In the world of finance, where every penny counts, finance teams often turn their attention to a critical tool called Purchase Price Variance.
This tool helps in benchmarking and keeping an eye on prices, which are essential for successful procurement.
Imagine it as your financial compass, guiding you through the intricate seas of procurement to help you find the best deals and stay on budget.
The purchase price variance is the variance created by the actual price paid to a vendor for material compared to the standard cost.
It can significantly impact your bottom line, so it’s essential to understand how to calculate it and what factors affect it.
This blog post will discuss what PPV is and how to calculate it. We’ll also look at some factors influencing it and tips to minimize PPV.
What is PPV?
The PPV finance is the difference between the purchase price and the actual cost of a good or service. It is also known as purchase price variance analysis. It measures how much a company spends on goods and services.
Why does it matter?
For businesses, it can affect your bottom line and profitability. It is also vital for inventory management because you want to purchase items at the right amount, not too much or too little stock.
Importance
This dynamic concept of Purchase Price Variance is more than just numbers on a ledger. It stands as a critical gauge for unraveling the ever-shifting tapestry of price fluctuations in the realm of goods and services.
When harnessed with precision, it unveils invaluable insights into the procurement team’s talent in achieving and sustaining cost-saving objectives, serving as a compass guiding the path to financial efficiency.
It is crucial to understand the standard price for goods and services when negotiating new purchases.
Procurement teams often use standard pricing or accepted benchmarks as a point of reference to evaluate bids.
Understanding the variation in pricing also provides visibility into the effectiveness of cost-saving strategies. Properly contextualized, PPV can highlight the success of procurement initiatives.
How to do the PPV calculation?
To calculate purchase price variance, you need to know the purchase price, the actual cost, and the quantity purchased.
the formula is,
PPV = ( Standard price – Actual cost ) / Actual quantity
For example, if a company buys office supplies for $100 but the actual cost is only $80, the PPV would be calculated as ($100 – $80) /100 = 20%.
That means the company spent 20% more on office supplies than needed.
The general model for calculating a quantity variance is:
Quantity Variance = (Standard Quantity – Actual Quantity)
This calculation tells you how much the actual quantity of products differs from the standard quantity. The result is expressed in terms of dollars or percentages.
This information can be helpful when trying to identify reasons for discrepancies. For example, if the purchase order stated that 500 widgets were ordered, but only 450 were received, the quantity variance would be (-50).
Positive cost variance
Positive cost variance occurs when the actual unit price of an item purchased is lower than its purchase price. That results in a favorable PPV, saving the organization money on purchases.
For example,
An organization planned to purchase 10 mobile handsets to gift its employees. The purchase price of each handset is $500. However, after negotiation with the supplier, the organization gets a handset for $400 each.
Now Purchase price is = $500 X 10 handsets = $5000
Actual cost is = $400 X 10 handsets = $4000
Let us calculate cost variance. Variance is $5000-$4000 = $1000
PPV on the purchase is positive and is a favorable variance of $1000 for 10 handsets
Reasons for It
Negotiation with suppliers
Achieving a positive purchase price variance can result from effective negotiations between the purchasing team and suppliers. While cost savings are important, successful negotiations consider other factors like delivery speed and contract terms that may affect overall cost efficiency.
Strategic supplier management
Effective supplier management can positively impact purchase price variance by improving procurement processes and enabling better price negotiations with suppliers. Standardizing procurement practices leads to consistent pricing and enhanced cost control.
Multi-year contract with the supplier
Opting for long-term contracts spanning multiple years can reduce costs per unit and mitigate variance caused by inflation or potential price increases. Accurate capacity planning and forecasting are essential in committing to multi-year agreements.
Negative cost variance
Negative cost variance occurs when the actual unit price of an item purchased is higher than its purchase price. This results in an unfavorable PPV.
Let us take the same example. The purchase price of each handset is $500. But, because of the increase in raw materials price, the supplier supplies each handset for $600.
Hence Purchase price is = $500 X 10 handsets = $5000
Actual cost is = $600 X 10 handsets = $6000
PPV on the purchase is negative and is an unfavorable variance of $1000 for 10 handsets.
Reasons for it
Uncontrolled spending
It refers to unauthorized purchases made by employees outside of proper procurement procedures. This can lead to higher prices as employees may not have access to the best deals or negotiated contracts.
Item quantity variations
Companies often receive discounted prices when they purchase goods and services in large quantities. If a company’s purchase volume decreases, they may lose the benefit of these volume-based discounts, which can negatively impact NPV.
Increase in raw material pricing
Rising inflation can result in increased costs for raw materials and components, making it challenging for companies to maintain their standard prices.
Factors that can impact PPV
Factors that can impact it include:
- Purchase quantity – if the buyer orders more products than expected.
- Purchase price – if the purchase price is higher or lower than expected.
- Purchase date – if it is earlier or later than expected.
- Shipping Terms – FOB (free on board) or CIF (cost, insurance, and freight) can affect which party is responsible for any variation in cost.
- Vendor discounts – if the buyer negotiates a deal with the vendor, that causes variance.
- Taxes – different tax rates in other states can cause it to vary.
- Product quality – if the product is of a lower or higher rate than expected, this will also affect it.
It’s essential to be aware of these factors to make informed decisions about your spending.
Examples of PPV in action
Example 1
For example, if a company orders 100 gadgets at a purchase price of $10 per widget, but the actual cost is $11 per widget, the variance would be ($10 – $11) / 100 = -$0.1 or -10%.
The company spent 10% more than it should have on the widgets.
Example 2
If a company orders 100 gadgets at a purchase price of $10 per widget, but the actual cost is $9 per widget, the variance would be ($10 – $9) / 100 = $0.1 or 10%.
The company saved 10% on the purchase price by ordering the gadgets lower than expected.
Tips for minimizing purchase price variance
- Compare prices before making a purchase
- Negotiate prices with suppliers
- Order smaller quantities to avoid overbuying
- Use purchase order forms to track orders and ensure accuracy
- Make sure you understand the shipping terms of your purchase
- Check for supplier discounts
- Stay up-to-date on market prices
- Keep track of purchase prices over time
FAQs
What is the price variance?
The price variance is the difference between the price at which a good or service is expected to be sold and the price at which it is sold.
Many factors influence price variance, including availability, demand, seasonality, and weather. In addition, in some cases, price variance can be caused by market manipulation or fraud.
How do you calculate purchase price variance in SAP?
To calculate PPV in SAP, you need to follow these steps:
1. Firstly, you need to identify the price variances for each purchase order.
2. To do this, compare the purchase order price with the standard purchase price.
3. Then, calculate the difference between the two amounts.
4. Finally, multiply this difference by the purchase order quantity.
When does the favorable cost variance occur?
The favorable cost variance usually occurs when the purchase price is more than the actual cost.
What are direct materials price variances?
Direct materials price variance (DMPV) is the variance between the actual purchase price of materials and the standard cost. This variance can be positive or negative, depending on whether the purchase price was higher or lower than the standard cost.
It is calculated by subtracting the standard cost of material from the actual purchase price.
DMPV = (actual purchase price – standard cost)
This calculation will help you understand how much money was saved (or lost) due to purchase price fluctuations. It’s important to note that the DMPV includes only the direct materials in a product, not indirect materials.
What causes Purchase Price Variance?
It can be attributed to several key factors, including:
1. Inflation: When prices rise across the board due to economic factors.
2. Fluctuations in Supplier Prices: Changes in the rates charged by suppliers.
3. Alterations in Product Quality or Specifications: Shifting standards can impact costs.
4. Freight and Transportation Expenses: The cost of getting goods from supplier to company.
5. Unforeseen Events: External factors like natural disasters or political instability can disrupt supply chains.
How does PPV affect company profitability?
PPV’s impact on profitability is profound. A negative PPV signifies that a company is spending more on goods and services than initially anticipated. This can significantly reduce profits and erode profit margins.
How can companies mitigate PPV risks?
Companies can minimize risks through:
1. Effective Procurement Policies: Crafting and implementing policies that optimize procurement practices.
2. Supplier Contract Negotiations: Negotiating favorable terms with suppliers to secure consistent pricing.
3. Close Spending Oversight: Monitoring spending patterns to identify and address areas of potential PPV risk.
How can companies harness PPV for performance improvements?
Ways PPV can be used to bring about improvements:
1. Tracking Trends: Monitoring PPV trends over time to detect areas of concern.
2. Root Cause Investigation: Delving into the reasons behind negative PPV to tackle issues at their source.
3. Proactive Resolution: Taking action to rectify the causes of negative PPV, such as adjusting procurement strategies or negotiating with suppliers.
What is the difference between purchase price variance and purchase quantity variance?
Purchase Price Variance relates to the price difference between the standard and actual costs, while Purchase Quantity Variance deals with differences in the expected and actual quantities purchased.
How can budget accuracy be improved with PPV?
By tracking PPV over time, you can pinpoint discrepancies in your budget. Consistently negative PPV for specific goods or services may prompt budget adjustments.
Can supplier relationships be improved via PPV?
Yes, certainly, by analyzing your PPV data can highlight suppliers with consistently higher prices, providing leverage for better negotiations.
Conclusion
PPV is the difference between a product or service’s purchase and selling price. This calculation considers discounts, rebates, allowances, and other deductions from the purchase price.
Understanding purchase price variance is essential for making sound pricing and inventory management decisions.
