Transaction Costs: Why Should Firms Control Spending Before the Invoice Arrives?

Firms should control spending before the invoice arrives because, by that point, a supplier has been chosen, a price agreed and the money committed, so the only real chance to question a purchase comes when an employee first asks to make it.

When Does a Business Commit to a Purchase?

A business usually commits to spending when it places an order, not when it pays. Finance can check an invoice against what was ordered and approved, but it cannot undo the decision behind it. Approval policies written on paper mean little if employees routinely order first and seek sign-off afterwards.

What Is a Purchase Requisition?

A purchase requisition is an internal request to buy something. The employee sets out what is needed, why, the expected cost and which department or project will pay. Once the request is approved, the business issues a purchase order to the supplier.

The value of a requisition lies in its timing. A manager may find the equipment is already sitting unused in another department. Procurement may know that an existing supplier offers better terms. Finance may spot a budget problem the employee was unaware of. None of these checks is useful once the goods have been ordered.

Why Do Expiring Budgets Encourage Waste?

Departments often treat an unspent budget as a reason to buy. Where unused money is lost at the year-end, budget rules create a perverse incentive: spending becomes a way to protect next year’s allocation rather than a response to genuine need.

In a study of 14.6 million US federal contracts from 2004 to 2009, Jeffrey Liebman and Neale Mahoney found that spending in the last week of the fiscal year (the government’s budget year) was 4.9 times higher than in a typical week and that IT projects bought in that final week received lower quality ratings.

Recurring costs deserve particular scrutiny, as a subscription that looks cheap each month can become a substantial commitment over several years.

Why Do Approvers Need the Same Information?

Knowledge inside a firm is spread unevenly. A department manager knows why equipment is needed, finance knows whether it fits the budget, and procurement knows about supplier contracts and similar requests elsewhere. This asymmetric information means each person may approve or reject a request without seeing the full picture.

Email makes this worse across several offices. Purchase requisition software can reduce it by collecting requests in a standard format, attaching supporting documents and sending each one to the right approver, so everyone works from the same record. The system owner and approvers must establish the rules governing budget ownership, approved responsibilities, and the type of information anticipated for each purchase type before implementing any systems based on these rules.

Many times, modifying the originating request for an item can substantially improve the request's quality, rather than simply adding an additional level of approvals.

Can Combining Orders Lower Prices?

Suppose three offices each order computer monitors from local suppliers in the same month. Each purchase may be sensible on its own, but nobody has considered the combined demand.

A single larger order could secure purchasing economies of scale, as suppliers often offer lower unit prices on bigger volumes. Delivery costs, timing and local needs sometimes make separate orders cheaper, but a firm can only weigh the options if procurement sees requests before orders are placed.

How Much Control Is Too Much?

Putting purchasing controls in place is not cost-free. Approval processes create transaction costs because they require time and resources to review and authorise purchases.

Having three different managers review and approve a standard purchase of £50 is likely cost the organisation more in staff time than the value of the purchase itself. The time lost while waiting for approvals could lead to some employees circumventing the purchasing process altogether.

Approval rules therefore work best when they vary. Routine orders placed with approved suppliers are typically processed quickly. Orders that are large, from unfamiliar sources, or with unusual specifications should be reviewed closely. Backup approvers can prevent a purchasing department from being completely shut down due to a single manager's holiday.

Do Early Spending Checks Save Money?

Early checks pay off only when they change decisions. Useful indicators include approval times, requests returned for missing information, purchases made before approval and duplicate orders identified.

Savings need careful counting. Avoiding a purchase of equipment the firm already owns cuts spending. Saving an employee two hours a month on approvals improves efficiency but does not necessarily reduce costs.

Reporting needs similar care. A request is not a commitment: it may be rejected, changed before an order is issued or invoiced at a different price. Treating requests, authorisations, purchase orders, invoices and payments as separate purchases can lead to the same transaction being counted multiple times. Equipment approved in October may not be paid for until December. Requisition information therefore helps with forecasting but does not provide a complete picture of cash flow.

The best test is whether the process helps the business make better decisions without adding unnecessary administration.