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Written by Marijn Overvest | Reviewed by Sjoerd Goedhart | Fact Checked by Ruud Emonds | Our editorial policy
Purchase Price Variance — Everything You Should Know
Key take-aways
- Here’s the formula for PPV calculation: PPV = (Actual Cost – Standard Cost) x Actual Quantity.
- Increase in actual costs yields a positive variance, whereas a negative variance results when actual costs decrease.
- Understanding PPV is crucial to gauge the effectiveness of cost-saving measures and initiatives.
Purchase price variance is an important factor for budget preparation, but why?
In this article, we will discuss what price purchase variance is and why it is important. Additionally, we will tell you the factors that can positively and negatively affect the price purchase variance.
Once you are done reading this article, you will be able to have a deeper understanding of purchase price variance. Thus, allowing you to know the price fluctuations for goods and services.
Price Purchase Variance: What is it?
Purchase price variance (PPV) is a measure of the difference between the actual cost paid for a product or raw material and the standard cost that was expected to be paid.
It is a common concept in cost accounting and is used to evaluate the efficiency of a company’s purchasing process. The formula is:
PPV = (Actual cost – Standard cost) x Actual quantity
An increase in actual costs results in a positive variance, while a decrease in actual costs results in a negative variance.
The standard price is the price that the company estimates it should pay for an item, taking into account quality level, purchasing quantity, and delivery speed.
However, the variance is determined based on this standard price, which is the result of multiple assumptions made by employees, and these assumptions may no longer be relevant to the company’s current purchasing situation. As a result, the variances may be excessively high or low, caused by incorrect assumptions.
The purchase price variance is an essential measurement to understand price changes in products and services. Proper utilization of this metric yields a crucial understanding of the procurement organization’s efficiency in achieving cost reduction objectives.
Why is it Important?
Knowing the standard pricing for goods and services is crucial in initiating negotiations for new purchases. Procurement teams often use these prices as a reference point to evaluate bids.
The knowledge of price variance in goods and services also sheds light on the effectiveness of cost-saving measures. PPV can indicate the success of procurement initiatives when analyzed in the appropriate context.
It is important to take note that an unfavorable variance does not always suggest a procurement strategy issue. The causes of the variance, whether external or internal, need to be put in perspective.
For example, external market forces like supply chain disruptions may influence pricing. In such cases, it may not be possible to negotiate prices down to meet the last purchase price (LPP) due to external market issues.
Factors that Positively Affect the PPV
Since most things in business carry a domino effect, there are many factors that affect either the increase or decrease of the purchase price variance. The following are tha factos that positively affect the PPV:
1. Effective Strategic Sourcing
Strategic sourcing can have a positive impact on purchase price variance by helping companies to improve their procurement processes and negotiate better prices with suppliers.
It helps companies to standardize their procurement practices, which can lead to more consistent pricing and better control over costs.
2. Successful Negotiations
Positive PPV may be the result of effective negotiation between the purchasing team and suppliers.
Although cost savings is a crucial aspect of a deal, it is not the only factor that determines a successful negotiation.
Negotiating other contract terms such as delivery speed or contract length may lead to a less favorable PPV, but it could enhance overall cost efficiency in situations where price is not the only factor to consider.
3. Multi-Year Pricing
Acquiring large quantities of goods through a contract spanning several years can lower the cost per unit and prevent variance caused by inflation or potential material price hikes.
Developing precise capacity planning and forecasting facilitates the commitment to multi-year agreements.
Factors that Negatively Affect the PPV
Now that we have tackled the variables that affect the purchase price variance, let us now dig deeper and enumerate the factors that negatively affect the PPV:
1. Inflation
Not all pricing factors are within the procurement’s control. Whenever the cost of raw materials or components increases, purchase price variances are likely to ensue.
Establishing strong supplier relationships and securing volume discounts can assist in mitigating the impact of escalating commodity prices.
2. Maverick Spend
Maverick spending is a contributor to unfavorable purchase price variance in an organization.
Inadequate spending controls by finance and procurement leave stakeholders to their own devices to acquire the resources and materials necessary for their success.
This leads to the purchase of the most accessible supplies, which frequently corresponds to the quickest delivery, but is not necessarily the most cost-efficient solution.
3. Loss of Volume Pricing
Changes to supplier programs or modifications in discount tier qualifications may lead to adverse price variations in goods. Through effective negotiation, such changes may be mitigated via supplier-side discounts as licensing volume increases.
Conclusion
A purchase price variance is a measure of the difference between the actual cost paid for a product or service and the standard cost that was expected to be paid. So, it also highlights how successful a company’s procurement process is, especially the negotiation.
The formula to get the PPV is: PPV = (Actual cost – Standard cost) x Actual quantity.
Moreover, an increase in actual costs results in a positive variance while a decrease in actual costs results in a negative variance.
Thus, it is important to know the standard pricing for goods and services is crucial in initiating negotiations for new purchases and procurement professionals often use these as reference points to evaluate bids. In addition, this also sheds light on the effectiveness of cost-saving measures and indicate the success of procurement initiatives when analyzed in the appropriate context.
Frequentlyasked questions
What is price purchase variance?
It is a measure of the difference between the actual cost paid for a product or raw material and the standard cost that was expected to be paid.
Why is it important?
It is important because it provides insight into the effectiveness of the procurement organization in delivering on cost savings goals.
How can an organization reduce price purchase variance?
An organization can reduce Purchase Price Variance by implementing effective procurement strategies, negotiating favorable contracts with suppliers, establishing strong supplier relationships, and monitoring market conditions.
About the author
My name is Marijn Overvest, I’m the founder of Procurement Tactics. I have a deep passion for procurement, and I’ve upskilled over 200 procurement teams from all over the world. When I’m not working, I love running and cycling.
