Controlling Costs: Invoices vs. Purchase Orders

Many builders still rely on invoices as the primary method for paying the trades and suppliers. Those builders perceive a benefit to being invoice-based; they do not see the value of working through the transition to being purchase order-based. We are going to look at several key areas and identify the benefits — and challenges — for both approaches. This is the first installment in a three-part series discussing this topic. 

First, we need to define the terms. 

Invoice: a document sent by the seller to the buyer once the work is complete, with an amount to be paid. An invoice will include a summary of the work provided. The buyer pays the seller based on the invoice.

Purchase order (PO): a document sent by the buyer to the seller prior to the work starting, with an amount that will be paid. A PO will include a summary of the work that is to be provided. The buyer pays the seller the amount of the PO.

Key Area 1: Cost Forecasting and Protection

Home builders should have the ability to know how much each of their homes will cost to build. This is a key line of defense in preventing margin creep and managing for profit. Retail pricing for the homes should be based on market pricing and not cost-based. 

The primary goal with true cost awareness is to be certain profits do not dip below the target. Builders who are not confident in their ability to truly know their homes’ value in the market will then add their target margin to the cost. Either way, having an accurate forecast is essential. The decision to be invoice or purchase order-based impacts the home builder’s ability to know costs and the ability to earn the planned profit.

Invoice

When a builder uses invoices, cost forecasting is based on budgets created through bidding and/or costs paid on recent homes built. Often budgets are padded to protect against cost increases because the estimating team does not want to be blamed for losing money and does not have the ability to know what future invoice amounts will be down to the dollar. Cost predictions are best guesses and the ability to know they were accurate is not possible until the invoice is received.  

The ability to protect against cost creep is inadequate because the costs for a home are not on a legally binding document such as a PO. The true cost for the invoice will only be determined when the work is complete. 

The home builder may be in for a surprise when the invoice arrives. When an invoice is given with a higher dollar amount than the budget, the accounting team must pass the invoice along to production and/or estimating and wait for a response. Someone will either touch base with the trade or supplier to work through the cost difference or, more likely, the amount will be paid as submitted. 

The reality is invoices make it very difficult to accurately predict what a home will cost. It is difficult to ensure budgets are being met and invoices do not allow for efficient handling of discrepancies when discovered. If a cost increase was done by the trade or supplier, it is very difficult to go back to them and negotiate a lower invoice amount on work already completed. 

Purchase Order

Predicting costs with POs is more accurate and reliable. The total cost for the home is the sum of the purchase orders and will not be more unless it is communicated in advance. Any additional work needing to be done must first have a variance purchase order (VPO) created by the estimating/purchasing team. If this is understood by the field, unknown costs will not occur. When using purchase orders, prices for the products are negotiated and locked in and can only change if approved beforehand. 

It is best practice to require a waiting period before a cost increase goes into effect. This amount of time should exceed the company’s typical time-frame from contract to PO release to protect the home builder from margin loss on homes sold but not yet released to production. 

Furthermore, once a PO is issued, it is binding and represents the total amount that will be paid to a trade or supplier once they complete their work. If POs are released at once and prior to the start of the home, the builder has the confidence the costs are locked in a legally binding document. 

While neither system is perfect and discretion is necessary to handle unique situations, using POs provides the home builder with a greater ability to accurately predict home costs from sale to completion. For a home in production, the total cost will be the sum of all POs paid, approved for payment, or open. That confidence cannot exist with invoices.

Coming up 

The next installments will include discussions on cost transparency, variance analysis, how payments are made, and the challenges of transitioning from invoices to purchase orders. The process is not easy but the ability to operate with more efficiency and cost protection is worth the effort.

This article is the first in a series of three addressing the issue of invoice vs. purchase orders and was originally published in the Builder Partnerships Newsletter on Aug 28, 2018.

Source: https://builderpartnerships.com/Default/ViewResource/281de5a9-3bab-e811-8333-be975d786a7d