Do you want to prevent unauthorized purchases of materials? Would you like your variance between estimate and actual costs to be less than 1 percent? Are you willing to invest time up front, before you start construction, to commit costs to your trade partners and suppliers? Do you want to get away from approving every invoice for job costs that comes into your office? Do you want to streamline your job cost reporting? If you answered yes to any of these questions, a purchase order system may be right for your company.
The best method for controlling material and trade contractor costs is committing costs up front and using a purchase order system for cost control. The key to a successful purchase order system is to commit as many costs as possible prior to starting the job. Committed costs can take the form of a written purchase order or a subcontract agreement. Many of the commitments can be established during the estimating process by obtaining trade contractor and supplier bids. A committed cost system is valuable for builders of any size, but to implement one takes discipline and does not happen overnight. However, if you are willing to invest the time and resources to implementing a committed costs system, there should be a significant effect on your bottom line.
Implementing a purchase order system affects all departments, from estimating to purchasing to field operations and accounting. Following is a step-by-step process of the commitment system:
Estimating. A good purchase order system starts with a tight job estimate. Spend time up front getting written bids from as many of your trade partners as possible before finalizing your estimate. Make sure that you develop a detailed specification list so that your trade partners know exactly what they are bidding. For materials, it is best to spend the time to take off a detailed material list from the plans and bid out the material list to get pricing.
The biggest problem that custom builders encounter in this area is estimating a job before the plans are fully complete or before they have all of the specifications and selections from the client. I have seen builders take control of this area by setting customer expectations up front so the customer does not expect a final bid until the plans, selections, and specifications are complete.
Purchasing. If you have developed a tight estimate with trade partner bids and supplier quotes, purchasing primarily becomes a mechanical exercise. In some integrated accounting systems, purchase orders can be automatically generated from the estimate. If your estimate is not tight, now is the time to get formal bids and quotes from your trade partners and material suppliers. The key to any good purchase order system is to have costs committed before the work commences.
Subcontract agreements should be issued to all known trade partners who will work on the job. The agreement should include payment terms, responsibility of the trade contractor, scope of work, and other legal terminology that your attorney thinks will protect your rights. If you are using your trade on various jobs you may want to have a blanket agreement that includes the legal terminology and responsibilities and then issue a work order to the trade with the particular scope and price for each particular house. If you pay your trade contractors based upon completion of specific tasks (e.g., 50 percent upon completion of rough and 50 percent upon completion of finish), you can actually issue work orders for each pay point that can later be used as the trade’s invoice.
Purchase orders should be issued to all known material suppliers. The PO should include the quantity, price, and terms as well as any legal terminology. I suggest that the PO be a three-part form with one part being faxed (you could save this copy if your system allows for e-mail issuance of the purchase order) or mailed to the supplier. The second part should be sent to the job file so the superintendent knows what material to expect, and one part should go to accounting. The accounting copy will be held in a file until the receiving ticket and invoice are received.
Work orders and purchase orders can be released at the beginning of the job or can be released throughout the job in stages. But in order for the system to run efficiently, the purchase order or work order must be issued before the phase of work commences.
At times during the job, additional materials may be needed or the trade partner may incur an extra cost as a result of items not being included in the spec or site conditions. In these cases it is best to issue a variance or field purchase order or work order (VPO). The VPO should include the same information as in the original work order or purchase order but should also include an area for a variance reason. A standard list of variance reasons (i.e., weather, site conditions, theft, incorrect quantity) should be developed in order to get consistency in variance reporting. Variance purchase orders can also be used to commit costs relating to customer change orders and extras.
Field. Once a purchase order, work order, or VPO is issued, the field should only be responsible for verifying that the work was completed in accordance with the terms of the work order and trade contractor agreement and verify the quantity of material delivered.
When materials are delivered, the superintendent should go through the receiving ticket and verify he received exactly what was ordered. The receiving ticket must be signed off on and turned into the office regularly. By approving the quantity and quality of material delivery in the field, the superintendent should no longer need to be concerned with approving supplier’s invoices that are matched to the receiving ticket and purchase order by accounting.
If trade contractors are being paid upon completion of specific tasks, and separate work orders are issued for each task, the superintendent should meet with the trade prior to the billing period cutoff. If the work was completed in accordance with the work order, the superintendent and trade partner should both approve the work order and send it to the office where it will be used as the trade partner’s invoice. For trades that are paid on a percentage-of-completion basis, this procedure could be modified: The superintendent and trade could authorize the percentage on the work order and have accounting calculate the pay amount based upon the total amount of the work order.
Accounting. With the work order being used as the trade contractor’s invoice, accounting should not even have to worry about obtaining invoices from the trades. The approved work order should simply be processed for payment.
For material suppliers that issue invoices, accounting should match the invoice with the receiving ticket and the purchase order. Invoices should also be reviewed for clerical accuracy. Any invoices that do not agree with the purchase order (as to price) and receiving ticket (as to quantity) go back to the superintendent for approval. The superintendent only needs to see material invoices that do not match up, thus reducing the amount of time the super spends reviewing every invoice.
Implementing a purchase order system. Implementing a purchase order system can be a painstaking process since it may entail making major changes in the way you do business with your trades and suppliers. It is critical that you communicate any changes you make to your system to your trade partners and suppliers. A custom builder I worked with held several breakfast meetings with all of his trade partners to describe the new procedures and to show that when the work order became the trades’ invoice it would help the trades in their own accounting process. As a result of the first set of meetings, he was able to get 80 percent of his trade partners on board with the program. The 20 percent unwilling to change were either granted a temporary exception or replaced with a new trade partner.
A purchase order system should be able to change the type of reporting you are currently reviewing on your jobs. Instead of just looking at estimates versus actual costs or actual costs incurred, you can focus at looking at variance reports. These reports are available in some integrated accounting systems. However, even if you do not have an integrated system that provides a variance report, it is easy to develop one in a spreadsheet. This report should be reviewed weekly with a discussion as to what went wrong (or right), why, and what can be done so that this variance does not recur.
Implementing a committed cost system can be time consuming up front but in the long run I have seen custom builders cut their direct construction costs by upwards of 5 percent using purchase orders and subcontract agreements.
Steve Maltzman, CPA, is president of Steve Maltzman and Associates in Colton, Calif. Visit him at www.smacfo.com.
