Bonus: Purchase order cost template.
When it comes to purchasing function, a heavily debated topic is the cost of processing a purchase order.
Are you curious about how much does it cost to process a purchase order in my organization?
Once you know the cost of the purchase order, you can identify cost-saving opportunities through purchasing automation and productivity improvements.
Before we get into how to measure the cost of a purchase order, let’s look at why this is important in the first place.
Companies are always looking to reduce the supply chain cost, and if you have a large operation where you are creating thousands of purchase orders in a year, the cost adds up.
If you can even reduce even $5 from the cost of a purchase order, then it could easily save you the cost of an FTE.
Assuming that you have 15,000 PO’s in a year – the total comes to $75,000 in this case, which is an average cost of FTE.
The cost of a purchase order includes different aspects, for example, confirming the unit cost with the supplier, cost of creating the purchase order, approving it, changes, etc.
If you can reduce the cost of processing a purchase order, that also means that you are reducing the complexity of your purchasing process.
Reduction in complexity leads to better outcomes for the profit or cost center.
Before you get started, download the purchase order cost template,
Then read on the rest of the article and calculate your own purchase order cost.
Reducing PO (purchase order) cost ultimately simplifies the purchase order process by reducing the number of steps.
Many purchasing organizations measure their effectiveness by tracking the KPI of cost per PO. Hence it is critical to improve on this KPI and reduce the cost continuously.
Any procurement department is challenged to do more with current resources. Reducing the PO cost allows the organization to re-allocate the resources to higher value-add activities.
Another Procurement KPI is savings contributed to Company’s bottom line.
If procurement can allocate more resources to negotiating cost savings vs. processing purchase orders, then that is a better result not just for procurement but for the entire organization.
When it comes to benchmarking the performance of the procurement organization, there are many benchmarks.
Different organizations conduct studies, and based on that; you can see that the average PO processing cost ranges anywhere between $50 to $1000.
Let’s look at some of the benchmarks.
APCQ: Cost per purchase order varies from $35.88 to a whopping $506.52.
As per CAPS research, the cost ranges from $53 to $ 741.
Next-level purchasing has a great blog post on this.
After looking at the benchmarks, most procurement leaders have one of the following two observations.
So which observation is correct?
In our view, both are correct.
There is no standard benchmark that you can apply to your situation to get the cost of processing a purchase order.
On the other hand, there is a business case for reducing the cost of purchase orders because this is an actual cost. Any efficiency you can gain by optimizing your purchasing process can result in hard savings.
Now you are saying; you got me confused!
Actually no. Instead of relying on a standard benchmark, the goal of this blog post is to introduce you to a methodology on how you should think about calculating the cost of a purchase order and let you be the judge of how accurate the calculation is.
If we can’t rely on benchmarks, how do we calculate the cost of a purchase order?
The short answer is getting to your numbers by looking at the various components of the cost factor in your purchase order cycle.
The cost of a purchase order includes creating a purchase order and the additional cost of the change order.
Now let’s look at the long answer.
In the steps below, we will walk you through a step-by-step process to calculate the cost of a purchase order.
The suggested approach is not perfect, so I’m sure some steps are missing.
If you have not done it yet, download the purchase order cost template,
then read the rest of the article and calculate your own purchase order cost.
The first step is to list down all stages in the purchasing process. If you already have a well-defined process, then that is great.
Here is an example of steps in the purchasing process
In this, you are documenting how the employee creates the requisition. For example, whether the process is manual or system-based. If system-based, do you have catalogs or other ways to reduce the data entry by the user?
Here you are documenting the steps which are involved in the approval process. The critical step is to note how many requisitions are approved at each approval level.
Are most of the requisitions approved by a manager, or do most of the requisitions go to an executive for approval?
Measuring this is important because executives are paid more than managers, so it is crucial to accurately document where the approvals are happening when calculating the cost of this step.
Here is interesting research by CAPS.
This step is to calculate the total efficiency of the purchase order process.
Let me explain. Based on the type and amount of the requisition, it might go to different people for approval.
So if you can reduce the number of steps or simplify your purchasing process, you can reduce the overall cost of the process.
We will cover this in a later section. For now, document the average number of steps in the whole process.
How do you create your purchase orders?
Are the purchase orders created manually, or are they created automatically by a system?
If the orders are created manually, then how many people are involved in this step.
Also, what are the different types of purchase orders you are creating?
If you have a buyer assigned to this task, this is your fixed cost and other variable costs.
For example – the time it takes to create a 1 line vs. 30 lines purchase order is significantly different. It takes time to enter the information like item details, quantity, shipment details, shipping costs, etc.
If you don’t have an inventory management system, you have to check for item inventory level and calculate economic order quantity.
If the process is fully automated, then that is great. In that case, you are already adopting the best practices.
Here are exciting statistics from CAPS research.
How is the purchase order sent to the supplier?
Do you email, fax, etc.
The manual process, of course, takes time, and if the process is automated, you have reduced at least one step in your purchasing process.
In addition, you might also have to create the PO in your accounting or ERP(Enterprise Resource Planning) system.
In the next step, we will calculate the time it takes for each of these steps.
Here you want to calculate the average time taken at each step. This step is tricky because you have to take the average of all the steps in the process.
For example, calculate the average time for steps required to approve a purchase requisition.
The time it takes to create a requisition for office supplies is significantly less than creating a requisition that includes a bill of material for new capital equipment.
Now I’m not asking you to look at every requisition and calculate the time for each of them. But you can do a high-level break up of the type of requisitions and the average time for each of them.
You can use a model like the following.
Calculate the weighted time and add all three types to get the average time. In this case example, the average time for creating a requisition is 12.5 minutes.
We mentioned that it is an estimated time because you can spend all the time on this to get a perfect measurement. The idea is to do a quick assessment.
Similarly, you can create the average time for each step you identified in the previous section.
It would help if you had average time for each of the following:
The next step is to estimate the cost of an individual role involved in the approval process.
I’m not suggesting that you ask people how much they are paid, but your finance department should be able to provide you with an average number you can plugin in your calculation.
Don’t just take the base salary but take the fully loaded cost, which includes company cost for employees—a simple rule of thumb is to add 30% to the employee’s salary.
For the procurement organization, you should be able to plug in the exact numbers.
Preferably calculate the cost per minute.
The reason is that the average time for requisition approval is in minutes, and you want to calculate the cost based on that time.
So with all this data, you are now ready to calculate the total cost of a purchase order.
Create an excel sheet that looks like the following.
Let’s first calculate the total cost per resource. You can adjust this to your own cost.
The resource type is the different resources involved in your approval process. Note that we include the resource type and not the resource title since that will take more time.
Again this is just an estimate.
The annual cost is the average loaded cost for each resource type.
Per-hour cost is the annual cost divided by 1820 hours.
You can check with your finance department on what they consider annual FTE hours.
Per-minute cost is, of course, per hour cost/60.
The numbers are rounded off to keep this simple.
Purchase Order Cost = Average time * Per minute cost of the resource
Add the total cost for each of the steps.
lease note that we assume that we created the purchase orders manually.
But if that is not the case, adjust the steps accordingly.
Bonus: Download the free PO cost template
In the example above, the cost of the purchase order is $62.7.
You can calculate the annual cost by taking your annual count of purchase orders * Cost of a PO.
In this example, we assumed that the annual purchase order count is 10,000 and the calculated annLet’sost is $627,000.
Even if you can reduce the cost by 20 – 30% ( Which is not unrealistic ) – that is annual cost savings of $125,400 to $188,100.
Of course, it is up to you to decide if this is worth your time and effort.
Procurement can categorize cost savings into hard savings and soft savings, or in other words, cost reduction or cost avoidance.
The same is true for the cost of the Purchase order.
Let’s assume you identified some changes to the purchasing process, which would reduce the number of steps required for approving the purchase order.
Another example is automation – you decided to invest in a purchasing system that would automate the process and reduce the cost.
Now let’s say making these changes require an investment of $X/year.
The obvious next step is to build a business case to secure funding and present it to your finance committee or boss.
99.99% of the time, finance would ask – would this lead to headcount reduction?
In most of the purchasing automation business cases, it generally doesn’t include headcount reduction as part of the cost-saving calculations.
If it does lead to headcount reduction, then the business case is straightforward. However, if that is not the case, here is how you should go about justifying the investment.
Even though it doesn’t lead to cost reduction, it does lead to the following.
Justifying the business case is very straightforward if you decide to justify the investment by increased Spend under management.
Let say your total vendor spend or sourceable Spend is $200M.
Sourceable Spend means spending, excluding payroll, taxes, employee benefits, and regulatory payments.
Current sourceable Spend: $200M
Current spend under management: $100M
Average savings delivered: 3% of the Spend under management [Change this number to what you are delivering].
Since you can increase your Spend under management by freeing up your resources, you can allocate these resources to high value-add activities.
Let’s say you increased Spend under management by 3% [arbitrary number, do your analysis to get to this number], which means an additional $6M [3% x $200M ] in Spend under management.
If your average rate of savings is 3% – that means you can now deliver an additional $180,000 [3% x $6 M ] in annual savings because of freeing up resources.
Are these savings enough to justify your investments? We think so, So run your numbers and see what hard savings you can deliver by re-allocating resources from tactical work to strategic work.
Congratulations on reading so far and believing in the business case for PO cost reduction.
Now let’s look at options at reducing the cost.
So what are the cost elements?
You can broadly divide the cost into two broader categories:
This category includes the cost for:
• Gathering information to create a requisition.
• Entering data into the system, whether creating a requisition or entering a purchase order in the system.
This category includes a review of the data by different users.
This could include:
• Review of requisition or order for data accuracy.
• Review of requisition or order by the manager for approval.
Let’s look at some ways to reduce the cost of the purchase order in these categories.
Approach 1 – Simplifying your purchase order process
Before you look into the automation of the purchase order process, look at your current purchasing process.
Simplifying your purchasing process can significantly help in reducing the cost of the entire purchase order process.
Let’s first consider the steps in the purchasing process and how to simplify it.
In this step, you look at your complete purchasing process and identify steps that are either redundant or time-consuming for the end-users.
Here end-users are company employees who are putting in the requisitions because that is the source of frustration and time in the entire purchasing process.
How many steps do you have in the approval process?
Is your approval process optimized?
Let’s take an example – let’s say you have a rule that everything above $1,000 needs to be approved by an executive of the Company.
Now let’s analyze how many requisitions are above that threshold.
Let’s say the result is that 5% or 10 % is above that threshold.
Then that makes sense because the idea is that senior management should only approve high ticket expenses.
This allows them to do cost control by rejecting unwanted expenses.
Contrary to that, let say 50% of requisitions are above the $1,000 threshold – then it might be time to review the approval process and decide whether you still need to send all such requisitions to the executive director.
You might need to increase the threshold.
This change will allow executives to effectively use their time and reduce the time spent on approving requisitions.
Are there any other review processes that procurement can eliminate?
For example, the requisitions for inventory items need to be reviewed by the inventory manager in some companies.
The review is generally in place to ensure that you don’t order items already in inventory or optimal inventory levels are maintained.
Instead of keeping the review during the creation of the requisitions or orders, maybe it is helpful to have this review done before entering the requisition/order in the system.
The alternative would be to shift the responsibility of order creation to a person in the inventory department to only place orders after verifying the inventory levels.
You should review every step in the purchasing process and question whether that step is adding value anymore.
You might find that a particular step was put in place ten years ago and for a reason which is not valid anymore.
Ok, I am stating the obvious here. ProcureDesk is a purchasing automation platform, so of course, we talk about automation!
On a serious note, smaller to mid-market companies can realize the value of automation but struggle with the business case for automation of the purchase order systems.
Hopefully, this analysis of the cost of a purchase order can help you strengthen that business case.
Let’s look at areas where automation can help.
Employees can significantly reduce the time for creating requisitions by leveraging a purchasing system.
Purchase order automation help in the following ways
Purchasing automation can significantly reduce the time it takes to get the purchase approved.
The benefits are as follows.
If you have a manual approval process, your users are spending the time to figure out the proper approval hierarchy.
In some cases, the approving managers might be routing the approvals to the right manager.
It is also possible that many purchase authorization requests are routed back and forth because it was routed to the wrong manager.
You can avoid all this by leveraging automation of the purchasing process.
The system can quickly identify the approval hierarchy based on Spend, department, and purchase category parameters.
Reduced approval time
The other benefit is the reduced approval time.
If the purchasing system has a mobile app, then Managers can use that to approve requisitions. Since most executives are on-road or busy in meetings, this can be a handy feature to reduce the time for approvals.
This step can be fully automated by leveraging a purchasing automation tool. Instead of buyers creating purchase orders manually in your system, the purchasing system can do this for you.
Also, most purchasing systems integrate with your accounting/ERP system, so the same PO data is also available in your ERP system.
It also saves you time on sending the PO to the supplier because that step can be fully automated based on the preference of your suppliers.
The obvious case where it doesn’t work is that if your supplier still demands a paper purchase order.
One obvious step in reducing the cost of a purchase order is to have a limited number of purchase orders. Fewer PO’s lead to a lower processing cost.
There are a couple of things the purchasing team can do to reduce the number of purchase orders issued by your company
Can the purchase be consolidated across departments or across different people within the departments?
For example – let’s take the case of products like office supplies. If the purchasing site is open to all users in the company
This though is convenient but if you were issuing purchase orders to vendors, then the cost could easily add up.
Instead of that, you can consolidate the purchase by having one department per person ordering those items. To further reduce the frequency of orders, you can order monthly.
This is a very simple example and might not be a consideration for you if you are a small company.
For items for which you want to maintain inventory, you might want to consider a vendor-managed inventory option.
In that case, you can significantly reduce the number of purchase orders
If you purchase recurring services – for example, cleaning services then instead of creating a purchase order every month, you can create a blanket order with the annual amount.
The vendor can invoice against that order till the amount is consumed.
Though it reduces the number of purchase orders, it does need an additional layer of diligence and compliance. You want to make sure that invoices are properly vetted before they are paid, otherwise, the vendor could charge extra and still get paid if the invoice amount is lower than the amount on the blanket order.
When it comes to calculating the cost of a purchase order, there are a lot of benchmarks available. Some might apply to you and some don’t.
The best approach is to calculate your own cost based on the approach we defined in this post. We agree that it takes some time but it is more reliable than using any standard benchmark.
Moreover, when it comes the time to invest in technology for purchasing automation, you can use these numbers to build the business case for investment and no one will question your assumptions about the cost per purchase order.
So click on the link below, download the template and start measuring the real purchase order cost.