In this episode, we discuss the controls associated with purchase orders. Purchase orders are an excellent control over purchases, though they are time-consuming to produce, and so are usually confined to more-expensive purchases. Key points in the podcast are noted below.

Why We Use Purchase Orders

I’ll start with a question: Why do we need purchase orders? Because it is useful to have someone with a considerable knowledge of product prices and ordering systems who can channel a company’s flow of purchases, rather than having every employee buying anything they want. The result should be lower prices and purchases from a relatively small group of qualified suppliers.

Primary Purchase Order Controls

There are four primary controls involving purchase orders. First is the mandatory purchase order authorization. This means that the purchasing staff must issue a purchase order for every purchase made by a company. By doing so, someone trained in buying is reviewing every purchase made. However, since purchase orders are very labor intensive to create, we need to devise several ways to reduce the burden on the purchasing staff. One is to allow small purchases, which inherently don’t require much oversight, by using procurement cards instead of purchase orders – I covered the controls for them in Episode 4. Another approach is to issue a blanket purchase order that covers all purchases for a specific item or commodity group for a relatively long period of time. Yet another alternative is to pre-approve certain suppliers for purchases, and allow employees to requisition items directly from those suppliers by using electronic catalogs.

This brings us to the second primary control. The purchasing staff should not be put in the position of authorizing a purchase, since they are not responsible for the expenses of each department whose employees want them to create a purchase order. Instead, we require employees to complete a purchase requisition form, which must be approved by their department manager. By doing so, the department manager is taking responsibility for each purchase, and understands that the cost of this purchase will be charged against his or her department’s budget.

The next primary control is to reject deliveries if there is no purchase order. After all, employees will purchase by the easiest and quickest means possible, and purchase orders are neither quick nor easy.

To ensure that they follow the purchasing rules, the receiving staff must reject deliveries if there is no authorizing purchase order number. This causes all kinds of grief if an item is rejected that is also desperately needed somewhere in the company, so a common alternative is to set such receipts aside for a short time while authorization can be affirmed. More on this issue in a moment.

The final primary control is to match supplier invoices to authorizing purchase orders. This will be dealt with in greater detail when I get to controls for the accounts payable function, but, in short, the accounts payable staff should match all supplier invoices to the quantities and prices listed on the authorizing purchase orders, and follow up on anything that does not match.

Secondary Purchase Order Controls

There are also a number of secondary controls for the purchasing function.

As I just noted, it may not be prudent to reject an unauthorized delivery, but having the receiving staff spend time tracking down who ordered the item outside of the normal purchasing rules is essentially enabling the person who broke the rules. There needs to be a penalty for this type of behavior. A good one is to charge that person’s department a stiff inter-company fee, such as $1,000 per incident, which should get the department manager’s attention, and keep this situation from arising again.

Here is another secondary control. If the purchasing system is a manual one that uses paper purchase orders, those purchase orders are the equivalent of gold – steal a few and you can authorize all kinds of purchases. To prevent this, prenumber the purchase orders, lock them up, and track the numbers to ensure that none are missing.

If the purchasing system uses a computer, then access to the purchasing database can also result in the unauthorized issuance of purchase orders. In this case, be sure to use password control to restrict unauthorized access to the database. This should also include the immediate cancellation of database access privileges for all employees who are leaving the company.

Whether purchase orders are created manually or through a computer, a useful control is to periodically examine all old open purchase orders. They may contain authorizations to purchase a few residual items that were never received, or may relate to entire orders that were never received. In either case, some investigation may reveal that these orders are no longer needed, so they can be cancelled.

And finally, the internal audit staff can also provide control over the purchasing process. For example, they can review purchases made by the purchasing staff to see if prices are unusually high; this may be a sign that a purchasing person is being paid a kickback by a supplier in exchange for ordering items at an excessively high price.

A separate controls issue is the use of a computerized materials management system. These systems can automatically issue purchase orders based on projected production requirements. Such systems remove a considerable burden from the purchasing staff, but there is a risk that the system will issue incorrect purchase orders, usually caused by incorrect information somewhere in the production database. As a control over this problem, it is customary for the purchasing staff to either review all automatically-generated purchase orders before flagging them for release, or at least review any orders involving unusual items or quantities.

Parting Thoughts

Here is my interpretation of purchase orders and related controls: They’re a strong control over purchases, but they are not necessary in several situations, where are as follows:

The expenses of a service-intensive company mostly relate to payroll, so the minor amount of other expenditures may not call for the use of purchase orders.

Purchase orders are a pain to create, so it is best to avoid them for small dollar purchases by using procurement cards instead. Similarly, any cost of goods sold purchases should be requisitioned by a materials management system. Therefore, only purchases falling out of these two areas should involve manually-created purchase orders.

Conversely, if a signature plate is used instead of a check signer, then the only real control over purchases is the purchasing department, which should insist on the use of purchase orders, subject to the restrictions I’ve just noted.