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How Contractor Purchasing Policies and Procedures Can Impact Profitability

by: Smith and Howard

May 27, 2015

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Winning the bid for a job is only the first step toward a profitable project. If you start out with a clear understanding of the job’s requirements and make a reasonable estimate of its costs, you’ll be in a good position to make money.

To maximize profitability, it’s important to plan carefully, communicate clearly and track your expenditures every step of the way. By establishing and following consistent purchasing policies, you can increase the chances of achieving your intended profit margin. You’ll also get a better idea of where, why and how a job can go wrong.

Generating the purchasing documents

With an effective purchasing policy, you agree — during the bidding process — on what the price of each expenditure will be, who will do the associated work and when that work will be completed. Thus, an effective purchasing system is a must. You want to document not only what you’re buying (generally materials, equipment and labor), but also the specific terms and requirements that must be met before the purchase can be completed and the invoice paid.

Whether you work with off-the-shelf purchasing software, develop a custom application or stick with a paper-based process, it’s important to cover all the bases. Your purchasing system should generate three documents for each vendor and stage of work:

  1. A purchase order or work order (PO/WO),
  2. A scope of work for each PO or WO, and
  3. A vendor/trade agreement for each supplier or subcontractor.

In a manufacturing or retail application, a PO is an accounting transaction indicating “you’ll buy X items for Y dollars.” But, for contractors, the PO/WO can serve as an important communication tool between the office and the field. The system should allow you to include notes and comments, indicating:

  • How the materials will be used,
  • When they must be delivered,
  • Where the supplier should park or unload, and
  • Any other policy you want to enforce on the job.

The PO/WO needs to describe both what you want done and how you want it executed. So there should be a separate scope for each PO/WO. Think of it as a written specification for the job or materials to be supplied.

For example, if you have one PO for rough electrical work and another for installing fixtures, provide a scope for each phase. Scope documents should be specific for each project, but they can often be reused from one job to another with minor editing.

Spelling out purchasing agreements

An important part of controlling costs and maintaining profitability is your relationship with each supplier and subcontractor with whom you work. Besides project-specific PO/WOs with accompanying scope information, your purchasing policy should require blanket vendor agreements (for suppliers) or trade agreements (for subcontractors, if you’re a general contractor) that cover multiple jobs.

These agreements can be executed once and kept on file, or maybe renewed annually. They should spell out ways you want other companies to work with yours, including specifications such as payment procedures and terms, required insurance coverage, and work authorization permissions. Executing consistent blanket agreements with all of your suppliers and subcontractors helps ensure that you can compare price quotes on an apples-to-apples basis.

Tracking the job

Following purchasing policies and procedures will inevitably generate many PO/WOs, but these documents are useful in several ways. First, each PO/WO serves as a binding contractual agreement with your vendor or subcontractor — a commitment to provide specific goods or services for a specific price.

Second, the full set of PO/WOs and scopes for a job gives the project manager a convenient way to set up the construction schedule and monitor work progress. He or she can easily verify satisfactory completion of each step and authorize payment, as well.

Third, because each PO/WO is associated with a specific vendor and task before the job starts, the payment process is streamlined. There’s no need to “code” incoming invoices; in fact, invoices may not be required at all, which saves time for everyone. Vendors simply reference the job and PO/WO number, and you pay the agreed-upon amount. Barring any variances (see the sidebar “Changes and variances”), the job cost should match the estimate — and your profit margin should be maintained.

Changes and variances

Even with the best purchasing policies and systems, there are likely to be times when additional materials and labor are required that weren’t included in the original purchase order or work order. When that happens, you must issue and approve a “variance purchase order” to cover it.

A change order is generally something requested by the customer — and is billable. But when the change is necessitated by bad weather, an estimating error, theft or something else, the VPO can serve as a tool to analyze what happened. That way, you can learn to avoid making the same error again down the road, and minimize its overall impact on your financial performance.

Considering the benefits of purchasing policies and procedures

Establishing and implementing formal purchasing policies may seem daunting — especially when you’re dealing with dozens of vendors and subcontractors. But the benefits of setting these policies and building a system with which to execute them are considerable.

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