or services for the purposes of acquiring inventory or services. These documents indicate intention to sellers and help purchasing agents to manage incoming orders. Once counter-signed (accepted), a purchase order becomes a legally binding document that protects both the buyer and seller in the event that either party does not uphold their end of the contract, though many are accompanied by an additional legal document outlining the terms and conditions of the sale in more specific terms.
While many businesses still rely on physical purchase orders, in today’s digital world, it is increasingly common for them to be electronically sent and received. These electronic purchase orders (EPOs) are sometimes referred to as e-purchasing, e-procurement, or e-purchase requisition documents.
What is the difference between a purchase order and an invoice?
In order to understand the difference between a purchase order and an invoice, we have to understand more about how invoices work.
What is an invoice?
In essence, an invoice, sometimes referred to as a bill or a tab (or a voucher in Europe), is a document sent from a seller to a buyer after a purchase to indicate the quantity, type, and price on a sale of goods or services. This document is sent in response to a counter-signed purchase order, which the seller will refer to as a sales invoice and the buyer will refer to as a purchase invoice. It confirms the sale and often is accompanied by payment terms if the sale has not already been paid for in full.
Purchase order vs. invoice: the comparison
How does a purchase order work?
Purchase orders work by explicitly outlining the quantity, type, and price of the requested goods and services for the purposes of acquiring inventory or services. They are detailed documents that make clear exactly the type of sale the buyer is proposing and they become legally binding once they are accepted by the seller. This protects buyers in the event that a seller attempts to back out of a deal and prevents sellers from modifying the sale without the consent of the buyer.
They contain basic information to ensure a smooth transaction: a purchase order number (PO number), a billing address, a shipping address, shipment dates, and, of course, the quantity, type, and price of the requested goods and services. While this information can be entered manually, software systems exist to eliminate human error and ensure a simple and timely transaction.
Purchase orders also help inventory managers to compare how much inventory they currently have to what they will have once the purchase order is fulfilled. They also track inventory as it is being shipped so managers know when to expect their inventory to arrive. This helps companies maintain their desired levels of inventory and removes risk of overstock or out-of-stock and allows inventory managers to make the necessary preparations for incoming inventory.
Purchase order processes
Since purchase orders are sent from buyers to sellers, there are a few two different sides to processing them from creation to fulfillment.
Processes for buyers
Purchase orders are created once a company has taken a count of their existing inventory and finds that they are approaching or below their par levels. Once the inventory reaches its reorder point, a purchase requisition is submitted to receive permission to place an order. When the purchase requisition (PR) is approved, a purchase order with a unique PO number is created to request the determined economic order quantity (EOQ) from the supplier. Once the document is sent to the supplier, it is marked as an “in-progress” purchase and will remain so until the inventory is received. Once the buyer receives the goods or services along with the goods receipt (GR, proof of product arrival), usually through scanning barcodes and matching it to the corresponding PO number, the purchase is marked as “processed” if paid in full or “requiring payment” if not.
Processes for sellers
When a seller receives a purchase order, they can either choose to accept it, decline it, or renegotiate the terms of sale. Once the buyer and seller come to an agreement, the seller uses the accepted purchase order to pull inventory or arrange services in accordance with the form. The seller then uses the purchase order to draft and send an invoice for the goods or services and sets the terms for payment if the goods are not already paid for in full. The invoice and inventory are then sent to the buyer and the seller marks the purchase order as either “filled” or “awaiting payment”. Sellers will often send follow-up reminders of payment terms and deadlines in order to ensure that the order is fulfilled.
Purchase orders in accounting
Purchase orders occupy space in the accounting books differently for buyers and sellers in addition to changing positions depending on the status of a sale.
For the buyer
In accounting, an in-progress purchase order that has received an invoice goes into accounts payable and is considered a liability until the seller has been paid and the purchase order is fulfilled. Funds are set aside to cover the cost of the purchase commitment (PC). Once a goods receipt is received, the purchase commitment funds are transferred to the “actual” expense of the purchased and physically held inventory. Before the account can be disbursed (paid off), it must go through an approval process to ensure that the invoice received matches the purchase order sent at which point the funds can be released and the seller can be paid.
For the seller
For vendors, the receipt of a purchase order does not equate to an accounting entry. Typically, the value of the accepted purchase order is marked as an asset in accounts receivable once the product has shipped and the invoice has been sent and the sale is considered to have occurred.
Purchase (order) power
The beginning of any inventory or service acquisition starts with a purchase order. Whether electronic or physical, they have the power to help inventory managers to keep track of what they have currently and what they have coming. They clarify the terms and conditions of a sale and legally protect buyers from any mishaps or malpractice in the buying process. Whether a business is large and established or still growing, when processed and accounted correctly, purchase orders streamline inventory operations and help businesses to operate optimally.