What Is Procure-to-Pay (P2P)?

Procure-to-pay (P2P) is an essential process for organizations that utilize external vendors or suppliers
and includes requisitioning, purchasing, receiving, invoicing, and paying for goods and services.
Essentially, the P2P process covers every step needed for a company to obtain and pay for goods and
services.

An Overview of the P2P Process

While the process can vary a bit from one organization to the next, the P2P process usually follows these
overarching steps:

1. IDENTIFY NEEDS

Before an organization can procure and pay for goods and services, they must first determine what they
need. This first step involves the applicable department (e.g., marketing, HR, sales, etc.) identifying what
is required, which potential vendor is the best fit, and how much the goods or services will cost.

2. CREATE PURCHASE REQUISITION

Next, the department must create a purchase requisition, an internal-facing request for purchase that
accounting must review. If accounting approves the purchase requisition, the purchasing department will
send a document called the purchase order (PO)—the official, external-facing purchase request—to the
vendor.

3. RECEIVE PURCHASE ORDER (PO) APPROVAL

Approving purchase orders can be a time-consuming process—especially for organizations with a manual
P2P process. That is because both the buyer and vendor must approve the PO, which can take several
rounds of internal and external modifications. But this back-and-forth is necessary for preventing errors
and ensuring all the information is correct. Keep in mind that purchase orders are different from
invoices.

4. RECEIVE VENDOR’S INVOICE

Once the purchased goods or services have been obtained, the vendor will send an invoice to the buyer,
whose accounts payable team will then begin the payment process. PO invoices are based on pre-
approved purchase orders, but there are also non-PO invoices, which are not connected to any purchase
orders. These should be avoided because they are significantly more difficult to process and track, as
they are not suitable for three-way matching.

5. PAY VENDORS THROUGH ACCOUNTS PAYABLE

Finally, the buyer’s accounts payable team will input the vendor invoice into the organization’s
accounting system—a process that, when done manually, is time-consuming and can be riddled with
costly errors. While modern organizations rely on software to help automate the process, some
companies still use the manual approach of the past, which requires each vendor invoice to get keyed
into the accounting system, pass through the appropriate people for approval, and then eventually get
paid out.
What Is Order-to-cash (O2C)?

The order-to-cash (O2C) process is the organization’s end-to-end procedure for order processing. O2C is
an important element of how your business approaches managing and improving customer
relationships.

The O2C process kicks off after your marketing and sales teams have accomplished their initial mission
and your customer first places an order. The process continues through the various stages of order
fulfillment and continues even after you have received payment for the order, when your team records
and analyzes all order-related data. In many organizations, O2C is a subset of Q2C, the difference being
that the O2C process begins later, as soon as the customer’s order has been placed.

An Overview of the O2C Process

There are generally five steps that make up the O2C process:

1. CUSTOMER ORDERS

The O2C cycle begins once a customer places an order for goods or services through the organization’s
order management system. Order management often involves sending automated notifications to sales
and procurement teams, as well as any other team or department involved in the initial stages of the
ordering process.

2. FULFILL THE ORDER

Once the order is placed, the organization prepares the product for shipment or schedules a service
appointment with the customer.

3. SHIP THE ORDER

Next, the product is shipped to the customer or the service is fulfilled at the proper date and time.
Inventory counts are updated and all related teams are notified of the order fulfillment. If a product is
out of stock or unavailable, the customer receives an immediate notification including details for
alternative fulfillment.

4. INVOICE THE CUSTOMER

After the product has been received or the service has been completed, the organization generates and
sends a detailed invoice including order specifics, prices, shipping dates, and other pertinent data, to the
customer for payment.

5. RECORD PAYMENT

The organization’s accounts receivable team records the customer’s completed payment in a detailed
ledger. This data is then analyzed in order to identify potential areas for improvement and greater
efficiency.
What Is Record-to-Report?

Record-to-report (R2R) is a finance and accounting management process that involves collecting,
processing, and presenting financial information in the form of documents that are used by management
to perform analysis and review.

The process is conducted in two distinct phases, with the first feeding into the second.

Record is the first phase and involves several steps that serve to properly document all activities, or
transactions, that have a financial impact on the business.

Report is the second phase and refers to the collection and compilation of that data into documents that
are referenced in evaluation of the business’s overall performance and financial health.

Both phases are equally important. The value of the reports produced in the second phase of the cycle is
dependent on the quality of the data gathered and processed in the first phase. It is critical that the
entire cycle be well administered, with minimal errors, to support an efficient process that produces
valuable insight for analysis.

Record-to-report is an integral element of a well-run business. It relies on timely and accurate accounting
data which is then used to produce documents that inform high-level evaluations. Those evaluations
support strategic thinking and decision-making, and allow stakeholders to make detailed analyses about
the business’s operations and its success.

Key Processes under RTR?

General Accounting, Reconciliation, Asset Management, Cost & Financial Accounting, Financial Planning
& Analysis, Control and Compliance, Closing and Reporting.

Comparing the Processes (P2P, O2C & RTR)

P2P and O2C are primarily focused on procurement and sales, respectively, while R2R is centered around
financial accounting and reporting. Q2C encompasses both sales and order fulfillment processes.

P2P and O2C are customer-driven processes, involving interactions with suppliers and customers,
respectively. R2R focuses on internal financial processes, and Q2C encompasses both internal and
external stakeholders.

P2P ensures cost-effective procurement, supplier management, and inventory control, while O2C focuses
on timely order fulfillment, revenue recognition, and cash flow management.

R2R ensures accurate financial reporting, compliance with regulations, and supports decision-making,
while Q2C aims to enhance sales efficiency, customer satisfaction, and revenue generation.

Accounting Terms

Accounting:
• Recording and reporting of financial transactions, including the origination of the transaction, its
recognition, processing, and summarization in the FINANCIAL STATEMENTS
Account:
• A report or statement showing expenses and incomes or receipts and payments

Capital:
• Money invested in any business.
• Shown on liabilities side of the Balance Sheet

Drawing:
• Money withdrawn from business by the proprietor or the partner for personal use
• It reduces capital

Liability:
• Legal obligation or money owed to someone during business
• Examples: Loans, creditors, bank overdraft etc.

Assets :
• Properties belonging to the business whether short term or long term, tangible or intangible
• Examples: Land, building, vehicles, goodwill etc.

Receipts :
• Any amounts received in the normal course of business.
• Example: Amount received from debtors, cash sales, interest on bank deposits etc.

Payments:
• Any amounts paid in the normal course of business to acquire anything or to settle a liability
• Examples: Payment for electricity, water etc

Expense:
• Any amounts incurred in normal course of business in an accounting period whether actually paid
or not.
• Example: Telephone expenses, purchase of raw materials, salaries etc.

Income:
• Any amounts earned in the normal course of business in an accounting period whether actually
received or not.
• Example: Sales, dividend received on investments etc.

Profit :
• Excess of income over expenditure
• Income – Expenses

Loss:
• Excess of expenditure over income
• Expenses – Income

Purchase:
• Buying or acquiring something by paying for it

Sales:
• Exchange of goods or services for money

Stock:
• Inventory of goods lying with business
• Shown on Asset side of the Balance Sheet

Debtors:
• Individual or an organization who owes money to us.
• Shown on the Asset side of the Balance Sheet

Accounts Payable:
• Stands for Accounts Payable
• Money owed to someone
• Also known as creditors, trade payables
• Shown on Liabilities side of the Balance Sheet

Accounts Receivable:
• Stands for Accounts Receivables
• Individual or an organization who owes money to us.
• Also known as debtors, trade receivables
• Shown on the Asset side of the Balance Sheet

Goods:
• Commodity or a tangible item which satisfies demand

Cost:
• Actual amount incurred to buy something or to manufacture something

Vouchers
• Written instruments that serves to confirm or vouch for a transaction
Discount
• Deduction from the list price.
• e.g., trade discount, cash discount, early payment discount etc.

Accounting Assumptions

Assumptions are agreed upon rules of accounting, and are basic, understood beliefs.
There are Four Basic Assumptions of Accounting:

1. Economic Business Entity

2. Going Concern
3. Monetary Unit
4. Time Period

Assumptions

Economic Business Entity Assumption

All of the business transactions should be separate from the business owner’s personal transactions
There should be no commingling of personal funds with business funds.

Going Concern Assumption

Financial statements are prepared under the assumption that the company will remain in business
indefinitely unless there is sufficient evidence otherwise.
If there is evidence that a company may possibly have a going concern issue, this must be disclosed
in the financial statements.

Monetary Unit Assumption

Assumes a stable currency is going to be the unit of record.
FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for
inflation.

Time Period Assumption

The entity’s activities are separated into periods of time such as months, quarters or years.
Transactions must be accounted for within the time period they occur regardless of when cash
is exchanged.
Accounting Principles:

Principles are accounting rules used to prepare, present, and report financial statements.
Principles dictate how events should be recorded and reported.
Accounting Entity Principle
The business entity concept states that the transactions associated with a business must be
separately recorded from those of its owners or other businesses
The founder, owner or directors and company are two separate legal entities.

Money Measurement Principle

Is also called the Measurability Concept
The money measurement concept underlines the fact that in accounting and economics generally,
every recorded event or transaction is measured in terms of money
Only transactions and events that are capable of being measured in monetary terms are recognized
in the financial statements
Example: Skills and competence of employees cannot be attributed an objective monetary value
and should therefore not be recognized as assets in the balance sheet. However, those transactions
related to employees that can be measured reliably such as salaries expense and pension
obligations are recognized in the financial statement

Full Disclosure Principle

All information pertaining to the operations and financial position of the entity must be reported
within the period of time in question.
Circumstances and events that make a difference to financial statement users should be disclosed.

Revenue Recognition Principle

Revenue is earned and recognized upon product delivery or service completion, without regard
to when cash is actually received.
Also called accrual basis accounting
Example: A customer purchases inventory from a company on credit. Even though no cash has
yet been received, the sale is recorded.

Matching Principle
The costs of doing business are recorded in the same period as the revenue they help generate,
regardless of when the money is actually paid.
Also called accrual basis accounting
Example: A company orders merchandise on credit and has 30 days in which to pay.
This purchase is recorded immediately, even though no cash has been paid.

Objectivity Principle
The objectivity principle states that accounting information and financial reporting should be
independent and supported with unbiased evidence
This means that accounting information must be based on research and facts, not merely a
preparer’s opinion, hence makes it relevant and reliable.
The two concepts of relevance and reliability encompass the objectivity principle. By making
financial statements more relevant and reliable, the objectivity principle makes the financial
information more usable for investors and creditors.
Example: Jim is an accountant who is the CFO of Fisher Corp. He leaves the company after he is
offered a partnership position in DHI and Associates, an audit firm. After six months of working at
the firm, he is assigned to the head auditor position on the Fisher Corp audit. This is a violation of
many GAAS rules, but it is also a violation of the objectivity principle
Accounting Concepts:

Concepts are the ground rules of accounting that should be followed when preparing financial
statements.
These are:
• Recognition Concept
• Measurement Concept

Recognition Concept
States that an item should be recognized (recorded) in the financial statements when:
• It can be defined by GAAP assumptions and principles
• It can be measured
• It is relevant to decision-making by users
• It is reliable

Measurement Concept
States that every transaction is measured by the stated unit of measurement, such as the dollar
The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by
GAAP

Accounting Constraints:

A constraint is a limit, regulation, or confinement within prescribed bounds.

This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information
They consist of:
• Cost Effectiveness Constraint
• Materiality Constraint
• Conservatism Constraint

Cost Effectiveness Constraint

Also called Cost Benefit Constraint
The cost of providing accounting information should not exceed the benefit of the information
it is reporting.
Example: Your checkbook register and bank statement differs by $0.10. Rather than waste time
to find the $0.10, the accountant should record the amount as miscellaneous expense or income.

Materiality Constraint
The term materiality refers to an accounting constraint that is used to determine the relative
importance or value of an item to one of the company's financial statements.
If an item is not deemed significant enough to influence the decision-making process of an
individual examining the company's financial statements, then that item is not considered
material.
Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized
as an asset and depreciated, but it is not recorded as an asset because the amount is immaterial,
the $10 can be recorded as an expense
Conservatism Constraint
Revenues are only recognized when there is a reasonable certainty that they will be realized
Expenses are recognized sooner, when there is a reasonable possibility that they will be incurred.
Accountants use their judgment to record transactions that require estimation.
Conservatism helps the accountant choose between 2 equally likely alternatives.
Requires the accountant to record the transaction using the less optimistic choice.
Example: There is the potential for a customer to sue the company. Although, the customer may
choose not to sue, the accountant will disclose this potential lawsuit to investors.

Accounting Period:

An Accounting Period is the Duration for which Account are Created and Recorded as per the Monetary
Events taken place for the specified time. A period is normally a Fiscal Year which Starts and End as per
the respective Country Rule. Like in India our Fiscal Year or Accounting Period Starts on 1st April and
Ends in the following year on 31st March.

Full Disclosure Materiality:

Information is material when its absence would influence the decisions of the
users of financial statements. Items are material when they have an excessive impact on
reported profits, or on individual line items within the financial statements.
Any Associated member have the right to know the needful information and such information are
disclosed accordingly.

Prudence:

Prudence would normally be exercised in setting up, for example, an allowance for doubtful accounts or
a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet
been
identified, but a prudent person would record a reserve in anticipation of a reasonable amount of these
expenses arising at some point in the future.
The prudence concept is only a general guideline. Ultimately, use your best judgment in determining
how and when to record an accounting transaction.

Cost Concept:

Many business decisions require a firm knowledge of several cost concepts. Different types of costs have
differing characteristics. Consequently, when reviewing a business case to determine which path to take,
it is useful to understand the following cost concepts.
Fixed, variable, and mixed costs.
By-Product Cost.
Allocated Cost.
Discretionary Cost.
Step Cost.
All the cost concepts noted here are critical elements of many types of management decisions.
Variable costs are the costs that vary in direct proportion to changes in the level of activity. This type of
cost increases or decreases depending on a company’s production or sales volume. Examples of variable
costs include raw materials, sales commissions, packaging, direct label, shipping expenses, etc.

When analyzing variable costs, it is important to consider each cost independently, in order to
understand what activity drives the cost. It can relate not only to the number of units produced, but also
to labor hours worked, units sold, customers processed, etc.

Fixed costs are the opposite of variable costs because they do not vary with changes in the level of
activity. They are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs
include administrative salaries, rents, property taxes, security, networking infrastructure support, etc.

Some fixed costs are classified as committed fixed costs and some as discretionary fixed costs.
Committed costs are costs that the management of an organization have a long-term responsibility to
pay. The non-payment of committed costs can result in disruption of business activities and legal
consequences apply if contractual costs and obligations are not met. Examples include depreciation,
rent, insurance, property taxes, etc.

Discretionary fixed costs are the costs that can be reduced or modified without significant impact on the
short-term day to day operations of a company. However, in the long-term their elimination can have a
negative impact in the company’s profitability. Examples of discretionary costs are advertising and
marketing expenses, employee training, research, and development, etc.

The nature of business defines its inherited fixed cost’s structure. Because airlines have high fixed costs
with gates, maintenance, aircrafts, etc., the costs do not change much with increases of volume. There is
not much cost difference in flying a plane empty or full. Which means that in their boom years, airlines
could be extremely profitable and in their lean years, they struggled considerably to cover these costs.

It is important to bear in mind that many fixed costs are only fixed for a certain level of production. Once
an activity threshold is met, these costs can increase or decrease according to the new activity level
reached by a company. These costs are called step up costs. For example: Sophia operates a company
that produces pencils. A machine costing £15,000 can produce up to 1,000 pencils. Considering that
Sophia has received an extra order of 2,000 pencils, her company must purchase an additional machine
to expand its production capacity. Therefore, the total cost will go up to £ 30,000 (2 machines x
£15,000).

Fixed costs can be spread over large production runs causing a decrease in the per unit fixed cost. On top
of that, as the volume goes up, quantity discounts can be applied reducing the variable cost per unit.
Companies can achieve economies of scale when production becomes efficient, i.e., cost advantages by
increasing production and lowering costs.

Within designated boundaries, certain revenue or expense levels are likely to occur. Outside that
relevant range, they will probably differ from the expected amount. The relevant range is the level of
activity, e.g., production or sales, at which a company is expected to perform. If you move outside the
relevant range, your cost assumptions are no longer valid. Any pricing data outside of this range is
irrelevant and need not be considered.
Another aspect of cost behavior that should be considered are the mixed costs. Also called semi variable
costs(Mixed Costs), they contain both fixed and variable components and are hard to evaluate because
they change in response to fluctuations in volume. To understand how mixed costs operate, take cell
phone agreements as an example. There are companies that charge a monthly fee plus usage charges for
excess minutes, which means there is some fixed amount plus a variable component tied to an activity.

Byproduct costing is a method of allocating costs to the main product and byproducts in a production
process. In industries where production results in multiple outputs, some of which are of lesser value
than the main product, these lesser-value outputs are considered byproducts. Byproduct costing is
essential to determine the cost of producing the main product accurately and to assign appropriate costs
to the byproducts.

In byproduct costing, the primary focus is on accurately assigning costs to the main product, and any
revenues generated from the sale of byproducts are typically treated as a reduction in the production
cost of the main product. There are several methods for allocating costs to byproducts, including the
sales value method, the production quantity method, and the constant per-unit method.

For example, in the petroleum refining industry, crude oil is processed to produce various products,
including gasoline, diesel, and jet fuel (main products), as well as asphalt, lubricants, and petroleum coke
(byproducts). Byproduct costing helps allocate the costs of refining crude oil among the main products
and byproducts to accurately reflect their production costs.

A discretionary expense is a cost that a business or household can survive without, if necessary.
Discretionary expenses are often defined as nonessential spending. This means a business or household
is still able to maintain itself even if all discretionary consumer spending stops.

Meals at restaurants and entertainment costs are examples of discretionary expenses.

Allocated costs are those costs which have been specifically identified and allocated to a particular cost
centre or project. They may be direct costs, such as labour or materials, or indirect costs, such as
overheads. Allocated costs may be fixed or variable, depending on the nature of the cost. They are used
to track and monitor the performance of a particular cost centre or project.

Step costs are expenses that are constant for a given level of activity, but increase or decrease once a
threshold is crossed. Step costs change disproportionately when production levels of a manufacturer, or
activity levels of any enterprise, increase or decrease. When depicted on a graph, these types
of expenses will be represented by a stair-step pattern.

Examples of Step Costs

A high-tech gear manufacturer makes 400 virtual reality headsets in one shift of eight hours with 25
employees and one supervisor. All the headsets are shipped out, and there is no inventory. Wages and
benefits for these employees amount to $6,500 per shift.

Then, demand increases by one headset. Because the production line is at full capacity, the company
must add another shift to manufacture 401 units to 800 units. The labor cost to produce 401 units
stepped up from $6,500 to $13,000.
A coffee shop can serve 30 customers an hour with one employee. If the shop receives anywhere from
zero to 30 customers per hour, it will only need to pay the cost of having one employee, say $50 ($20 for
the employee, $30 for all other expenses, fixed and operating). If the shop begins receiving 31 or more
customers per hour, it must hire a second employee, increasing its costs to $70 ($40 for two employees,
$30 for others).

Matching and Dual Entry Concept

The matching concept exists only in accrual accounting. This principle requires that you match revenues
with the expenses incurred to earn those revenues, and that you report them both at the same time. ...
Further, you would record only the portion of the expense attributable to each individual item as it got
sold.
The dual aspect concept states that every business transaction requires recordation in two different
accounts. This concept is the basis of double entry accounting, which is required by all accounting
frameworks in order to produce reliable financial statements.

Cash Basis and Accrual Basis

The cash basis and accrual basis of accounting are two different methods used to record accounting
transactions. The core underlying difference between the two methods is in the timing of transaction
recordation. When aggregated over time, the results of the two methods are approximately the same. A
brief description of each method follows:
Cash basis: Revenue is recorded when cash is received from customers, and expenses are recorded
when cash is paid to suppliers and employees.
Accrual basis: Revenue is recorded when earned and expenses are recorded when consumed.

What is GAAP (generally accepted accounting principles)?

GAAP (generally accepted accounting principles) is a collection of commonly followed accounting rules
and standards for financial reporting. The acronym is pronounced gap.

GAAP specifications include definitions of concepts and principles, as well as industry-specific rules. The
purpose of GAAP is to ensure that financial reporting is transparent and consistent from one public
organization to another, and from one accounting period to another.

GAAP emerged in the 1970s and involved the following four major rules and standards:

Accrual accounting methods. GAAP uses accrual accounting, which records revenue when a service or
good is sold but not when payment is received; direct expenses for goods sold are recorded when a sale
is transacted, and indirect expenses are recorded when expenses are paid.

Depreciation and capital expenditures. Costs of major asset acquisitions are accounted for over the
entire life of the asset. For example, an item with a 10-year life is accounted for at 10% for 10 years.
Reporting of historical costs. Some assets -- such as property, equipment, and facilities -- are accounted
for using original purchase costs rather than current market values.

Reporting of bad debts. Companies with significant money owed by customers, or accounts receivable,
must report the possibility that some or all that money may not be received and becomes lost revenue.

What are the 10 principles of GAAP?

GAAP is outlined by the following 10 general concepts or principles.

Regularity. The business and accounting staff apply GAAP rules as standard practice.

Consistency. Accounting staff apply the same standards through each step of the reporting process and
from one reporting cycle to the next, paying careful attention to disclose any differences.

Sincerity. Accounting staff provide objective and accurate information about business finances.

Permanence. Accounting staff use consistent procedures in financial reporting, enabling business
finances to be compared from report to report.

Non compensation. Accountants provide complete transparency of positive and negative factors without
any compensation. In other words, they do not get paid based on how good or bad the reporting turns
out.

Prudence. Financial data is based on documented facts and is not influenced by guesswork.

Continuity. Financial data collection and asset valuations should not disrupt normal business operations.

Periodicity. Financial data should be organized and reported according to relevant accounting periods.
For example, revenue or expenses should be reported within the corresponding quarter or other
reporting period.

Materiality. Accountants must rely on material facts and disclose all material financial and accounting
facts in financial reports.

Good Faith. There is an expectation of honesty and completeness in financial data collection and
reporting.

10 GAAP concepts

Organizations that follow GAAP rules and standards adhere to these 10 concepts.

Beyond these 10 general principles, public U.S. companies adhering to GAAP are expected to observe
the following four additional guidelines to support the consistency and accuracy of financial statements.

Recognition. Financial reporting should recognize and include all business assets, revenue, liabilities, and
expenses.

Measurement. Financial statements should report financial results following GAAP standards.
Presentation. Financial statements should include four major elements: income statement, balance
sheet, cash flow statement, and a summary of shareholder equity or ownership.

Disclosure. Financial reporting should include any notes and descriptions needed to completely explain
financial information contained in reports.

Who uses GAAP?

Accountants and other financial professionals use GAAP rules and standards to organize and present the
financial reporting periodically required by publicly traded companies within the U.S.

Since GAAP is intended to ensure complete, accurate, and consistent financial reporting between
businesses, it affects investment decisions by enabling investors to objectively compare business
performance and influences the stability of the investment market.

There is no universal GAAP standard and the specifics vary from one geographic location or industry to
another. The U.S. Securities and Exchange Commission (SEC) mandates that financial reports adhere to
GAAP requirements. The Financial Accounting Standards Board stipulates GAAP overall and the
Governmental Accounting Standards Board stipulates GAAP for state and local government. Publicly
traded companies must comply with both SEC and GAAP requirements.

What Are International Financial Reporting Standards (IFRS)?

International Financial Reporting Standards (IFRS) are a set of accounting rules for the financial
statements of public companies that are intended to make them consistent, transparent, and easily
comparable around the world.

IFRS currently has complete profiles for 167 jurisdictions, including those in the European Union. The
United States uses a different system, the generally accepted accounting principles (GAAP).1

The IFRS is issued by the International Accounting Standards Board (IASB).

The IFRS system is sometimes confused with International Accounting Standards (IAS), which are the
older standards that IFRS replaced in 2001

GAAP vs. IFRS: What is the difference?

Many countries around the world have adopted International Financial Reporting Standards (IFRS). IFRS
is designed to provide a global framework for how public companies prepare and disclose their financial
statements. Today, IFRS is the preeminent international accounting standard for financial reporting, and
144 out of 166 countries or jurisdictions around the world use IFRS. Although GAAP and IFRS serve the
same fundamental purposes, there are some key differences between them, including the following.

How inventory cost is handled. GAAP enables the last-in/first-out inventory cost method, but IFRS does
not.
How development costs are handled. GAAP treats development costs, such as the creation of software
or other intellectual property as expenses, but IFRS treats development as a capital investment that is
expensed and amortized over time.

How write-downs are handled. GAAP does not allow inventory or asset write-downs or reductions in
value to be reversed, but IFRS allows write-downs to be reversed if inventory or asset values change.

How fixed assets are handled. GAAP records and reports fixed assets, including property, facilities, and
equipment at historical cost, while IFRS enables businesses to adjust fixed assets at fair market value.

Adopting a single set of worldwide standards simplifies accounting procedures for international
countries and provides investors and auditors with a cohesive view of finances. IFRS provides general
guidance for the preparation of financial statements, rather than rules for industry-specific reporting.

General Ledger and Sub Ledger

A general ledger is the master set of accounts that summarize all transactions occurring within an
entity. There may be a subsidiary set of ledgers that summarize into the general ledger. The general
ledger, in turn, is used to aggregate information into the financial statements of a business; this can
be done automatically with accounting software, or by manually compiling financial statements
from the information in a trial balance report (which is a summarization of the ending balances in
the general ledger).
A subsidiary ledger stores the details for a general ledger control account. Once information has
been recorded in a subsidiary ledger, it is periodically summarized and posted to a control account
in the general ledger, which in turn is used to construct the financial statements of a company. Most
accounts in the general ledger are not control accounts; instead, individual transactions are
recorded directly into them. Subsidiary ledgers are used when there is a large amount of transaction
information that would clutter up the general ledger

Trial Balance

A trial balance is prepared after posting journal entries into the ledger and balancing the accounts. This
balance depicts the difference between the summations on the debit side and the credit side. If the
value of the debit side is more, it is called the debit balance, and if the credit side is more, it becomes
the credit balance.

In a trial balance, debit and credit balances are posted in separate columns. Here, if the sum of the debit
balance is equal to that of the credit balance, then bookkeeping entries are considered accurate.

Let us know more about the use of trial balance with examples!

What is Trial Balance?

Trial Balance is a financial statement summarizing the debit and credit balance of the ledger accounts to
verify arithmetical accuracy of financial books.
It is prepared towards the end of a financial year to draw financial statements like profit and loss
accounts and balance sheets. Thus, preparing a trial balance is the first step in closing the financial books
of an accounting period.

What Are the Features of Trial Balance?

The primary features of a trial balance are:

Trial balance in accounting is a summary of all debit and credit ledger balances, including cash book

This financial statement serves as a vital tool to establish the arithmetical accuracy of transactions in the
books of accounts

It is not a part of the Double Entry System of bookkeeping but serves only as a working reference

This can be prepared anytime as and when required, like, weekly, monthly, quarterly and half-yearly

It can establish a link between the profit and loss account and the balance sheet

Trial balance is not conclusive proof of accuracy since it cannot disclose some errors like an error of
principle

What Are the Purposes or Objectives of Trial Balance?

The different purposes of using a trial balance are:

1. Confirms Accuracy of Ledger Accounts

A trial balance examines whether posting and other accounting processes have been carried out without
committing arithmetical errors.

2. Helps Prepare Final Accounts

Financial statements are normally prepared to refer to the trial balance; otherwise, it would turn out to
be difficult. Hence, the preparation of financial statements is the second purpose of preparing a trial
balance.

3. Acts as a Summary for Each Account

A trial balance is a summary of the ledger account. It helps in referring to the ledger only during the
requirement of more details in respect of an account.
4. Finds Errors During Bookkeeping

Trial balance is a statement that helps in locating errors related to bookkeeping. However, it cannot
disclose all errors but only the arithmetical inaccuracies.

How to Prepare a Trial Balance?

After recording transactions in the journal and posting them in the ledger, the next step in the
accounting process is to prepare a trial balance.

The following steps will show the steps on how to prepare a trial balance:

Step 1: Balance All Ledger Accounts

The difference between total debit entries and total credit entries of every ledger account must be
balanced.

Step 2: Prepare the Trial Balance Worksheet

Prepare a four-column worksheet referring to the trial balance format.

Step 3: Apply the Golden Rule of Accounting

The golden rule in accounting states to debit what you receive and credit what is going out. This step is
mostly used to recheck whether the entries in both journal and ledger have been done correctly.

Step 4: Fill in the Amount Beside Each Account Head in the Worksheet

Fill in the trial balance worksheet with the respective account number and account heads in their
respective debit or credit column.

Step 5: Add the Values of Both Columns

Calculate the sum of both debit and credit columns. In an error-free trial balance, these two summations
would be equal.

Step 6: Close the Trial Balance with a Balancing Figure

Once you calculate the totals and confirm that they are the same, close the trial balance. If the totals are
unmatched, find the error and rectify it with proper adjustments.

What Are the Types of Trial Balance?

There are primarily 3 types of trial balances prepared at different accounting cycle stages. They are as
follows:

1. Adjusted Trial Balance

An adjusted trial balance is prepared after completing the adjustment entries and balancing the book. It
is used to prepare financial statements and make sure that errors are rectified and accurate.

2. Unadjusted Trial Balance

An unadjusted trial balance is a record of daily transactions and can balance a ledger by adjusting
entries. However, it is prepared before completing journal entries with the help of a ledger.

3. Post-closing Trial Balance

A post-closing trial balance enters each account with zero net balance on the balance sheet. It verifies
whether the debit and credit balances are identical and shows them after completing the closing entries.
In addition, this type of trial balance also acts as an opening trial balance for the upcoming year.

What Are the Errors that Can Cause a Mismatch in Trial Balance?

The different types of errors that can cause a mismatch in trial balance are as follows:

Errors of Omission: An error of omission occurs when transactions are completely omitted from getting
recorded in the books of account. Moreover, this type of error is hard to detect.

Errors of Commission: An error of commission occurs if an amount is entered correctly but to the wrong
account.
Compensating Errors: A compensating error is a group of errors committed in such a way that one
mistake compensates the other. This results in balancing a trial balance.

Principle Error: A principal error arises due to an incorrect application of the principle of accounting and
does not get disclosed by a trial balance.

Error of Original Entry: An original entry error occurs if a double-entry transaction includes a wrong
amount on both sides.

Reversal Entry: When a double-entry transaction is entered with the correct amount but the account to
be credited is debited and vice versa, it is called a reversal error.

Important Principles Used in the Preparation of a Trial Balance

The important principles used in the preparation of a trial balance are:

All personal, real and nominal accounts are considered in preparing a trial balance

In case an account is showing a NIL balance in the ledger, it is not posted in a trial balance

The revenue account carries a credit balance on the balance sheet

The purchase or consumption account carries a debit balance on the balance sheet

Sale returns and purchase returns appear as separate accounts in a trial balance

The opening stock balance is derived from profit and loss account as it is not available as a closing
balance in the previous year’s trial balance

All expenses carry a debit balance, and income or gains carry a credit balance

The balancing figure of both asset and liability sides must match at the end

What Are the Accounts in a Trial Balance?

A trial balance is a financial statement containing all major accounting items like assets, liabilities, equity,
revenues, incomes, expenses and losses.

The accounts of assets, expense and loss have a debit balance, whereas the accounts of liability, gain,
revenue and equity have a credit balance.

What Are the Advantages of a Trial Balance?

The advantages of preparing a trial balance are:

It helps in summarising all financial transactions of a business and proves the arithmetical accuracy of
the books of account.
The balance of a debit or credit side of any ledger account can be identified by referring to a trial
balance.

It locates or detects an error in the accounting balances.

Trial balance proves that a double-entry system of recording transactions is being followed by an
accountant.

These financial statements serve as a summary of all ledger accounts and help in the easy preparation of
final accounts.

What Are the Limitations of a Trial Balance?

The limitations of preparing a trial balance are:

These financial statements can only be prepared if the accountant follows the double-entry system of
accounting.

It cannot show all errors or whether all journal entries have been posted correctly.

It leads to recording both aspects of a transaction twice in the books of account.

If the correct amount is posted on the correct side but in the wrong account, it is not reflected in a trial
balance.

A wrong amount recorded in the books of original entry and the same amount being incorrectly debited
and credited cannot be identified by a trial balance.

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Final Word

Trial balance is an essential part of the accounting process and helps in preparing financial statements. It
also provides a summary of the financial activities of a company, thus helping the management to make
important decisions. Here, the debit and credit balances are posted separately and balanced, which also
helps in rectifying errors.

Income Statement

Income, expenses, and profit/loss

The Income Statement is one of a company’s core financial statements that shows their profit and loss
over a period of time. The profit or loss is determined by taking all revenues and subtracting all
expenses from both operating and non-operating activities.
The income statement is one of three statements used in both corporate finance (including financial
modeling) and accounting. The statement displays the company’s revenue, costs, gross profit, selling and
administrative expenses, other expenses and income, taxes paid, and net profit in a coherent and logical
manner.

The statement is divided into time periods that logically follow the company’s operations. The most
common periodic division is monthly (for internal reporting), although certain companies may use a
thirteen-period cycle. These periodic statements are aggregated into total values for quarterly and
annual results.

This statement is a great place to begin a financial model, as it requires the least amount of information
from the balance sheet and cash flow statement. Thus, in terms of information, the income statement is
a predecessor to the other two core statements.

Components of an Income Statement

The income statement may have minor variations between different companies, as expenses and income
will be dependent on the type of operations or business conducted. However, there are several generic
line items that are commonly seen in any income statement.

The most common income statement items include:

Revenue/Sales

Sales Revenue is the company’s revenue from sales or services, displayed at the very top of the
statement. This value will be the gross of the costs associated with creating the goods sold or in
providing services. Some companies have multiple revenue streams that add to a total revenue line.

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is a line-item that aggregates the direct costs associated with selling products
to generate revenue. This line item can also be called Cost of Sales if the company is a service business.
Direct costs can include labor, parts, materials, and an allocation of other expenses such as depreciation
(see an explanation of depreciation below).

Gross Profit

Gross Profit Gross profit is calculated by subtracting Cost of Goods Sold (or Cost of Sales) from Sales
Revenue.

Marketing, Advertising, and Promotion Expenses

Most businesses have some expenses related to selling goods and/or services. Marketing, advertising,
and promotion expenses are often grouped together as they are similar expenses, all related to selling.

General and Administrative (G&A) Expenses

SG&A Expenses include the selling, general, and administrative section that contains all other indirect
costs associated with running the business. This includes salaries and wages, rent and office expenses,
insurance, travel expenses, and sometimes depreciation and amortization, along with other operational
expenses. Entities may, however, elect to separate depreciation and amortization in their own section.

EBITDA

While not present in all income statements, EBITDA stands for Earnings before Interest, Tax,
Depreciation, and Amortization. It is calculated by subtracting SG&A expenses (excluding amortization
and depreciation) from gross profit.

Depreciation & Amortization Expense

Depreciation and amortization are non-cash expenses that are created by accountants to spread out the
cost of capital assets such as Property, Plant, and Equipment (PP&E).

Operating Income (or EBIT)

Operating Income represents what’s earned from regular business operations. In other words, it’s the
profit before any non-operating income, non-operating expenses, interest, or taxes are subtracted from
revenues. EBIT is a term commonly used in finance and stands for Earnings Before Interest and Taxes.

Interest

Interest Expense. It is common for companies to split out interest expense and interest income as a
separate line item in the income statement. This is done in order to reconcile the difference between
EBIT and EBT. Interest expense is determined by the debt schedule.

Other Expenses

Businesses often have other expenses that are unique to their industry. Other expenses may include
fulfillment, technology, research and development (R&D), stock-based compensation (SBC), impairment
charges, gains/losses on the sale of investments, foreign exchange impacts, and many other expenses
that are industry or company-specific.

EBT (Pre-Tax Income)

EBT stands for Earnings Before Tax, also known as pre-tax income, and is found by subtracting interest
expense from Operating Income. This is the final subtotal before arriving at net income.

Income Taxes

Income Taxes refer to the relevant taxes charged on pre-tax income. The total tax expense can consist of
both current taxes and future taxes.

Net Income
Net Income is calculated by deducting income taxes from pre-tax income. This is the amount that flows
into retained earnings on the balance sheet, after deductions for any dividends.

Balance Sheet: Explanation, Components, and Examples

What Is a Balance Sheet?

The term balance sheet refers to a financial statement that reports a company's assets, liabilities, and
shareholder equity at a specific point in time. Balance sheets provide the basis for computing rates of
return for investors and evaluating a company's capital structure.

In short, the balance sheet is a financial statement that provides a snapshot of what a company owns
and owes, as well as the amount invested by shareholders. Balance sheets can be used with other
important financial statements to conduct fundamental analysis or calculate financial ratios.

KEY TAKEAWAYS

A balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder
equity.

The balance sheet is one of the three core financial statements that are used to evaluate a business.

It provides a snapshot of a company's finances (what it owns and owes) as of the date of publication.

The balance sheet adheres to an equation that equates assets with the sum of liabilities and shareholder
equity.

Fundamental analysts use balance sheets to calculate financial ratios.

An Introduction To The Balance Sheet

How Balance Sheets Work

The balance sheet provides an overview of the state of a company's finances at a moment in time. It
cannot give a sense of the trends playing out over a longer period on its own. For this reason, the
balance sheet should be compared with those of previous periods.

Investors can get a sense of a company's financial well-being by using a number of ratios that can be
derived from a balance sheet, including the debt-to-equity ratio and the acid-test ratio, along with many
others. The income statement and statement of cash flows also provide valuable context for assessing a
company's finances, as do any notes or addenda in an earnings report that might refer back to the
balance sheet.

1
The balance sheet adheres to the following accounting equation, with assets on one side, and liabilities
plus shareholder equity on the other, balance out:

Assets = Liabilities + Shareholders’ Equity

This formula is intuitive. That is because a company must pay for all the things it owns (assets) by either
borrowing money (taking on liabilities) or taking it from investors (issuing shareholder equity).

If a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will
increase by $4,000. Its liabilities (specifically, the long-term debt account) will also increase by $4,000,
balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will
increase by that amount, as will its shareholder equity. All revenues the company generates in excess of
its expenses will go into the shareholder equity account. These revenues will be balanced on the assets
side, appearing as cash, investments, inventory, or other assets.

Balance sheets should also be compared with those of other businesses in the same industry since
different industries have unique approaches to financing.

Special Considerations

As noted above, you can find information about assets, liabilities, and shareholder equity on a
company's balance sheet. The assets should always equal the liabilities and shareholder equity. This
means that the balance sheet should always balance, hence the name. If they don't balance, there may
be some problems, including incorrect or misplaced data, inventory or exchange rate errors, or
miscalculations.

Each category consists of several smaller accounts that break down the specifics of a company's finances.
These accounts vary widely by industry, and the same terms can have different implications depending
on the nature of the business. But there are a few common components that investors are likely to come
across.

What Does a Company Balance Sheet Tell You?

Components of a Balance Sheet

Assets

Accounts within this segment are listed from top to bottom in order of their liquidity. This is the ease
with which they can be converted into cash. They are divided into current assets, which can be
converted to cash in one year or less; and non-current or long-term assets, which cannot.

Here is the general order of accounts within current assets:

Cash and cash equivalents are the most liquid assets and can include Treasury bills and short-term
certificates of deposit, as well as hard currency.

Marketable securities are equity and debt securities for which there is a liquid market.

Accounts receivable (AR) refer to money that customers owe the company. This may include an
allowance for doubtful accounts as some customers may not pay what they owe.

Inventory refers to any goods available for sale, valued at the lower of the cost or market price.

Prepaid expenses represent the value that has already been paid for, such as insurance, advertising
contracts, or rent.

Long-term assets include the following:

Long-term investments are securities that will not or cannot be liquidated in the next year.

Fixed assets include land, machinery, equipment, buildings, and other durable, generally capital-
intensive assets.

Intangible assets include non-physical (but still valuable) assets such as intellectual property and
goodwill. These assets are generally only listed on the balance sheet if they are acquired, rather than
developed in-house. Their value may thus be wildly understated (by not including a globally recognized
logo, for example) or just as wildly overstated.

Liabilities

A liability is any money that a company owes to outside parties, from bills it has to pay to suppliers to
interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities are due within one
year and are listed in order of their due date. Long-term liabilities, on the other hand, are due at any
point after one year.

Current liabilities accounts might include:

Current portion of long-term debt is the portion of a long-term debt due within the next 12 months. For
example, if a company has 10 years left on a loan to pay for its warehouse, 1 year is a current liability and
9 years is a long-term liability.

Interest payable is accumulated interest owed, often due as part of a past-due obligation such as late
remittance on property taxes.

Wages payable is salaries, wages, and benefits to employees, often for the most recent pay period.

Customer prepayments is money received by a customer before the service has been provided or
product delivered. The company has an obligation to (a) provide that good or service or (b) return the
customer's money.

Dividends payable is dividends that have been authorized for payment but have not yet been issued.

Earned and unearned premiums is like prepayments in that a company has received money upfront, has
not yet executed on their portion of an agreement, and must return unearned cash if they fail to
execute.
Accounts payable is often the most common current liability. Accounts payable is debt obligations on
invoices processed as part of the operation of a business that are often due within 30 days of receipt.

Long-term liabilities can include:

Long-term debt includes any interest and principal on bonds issued

Pension fund liability refers to the money a company is required to pay into its employees' retirement
accounts

Deferred tax liability is the amount of taxes that accrued but will not be paid for another year. Besides
timing, this figure reconciles differences between requirements for financial reporting and the way tax is
assessed, such as depreciation calculations.

Some liabilities are considered off the balance sheet, meaning they do not appear on the balance sheet.

Shareholder Equity

Shareholder equity is the money attributable to the owners of a business or its shareholders. It is also
known as net assets since it is equivalent to the total assets of a company minus its liabilities or the debt
it owes to non-shareholders.

Retained earnings are the net earnings a company either reinvests in the business or uses to pay off
debt. The remaining amount is distributed to shareholders in the form of dividends.

Treasury stock is the stock a company has repurchased. It can be sold later to raise cash or reserved to
repel a hostile takeover.

Some companies issue preferred stock, which will be listed separately from common stock under this
section. Preferred stock is assigned an arbitrary par value (as is common stock, in some cases) that has
no bearing on the market value of the shares. The common stock and preferred stock accounts are
calculated by multiplying the par value by the number of shares issued.

Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess
of the common or preferred stock accounts, which are based on par value rather than market price.
Shareholder equity is not directly related to a company's market capitalization. The latter is based on the
current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any
price.

Par value is often just a very small amount, such as $0.01.

Importance of a Balance Sheet

Regardless of the size of a company or industry in which it operates, there are many benefits of reading,
analyzing, and understanding its balance sheet.

First, balance sheets help to determine risk. This financial statement lists everything a company owns
and all its debt. A company will be able to quickly assess whether it has borrowed too much money,
whether the assets it owns are not liquid enough, or whether it has enough cash on hand to meet
current demands.

Balance sheets are also used to secure capital. A company usually must provide a balance sheet to a
lender in order to secure a business loan. A company must also usually provide a balance sheet to
private investors when attempting to secure private equity funding. In both cases, the external party
wants to assess the financial health of a company, the creditworthiness of the business, and whether the
company will be able to repay its short-term debts.

Managers can opt to use financial ratios to measure the liquidity, profitability, solvency, and cadence
(turnover) of a company using financial ratios, and some financial ratios need numbers taken from the
balance sheet. When analyzed over time or comparatively against competing companies, managers can
better understand ways to improve the financial health of a company.

Last, balance sheets can lure and retain talent. Employees usually prefer knowing their jobs are secure
and that the company they are working for is in good health. For public companies that must disclose
their balance sheet, this requirement gives employees a chance to review how much cash the company
has on hand, whether the company is making smart decisions when managing debt, and whether they
feel the company's financial health is in line with what they expect from their employer.

Limitations of a Balance Sheet

Although the balance sheet is an invaluable piece of information for investors and analysts, there are
some drawbacks. Because it is static, many financial ratios draw on data included in both the balance
sheet and the more dynamic income statement and statement of cash flows to paint a fuller picture of
what is going on with a company's business. For this reason, a balance alone may not paint the full
picture of a company's financial health.

A balance sheet is limited due its narrow scope of timing. The financial statement only captures the
financial position of a company on a specific day. Looking at a single balance sheet by itself may make it
difficult to extract whether a company is performing well. For example, imagine a company reports
$1,000,000 of cash on hand at the end of the month. Without context, a comparative point, knowledge
of its previous cash balance, and an understanding of industry operating demands, knowing how much
cash on hand a company has yields limited value.

Different accounting systems and ways of dealing with depreciation and inventories will also change the
figures posted to a balance sheet. Because of this, managers have some ability to game the numbers to
look more favorable. Pay attention to the balance sheet's footnotes in order to determine which systems
are being used in their accounting and to look out for red flags.

Last, a balance sheet is subject to several areas of professional judgement that may materially impact
the report. For example, accounts receivable must be continually assessed for impairment and adjusted
to reflect potential uncollectible accounts. Without knowing which receivables, a company is likely to
receive, a company must make estimates and reflect their best guess as part of the balance sheet.

The cash flow statement is a central component of corporate cash flow management. While it is often
transparently reported to stakeholders on a quarterly basis, parts of it are usually maintained and
tracked internally daily.

The cash flow statement comprehensively records all a business’s cash flows. It includes:

Cash received from accounts receivable (AR)

Cash paid for accounts payable (AP)

Cash paid for investing

Cash paid for financing

The bottom line of the cash flow statement reports how much cash a company has readily available.

The cash flow statement is broken down into three parts: operating, investing, and financing. The
operating portion of cash activities tends to vary based heavily on the net working capital which is
reported on the cash flow statement as a company’s current assets minus current liabilities. The other
two sections of the cash flow statement are somewhat more straightforward with cash inflows and
outflows pertaining to investing and financing.

Managing Cash Through Internal Controls

There are many internal controls used to manage and ensure efficient business cash flows. Internal
controls are various accounting and auditing mechanisms that companies can use to ensure that their
financial reporting is compliant with regulations. These tools, resources, and procedures improve
operational efficiency and prevent fraud.

Some of a company’s top cash flow considerations include the:

Average length of AR

Collection processes

Write-offs for uncollected receivables

Liquidity and rates of return (RoR) on cash equivalent investments

Credit line management

Available operating cash levels

Cash Management of Working Capital

Cash flows pertaining to operating activities are generally heavily focused on working capital, which is
impacted by AR and AP changes. Investing and financing cash flows are usually extraordinary cash events
that involve special procedures for funds.

A company’s working capital is the result of its current assets minus current liabilities. Working capital
balances are important in cash flow management because they show the number of current assets a
company must cover its current liabilities.

Working capital generally includes the following:

Current Assets: Cash, accounts receivable within one year, inventory

Current Liabilities: All accounts payable that are due within one year and short-term debt payments that
come due within one year

Companies strive to have current asset balances that exceed current liability balances. If current
liabilities exceed current assets a company would likely need to access its reserve lines for its payables.

Companies usually report the change in working capital from one reporting period to the next within the
operating section of the cash flow statement. If a company has a positive net change in working capital,
it increases its current assets to cover its current liabilities, thereby increasing the total cash on the
bottom line. A negative change means a company increases its current liabilities, which reduces its ability
to pay them efficiently and its total cash on the bottom line.

There are several things a company can do to improve both receivables and payables efficiency,
ultimately leading to higher working capital and better operating cash flow. Companies that operate with
invoice billing can reduce the days payable or offer discounts for quick payments. They may also choose
to use technologies that facilitate faster and easier payments such as automated billing and electronic
payments.

Advanced technology for payables management can also be helpful. Companies may choose to make
automated bill payments or use direct payroll deposits to help improve payables cost efficiency.

Cash Management and Solvency Ratios

Companies can also regularly monitor and analyze liquidity and solvency ratios within cash management.
External stakeholders find these ratios important for a variety of analysis purposes as well. The two main
liquidity ratios analyzed in conjunction with cash management include the quick ratio and the current
ratio.

The quick ratio is calculated from the following:

Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities

The current ratio is a little more comprehensive. It is calculated from the following:

Current Ratio = Current assets ÷ Current Liabilities

Solvency ratios look at a company’s ability to meet all its obligations in the long term. Some of the most
popular solvency ratios include debt to equity, debt to assets, cash flow to debt, and the interest
coverage ratio.

Why Is Cash Management Important?

Cash management is the process of managing cash inflows and outflows. This process is important for
individuals and businesses because cash is the primary asset used to invest and pay any liabilities. There
are many cash management options available. Cash management not only provides entities with a
window into their financial situations but it can also be used to improve their profitability by fixing their
liquidity problems.

How Can You Improve Your Cash Management?

There are several ways an individual or business can improve their cash management. Some of these
steps include improving their accounts receivables (increasing income, encouraging clients to pay
early/on time), investing excess cash, seeking out better financing rates on debt, safeguarding bank
accounts to prevent fraud, and implementing better accounts payable processes.

What Is an Example of Cash Management?

Cash management can come in various forms, including the improvement of accounts payable
processes. Let us say a business has an existing (and good) relationship with a vendor. The two have
been doing business with one another for the last five years. The vendor ships supply to the business
every month and requires payment on its invoices every 30 days. Since the two have an amicable
relationship, the business negotiates payment for invoices every 45 days.
The Bottom Line

Cash management is the process of successfully taking care of cash inflows and outflows. It's a process
that's important to individuals and also for businesses. Being able to do manage cash efficiently means
that the entity can keep money in its reserves, pay off its financial obligations, and invest for future
development.

What Is Working Capital Management?

Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to their most effective use.

Working Capital

Understanding Working Capital Management

The primary purpose of working capital management is to enable the company to maintain sufficient
cash flow to meet its short-term operating costs and short-term debt obligations. A company's working
capital is made up of its current assets minus its current liabilities.1

Current assets include anything that can be easily converted into cash within 12 months. These are the
company's highly liquid assets. Some current assets include cash, accounts receivable, inventory, and
short-term investments. Current liabilities are any obligations due within the following 12 months. These
include accruals for operating expenses and current portions of long-term debt payments.1

Working capital management monitors cash flow, current assets, and current liabilities using ratio
analysis, such as working capital ratio, collection ratio, and inventory turnover ratio.2

Main Components of Working Capital Management

Certain balance sheet accounts are more important when considering working capital management.
Though working capital often entails comparing all current assets to current liabilities, there are a few
accounts more critical to track.

Cash

The core of working capital management is tracking cash and cash needs. This involves managing the
company's cash flow by forecasting needs, monitoring cash balances, and optimizing cash inflows and
outflows to ensure that the company has enough cash to meet its obligations. Because cash is always
considered a current asset, all accounts should be considered. However, companies should be mindful of
restricted or time-bound deposits.

Receivables

To manage capital, companies must be mindful of their receives. This is especially important in the short-
term as they wait for credit sales to be completed. This involves managing the company's credit policies,
monitoring customer payments, and improving collection practices. At the end of the day, having
completed a sale does not matter if the company is unable to collect payment on the sale.
Payables

Payables in one aspect of working capital management that companies can take advantage of that they
often have greater control over. While other aspects of working capital management may be out of the
company's hands (i.e., selling goods or collecting receivables), companies often have a say in how they
pay suppliers, what the credit terms are, and when cash outlays are made.

Inventory

Companies’ primary consider inventory during working capital management as it may be most risky
aspect of managing capital. When inventory is sold, a company must go to the market and rely on
consumer preferences to convert inventory to cash. If this cannot be completed in a timely manner, the
company may be forced to have short-term resource stuck in an illiquid position. Alternatively, the
company may be able to quickly sell the inventory but only with a steep price discount.

Types of Working Capital

In its simplest form, working capital is just the difference between current assets and current liabilities.
However, there are many different types of working capital that each may be important to a company to
best understand its short-term needs.

• Permanent Working Capital: Permanent working capital is the number of resources the
company will always need to operate its business without interruption. This is the minimum
amount of short-term resources vital to operations.

• Regular Working Capital: Regular working capital is a component of permanent working capital.
It is the part of the permanent working capital that is required for day-to-day operations and
makes up the "most important" part of permanent working capital.

• Reserve Working Capital: Reserve working capital is the other component of permanent
working capital. Companies may require an additional amount of working capital on hand for
emergencies, seasonality, or unpredictable events.

• Fluctuating Working Capital: Companies may be interested in only knowing what their variable
working capital is. For example, companies may opt into paying for inventory as it is a variable
cost. However, the company may have a monthly liability relating to insurance it does not have
the option to decline. Fluctuating working capital only considers the variable liabilities the
company has complete control over.

• Gross Working Capital: Gross working capital is simply the total amount of current assets of a
business before considering any short-term liabilities.

• Net Working Capital: Net working capital is the difference between current assets and current
liabilities.

Why Manage Working Capital?

Working capital management can improve a company's cash flow management and earnings quality
through the efficient use of its resources. Management of working capital includes inventory
management as well as management of accounts receivable and accounts payable.
Working capital management also involves the timing of accounts payable (i.e., paying suppliers). A
company can conserve cash by choosing to stretch the payment of suppliers and to make the most of
available credit or may spend cash by purchasing using cash—these choices also affect working capital
management.

The objectives of working capital management, in addition to ensuring that the company has enough
cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and
maximizing the return on asset investments.1

Working Capital Management Ratios

Three ratios that are important in working capital management are the working capital ratio (or current
ratio), the collection ratio, and the inventory turnover ratio.

Current Ratio (Working Capital Ratio)

The working capital ratio or current ratio is calculated by dividing current assets by current liabilities. The
current ratio is a key indicator of a company's financial health as it demonstrates its ability to meet its
short-term financial obligations.2

A working capital ratio below 1.0 often means a company may have trouble meeting its short-term
obligations. That is because the company has more short-term debt than short-term assets. In order to
pay all its bill as they come due, the company may need to sell long-term assets or secure external
financing.2

Working capital ratios of 1.2 to 2.0 are considered desirable as this means the company has more current
assets compared to current liabilities. However, a ratio higher than 2.0 may suggest that the company is
not effectively using its assets to increase revenues. For example, a high ratio may indicate that the
company has too much cash on hand and could be more efficiently utilizing that capital to invest in
growth opportunities.2

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO), is a measure of how efficiently a
company manages its accounts receivable. The collection ratio is calculated by multiplying the number of
days in the period by the average amount of outstanding accounts receivable. Then, this product is
divided by the total amount of net credit sales during the accounting period. To find the average amount
of average receivables, companies most often simply take the average between the beginning and
ending balances.2

The collection ratio calculation provides the average number of days it takes a company to receive
payment after a sales transaction on credit. Note that the days sales outstanding ratio does not consider
cash sales. If a company's billing department is effective at collecting accounts receivable, the company
will have quicker access to cash which is can deploy for growth. Meanwhile, if the company has a long
outstanding period, this effectively means the company is awarding creditors with interest-free, short-
term loans.2

Inventory Turnover Ratio

Another important metric of working capital management is the inventory turnover ratio. To operate
with maximum efficiency, a company must keep sufficient inventory on hand to meet customers' needs.
However, the company also needs to strive to minimize costs and risk while avoiding unnecessary
inventory stockpiles.3

The inventory turnover ratio is calculated as cost of goods sold divided by the average balance in
inventory. Again, the average balance in inventory is usually determined by taking the average of the
starting and ending balances.

The ratio reveals how rapidly a company's inventory is being used in sales and replaced. A relatively low
ratio compared to industry peers indicates a risk that inventory levels are excessively high, meaning a
company may want to consider slowing production to ease the cost of insurance, storage, security, or
theft. Alternatively, a relatively high ratio may indicate inadequate inventory levels and risk to customer
satisfaction.3

Working Capital Cycle

In addition to the ratios discussed above, companies may rely on the working capital cycle when
managing working capital. Working capital management helps maintain the smooth operation of the net
operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of time required
to convert net current assets and liabilities into cash. The working capital cycle is a measure of the time it
takes for a company to convert its current assets into cash, or:

Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle - Payable Cycle

The working capital cycle represents the period measured in days from the time when the company pays
for raw materials or inventory to the time when it receives payment for the products or services it sells.
During this period, the company's resources may be tied up in obligations or pending liquidation to cash.

Inventory Cycle

The inventory cycle represents the time it takes for a company to acquire raw materials or inventory,
convert them into finished goods, and store them until they are sold. During this stage, the company's
cash is tied up in inventory. Though it starts the cycle with cash on hand, the company agrees to part
ways with working capital with the expectation that it will receive more working capital in the future by
selling the product at a profit.

Accounts Receivable Cycle

The accounts receivable cycle represents the time it takes for a company to collect payment from its
customers after it has sold goods or services. During this stage, the company's cash is tied up in accounts
receivable. Though the company was able to part ways with its inventory, its working capital is now tied
up in accounts receivable and still does not give the company access to capital until these credit sales are
received.

Accounts Payable Cycle

The accounts payable cycle represents the time it takes for a company to pay its suppliers for goods or
services received. During this stage, the company's cash is tied up in accounts payable. On the positive
side, this represents a short-term loan from a supplier meaning the company can hold onto cash even
though they have received a good. On the negative side, this creates a liability that needs to be
managed.

Limitations of Working Capital Management

With strong working capital management, a company should be able to ensure it has enough capital on
hands to operate and grow. However, there are downsides to the approach. Working capital
management only focuses on short-term assets and liabilities. It does not address the long-term financial
health of the company and may sacrifice the best long-term solution in favor for short-term benefits.

Even with the best practices in place, working capital management cannot guarantee success. The future
is uncertain, and it's challenging to predict how market conditions will affect a company's working
capital. Whether its changes in macroeconomic conditions, customer behavior, and supply chain
disruptions, a company's forecast of working capital may simply not materialize as they expected.

Last, while effective working capital management can help a company avoid financial difficulties, it may
not necessarily lead to increased profitability. Working capital management does not inherently increase
profitability, make products more desirable, or increase a company's market position. Companies still
need to focus on sales growth, cost control, and other measures to improve their bottom line. As that
bottom line improves, working capital management can simply enhance the company's position.

inventory management

Inventory management is the supervision of noncapitalized assets -- or inventory -- and stock items. As a
component of supply chain management, inventory management supervises the flow of goods from
manufacturers to warehouses and from these facilities to point of sale. A key function of inventory
management is to keep a detailed record of each new or returned product as it enters or leaves a
warehouse or point of sale.

Organizations from small to large businesses can make use of inventory management to track their flow
of goods. There are numerous inventory management techniques, and using the right one can lead to
providing the correct goods at the correct amount, place, and time.

Inventory control is a separate area of inventory management that is concerned with minimizing the
total cost of inventory, while maximizing the ability to provide customers with products in a timely
manner. In some countries, the two terms are used synonymously.

Why is inventory management important?

Effective inventory management enables businesses to balance the amount of inventory they have
coming in and going out. The better a business controls its inventory, the more money it can save in
business operations.

A business that has too much stock has overstock. Overstocked businesses have money tied up in
inventory, limiting cash flow and potentially creating a budget deficit. This overstocked inventory, which
is also called dead stock, will often sit in storage, unable to be sold, and eat into a business's profit
margin.
But if a business does not have enough inventory, it can negatively affect customer service. Lack of
inventory means that a business may lose sales. Telling customers, they do not have something, and
continually backordering items, can cause customers to take their business elsewhere.

An inventory management system can help businesses strike the balance between being under- and
overstocked for optimal efficiency and profitability.

The inventory management process

Inventory management is a complex process, particularly for larger organizations, but the basics are
essentially the same, regardless of the organization's size or type. In inventory management, goods are
delivered in the receiving area of a warehouse -- typically, in the form of raw materials or components --
and are put into stock areas or onto shelves.

Compared to larger organizations with more physical space, in smaller companies, the goods may go
directly to the stock area instead of a receiving location. If the business is a wholesale distributor, the
goods may be finished products, rather than raw materials or components. Unfinished goods are then
pulled from the stock areas and moved to production facilities where they are made into finished goods.
The finished goods may be returned to stock areas where they are held prior to shipment, or they may
be shipped directly to customers.

Inventory management uses a variety of data to keep track of the goods as they move through the
process, including lot numbers, serial numbers, cost of goods, quantity of goods and the dates when
they move through the process.

Inventory management systems

Inventory management software systems generally began as simple spreadsheets that track the
quantities of goods in a warehouse but have become more complex since. Inventory management
software can now go several layers deep and integrate with accounting and enterprise resource planning
(ERP) systems. The systems keep track of goods in inventory, sometimes across several warehouse
locations. Inventory management software can also be used to calculate costs -- often in multiple
currencies -- so accounting systems always have an accurate assessment of the value of the goods.

Some inventory management software systems are designed for large enterprises and can be heavily
customized for the requirements of an organization. Large systems were traditionally run on premises
but are now also deployed in public cloud, private cloud, and hybrid cloud environments. Small and
midsize companies typically do not need such complex and costly systems, and they often rely on
standalone inventory management products, generally through software as a service (SaaS) application.
 Inventory
management software helps businesses track inventory, so purchasing departments know what they
need to order and sales teams know what is available to sell.

Inventory management techniques

Inventory management uses several methodologies to keep the right amount of goods on hand to fulfill
customer demand and operate profitably. This task is particularly complex when organizations need to
deal with thousands of stock-keeping units (SKUs) that can span multiple warehouses. The
methodologies include:

• Stock review, which is the simplest inventory management methodology and is, generally, more
appealing to smaller businesses. Stock review involves a regular analysis of stock on hand versus
projected future needs. It primarily uses manual effort, although there can be automated stock
review to define minimum stock levels that then enables regular inventory inspections and
reordering of supplies to meet the minimum levels. Stock review can provide a measure of
control over the inventory management process, but it can be labor-intensive and prone to
errors.

• Just-in-time (JIT) methodology, in which products arrive as they are ordered by customers and is
based on analyzing customer behavior. This approach involves researching buying patterns,
seasonal demand and location-based factors that present an accurate picture of which goods are
needed at certain times and places. The advantage of JIT is customer demand can be met
without needing to keep large quantities of products on hand and in close to real time. However,
the risks include misreading the market demand or having distribution problems with suppliers,
which can lead to out-of-stock issues.
 • ABC analysis methodology, which classifies inventory into three categories that represent the
inventory values and cost significance of the goods. Category A represents high-value and low-
quantity goods, category B represents moderate-value and moderate-quantity goods, and
category C represents low-value and high-quantity goods. Each category can be managed
separately by an inventory management system. It is important to know which items are the
best sellers to keep enough buffer stock on hand. For example, more expensive category A items
may take longer to sell, but they may not need to be kept in large quantities. One of the
advantages of ABC analysis is that it provides better control over high-value goods, but a
disadvantage is that it can require a considerable number of resources to continually analyze the
inventory levels of all the categories.

• Economic order quantity (EOQ) methodology, in which a formula determines the optimal time
to reorder inventory in a warehouse management system. The goal here is to identify the largest
number of products to order at any given time. This, in turn, frees up money that would
otherwise be tied up in excess inventory and minimizes costs.

• Minimum order quantity (MOQ) methodology, in which the smallest amount of product a
supplier is willing to sell is determined. If a business can't purchase the minimum, the supplier
won't sell it to them. This method benefits suppliers, enabling them to quickly get rid of
inventory while weeding out bargain shoppers.

• First in, first out (FIFO) methodology, in which the oldest inventory is sold first to help keep
inventory fresh. This is an especially important method for businesses dealing with perishable
products that will spoil if they aren't sold within a specific time period. It also prevents items
from becoming obsolete before a business has the chance to sell them. This typically means
keeping older merchandise at the front of shelves and moving new items to the back.

• Last in, first out (LIFO) methodology, in which the newest inventory is typically recorded as sold
first. This is a good practice when inflation is an issue and prices are rising. Because the newest
inventory has the highest cost of production, selling it before older inventory means lower
profits and less taxable income. LIFO also means the lower cost of older products left on the
shelves is what's reported as inventory. However, this is a difficult technique to put into practice,
as older items that sit around have a chance of becoming obsolete or perishing.

• Safety stock methodology, in which a business sets aside inventory in case of an emergency. The
safety stock approach also provides a signal that it's time to reorder merchandise before dipping
into the safety stock. It's a good idea for businesses to work safety stock into their warehouse
management strategy in case their supply chain is disrupted.

Inventory management vs. inventory control

Both inventory management and inventory control are essential to running a successful direct sales and
channel operation. Inventory management is the overall strategy to ensure adequate inventory, and
inventory control encompasses the processes and tools used to track existing inventory. Businesses may
choose to use an inventory control system on its own but will benefit from using both together. Here are
the essential differences:

Inventory management
Inventory management is a strategy that ensures businesses always have the right amount of inventory
at the right time and in the right place. Inventory management tools enable businesses to:

• calculate safety stock;

• calculate reorder points;

• accomplish demand planning and forecasting;

• identify obsolete items;

• optimize warehouse layout; and

• identify fill rate percentage.

Inventory control

Inventory control addresses inventory already in a business's possession. It works at the transactional
layer of an ERP system and enables businesses to:

• receive inventory;

• process interbranch transfers;

• process receipts;

• pack and ship stock;

• process customer invoices; and

• process supplier purchase orders.

What Is Inventory? Definition, Types, and Examples

What Is Inventory?

The term inventory refers to the raw materials used in production as well as the goods produced that are
available for sale. A company's inventory represents one of the most important assets it has because
the turnover of inventory represents one of the primary sources of revenue generation and subsequent
earnings for the company's shareholders. There are three types of inventories, including raw materials,
work-in-progress, and finished goods. It is categorized as a current asset on a company's balance sheet.

KEY TAKEAWAYS

• Inventory is the raw materials used to produce goods as well as the goods that are available for
sale.

• It is classified as a current asset on a company's balance sheet.

• The three types of inventories include raw materials, work-in-progress, and finished goods.

• Inventory is valued in one of three ways, including the first-in, first-out method; the last-in, first-
out method; and the weighted average method.
 • Inventory management allows businesses to minimize inventory costs as they create or receive
goods on an as-needed basis.

Understanding Inventory

Inventory is a very important asset for any company. It is defined as the array of goods used in
production or finished goods held by a company during its normal course of business. There are three
general categories of inventory, including raw materials (any supplies that are used to produce finished
goods), work-in-progress (WIP), and finished goods or those that are ready for sale.

As noted above, inventory is classified as a current asset on a company's balance sheet, and it serves as a
buffer between manufacturing and order fulfillment. When an inventory item is sold, its carrying cost
transfers to the cost of goods sold (COGS) category on the income statement.

Inventory can be valued in three ways. These methods are the:

• First-in, first-out (FIFO) method, which says that the cost of goods sold is based on the cost of the
earliest purchased materials. The carrying cost of remaining inventory, on the other hand, is
based on the cost of the latest purchased materials

• Last-in, first-out (LIFO) method, which states that the cost of goods sold is valued using the cost
of the latest purchased materials, while the value of the remaining inventory is based on the
earliest purchased materials.

• Weighted average method, which requires valuing both inventory and the COGS based on the
average cost of all materials bought during the period.

Company management, analysts, and investors can use a company's inventory turnover to determine
how many times it sells its products over a certain period. Inventory turnover can indicate whether a
company has too much or too little inventory on hand.

Special Considerations

Many producers partner with retailers to consign their inventory. Consignment inventory is the inventory
owned by the supplier/producer (generally a wholesaler) but held by a customer (generally a retailer).
The customer then purchases the inventory once it has been sold to the end customer or once they
consume it (e.g., to produce their own products).

The benefit to the supplier is that their product is promoted by the customer and readily accessible
to end users. The benefit to the customer is that they do not expend capital until it becomes profitable
to them. This means they only purchase it when the end user purchases it from them or until they
consume the inventory for their operations.

Inventory Management

Possessing a high amount of inventory for a long time is usually not a good idea for a business. That's
because of the challenges it presents, including storage costs, spoilage costs, and the threat of
obsolescence.
Possessing too little inventory also has its disadvantages. For instance, a company runs the risk of market
share erosion and losing profit from potential sales.

Inventory management forecasts and strategies, such as a just-in-time (JIT) inventory system can help
companies minimize inventory costs because goods are created or received only when needed.

Types of Inventories

Remember that inventory is generally categorized as raw materials, work-in-progress, and finished
goods. The IRS also classifies merchandise and supplies as additional categories of inventory.1

Raw materials are unprocessed materials used to produce a good. Examples of raw materials include:

• Aluminum and steel for the manufacture of cars

• Flour for bakeries that produce bread

• Crude oil held by refineries

Work-in-progress inventory is the partially finished goods waiting for completion and resale. WIP
inventory is also known as inventory on the production floor. A half-assembled airliner or a partially
completed yacht is often considered to be work-in-process inventory.

Finished goods are products that go through the production process, and are completed and ready for
sale. Retailers typically refer to this inventory as merchandise. Common examples of merchandise
include electronics, clothes, and cars held by retailers.

How Do You Define Inventory?

Inventory refers to a company’s goods and products that are ready to sell, along with the raw materials
that are used to produce them. Inventory can be categorized in three different ways, including raw
materials, work-in-progress, and finished goods.

In accounting, inventory is considered a current asset because a company typically plans to sell the
finished products within a year.

Methods to value the inventory include last-in, first-out (LIFO); first-in, first-out (FIFO); and the weighted
average method.

What Is an Example of Inventory?

Consider a fashion retailer such as Zara, which operates on a seasonal schedule.2 Because of the fast
fashion nature of turnover, Zara, like other fashion retailers is under pressure to sell inventory rapidly.
Zara's merchandise is an example of inventory in the finished product stage. On the other hand, the
fabric and other production materials are considered a raw material form of inventory.

What Can Inventory Tell You About a Business?

One way to track the performance of a business is the speed of its inventory turnover. When a business
sells inventory at a faster rate than its competitors, it incurs lower holding costs and decreased
opportunity costs. As a result, they often outperform, since this helps with the efficiency of its sale of
goods.
Inventory management encompasses many processes, but in its simplest form it refers to storing and
organizing a company’s products. It includes such activities as ordering, restocking, storing and inventory
forecasting.

Strategically managing inventory gets more challenging in accordance with growth of units sold. In
today’s hyper-competitive marketplace, good inventory management is an often overlooked but critical
aspect for any ecommerce business. It is vital that the inventory management process is efficient, cost
effective, and accurate. If you do not have all of those components in place you may run considerable
risk of failing to meet customer demand and losing money with your ecommerce fulfillment efforts.

11 Inventory Management Terms You Should Know

There can be a steep learning curve for understanding inventory management, even if you own a
product-based company that deals with physical inventory. We are going to start with the key basic
terminology and acronyms and define them to help build your knowledge of inventory management.

Days Inventory Outstanding

Days inventory outstanding (DIO) represents the number of days the current inventory will last. A lower
DIO indicates a shorter time required to clear out inventory. DIO is also referred to as days sales of
inventory (DSI), days in inventory (DII), or simply days inventory.

Economic Order Quantity

Economic order quantity (EOQ) is a term for the ideal quantity a company should purchase to minimize
its inventory costs, like shortage or carrying costs. The overall goal of economic order quantity is to
decrease spending; its formula is used to identify the greatest number of units needed (per order) to
reduce buying. One of the primary gains of the EOQ model is customized recommendations for your
company. At times, EOQ may suggest investing in a larger order to take advantage of discount bulk
buying and to cut down on total costs associated with multiple shipments.

Finished Goods Inventory

Finished goods inventory includes all products that have been completed by the manufacturing or
production process — or that have been purchased in completed form — and that are available for sale.
This term typically applies to manufacturers, since their goods can be in multiple forms, such as raw or in
production. Retailers usually only maintain ready-to-sell items, meaning all their goods are finished.

Inventory Cycle Count

An inventory cycle count is part of a company’s inventory auditing procedure. In an inventory cycle
count, a subset of inventory is counted on a certain day to help maintain accurate inventory levels.
Unlike a full inventory count, an inventory cycle count is less disruptive to operations — though it does
not offer as much accuracy across the board.

Reorder Point

A reorder point is the quantity at which you reorder an item to replenish its supply. The reorder point
will differ greatly from product to product and business to business. For example, a product that sells
quickly and in large amounts would generally have a higher reorder point than a slower moving product.
Safety Stock

Safety stock refers to the extra amount of a product that you keep to mitigate the risk of stockouts.
Supply and demand can shift unpredictably, and having safety stock helps ensure you are able to fulfill
orders. The benefit is that sales are uninterrupted; however, purchasing and storing extra products ties
up more money in inventory.

SKU

SKU stands for stock keeping unit, which is used in conjunction with a barcode system to represent a
distinct item. SKUs are typically printed on products as scannable labels and hold item-specific data such
as price, manufacturer, and other product details. Businesses use SKUs to identify products and keep
track of inventory levels.

Stockout

As the name implies, a stockout means you’ve run out of a product. Stockouts may occur for any number
of reasons: an unexpected surge in customer demand, not ordering enough of a product, an erroneous
delivery from a supplier, inaccurate stock counts in the warehouse, theft, or a combination of these.

Write-Downs

The reason some companies in your industry are successful is because they have efficient inventory
management. Implementing an inventory management system (IMS) can help you identify the root
cause of slow-moving inventory and find ways to reduce excess and obsolete stock. Inventory
management also helps you sell off excess and obsolete stock more effectively through the process
of write-downs. By reducing the price of an item, you can still make a profit. But failing to find a way to
utilize obsolete stock will lead to a write-off where the product is considered a loss to your company.

Supply Chain

A supply chain is the network of organizations, resources, activities, and technology that works together
to create, sell, and distribute products to customers. A supply chain can have many complex touch
points, depending on things like the number or amount of raw materials involved in manufacturing a
product, the type of product, and who and where the end customer is.

Distributed Inventory

Having warehouses in multiple locations can help you provide more affordable and faster shipping to
customers, and helps you make region-popular items more accessible. If you have warehouses located
strategically around the country, you will have an easier time reaching customers in their shipping zone,
saving you money, and delivering in a timelier fashion.

Bottom Line

If you establish the best practices for inventory management it can be an incredible help in efficiently
running your business. It is important to make the right choices that can scale and grow with your
business. Great inventory management will save money, time, and improve customer service. Remember
that with an effective inventory management system in place you can keep your business profitable,
analyze sales patterns and predict future sales, and prepare for the unexpected. With a proper inventory
management, a business has a better chance to survive and thrive.

Business owners have always been looking for ways to optimize inventory levels without hurting their
profits.

It is essential to evaluate your business on a regular basis to ensure that you are on track to succeed.
That is why, in this article, we will be focusing on inventory costs and how to manage it.

How has your small business's inventory management turned out so far?

Have you had the right products available when you needed them?

Did you lose out on business when items were out of stock?

Did you lose money due to excess inventory stock?

Before we go into the above, let us understand the different kinds of inventory management and
inventory costs.

5 Types of Inventory Costs

Ordering, holding, carrying, shortage and spoilage costs make up some of the main categories of
inventory-related costs. These groupings broadly separate the many different inventory costs that exist,
and below we will identify and describe some examples of the different types of cost in each category.

The other requires a certain amount of calculation to understand the impact it has on your Gross Profit.
Let us look at types of costs:

1. Ordering Costs

Ordering costs include payroll taxes, benefits and the wages of the procurement department, labor costs
etc. These costs are typically included in an overhead cost pool and allocated to the number of units
produced in each period.

• Transportation costs

• Cost of finding suppliers and expediting orders

• Receiving costs

• Clerical costs of preparing purchase orders

• Cost of electronic data interchange

2. Inventory Holding Costs

This is simply the amount of rent a business pays for the storage area where they hold the inventory. This
can be either the direct rent the company pays for all the warehouses put together or a percentage of
the total rent of the office area utilized for storing inventory.

• Inventory services costs

• Inventory risk costs

 • Opportunity cost - money invested in inventory

• Storage space costs

• Inventory financing costs

3. Shortage Costs

Shortage costs, also known as stock-out costs, occurs when businesses become out of stock for various
reasons. Some of the reasons might be as below:

• Emergency shipments costs

• Disrupted production costs

• Customer loyalty and reputation

4. Spoilage Costs

Perishable inventory stock can rot or spoil if not sold in time, so controlling inventory to prevent spoilage
is essential. Products that expire are a concern for many industries. Industries such as the food and
beverage, pharmaceutical, healthcare, and cosmetic industries, are affected by the expiration and use-by
dates of their products.

5. Inventory Carrying Costs

This is the lesser-known aspect of inventory cost. This cost requires a certain amount of calculation to
understand the extent of its impact on your P&L statement. Inventory carrying costs refers to the
amount of interest a business loses out on the unsold stock value lying in the warehouses.

Example of Inventory Carrying Cost

To understand the inventory carrying costs better, let us take an example of an importer of goods. When
he imports goods into his country, they are first received at a dock.

Multiple customs department clearances are required before they can be transported to the company
warehouse. Now let us say, due to some deficiency in the documentation, the goods get held up in the
customs clearance department.

As everyone is aware, until the goods get cleared, there are charges that the customs department levies
to hold these goods, and these charges rise exponentially. The costs further depend on the value of
goods being held and the volume/area they use up to store them at the dock.

We can compare this by considering these additional charges that a business owner has to bear on the
goods like the interest charges the business owner bears, which is a normal scenario that is invisible.

The dock is the warehouse, while the customs department's charges can be compared to the interest
income the business loses out on the principal value of the goods.

While these custom department penalties are still visible, the only difference is the interest a business
loses out on the stock is never considered.

Understanding Stock Categorization

It is necessary to categorize all the stock items into the below four brackets

1. High Value - Fast Moving

2. High Value - Slow Moving

3. Low Value - Fast Moving

4. Low Value - Slow Moving

Let us analyze the treatment to be given to each of the 4 categories mentioned.

1. High Value - Fast Moving

You must analyze the sales trends for these items and understand the average quantity sold per day.

Based on this parameter, we should have stock in the warehouse equivalent to its lead time.

For example, if the lead time for a High-Value product is 7 days, and per day sales are 100 quantities of
this product, then there must be always 700 qty of this item in the warehouse.

This will ensure the inventory never runs out of this stock item.

2. High Value - Slow Moving

Since the value of such items is high while they do not sell much, the inventory team can consider
ordering them only when required by the customer.

It is also necessary to also analyze the ordering pattern for this kind of product by the customers.

E.g., if a particularly high-value product is usually ordered in April by a set of customers. In that case, we
should keep stock of such a product only for April to fulfill its demand.
Another good strategy that can be followed for such stock items is the drop ship methodology. Drop ship
methodology implies that instead of storing stocks within the warehouses, you directly ask your vendor
to dispatch it at the customer's location.

This ensures you never have to bear the inventory holding or carrying charges for such stock items.

3. Low Value - Fast Moving

Since these stocks' value is low, keeping them in stock will not hurt the costs much. But a good strategy
would be to estimate their lead time, per day sales, and keep at least as much stock as is required till the
lead time.

This approach is like the one followed for Step 1. However, we can afford to have a little extra quantity
that can act as a cushion for the sales team to up-sell or cross-sell.

4. Low Value - Slow Moving

This is the category that hurts the business the least, but depending on the nature of your business, this
may be the most crucial category, as they can consist of spare parts required by machinery or items
which are probably not available with any trader.

Many small business owners often ignore this category and do not stock these items. A good strategy
would be to estimate the yearly requirement of these stocks after analyzing the sales pattern for the last
4-5 years. Based on the analysis, maintain an average monthly stock level for these stock items.

These are essential as it may help set a differentiating image of your business in competition to other
businesses.

Business owners may classify their stocks into the above categories and understand their approach for
their inventory. However, businesses must consider another aspect in addition to the above pointers,
which is the volume of stock item.

If the volume of any stock item lying in any of the above four categories is high, it would directly impact
the inventory holding charges.

They would require a bigger warehouse to store them. If such items fall in the first or the third category,
you will need to follow multiple strategies to keep your inventory costs in check.

Inventory Valuation Methods: Definition and Types

Through inventory valuation, a business determines the value of its inventory at the end of an
accounting period. Depending on which inventory valuation method you use, you can gain a better
understanding of your business's current financial standing and position for future profit and growth.

In this article, we discuss the main inventory valuation methods and share tips on how to choose the
most appropriate one for your business and its accounting purposes.

What are inventory valuation methods?

Inventory valuation methods are various ways of determining the total value of the materials and
products that are still in a company's inventory at the end of an accounting period. It is a significant part
of the cost of goods calculation, which is the total of all costs used to create a sold good or service. It can
also be used as security for attracting a loan and is recorded in the organization's balance sheet as a
current asset.

The elements that make up the inventory valuation are mainly the costs for purchasing the inventory,
turning it into a sellable form and transporting it to a location where it can be sold. These can be
expenses with labor, materials, handling, factory overhead, transportation and import duties. However,
the valuation does not include administrative costs or the various costs needed to sell the product.

Some of the reasons why inventory valuation is important for an organization are:

• It affects the cost of goods sold. If the inventory at the end of the accounting period is
calculated at a high value, the cost of goods sold gets charged with less expense. Alternatively, a
lower valuation usually increases the cost of goods sold.

• It can affect the amount of income taxes paid. Depending on the valuation method, the
inventory value can be used to reduce the amount of paid income taxes

• It can alter profit reports. An incorrect valuation can cause incorrectly reported profits in two
consecutive accounting periods, which may affect the company's business decisions

Types of inventory valuation methods

The most often used inventory valuation methods are:

Specific identification

This method involves calculating the costs of each unit of product. Although it is a very straightforward
and accurate way of evaluating current inventory, it is usually difficult to use, as it can only apply to
inventories with items that are clearly registered and identified. Besides registering every product in the
inventory, you also need to be able to determine the individual cost for each.

First in, first out (FIFO)

This method automatically assumes that the first goods that were purchased were also the first sold. It is
usually a reasonably accurate assumption and it also makes sense from a business point of view, as
selling the oldest items in the inventory reduces the risks of them becoming obsolete.

Last in, first out (LIFO)

This method automatically assumes that the last item in the inventory that was purchased is the first one
sold. It is rarely used in practice, as the company using it would have a great risk of only selling the most
recently purchased or manufactured products and having their older products become obsolete and
unsellable.

Weighted average cost method (WAC)

This method consists of assigning an average cost of production to all inventory products. This average is
determined by dividing the cost of goods that are currently available for sale by how many of them there
are in the inventory, resulting in an average cost per unit. The resulted value is usually an average
between the oldest and the newest products purchased and placed in stock.

Tips for choosing an inventory valuation method

Consider these tips when choosing an appropriate inventory valuation method for your business:

• For calculating COGS: If you have a further objective of calculating the cost of goods sold, the
FIFO and WAC methods are usually the most appropriate. Given the fact that most businesses
manage to sell their oldest items, the FIFO method may be a more accurate estimate of your
gross margins.

• For evaluating the entire inventory: If you want to calculate the overall value of your company's
inventory, the WAC method is widely regarded as the most correct method to use. This is
especially recommended when the product price fluctuates, as you can create an average that
may be a better representation than an exact value at a certain point in time.

• For companies that only make one product: If your company only produces a single product,
using the WAC method can be a quick and accurate way of valuing your inventory

• For tax purposes: Although rarely used, the LIFO method may be acceptable to save the
company income taxes. However, this only works in businesses where the value of the inventory
increases as time passes, such as companies that sell wines or rare watches.

• For large inventory items: The specific identification method is typically a good choice when
dealing with large inventory items, such as cars.

• For quickly perishable goods: If your company produces quickly perishable goods, the FIFO
method may be the most appropriate, as it prioritizes the sale of older products.

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Inventory valuation examples

Consider these examples of how you can use inventory valuation methods:

First in, first out method

A company purchases chocolate bars on two separate occasions over the course of a month, at two
different prices and with the purpose of reselling them. The purchases were:

25 chocolate bars for $1 per piece

10 chocolate bars for $1.50 per piece

At the end of the month, the business has sold 20 chocolate bars. Using the first in, first out method, we
calculate the 20 sold chocolate bars at the initial price, which was $1 per piece, meaning that the cost of
goods sold is $20. The inventory still contains 15 chocolate bars, with five of them valued at $1 each and
the other 10 valued at $1.50 each. In conclusion, the remaining inventory value is (5 bars x $1 cost) + (10
bars x $1.50 cost) = $20

Weighted average method

A company purchases chocolate bars on three separate occasions, at three different prices. It then sells
40 of them. The purchases were:

20 bars for $1 per piece

20 bars for $1.5 per piece

20 bars for $2 per piece

According to the weighted average cost inventory valuation, you need to calculate the average cost of
the products in your inventory. If you have 60 chocolate bars for which you have paid $90 in total (20 x 1
+ 20 x 1.5 + 20 x 2), this means that the average cost for an inventory item is 90/60, meaning that each
chocolate bar has an average cost of $1.5. After selling the 40 chocolate bars, 20 remain in inventory.

The value of the remaining inventory is then calculated by multiplying 20 with the $1.5 average cost,
meaning that the inventory is worth a total of $30.

Formula for Calculating Economic Order Quantity (EOQ)

The formula for EOQ is:

What the Economic Order Quantity Can Tell You

The goal of the EOQ formula is to identify the optimal number of product units to order. If achieved, a
company can minimize its costs for buying, delivering, and storing units. The EOQ formula can be
modified to determine different production levels or order intervals, and corporations with large supply
chains and high variable costs use an algorithm in their computer software to determine EOQ.
EOQ is an important cash flow tool. The formula can help a company control the amount of cash tied up
in the inventory balance. For many companies, inventory is its largest asset other than its human
resources, and these businesses must carry sufficient inventory to meet the needs of customers. If EOQ
can help minimize the level of inventory, the cash savings can be used for some other business purpose
or investment.

The EOQ formula determines the inventory reorder point of a company. When inventory falls to a certain
level, the EOQ formula, if applied to business processes, triggers the need to place an order for more
units. By determining a reorder point, the business avoids running out of inventory and can continue to
fill customer orders. If the company runs out of inventory, there is a shortage cost, which is
the revenue lost because the company has insufficient inventory to fill an order. An inventory shortage
may also mean the company loses the customer or the client will order less in the future.

Example of How to Use EOQ

EOQ considers the timing of reordering, the cost incurred to place an order, and the cost to store
merchandise. If a company is constantly placing small orders to maintain a specific inventory level, the
ordering costs are higher, and there is a need for additional storage space.

Assume, for example, a retail clothing shop carries a line of men’s jeans, and the shop sells 1,000 pairs of
jeans each year. It costs the company $5 per year to hold a pair of jeans in inventory, and the fixed cost
to place an order is $2.

The EOQ formula is the square root of (2 x 1,000 pairs x $2 order cost) / ($5 holding cost) or 28.3 with
rounding. The ideal order size to minimize costs and meet customer demand is slightly more than 28
pairs of jeans. A more complex portion of the EOQ formula provides the reorder point.

Limitations of EOQ

The EOQ formula assumes that consumer demand is constant.1 The calculation also assumes that both
ordering and holding costs remain constant. This fact makes it difficult or impossible for the formula to
account for business events such as changing consumer demand, seasonal changes in inventory costs,
lost sales revenue due to inventory shortages, or purchase discounts a company might realize for buying
inventory in larger quantities.

Purchasing

Purchasing is the process a business or organization uses to acquire goods or services to accomplish its
goals. Although there are several organizations that attempt to set standards in the purchasing process,
processes can vary greatly between organizations.

Procurement vs. purchasing

Procurement is a long-term plan for strategically sourcing and acquiring services and materials from
suppliers. It is a strategic process an organization uses in carefully analyzing external and internal data to
inform decision-making. This plan includes maintaining and establishing relationships with vendors to
deliver top-quality supplies while minimizing risk and cost and receiving value for your purchases. This
process focuses on acquiring the materials the company needs at the best available price.
In contrast, purchasing is a part of the procurement process relating to the transactional activities
between you and your suppliers. It includes receiving invoices, writing, and submitting purchase orders,
receiving orders, and making payments. The primary element of purchasing is acquiring a specific
quantity of goods or services at an agreed price on a particular date.

Sourcing

Sourcing refers to the process of finding and assessing suppliers in order to procure goods and services.
The sourcing process can be very complex and may involve multiple stages, depending on the nature of
the product or service being procured

Difference between Purchasing & Sourcing

Purchasing is sometimes used interchangeably with procurement and sourcing. Therefore, it pays to
understand the difference between the various functions — starting with the key differences between
sourcing and purchasing.

First, sourcing includes finding products or services internally and through partnerships or joint ventures
with other companies. On the other hand, purchasing refers to acquiring products or services from
outside your company. It could include buying products or services from suppliers, off-the-shelf
providers, or even through auctions or online bidding.

Second, sourcing usually involves a longer lead time than purchasing. It means that you might have to
wait for the product or service to be produced before you can start using it. On the other hand,
purchasing can often take less time due to the speed of the supply chain.

Third, sourcing is more cost-intensive than purchasing. It is because you will likely have to pay more for
the product or service than if you bought it from an external provider. Additionally, you may have to
account for any additional costs associated with procuring the product or service, such as transportation
and customs fees.

Finally, sourcing is about finding quality products from independent producers or small businesses.
Purchasing is about buying products from larger, more established companies.

Supply Management

The term supply management refers to the act of identifying, acquiring, and managing resources and
suppliers that are essential to the operations of an organization. Also known as procurement, supply
management includes the purchase of physical goods, information, services, and any other necessary
resources that enable a company to continue operating and growing.

Most people consider supply chain management as the way corporations buy raw materials and finished
goods. But supply management is more than simply buying products and contracting for services. It is a
systematic business process that goes further than procurement to include the coordination of pre-
production logistics and inventory management, along with budgeting, employees, and other key
information to keep the business running smoothly.

The main goals within supply management are cost control, the efficient allocation of resources, risk
management, and the effective gathering of information to be used in strategic business decisions.

Oversight and management of suppliers and their contributions to a company's operations, for example,
should be of paramount importance. Supply management personnel within a company or institution are
generally responsible for the following:

• Identifying, sourcing, negotiating, and procuring a service or good that is essential to a

company's ongoing operations according to the wishes of the organization's leaders and
supervisors

• Formulating a strategy for developing and maintaining relationships with suppliers—and then
executing on it—as well as holding suppliers accountable

• Utilizing technology and procedures that facilitate the procurement process

• Considering the theories of supply and demand and what influence they have on supply
management

Supply management divisions within large corporations can be very extensive, complete with huge
budgets and hundreds of workers. Their success is usually measured by how much money they can save
the company. A company's ability to execute on supply management goals can directly benefit the stock
price by increasing metrics such as gross and net margins, cash flow, and cost of goods sold (COGS).

Conducting proper risk management is equally important to a company's success. For example,
anticipating and mitigating the impact of an unexpected interruption in the delivery of a key component
can keep a company running smoothly. But the failure to account for risk in a company's supply chain can
spell disaster.

While it is easy to understand how supply management directly affects the results of a large purchaser or
manufacturer, supply management is just as important to service-based firms. The internet, when paired
with broad improvements to logistical networks worldwide, has helped turn supply management into a
key strategic objective at most large companies, capable of saving millions and increasing efficiency
company-wide.

Supply Chain Management

Supply chain management is the management of the flow of goods and services and includes all
processes that transform raw materials into final products. It involves the active streamlining of a
business's supply-side activities to maximize customer value and gain a competitive advantage in the
marketplace
Supply chain management (SCM) represents an effort by suppliers to develop and implement supply
chains that are as efficient and economical as possible. Supply chains cover everything from
production to product development to the information systems needed to direct these undertakings.

Typically, SCM attempts to centrally control or link the production, shipment, and distribution of a
product. By managing the supply chain, companies can cut excess costs and deliver products to the
consumer faster. This is done by keeping tighter control of internal inventories, internal
production, distribution, sales, and the inventories of company vendors.

SCM is based on the idea that nearly every product that comes to market results from the efforts of
various organizations that make up a supply chain. Although supply chains have existed for ages, most
companies have only recently paid attention to them as a value-add to their operations.

5 Parts of SCM

The supply chain manager tries to minimize shortages and keep costs down. The job is not only about
logistics and purchasing inventory. According to Salary.com, supply chain managers “oversee and
manage overall supply chain and logistic operations to maximize efficiency and minimize the cost of
organization's supply chain."1

Productivity and efficiency improvements can go straight to the bottom line of a company. Good supply
chain management keeps companies out of the headlines and away from expensive recalls and lawsuits.
In SCM, the supply chain manager coordinates the logistics of all aspects of the supply chain which
consists of the following five parts.

Planning

To get the best results from SCM, the process usually begins with planning to match supply with
customer and manufacturing demands. Firms must predict what their future needs will be and act
accordingly. This relates to raw materials needed during each stage of manufacturing, equipment
capacity and limitations, and staffing needs along the SCM process. Large entities often rely
on ERP system modules to aggregate information and compile plans.

Sourcing

Efficient SCM processes rely very heavily on strong relationships with suppliers. Sourcing entails working
with vendors to supply the raw materials needed throughout the manufacturing process. A company
may be able to plan and work with a supplier to source goods in advance. However, different industries
will have different sourcing requirements. In general, SCM sourcing includes ensuring:

• the raw materials meet the manufacturing specification needed to produce goods.

• the prices paid for the goods are in line with market expectations.

• the vendor has the flexibility to deliver emergency materials due to unforeseen events.

• the vendor has a proven record of delivering goods on time and in good quality.

Supply chain management is especially critical when manufacturers are working with perishable goods.
When sourcing goods, firms should be mindful of lead time and how well a supplier can comply with
those needs.
Manufacturing

At the heart of the supply chain management process, the company transforms raw materials by using
machinery, labor, or other external forces to make something new. This final product is the ultimate goal
of the manufacturing process, though it is not the final stage of supply chain management.

The manufacturing process may be further divided into sub-tasks such as assembly, testing, inspection,
or packaging. During the manufacturing process, a firm must be mindful of waste or other controllable
factors that may cause deviations from original plans. For example, if a company is using more raw
materials than planned and sourced for due to a lack of employee training, the firm must rectify the
issue or revisit the earlier stages in SCM.

Delivering

Once products are made and sales are finalized, a company must get the products into the hands of its
customers. The distribution process is often seen as a brand image contributor, as up until this point, the
customer has not yet interacted with the product. In strong SCM processes, a company has robust
logistic capabilities and delivery channels to ensure timely, safe, and inexpensive delivery of products.

This includes having a backup or diversified distribution methods should one method of transportation
temporarily be unusable. For example, how might a company's delivery process be impacted by record
snowfall in distribution center areas?

Returning

The supply chain management process concludes with support for the product and customer returns. Its
bad enough that a customer needs to return a product, and it’s even worse if its due to an error on the
company's part. This return process is often called reverse logistics, and the company must ensure it has
the capabilities to receive returned products and correctly assign refunds for returns received. Whether
a company is performing a product recall or a customer is simply not satisfied with the product, the
transaction with the customer must be remedied.

Many consider customer returns as an interaction between the customer and the company. However, a
very important part of customer returns is the intercompany communication to identify defective
products, expired products, or non-conforming goods. Without addressing the underlying cause of a
customer return, the supply chain management process will have failed, and future returns will likely
persist.

Types of Supply Chain Models

Supply chain management does not look the same for all companies. Each business has its own goals,
constraints, and strengths that shape what its SCM process looks like. In general, there are often six
different primary models a company can adopt to guide its supply chain management processes.

• Continuous Flow Model: One of the more traditional supply chain methods, this model is often
best for mature industries. The continuous flow model relies on a manufacturer producing the
same good over and over and expecting customer demand will little variation.
 • Agile Model: This model is best for companies with unpredictable demand or customer-order
products. This model prioritizes flexibility, as a company may have a specific need at any given
moment and must be prepared to pivot accordingly.

• Fast Model: This model emphasizes the quick turnover of a product with a short life cycle. Using
a fast chain model, a company strives to capitalize on a trend, quickly produce goods, and ensure
the product is fully sold before the trend ends.

• Flexible Model: The flexible model works best for companies impacted by seasonality. Some
companies may have much higher demand requirements during peak season and low volume
requirements in others. A flexible model of supply chain management makes sure production
can easily be ramped up or wound down.

• Efficient Model: For companies competing in industries with very tight profit margins, a
company may strive to get an advantage by making their supply chain management process the
most efficient. This includes utilizing equipment and machinery in the most ideal ways in
addition to managing inventory and processing orders most efficiently.

• Custom Model: If any model above does not suit a company's needs, it can always turn towards
a custom model. This is often the case for highly specialized industries with high technical
requirements such as an automobile manufacturer.

Example of SCM

Understanding the importance of SCM to its business, Walgreens Boots Alliance Inc. decided to
transform its supply chain by investing in technology to streamline the entire process. For several years
the company has been investing and revamping its supply chain management process. Walgreens was
able to use big data to help improve its forecasting capabilities and better manage the sales and
inventory management processes.2

This includes the 2019 addition of its first-ever Chief Supply Chain Officer, Colin Nelson. His role is to
boost customer satisfaction as the company increases its digital presence. Beyond that, in 2021, it
announced it would be offering free two-hour, same-day delivery for 24,000 products in its stores

Supply Management vs. Supply Chain Management

The terms supply management and supply chain management are sometimes used interchangeably. But
there is a difference. Supply chain management refers to the management of how goods and services
flow through the production process—from raw material to finished goods that end up in the hands of
consumers. This includes shipping, production, and distribution of products, goods, and services.

Supply chain management requires suppliers and managers to be as efficient as possible. This means
they must make sure activities are streamlined so there are no shortages, costs are kept down, and
businesses can remain competitive in the market.
Source->Supplier->Converter->Distributor->Retailer->End/User->Consumers

The importance of Procurement

Procurement is an essential part of any business operation, whether small or large. It is the process of
obtaining goods and services from suppliers to meet the needs of an organization. Procurement involves
finding the right suppliers, negotiating prices, and ensuring timely delivery of products or services. In this
article, we will discuss why procurement is important in business and how it adds value to an
organization.

Firstly, procurement helps in cost savings. By finding the right suppliers and negotiating prices,
procurement can help businesses save money on their purchases. This is especially important for
businesses that have a tight budget. Procurement can also help businesses identify areas where they can
reduce costs and improve efficiency.

Secondly, procurement helps in maintaining the quality of goods and services. By selecting reliable and
reputable suppliers, businesses can ensure that the products or services they receive meet their quality
standards. Procurement can also help businesses identify suppliers who are compliant with industry
regulations and standards.

Thirdly, procurement helps in managing risks. By conducting due diligence on suppliers, businesses can
identify any potential risks or issues before they become a problem. This includes assessing suppliers'
financial stability, reputation, and ability to meet delivery deadlines. Procurement can also help
businesses develop contingency plans to manage any potential risks.
Fourthly, procurement helps in enhancing supplier relationships. By working closely with suppliers,
businesses can build strong relationships based on mutual trust and respect. This can lead to better
communication, more favorable pricing, and improved delivery times. Strong supplier relationships can
also help businesses develop new products or services and improve their overall competitiveness.

Finally, procurement helps in improving the overall efficiency of an organization. By streamlining the
procurement process, businesses can reduce the time and resources required to obtain goods and
services. This includes automating procurement processes, implementing e-procurement systems, and
using data analytics to optimize procurement strategies. This can result in significant cost savings and
improved productivity.

In conclusion, procurement is an important function in any business operation. It helps businesses save
money, maintain quality, manage risks, enhance supplier relationships, and improve overall efficiency. By
investing in procurement, businesses can improve their bottom line and gain a competitive advantage in
their industry.

What Are Procurement Activities and Why Is It Important?

Are you curious about procurement activities and how they impact your business? Procurement is the
process of acquiring goods, services, and works from external sources. It is a fundamental aspect of
any organization that aims to grow and expand its operations. In this blog post, we will explore what
procurement entails, why it is important for businesses of all sizes, and how it can help drive success in
today’s competitive market. Buckle up as we take a deep dive into the world of procurement!

What are Procurement Activities?

Procurement is an essential activity in the business world. It helps companies get the necessary items
they need to function, while also establishing a process for selecting suppliers. Procurement activities
can be divided into two main categories: procurement planning and procurement
execution. Procurement planning involves creating a purchasing plan and determining what needs to be
purchased. Procurement execution is the actual buying of goods or services.

Procurement planning helps companies identify what they need and how much it will cost. It can also
help determine the best supplier for the company. Once the procurement plan has been created,
procurement execution involves locating, negotiating with, and contracting with suppliers. During
procurement execution, it is important to track costs and performance so that decisions about future
purchases can be made correctly.

The Importance of Procurement Activities

Procurement activities are the process by which goods and services are acquired for use or sale by an
organization. Procurement is a critical part of any business, as it helps to ensure that the organization
gets the resources it needs in a timely and cost-effective manner.

procurement can be subdivided into two main categories: buying (acquisition of products) and selling
(acquisition of services). buying typically involves acquiring products while selling involves acquiring
services. Procurement processes can be divided into six main steps: market analysis, assessment of
competition, pricing, contracting mechanisms, quality control/assurance, and delivery.
The importance of procurement cannot be overstated. A poorly executed procurement process can lead
to unnecessary spending and wasted resources. Moreover, a poorly executed procurement process can
also lead to problems with quality control and delivery. As such, it is important for businesses to have
well- implemented procurement processes in place so that they can get the resources they need in a
timely and cost-effective manner.

The Different Types of Procurement Activities

Procurement activities can be broadly classified into two categories: procurement planning and
procurement execution. Procurement planning involves developing a comprehensive plan for acquiring
specific goods or services, while procurement execution involves carrying out the plan.

Procurement planning typically involves three stages: analysis, formulation, and selection. In the analysis
stage, buyers identify the need for the goods or services and evaluate potential suppliers. In the
formulation stage, they develop a detailed proposal that includes specifications of the goods or services
to be purchased and any associated pricing information. In the selection stage, they select the best
supplier based on price and quality.

Procurement execution typically involves four steps: acquisition, solicitation, negotiation, and delivery. In
acquisition step, buyers submit an offer to buy products or services from a selected supplier. If a supplier
accepts the offer, negotiations begin to determine terms of sale. If no agreement is reached within a
predetermined amount of time (usually 30 days), either party can withdraw their offer without penalty.
If an agreement is reached, negotiations continue to resolve any remaining disagreements. Once all
disputes have been resolved, delivery takes place; however, this process may be delayed if there are any
outstanding disagreements between buyer and supplier.

Ways to Improve Your Procurement Process

procurement activities are essential in order to fulfill your organization’s needs efficiently and cost-
effectively. Procurement can help you identify the right suppliers, minimize waste, and optimize
resources. It can also improve contract compliance and coordination.

To improve your procurement process, consider these tips:

1. Define Your Needs Prior To initiating any procurement activities, it is important to clearly define your
requirements. This will help you avoid potential confusion and ensure that you are getting the best
possible value for your money.

2. Conduct Market Research When sourcing products or services, it is important to conduct market
research to find the best available options. This will help you reduce wasted time and money on inferior
options.

3. Use A Procurement Strategy Planning is key when it comes to implementing a successful procurement
process. use a procurement strategy that addresses all your specific needs and objectives. This will help
you speed up the process while minimizing waste and expense.

Procurement-> Contributing to Competitive Advantage

The primary goal for a procurement organization is to deliver value. An effective procurement
department lowers operational costs by purchasing supplies and services at the best available price.
In addition, optimal procurement practices enable the organization to take advantage of warranties
and/or discounts that are often forgotten or not properly managed.

However, if you cannot see what your organization is spending it is nearly impossible to manage costs
effectively. Minimizing dark purchasing practices is key. An effective procurement process supports
having total visibility into an organization’s expenditures for all purchasing activity, which gives you the
ability to reduce procurement costs, improve relationships with stakeholders, and track purchasing
patterns to make financial improvements in the long-run.

If you can control costs, you are able to make your products more cost competitive in the market.

Greater efficiency
The fundamental purpose of all sourcing and procurement activity is to utilize the external market and
suppliers in an optimal manner to gain a competitive advantage.

Every item or service being sourced should contribute, directly or indirectly, toward competitive
positioning. When an organization has an effective procurement process, procurement can eliminate
redundancies in the operation, promote collaboration and distinguish between good and
underperforming suppliers.

An efficient procurement process provides an organization with economies of scale, which allow it to
reduce costs and produce more for less, creating a competitive advantage. Efficiency within your supplier
relationships allows your procurement team to easily determine your suppliers’ capabilities, interests,
competitiveness, and financial strength, which will give you the ability optimize your supplier base,
weeding out under-performers and working with suppliers that have ability to enhance your
organization’s competitive advantage.

Embrace innovation
Procurement professionals are increasingly required to not only possess the necessary skills to deliver
cost savings, satisfy social responsibility targets, manage supplier relationships, and manage risk, but also
are now expected to be innovative in order to gain a competitive advantage.

Procurement’s contribution to innovation can occur in the product development phase, because 70% to
80% of the cost of a product or service is determined during the design or specification phase, which has
a direct impact on the organization’s competitive advantage in the marketplace.

In addition, innovation within the procurement department can improve the communication of complex
data, support the negotiation phase through online auctions and bidding systems or online catalogues,
which allow you to check product availability, place, and track orders, and make payments.

These tools have become more vital to efficiently procuring goods and services than ever before, thereby
removing cost from the process.

Mitigate supplier risk

This is critical. Supplier risk events can happen in four general areas: strategy, compliance, financial, and
operational.
Risk mitigation includes risk avoidance, risk reduction and risk sharing, which should be continuous and
evolving in order to addresses all the risks associated with the organizations’ past, present, and future
activities.

An effective procurement process must address a sustainable method of identifying, assessing, and
solving supplier risks. When a lack of preparedness in risk management does not match the pattern of a
company’s potential vulnerabilities, the results can impact an organization’s ability to compete.

Procurement organizations must evaluate their current process to account for their organizational
vulnerabilities and ensure that remedies, or at least temporary solutions, are in place.

Support supply chain resiliency

A procurement process should address solutions and continuity to unexpected conditions such as
economic uncertainty, labor fluctuations and natural disasters.

The challenges of 2020 have caused procurement departments to adjust their strategies to manage
interruptions in supply and cash flow, while providing continuous service to their stakeholders.

In this new reality, procurement must change its strategic thinking from just-in-time to just-in-case,
making its process resilient to accommodate these unforeseen situations. According to Christopher and
Holweg, supply chain resilience allows an organization to design a network of partners that is strong
enough to adapt to unexpected disruptions while maintaining control and – if possible – continuing past
the disruption more favorably, gaining a competitive advantage.

A resilient and robust procurement process that can account for future and sometimes disastrous
changes that may happen when procurement operations and supply chains are re-defined will fare far
better in the long run.

Start->Forecast/Requirement Planning->Need Clarifications/Requisition->Supplier identification-

>Approval/Contract/PO Generation->Receive Materials & Documents->Settlement/Payment/Measure
Performance

What Is a Purchase Requisition?

A purchase requisition is an internal document indicating the desire to purchase goods or services for
the business. An employee fills out a purchase requisition and submits it to the appropriate individuals
or departments for review and approval. Reviewers may include both the employee's line manager
and the company's central procurement or purchasing department. Once the purchase requisition is
approved, the business then issues a purchase order for the requested items to the appropriate
vendor.
Purchase requisition vs. purchase order:

People often confuse purchase requisitions with purchase orders, but they are created at different
stages in a business's procurement process. A purchase requisition is an initial internal request made
by an employee who needs to acquire goods or services for the business. Once the purchase
requisition is approved, a purchase order for the items is sent to a supplier. Unlike a purchase
requisition, a purchase order (once approved by the buyer and supplier) is a legally binding contract
that outlines exactly what the business intends to buy and for how much money.

Key differences
 The key differences between a purchase requisition and a purchase order are as follows:

Purchase Requisition Purchase Order

What it is Internal request to make a purchase Confirmation of an order

Who creates it Any employee Purchasing/procurement group

When it is created At start of procurement process, when an employee sees When a business is ready to place an order
a need to buy goods or services for goods or services

Who receives it Head of department, purchasing/procurement Vendor

department, and any other approvers

What information it ▪ Date of requisition ▪ Date of purchase order

contains
▪ Requisition number ▪ Purchase order number

▪ Name and department of requester ▪ Name of buyer (business)

▪ Products/services requested ▪ Description of goods and services

being purchased
▪ Quantity and estimated price
▪ Quantity and price
▪ Reason for purchase
▪ Payment terms
▪ Suggested vendor/supplier
▪ Billing and shipping addresses
▪ Approver names/signatures
▪ Delivery date

▪ Name of vendor

▪ Approver names/signatures

So, what is an RFX? What does RFX mean? In procurement, the acronym RFX means request for X, where
X is a variable that stands in for different types of vendor questionnaires. For example, RFX could stand
for request for proposal (RFP), request for quotation (RFQ), request for information (RFI) and so on.

The term is commonly used in procurement and request management when discussing sourcing
processes that may require more than one type of RFX. It may be used as a placeholder when a specific
type of information request has not yet been selected. For instance, if you know you need to make an IT
software purchase, but you are not yet sure if you need to use an RFI vs RFP vs RFQ. Additionally, you
may also encounter it when searching for strategic sourcing solutions. While a lot of sourcing technology
is classified as RFP specific, any RFP software tool can easily be used for every kind of question-and-
answer document.

10 kinds of RFX documents

There are a lot of different vendor questionnaires that fall into the definition of an RFX. As you may
expect, some are very well known and commonly used while others are specific to a particular industry
or region.

Here you will find an overview and key information about every type of RFX. We will start with the most
searched RFX meanings and move down the list into more obscure RFX types.

Request for proposal — RFP

Definition: RFP, meaning request for proposal, is a formal, standardized questionnaire issued to
prospective vendors to compare them and select the best option. In addition to RFP questions, the
document contains information about the project challenges, goals, and scope.

Use case: An RFP indicates that an organization is ready to make a purchase. Typically, it requests general
information and asks a combination of complex and closed-ended questions. Thanks to their detail, RFPs
are a good fit for high-value strategic sourcing projects.

Request for information — RFI

Definition: The request for information, abbreviated as RFI, is used to collect general information from
vendors. Indeed, while it still takes a question-and-answer format, the RFI is more casual than many
other RFX documents.

Use case: The request for information educates. Procurement managers use RFIs to explore solutions,
test market conditions and plan future purchases. Unlike other RFX documents, an RFI is not typically
used to select a vendor and it does not necessarily indicate that a contract will be awarded in the future.

Request for quotation — RFQ

Definition: The request for quotation questionnaire asks vendors to detail their pricing proposal and
payment terms. Generally, when issuing an RFQ, price is the most important consideration.

Use case: Requests for quotation should only be used when you know very specifically what you need.
Other RFX documents allow vendors to propose creative alternatives, but the RFQ is different. Indeed,
the format requires you to clearly detail your deliverables, specifications, quantities, and requirements.

Request for qualifications — RFQ

Definition: Slightly less common than the request for quotation, a request for qualifications is also
referred to as an RFQ. The questions in this type of RFX focus primarily on vendor expertise and
experience. Consequently, the vendor response is not a proposal, but is instead referred to as a
statement of qualifications or SOQ.

Use case: The request for qualifications is commonly used in construction and other large-scale
purchases when expertise is paramount.

Request for proposal lite — RFP lite

Definition: A variation of the traditional RFP, the RFP lite, is an abbreviated request for proposal.
Sometimes called a short-form RFP or simple RFP, this RFX may have as few as 10 questions, rather than
the dozens often found in a traditional RFP.

Use case: Because it is shorter, the RFP lite is fast, but it also must be very straightforward. Typically, the
RFP lite is a good fit for low-risk, routine, or recurring procurement projects. For instance, if you need to
verify that your incumbent vendor is providing competitive services and rates.

Electronic request for proposal— eRFP

Definition: eRFP stands for electronic request for proposal. Essentially, the eRFP is a digital version of an
RFP.

Use case: Many procurement teams have embraced digital transformation and moved many processes,
including sourcing, to digital platforms. For many, this means using a cloud-based RFP management
system to improve processes increasing efficiency and collaboration for vendors and stakeholders alike.

Request for tender — RFT

Definition: A request for tender, or RFT, is very similar to an RFP. Used outside of North America, a
tender is like a proposal. The questionnaire asks vendors how they would meet the business’s unique
needs.

Use case: Just like an RFP, the RFT is used as a part of vendor selection. Using this type of RFX means that
a buyer has a need, is ready to select a vendor and make a purchase.

Request for bid — RFB

Definition: Abbreviated as RFB, a request for bid is another RFX that has a similar meaning to an RFP. A
request for bid, sometimes called an invitation for bid (IFB) includes a list of questions intended to gather
vendor information. One key distinction of the RFB is that it usually requires vendors to submit sealed
bids that are not opened until the submission due date passes as defined in the RFP timeline.

Use case: A request for bid can be used for buying the same goods and services as an RFP. RFBs are more
common outside of North America. Additionally, because of their sealed nature, they are preferred by
procurement teams that are subject to regulations.

Request for offer — RFO

Definition: RFO, or a request for offer, is a questionnaire that invites vendors to submit a proposed
solution to a buyer’s stated challenge. It provides slightly more leeway for vendor creativity than other
RFX tools.

Use case: If you can provide clear guidance to vendors, but are open to other solutions, the request for
offer is a good option. The RFO is a somewhat newer term that reflects procurement’s desire to move
more toward collaborative processes.

Request for partner — RFP

Definition: An alternative to the traditional RFP, the new term, request for partner is another RFX type
that encourages more transparent collaboration between buyers and sellers. While it outlines the
background and context for the procurement process, it relies on communication rather than a one-
sided collection and review of proposals.

Use case: The request for partner is best used for highly-strategic, long-term projects. This approach
emphasizes the importance of building relationships.

RFX process overview

Regardless of which RFX you choose to use, the basics steps involved remain mostly the same. Indeed,
the RFX process involves only three steps: creation, administration, and evaluation.

1. RFX creation

The first step in any RFX process is creating the document. This includes conducting initial research,
planning your process, and writing the RFX. These steps remain the same whether you use an RFI, RFQ
or RFP.

Gather information

No matter what type of questionnaire you are using, start by gathering important information about the
need or project. What problem are you solving? Who needs to be involved in the process? What are the
deliverables? How much can you spend? Clearly defining your goals, scope and budget at the beginning
helps ensure a smooth process.

Plan your process

Once you have done the initial research and talked with stakeholders, it’s time to plan your RFX timeline.
Assign dates to key milestones in the project to help keep your team on track. Additionally, having a clear
timeline helps vendors engage with your project.

Write your RFX

Now, it’s time to create your vendor questionnaire. As you do this, try to consider the document from
the vendor perspective. What information do they need to provide you with helpful answers? To start,
include project background, current state, a problem statement, and scope. Next, determine what RFX
questions would be most helpful.

2. RFX administration
Select vendors and publish

Who are you sending your RFX to? It is best to limit your RFX to three to six vendors that meet your
needs. If you are a private business, you can send your RFX directly to them. However, if you are making
a purchase on behalf of a government organization, you may need to publish the RFP publicly to meet
regulatory guidelines.

Respond to questions

No matter what kind of RFX you issue, vendors will almost certainly have follow-up questions. Make sure
your RFX timeline provides a question-and-answer period to ensure you get high-quality answers.
Additionally, ensure fairness and transparency by providing the same answers to every participating
vendor.

Send reminders

As your RFP deadline approaches, it is wise to reach out to vendors who have not yet responded. When
your due date is about a week away, send a follow up reminder to check in and encourage participation.

3. RFX evaluation

Score the proposals

Finally, we have arrived at the last step of the RFX process. Hopefully you have three or more qualified
bids. Go through each response individually and score them using your evaluation criteria and weighted
scoring. Leverage RFP automation capabilities in strategic sourcing software for this step if available.

Review results

Now that you have scored the vendor proposals, review the strengths and weaknesses of each. Use
a vendor comparison matrix to see responses side by side and determine which option is the best for
your purposes.

Select a vendor or determine next steps

If you are ready to make a purchase, the last step is to select a winner. On the other hand, if you are not
quite ready to buy, use the information you have gathered to narrow your vendor selection to a shortlist
or to direct additional planning.

Ultimately, the meaning of RFX depends on how you use it. But it is a helpful term to represent all the
different types of documents that the procurement team uses to manage the RFX process.

A statement of work (SOW) is a document that provides a description of a given project's requirements.
It defines the scope of work being provided, project deliverables, timelines, work location, and payment
terms and conditions.

Statement of work management is simply the process for ensuring the agreed-upon scope of services
within the SOW are being completed on time and on budget.

Whomever is responsible for SOW management is responsible for creating efficiencies, risk mitigation,
any special requirements, and supplier management and negotiations. Ultimately, finding savings
opportunities and reporting on a project's overall success.

SOWs are commonly used along with a:

Request for Proposal (RFP)

Organizations typically use this document to request pricing, provide requirements, and define a period
of performance. Enough information that a service provider can respond back with an accurate bid for a
project.

Master Services Agreement (MSA)

This is the governing document that outlines two parties’ terms and conditions for an entire relationship.
The statement of work document usually only covers details belonging to a single project or scope of
work.

How are SOWs created?

There are many SOW templates available to help get managers started. However, to write a statement of
work can be somewhat complex. Getting everything included to ensure the scope of services is detailed
enough is critical.

Elements of an SOW can include:

• Purpose of the project

• Scope of work being performed

• Location of the project, project length, and any work requirements

• Expected deadlines and deliverables

• Acceptance criteria

• Any hardware and software required

• Performance-based standards to be met

Creating a thorough SOW can eliminate the risk that can come if there are any misunderstandings or
disputes between parties on any of the elements above.

A concise and well written SOW, mitigates the risk of overspend by ensuring both supplier and
organization have a clear understanding of, and accountability for, the work involved. Bolstering the
upfront agreement, lessens the opportunity for misunderstandings resulting in contract extensions and
associated costs.

What are the different types of SOWs?

There are three standard SOW categories that companies use for defining scope and procuring services.
Some are more popular than others within certain industries, but they all have similar components that
define its success.
 1. Design or detail statement of work

This category of SOW defines the exact requirements needed to complete a project. It tells the supplier
exactly how to do the work and what processes to follow.

Additionally, it defines all requirements and any specific industry-related regulations that must be
followed by the contractors. Typically, the organization using design SOWs assumes most of the risk for
the project.

2. Level of effort

This SOW is used for any kind of service. In a very general way, it details work hours and any material
needed to perform the service over a given time.

3. Performance-based statement of work

A performance-based SOW clearly lays out the project’s purpose, resources that will be provided, and
deliverables that will be accomplished. But it does not provide details about how the work needs to be
performed.

This is the preferred SOW for most companies. This SOW offers the most flexibility, focuses on project
outcomes, and shares risk between parties.

What are the benefits of managing SOWs?

• Benefits can include:

• Increased cost savings opportunities

• Supplier performance and risk mitigation

• Greater process efficiencies

• Detailed reporting

• Project performance management

• Visibility into all outsourced projects within a single purview

• Improved workforce management

• Organizational compliance and risk mitigation

Providing successful SOW management gives hiring managers the tools necessary to make informed
buying decisions and maximizes productivity throughout an organization.
Additionally, unexpected circumstances, scope creep, and post-contract changes can require
amendments to the original SOW. Strong SOW management offers the tracking and reporting necessary
to enable business leaders to make such changes.

It also provides confidence that the project will be delivered on time and within budget.

What is the difference between SOW and Services Procurement?

Services Procurement is the process for requisitioning people-based services at an enterprise-level with
an agreed-upon scope and deliverables.

As we have just discovered, the scope of services and deliverables is what is included in a statement of
work. This is used to monitor and deliver agreed-upon Service Level Agreements (SLAs).

Some organizations use services procurement and statement of work terminology interchangeably
because this category of spend is almost always detailed within an SOW.

Simply put, the SOW is a governing document, and services procurement is the category of spend being
managed within it. There can (and should be) be multiple SOWs managed as part of a services
procurement programme.

What is a Purchase Order Form?

A purchase order form is a template used for a purchase order. The purchase order is a written (or
electronic) document meant to record business transactions between a buyer and a seller. The buyer
issues the purchase order, and once the seller accepts the order, a legally binding contract forms
between the two parties.

What Does a Purchase Order Include?

A basic purchase order features the following elements:

• Buyer: Name, address, and the contact information of the party paying for the goods.

• Seller: Name, address, and the contact information for the party accepting payment for the
goods.

• Purchase Order Number: A unique identifier assigned to each purchase order for easy tracking.

• Order Information/Item Description: The details, quantity of goods, unit price and total cost of
goods.

• Shipping Address: Where the goods will be shipped.

• Shipping Date: When the goods will be delivered to the final location

• Billing Address: Where the seller should send the invoice for payment so the buyer can make
payment
 • Signatures: Each purchase order should contain at least two signatures: one (or more) for the
person or people authorizing the purchase on behalf of the business and one (or more) for the
person or people accepting the order on behalf of the seller.

• Order Date: The date which the business transaction occurred.

A purchase order may also be referred to as a PO or a contract purchase agreement. The buyer may also
be referred to as the vendee, purchaser, or customer. The seller may also be referred to as the vendor or
supplier.

The PO must identify:

• What is being purchased and how many or how much

• Where the goods are being shipped

• Payment terms – when the payment should be made and for how much

• Who the buyer and seller are in this particular transaction

It’s also a good idea to include other details, such as:

• Currency: Will the goods be charged and paid for with U.S. dollars or another foreign currency?

• Payment Method: Will the buyer pre-pay, pay in cash, use a credit card, or a check?

• Delivery Method: How will the goods be delivered? Who is the carrier? Will they be delivered by
courier or picked up?

• Shipping Costs: The cost associated with packing and sending the goods to the buyer.

• Which Party is Paying Shipping Costs: This should be decided ahead of time. Shipping costs
should only be entered when the buyer is paying for shipping. Use a carrier calculator, provided
by USPS, UPS, and FedEx to estimate the shipping costs based on package weight.

• Shipping Information/Tracking Number: Like the PO number, this is a unique identifier that is
used to track the progress of goods delivered. It is provided by the seller when they ship the
items and updated as it makes its journey from the seller to the buyer. It provides an estimated
delivery date and time depending on the shipping service used, and depending on the service,
can also be used to confirm receipt of goods – such as by requiring a signature at delivery.
Carriers generally keep a record of signatures at delivery so if any issues arise, the packages can
be further traced.

• Insurance: Will the seller insure the goods to protect both parties in the event the package is lost
or damaged?

• Terms and Conditions: Any fine print regarding whether goods can be returned or what will
happen and who is responsible if items are lost or damaged during delivery. If goods can be
returned, indicate the return time frame and whether the buyer will pay a restocking fee or
return shipping fee.

• Governing Law: By default, the seller’s state laws will apply.

Elements of a Purchase Order

Section Information To Include

Buyer name • Show the name of your company or organization along with its logo
and address
• Show company contact details, including address, email, and telephone number

• Mention shipping address and billing address if the two are different

• Optionally mention the name, designation, and contact details of the individual
creating the order or the individual to contact in case of queries

• Optionally, you can mention the department within your organization where the
purchase is originating

Buyer tax • Depending on your local regulations, you may be required to explicitly mention
number your tax registration number for the supplier to provide you with a tax invoice.

Seller name • Address the supplier by providing the name of the supplier’s company /
and address organization, and contact details

• If available, mention the name and designation of the sales rep to whom the
purchase order is address

PO number • Provide a unique document number through which the purchase order can be
referenced in correspondence

Dates • There are several different dates that are referred to on a purchase order. At the
top, is a document date, usually the date the purchase order is created or
approved for submission to suppliers

• Additional dates, clearly labeled, can also be provided, usually at the end of the
purchase order within the “Terms and conditions” section. These can include:

o Expiry date: The date till which the purchase order is valid. A supplier
must indicate acceptance of the purchase order on or before this date

o Delivery date: The date by which the order must be fulfilled, goods
delivered (or dispatched)

o Acceptance date: The date (or in some cases the period after fulfillment
of the order) by which the buyer must indicate acceptance of order
completion. If accepted by the supplier, the buyer is allowed a period to
inspect the goods and decline any items that do not meet requirements
such as quality etc.

Bill of • The bill of quantities is a list comprising each of the ordered items, with a clearly
quantities / specified item name, item description, quantity and unit price for each product or
Item list service being ordered.
 • This can include additional details and specifications of the items ordered, item
codes and SKU numbers

• Additionally taxes applicable on each item can be enumerated separately.

• The bill of quantities is often summed up at the bottom to show a total order
value, and can include sub-totals showing a breakdown of the price of goods,
taxes, delivery charges, and discounts.

Terms and • Payment terms: Clearly mention the payment terms agreed with the supplier. This
conditions can include specifying whether payment is before delivery or after delivery, and if
there are any credit terms provided by the supplier. Credit payment terms can be
defined in terms of the number of days of credit offered e.g. 60 days credit or Net
30, Net 45, Net 90 etc.

• Shipping and delivery terms: Mention whether delivery is included in the

purchase order price or if delivery is separate. Can add further information about
mode of shipment and delivery.

• Acceptance terms: Mention any specific terms and conditions governing your
acceptance of the delivery, including return, rejection or refund policy agreed with
the supplier.

Signature • At the end of the purchase order, to formally validate the document, a signature
and approval can be added or the name and designation of the creator and approver of the
purchase order can be provided to confirm the purchase order.
1. Pre-Receiving

Before receiving a shipment, business owners must complete pre-receiving tasks to ensure smooth
movement and timely delivery of stocks to the warehouse. In most cases, a Warehouse Receiving Order
(WRO) label is created containing essential package details.

These details are encoded in barcodes attached to every shipment, making it easier to scan and verify
the received products through the receiving module of the Warehouse software.

2. Receiving and Unloading Stocks

Once the inbound shipment reaches the warehouse, the receiving staff unloads the cargo. Having full
details of the inventory beforehand helps optimize the warehouse receiving process. Depending on the
size and volume of the incoming consignment, warehouse operators can allocate employees and heavy
machinery like pallet jacks and forklifts efficiently.

Digital Warehouse software leverages data and advanced analytics to recommend the optimal allocation
of workers and equipment needed for shortening the dock-to-stock cycle.

Monthly roundup of top stories in e-commerce fulfillment and warehousing.

3. Inspection of received inventory

Damaged products, broken seals, lost items, a mismatch in product SKU, or other details are verified at
the time of unloading. The products received should match the contents listed on the WRO, and any
discrepancy or damaged product should be kept aside to be discussed with the manufacturer.
This is essential for preventing any faulty item from reaching the customer. It is also important to capture
the details during the inspection process in the QA module of the warehouse software to identify
patterns and prevent and minimize future errors.

4. Putaway

Once all the cargo is inspected and unloaded, the person in charge of receiving acknowledges the same.
Inventory numbers are assigned to the products, after which they are segregated per size, category,
expiry date, and other parameters.

They are then sent for storage in the warehouse. Details of the inventory received, damaged products,
and where it is stored are updated in the system.

In warehouses that still need to be digitized, the putaway warehouse process tends to be inefficient
since the warehouse associates spend time locating the storage shelves through a suboptimal path.

Common Flaws & Mistakes in Warehouse Receiving Process

A typical warehouse deals with several problems daily. Some of these include:

- Long waiting times for the inbound trucks to unload as docks are backed up.

- Forklift operators loading pallets prematurely, creating gaps in the inventory.

- Disorganized storage leading to suboptimal space utilization.

- Inefficient staffing of associates due to lack of system-driven work.

- Lack of awareness of the work processes amongst the workforce.

- Inaccurate inventory tracking, resulting in misplaced and lost inventory.

These issues cause the warehouse to spend more time and resources and slow the order fulfillment
cycle, leading to decreased customer satisfaction.

Enforcing changes in the warehouse receiving process to make it streamlined and efficient can resolve
most of these issues. Let us see how the receiving processes can be further improved using smart
warehouse systems.

How can the warehouse receiving process be improved?

Improving the efficiency of the receiving warehouse process in a warehouse reduces the raw material to
finished goods conversion cycles for manufacturing businesses. It can enhance the order lead times for
retail and e-commerce businesses.

Here are some of the ways in which the goods-receiving processes can be improved and made error-
free:

1. Implement a modern warehouse system

Many warehouse processes are involved in the goods receipt process that can be time-consuming and
tedious to perform. Manually tracking and documenting tasks such as inventory movement, labor &
equipment availability, and product details make them error-prone.
Modern warehouse software solutions can help businesses automate and optimize these mundane tasks
and reduce unnecessary errors. Implementing a robust warehouse system can help plan the inbound
inventory movement more efficiently to avoid overflow and excess inventory. On the other hand, it can
also predict potential stockout situations and trigger replenishment orders.

2. Tracking the right metrics

Gathering data at every step of the receiving warehouse process is not good enough. The data should be
analyzed to identify trends and patterns for the root causes.

Warehouse systems with inbuilt analytics and reporting capability can help in tracking metrics such as:

- Dock to stock cycle time

- Inventory stored at every location

- Putaway items per hour

- Average storage cost per unit

- Truck turnaround times at the dock

The metrics are critical for designing and implementing effective systems that reduce cycle time and
errors.

3. Use a well-defined labeling structure.

A well-defined labeling structure incorporating modern technologies like barcoding, RFID tags, and
automated pallet management systems makes it easier for warehouse operators to instantly update
stock information in the system as soon as they unload.

Having detailed information about your inventory gives you more control and insights into the supplier's
performance regarding lead times, reliability, and quality.

4. Manage labor & booking efficiently

Labor expenses amount to 50 to 70 percent of the warehousing operating budget, making it the most
significant cost line item.

Efficient system-driven workforce management prevents under or over-allocation of resources and helps
balance workload.

Warehouse software can automate effective workforce management, thereby keeping up warehouse
productivity levels and avoiding injuries and safety incidents.

5. Conduct Inspection

Regular inventory audits, including physical counts and cutoff analyses, can assist in spotting inventory
imbalances before they become a problem. It will help to plan the future warehouse receiving.

6. Double Check Documents

Double-checking the inventory received and the document for purchasing orders will help to receive the
correct products. It is also simpler for staff to thoroughly review paperwork and spot missing stock by
implementing a system for all receiving and shipping documents that assign numbers to each document
type and labels various forms in a sequential sequence.

Benefits of an Effective Warehouse Receiving Process

An optimized receiving warehouse process aims to guarantee that the suppliers deliver the specified
goods in the appropriate quantities, in good condition, and on time.

The inconsistency of the inventory data caused by inaccurate receiving processes makes it challenging to
fulfill customer orders. Effective optimization of the warehouse receiving warehouse process provides
businesses with multiple benefits discussed below.

1. Accurate Stock counts

Having accurate stock counts help in preventing issues like inventory stockouts and shrinkages.
Inaccurate stock counts lead to customer disappointment as they cannot buy their preferred products.
Hence, brands can provide superior customer experience by ensuring accurate stock counts as a
byproduct of an effective receiving process.

It also helps companies to manage sales forecasts. For instance, a comprehensive receiving process
allows companies to check whether they have received the items in the correct order and inventory
level. Additionally, the brand can replenish an item on demand or notify the customers regarding
product availability when it is out of stock.

2. Fewer Overstocking and Understocking Items

A brand experiences stockout when there is insufficient inventory to fulfill customer demand. On the
other hand, the company sometimes needs a more accurate inventory count to stock products.

Sometimes retailers need the idea of the dead stock items that eat up the warehouse space. An effective
warehouse receiving process helps brands determine which items to order more and ways to remove the
dead stocks.

3. Efficient Inventory Storage System

An efficient receiving process can also affect managing and tracking inventory. It will help lower
inventory management costs by reducing shipment costs and improving transit times.

Brands using a WMS can track their warehouse operations and inventory efficiently. WMS is used for
scanning the list when received. It also marks and records the areas where the products are stored. WMS
also provides warehouse order picking, packing, and shipping instructions to associates that induce
error-free fulfillment.

What are direct materials?

Direct materials are the materials used during production and are directly reflected in the final product.
They include the raw materials, parts or sub-parts needed to produce a product. Since the cost of direct
materials is quantifiable, they are easily and accurately allocated to individual production or batches and
their production costs. Tracking and documenting the cost of these materials is important because they
impact the cost of a product or service.

Examples of direct materials

Here are two examples of direct materials:

• If a company manufactures ceramic coffee mugs, the clay needed to make the mugs is a direct
material because it is needed for the final product.

• Automobile manufacturers need steel, rubber, and plastic to build vehicles. These materials are
direct materials because they are reflected in the final product.

In these examples, each company would account for those specific materials by including them in
production costs.

Accounting for direct materials

Accounting for direct materials is straightforward because they are easy to identify, calculate and
allocate. Companies usually track direct materials through a formal inventory record keeping system and
report and file them in financial statements under production costs, such as work-in-progress inventory,
finished goods and cost of goods sold. For inventory calculation purposes, the direct materials account
includes the cost of materials used rather than materials purchased. Correctly documenting and
accounting for direct materials allows for the proper allocation of resources and calculation of expected
profits and profit margins.

Direct materials variance

The direct materials quantity variance measures the number of materials used in production and is
especially relevant when the production of a single product requires two or more direct materials. It is
also a tool of quality control concerning spillage, but may also indicate the need to advise the investment
of new machinery with lower variance. Companies use this measure to assess the efficiency of material
usages throughout the entire productions department, in the specific production line and for specific
products. The results generated from direct material usage variance can help you control excess usage
and help to make strategic financial decisions.

Calculating direct materials variance

There are two ways to measure direct materials variances, which are:

• Material yield variance: The difference between the amount of material the company uses
during production and the amount it expects to use, multiplied by the budgeted cost of the
materials

• Purchase price variance: The difference between the price paid to purchase an item and its
budgeted price, multiplied by the number of units purchased
A favorable direct materials variance is when the price of materials or the quantity of materials used is
lower than the expected price or quantity.

What are indirect materials?

Indirect materials are the materials used in manufacturing and production processes that cannot be
linked to a specific product or job because they are not integrated or used in substantial amounts into a
product or job. They are not easy to identify or measure and there is usually no formal record keeping
system documents or tracks them. Production generally use indirect materials in small quantities or on a
per-product basis.

Accounting for indirect materials

Companies typically use an informal inventory record keeping system to track indirect materials. They
include the cost of indirect materials in overhead costs or operating expenses or charge them as an
incurred business expense. Including indirect materials as a part of overhead costs tends to be the more
accurate accounting method. When using small amounts of indirect materials, it's acceptable to charge
them to expense as incurred.

Examples of indirect materials

Car manufacturers require various materials to produce cars. The assembly machines that put the auto
parts together during production require regular maintenance for the machines to run smoothly during
production. The machine oil that maintains the equipment is an indirect material because it can't be
traced directly to an individual car in production. Examples of indirect materials include:

• Cleaning supplies

• Office supplies such as tape, glues, and adhesives

• Personal protective equipment, such as helmets and gloves

• Disposable tools

• Equipment rentals

• Spare parts for machinery

• Screws, nuts and bolts

• Fitting and fasteners

• Oil

Direct vs. indirect materials

There are some key distinctions between direct and indirect materials. While both materials are essential
in the manufacturing and production process of a product, they serve different purposes and impact cost
and budgeting differently. Differences between direct and indirect materials include:

1. Traceability to final product

The primary difference between direct and indirect materials is their traceability to the final product. The
usage of direct materials specifically targets what is needed to create a given product or service, and this
usage is explicitly tied to the final product. Indirect materials are not used as direct inputs in the
production process because they are not tied to the production of a specific product or service, even
though they are still used during the process. Indirect materials primarily target the company's day-to-
day operational and administrative needs.

2. Quantity of materials used in production

Companies typically order and use direct materials in larger quantities because they make up the
primary component of a good or service. Comparatively, companies use insubstantial amounts of
indirect materials, and these materials contribute to the operational needs of the company.

3. Accounting practices for materials

The difference between direct and indirect costs can impact your bookkeeping practices when putting
together financial statements and tax returns. Since companies can trace direct materials to a specific
product, they can include the cost of the materials in production costs, including work-in-progress
inventory, finished goods and cost of goods sold. Accounting for indirect materials is not as
straightforward because companies use them in lower quantities. Direct materials contribute to direct
costs, which are commonly not tax deductible. Indirect materials are usually tax deductible.

What is direct procurement?

Direct procurement is the process of acquiring the products, supplies, goods, and services you need for
your core business activity.

Direct procurement, in essence, is about acquiring those essential products and services that make their
way right to your end customers with some processing.

It deals with the inputs that form the backbone of what your organization offers.

Some examples of direct procurement include:

• a baker buying the flour for making bread

• a construction company making an order for the cement and blocks for an ongoing project

• a fabric factory ordering textiles and cloth materials for processing and sewing down the line

Note: Direct procurement features mostly in physical manufacturing industries where direct raw
materials are processed into physical products.

What is indirect procurement?

Indirect procurement also known as indirect spend, deals with acquiring products and services that
support a business’s operations, albeit in a non-essential role. These indirect supplies include office
supplies & stationery, decorations, etc.
Indirect supplies are, in their own way, still essential to your organization. But they do not exert any
direct input into the finished products and services you deliver to your customers.

Rather, they play a supporting role to ensure that the process of turning direct supplies into finished
goods goes smoothly.

Some examples of indirect supplies include:

• SaaS subscriptions, e.g., Slack, Asana, Kissflow

• employee development resources, e.g., books

• office decorations,

• office equipment such as laptops & personal computers.

Indirect supplies are more pronounced in digital fields where there are no tangible goods, but mostly
services delivered to customers.

Differences between direct and indirect procurement

The key difference between direct and indirect procurement is the function they address.
While direct procurement focuses on securing the core supplies that are processed and delivered to your
customers, whereas indirect procurement deals with the supply of spontaneous goods.The different
functions of both direct and indirect procurement mean that there are differences in how both operate.
As a result, you need to slightly tweak your approach to both branches to get them right.

What Is a Stakeholder?

A stakeholder is a party that has an interest in a company and can either affect or be affected by the
business. The primary stakeholders in a typical corporation are its investors, employees, customers, and
suppliers.

However, with the increasing attention on corporate social responsibility, the concept has been extended
to include communities, governments, and trade associations.

KEY TAKEAWAYS:

• A stakeholder has a vested interest in a company and can either affect or be affected by a
business' operations and performance.

• Typical stakeholders are investors, employees, customers, suppliers, communities, governments,

or trade associations.

• An entity's stakeholders can be both internal or external to the organization.

• Shareholders are only one type of stakeholder that firms need to be cognizant of.

• The public may also be construed as a stakeholder in some cases.

Understanding Stakeholders

Stakeholders can be internal or external to an organization. Internal stakeholders are people whose
interest in a company comes through a direct relationship, such as employment, ownership, or
investment.

External stakeholders are those who do not directly work with a company but are affected somehow by
the actions and outcomes of the business. Suppliers, creditors, and public groups are all considered
external stakeholders.

Stakeholder capitalism is a system in which corporations are oriented to serve the interests of all their
stakeholders.

Example of an Internal Stakeholder

Investors are internal stakeholders who are significantly impacted by the associated concern and its
performance. If, for example, a venture capital firm decides to invest $5 million in a technology startup in
return for 10% equity and significant influence, the firm becomes an internal stakeholder of the startup.

The return on the venture capitalist firm's investment hinges on the startup's success or failure, meaning
that the firm has a vested interest.

Example of an External Stakeholder

External stakeholders, unlike internal stakeholders, do not have a direct relationship with the company.
Instead, an external stakeholder is normally a person or organization affected by the operations of the
business. When a company goes over the allowable limit of carbon emissions, for example, the town in
which the company is located is considered an external stakeholder because it is affected by the
increased pollution.

Conversely, external stakeholders may also sometimes have a direct effect on a company without a clear
link to it. The government, for example, is an external stakeholder. When the government initiates policy
changes on carbon emissions, the decision affects the business operations of any entity with increased
levels of carbon.

Issues Concerning Stakeholders

A common problem that arises for companies with numerous stakeholders is that the various
stakeholder interests may not align. In fact, the interests may be in direct conflict. For example, the
primary goal of a corporation, from the perspective of its shareholders, is often thought to be to
maximize profits and enhance shareholder value.

Since labor costs are unavoidable for most companies, a company may seek to keep these costs under
tight control. This is likely to upset another group of stakeholders, its employees. The most efficient
companies successfully manage the interests and expectations of all their stakeholders.

It is a widely-held myth that public corporations have a legal mandate to maximize shareholder wealth.
In fact, there have been several legal rulings, including by the Supreme Court, brought on by other
stakeholders, clearly stating that U.S. companies need not adhere to shareholder value maximization.1
Stakeholders vs. Shareholders

Shareholders are only one type of stakeholder. All stakeholders are bound to a company by some type of
vested interest, usually for the long term and for reasons of need. A shareholder has a financial interest,
but a shareholder can also sell their stock in the company; they do not necessarily have a long-term need
for the company and can usually get out at any time.

For example, if a company is performing poorly financially, the vendors in that company's supply
chain might suffer if the company limits production and no longer uses its services. Similarly, employees
of the company might lose their jobs. However, shareholders of the company can sell their stock and
limit their losses.

What Are the Different Types of Stakeholders?

Examples of important stakeholders for a business include its shareholders, customers, suppliers, and
employees. Some of these stakeholders, such as the shareholders and the employees, are internal to the
business. Others, such as the business’s customers and suppliers, are external to the business but are
nevertheless affected by the business’s actions. These days, it has become more common to talk about a
broader range of external stakeholders, such as the government of the countries in which the business
operates, or even the public at large.

What Is an Example of a Stakeholder?

If a business fails and goes bankrupt, there is a pecking order among various stakeholders in who gets
repaid on their capital investment. Secured creditors are first in line, followed by unsecured creditors,
preferred shareholders, and finally owners of common stock (who may receive pennies on the dollar, if
anything at all). This example illustrates that not all stakeholders have the same status or privileges. For
instance, workers in the bankrupt company may be laid off without any severance.

What Are the Stakeholders in a Business?

Stakeholders in a business include any entity that is directly or indirectly related to how a company
operates, whether it succeeds, or if it fails. First the owners of the business. These can include actively-
involved owners as well investors who have passive ownership. If the business has loans or debts
outstanding, then creditors (e.g., banks or bondholders) will be the second set of stakeholders in the
business. The employees of the company are a third set of stakeholders, along with the suppliers who
rely on the business for its own income. Customers, too, are stakeholders who purchase and use the
goods or services the business provides.

Why Are Stakeholders Important?

Stakeholders are important for several reasons. For internal stakeholders, they are important because
the business’s operations rely on their ability to work together toward the business’s goals. External
stakeholders on the other hand can affect the business indirectly.

For instance, customers can change their buying habits, suppliers can change their manufacturing and
distribution practices, and governments can modify laws and regulations. Ultimately, managing
relationships with internal and external stakeholders is key to a business’s long-term success.

Are Stakeholders and Shareholders the Same?

Although shareholders are an important type of stakeholder, they are not the only stakeholders.
Examples of other stakeholders include employees, customers, suppliers, governments, and the public at
large. In recent years, there has been a trend toward thinking more broadly about who constitutes the
stakeholders of a business.

The Bottom Line

Stakeholders are individuals, groups or any party that has an interest in the outcomes of an organization.
Stakeholders can be internal or external and range from customers, shareholders to communities and
even governments.

Why are good stakeholder relationships important?

Having a good relationship with your stakeholders is important because it helps you get to know their
needs, interests, and requirements. This can help you make informed business decisions that meet their
expectations and improve the company's chance of success. Forming strong relationships with
stakeholders may also give you access to new ideas and suggestions that you did not think of before.

How to manage relationships with stakeholders

Here are four steps you can follow to create and maintain successful relationships with your
stakeholders:

1. Identify stakeholders

Before you engage with your stakeholders, determine who they are. As there are many types of
stakeholders, both internally and externally, you may need different stakeholder engagement plans for
different types. To do this easily, consider creating a power interest matrix that allows you to organize
stakeholders into the following four categories:

• High power and high interest: These stakeholders may be primarily responsible for decision-
making, meaning they have a big impact on how successful a project or company is. This means
that regularly engaging with stakeholders in this category is important.

• High power and less interest: Stakeholders in this group may have decision-making power, but
are not interested in constant updates. Try to put effort into maintaining a relationship with
these stakeholders without over communicating.

• Low power and high interest: When you have updates, provide them to stakeholders in this
group to ensure they feel appreciated. This can minimize issues and allow you to gain
suggestions that may improve the company's success.

• Low power and less interest: You can monitor stakeholders in this group to minimize issues
before they occur, but you may not spend as much time nurturing relationships with them.

You can also identify key stakeholders by asking yourself some of the following questions:

• Who directly impacts the company or project's success?

• Who is interested in the company's success?

 • Can the business continue to succeed without this individual, group, or organization?

• Who performs tasks that make the business successful?

• Who tests and uses the company's product or service?

• Who makes financial decisions that impact the company?

2. Identify the purpose of the engagement

Once you categorize your stakeholders, you can create an engagement plan to maintain or improve your
relationship with them. You may need multiple plans to appeal to each group of stakeholders. Start by
identifying the purpose of your engagement to ensure it's valuable. The purpose or goal of your
engagement depends on your industry and position, but here are some examples of engagement
purposes you might have if you work in retail:

• issuing special offers

• developing new products or services

• improving customer service

• providing information about promotions

• implementing a pricing strategy

3. Create a communication strategy

Once you know what you want to discuss with your stakeholders, find their preferred method of
communication. For example, some stakeholders may want weekly e-mail updates, while others may
prefer face-to-face meetings once a month. Using their preferred method of communication shows your
stakeholders you respect them and their time, helping you strengthen your relationship. You can also
talk to your stakeholders about how frequently they want communication from you so you can meet
their expectations. Then, create a communication plan that you can easily refer to before contacting your
stakeholders.

4. Implement your plan

Once you have a communication plan, implement it to improve or maintain your relationship with
stakeholders. Staying in contact regularly with them can help you identify any issues or concerns they
may have, so you can address them quickly. When communicating with your stakeholders, ensure it is an
open dialogue so they feel comfortable offering suggestions and feedback. Review your plan regularly to
ensure its successful and relevant, especially when you gain new stakeholders or their interest changes.
What Is 3-Way Matching in Accounts
Payable?

3-way matching is a procedure for processing a vendor invoice to ensure that a

payment is complete and accurate. The goal of 3-way matching is to highlight any
discrepancies in three important documents in the purchasing process.
The three documents that must have matched totals include purchase orders,
order receipts/packing slips, and invoices. Ensuring that these documents are
matched before paying an invoice saves businesses from overpaying or paying for
an item that they did not receive.

How Does 3-Way Matching Work?

3-way matching works by having accounts payable review the quantities, prices,
and terms to ensure that what is ordered (via the purchase order) matches the
goods received (via the order receipt/packing slip) which matches what they are
being charged (via the invoice).
This process is important for large purchases or purchases with newer vendors,
but businesses may choose not to use three-way matches for small or recurring
purchases.
Let’s explore the three critical documents that accounts payable teams use to
enforce 3-way matching before paying a supplier invoice.
1. Purchase Orders
A purchase order (PO) is an official confirmation sent from the buyer’s
purchasing department to a vendor that authorizes a purchase. POs
generally include the buyer’s company name, date, description and
quantity of the goods or services, price, mailing address, payment
information, invoice address, and PO number.
2. Order Receipts/Packing Slips
Along with the goods delivered, vendors provide an order receipt as proof
of payment and delivery. It details exactly what is in the shipment or
order. Order receipts typically include the same information as in the
invoice, as well as the method of payment.

Invoices
3.
An invoice is sent from the purchaser to the vendor to request payment
for a purchase. Invoices include the same information as the purchase
order, as well as an invoice number, vendor contact information, any
credits or discounts for early payments, payment schedule, and total
amount due.
If any issues are found—inaccurate quantities, wrong prices, damaged
goods, or more—payment is not sent until the issue is rectified. Once the
invoice has been validated by the 3-way matching process, payment is
sent according to the terms.
What Is the Difference Between 3-Way, 2-
Way, and 4-Way Matching?
Some accounts payable teams may rely on two-way or four-way matching—rather
than 3-way matching—to ensure that invoices are accurate. The difference
between these methods involves the documents used and confirmation needed
before payment is released.

2-Way Matching
Only the invoice and the purchase order are matched before payment is
released. This more basic method is used when only two documents are
available, or for regularly recurring payments such as software
subscriptions.

3-Way Matching
Considered the industry standard, this process involves matching the
invoice, purchase order, and packing slip/order receipt.

4-Way Matching
This involves the same documents as 3-way matching but adds the more
rigorous element of human confirmation. This confirmation could be a
visual inspection (such as checking if repairs are sufficient) or a verbal
confirmation (such as stating that a training session was successfully
delivered).
Accounts payable can use these different methods of invoice matching for
different situations. At their discretion, they can decide if two-way
matching or three-way matching is enough, or if the added confirmation
of four-way matching is required.

What Are the Benefits of 3-Way Matching?

There are multiple benefits of 3-way matching that inspire accounts payable
teams to take the time to do it. Four of the most important benefits of 3-way
matching is the following:

Reduces Manual Errors and Incorrect

Payments
Verifying that data is consistent across purchase orders, receipts, and
invoices help businesses avoid overpaying, paying for duplicate items,
and paying for things they have not received.

Ensures Optimal Vendor Relationships

High-quality vendors respect the importance of purchase orders, invoices,
and receipts in the accounts payable process. Frequent mistakes on
receipts and invoices can be a sign of a broader business issue, and may
indicate that it is time to begin shopping around.

Prepares Businesses for Audits

Auditors are specifically on the lookout for financial discrepancies.
Compiling these documents in advance of an audit and checking that the
numbers line up using the 3-way matching process shows auditors that
your business is well-organized and financially responsible.

Reduces Risk of Fraud

According to a 2022 survey, 58% of AP departments report being targeted

by email scams that include fake invoices or wire transfer information. 3-

way matching helps ensures that fraudulent invoices are not paid because
they should not match existing POs and receipts.

What Are the Disadvantages of 3-Way

Matching? Why Is Manual 3-Way
Matching Bad?

While it is always an important internal control, the disadvantages of 3-way

matching come into play when it is done manually, rather than automated. When
done manually, it can be labor-intensive, time-consuming, and a considerable cost
to your organization.
The manual three-way matching process generally looks like this:

Thumbing through stacks of paperwork to find the three documents you

need
Visually scanning each document to ensure the numbers are aligned
Logging a confirmation of the match in a spreadsheet
Manually approving the payment for release
Not only is this inefficient, but it is also highly susceptible to human error

What Are Common Exceptions in 3-Way

Matching?

Sometimes, an exception is found between the three documents in 3-way

matching (which means the process worked). When this happens, the buyer will
typically reach out to the vendor for clarification to make sure they are paying the
right amount and received the goods or services they ordered.
Common exceptions in 3-way matching include:
Incorrect Total Amount
When the total amount on the invoice is higher than on the purchase
order or packing slip. This could indicate that the vendor used an
incorrect unit price or just be a data entry error.

Incorrect Shipping Amount

When a vendor delivers more or less than the amount ordered. Finding a
mismatch here may also indicate that you were charged for more or less
because you did not receive the exact amount that you ordered.

Missing Receipt or Packing Slip

When a vendor delivers an order without a goods receipt, packing slip, or
a receiving report, it cannot be paid under the 3-way match system because
that crucial document is missing. When this happens, the buyer’s
receiving department can reach out to the vendor for a replacement
packing slip or receipt.

Mismatched Tax Amount

This usually happens alongside incorrect total amounts since taxes are
calculated based on the wrong amount. Other errors can happen here as
well, especially in interstate or international transactions where taxes
are not straightforward.

Duplicate Invoice
Ever so often, suppliers will send the same invoice twice. This is most
likely a clerical error on their part and not an attempt to get double paid
but should be checked against nonetheless. This is easily caught when the
AP team goes to sign off on a 3-way matched invoice and sees that the
invoice has already been paid.

Charged For the Same Items on Multiple

Invoices
Some vendors might make the mistake of throwing the same items on
multiple invoices. Luckily, procurement teams will have sent a PO for the
specific items they ordered, so this should be caught in the 3-way match
process when those items do not line up exactly as they were on the PO.
 Manual Matching vs Automated Matching

Manual Automated

Manual paperwork Digital processes

Optical character recognition (OCR) and AI used to

Human eyes scan each line item to match on
each document automatically read and match documents

Automated invoice approval processes and payments

Manual approvals and payments

Prone to human error Reduced error rate

Lengthy processes cause late payments Faster payments and access to early payment
discounts

Goods received note

Goods Received Note (GRN) is an important proof for businesses that plays a major role in the accounts
payable process. This simple document can help businesses avoid undesired burdens in the long run.

Meaning of Goods Received Note (GRN)

Goods received note is a document that acknowledges the delivery of goods to a customer by a supplier.
A GRN consists of a record of goods that the buyer has received. This record helps the customer compare
the goods delivered against the goods ordered.

When the buyer receives the goods, the store’s department will inspect them against the purchase order
and examine their physical condition. Once they ascertain that all goods are received in perfect physical
condition, the department issues the GRN. In cases where the goods received do not match the
specifications of the purchase order, the buyer may reject these goods. The buyer issues the GRN only
for approved goods and executes a fresh purchase order for the rejected batch.

The responsibility of issuing GRN is on the store’s department. It is prepared in several copies, each for
the supplier, procurement department, accounts department, and store’s department retention.

Uses of goods received note

A GRN acts as a confirmation mechanism for delivering goods for both parties. GRN is applicable in case
of many situations:

• Record for the future: A record of goods received can be used as a reference for future cases
such as resolving disputes or audit trails.
 • Examining goods received: GRN helps validate the quantity and quality of goods received by the
buyer. It helps to inform the supplier that the goods are of an acceptable standard.

• Inventory management: GRN assists in keeping track of inventory levels and thereby helps
maintain accurate inventory levels.

• Assist in accounting: With the help of GRN, accountants can confirm inventory balances and
update the stock ledger against purchase entries. This also helps in managing accounts payable.
Items not received as per GRN can be subtracted, and the suppliers may pay the balance.

Format of goods received note

A GRN must consist of the following features to depict complete information of the delivery:

• Name of supplier

• Time and date of the delivery

• Details of products received include name, quantity, type, etc.

• Signature of stores manager

• Signature of supplier/representative of the supplier

Process to issue goods received note

A GRN helps improve efficiency in the delivery stage of the procurement process. The following process
flow is followed:

• Receive invoices and purchase orders for the goods.

• Supervise unloading of goods at the location.

• Conduct physical verification of goods received to ensure quantity and quality of materials is as
per the purchase order. Perform quality tests on a few materials.

• Inform the supplier in case of shortfall in quantity or disputed goods.

• Once verified, the store’s department will issue copies of GRN instead of approved goods. The
notes must be signed by the store’s department manager and verifier. A copy is given to the
supplier to acknowledge receipt of goods. The other copies are sent to the relevant
departments.

• On receipt of the GRN, the accounts department will update the store’s ledger account.

A GRN has the following format:

Goods Received Note

Supplier Name: ……………………………… Date & Time ………………………………

Order Number: ……………………………… Delivery Location ………………………………………..

Sr. No Goods Description Size Quantity Comments

Total:

Received By: ……………………………….. Checked By: …………………………………

The goods received note is concrete proof of receipt of goods. It helps maintain inventory records that
come in and ensures the right quantity of goods are always available. GRN helps mitigate disputes that
could arise due to faulty goods received. It serves to reconcile supplier invoices with the goods received
to make accurate payments. It is also documentary evidence that accountants can rely on to maintain
error-free account balances.