Written by Marijn Overvest | Reviewed by Sjoed Goedhart | Fact Checked by Ruud Emonds | Our editorial policy
Purchase Price Variance (PPV) — Formula and Explanation
What is purchase price variance?
- Purchase price variance is the difference between the actual cost paid for raw material/product and the standard cost that was expected to be paid.
- Understanding the purchase price variance is crucial to gauge the effectiveness of cost-saving measures and initiatives.
- A positive variance occurs when actual costs increase, while a negative variance happens when actual costs decrease.
What is Purchase Price Variance (PPV)?
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 purchase price variance 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.
Purchase Price Variance Example Formula
To understand how the Purchase Price Variance (PPV) formula is applied in real-world situations, let’s consider a case involving General Motors (GM), a major global car manufacturer.
In 2021, during a period of global supply chain disruptions, GM experienced rising costs for raw materials, especially steel and semiconductor chips. The company had established a standard price for semiconductor chips based on pre-pandemic supply agreements. However, due to increased demand and limited supply, the actual price of these chips rose sharply.
Let’s assume the standard price per semiconductor chip was $25, but due to the market shortage, GM had to pay $40 per chip. For a production batch requiring 100,000 chips, the purchase price variance would be calculated as follows:
PPV = (Actual cost – Standard cost) x Actual quantity
PPV = ($40 – $25) x 100,000 = $1,500,000
This resulted in an unfavorable PPV of $1.5 million, meaning GM had to spend significantly more than planned due to external market forces.
While this variance appears negative, it doesn’t necessarily point to a procurement failure. Instead, it may reflect external economic factors that can influence material costs beyond what was forecasted. To manage such risks, companies like GM often rely on strong supplier partnerships and long-term sourcing strategies.
The Importance of Purchase Price Variance
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 Purchase Price Variance
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 the factors 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 Purchase Price Variance
Now that we have tackled the variables that affect the purchase price variance, let us 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 spend or 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 Purchase Price Variance 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 that 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 indicates the success of procurement initiatives when analyzed in the appropriate context.
To help you determine and calculate what a product should cost, I have created a free-to-download editable cost price breakdown template. It’s a PowerPoint file, together with an Excel file, that can help you manage your purchase price variances more effectively. I even created a video where I’ll explain how you can use this template.
Frequentlyasked questions
What is purchase price variance?
Purchase Price Variance (PPV) is a metric that measures the difference between the actual cost paid for a product or raw material and the standard or expected cost. It reflects how closely procurement costs align with anticipated spending.
Why is Purchase Price Variance important in procurement?
Purchase Price Variance is essential because it offers insight into the effectiveness of a procurement team’s cost-saving initiatives. It helps organizations assess if they are achieving their budgetary goals or if adjustments in sourcing strategies are needed.
How can an organization reduce unfavorable Purchase Price Variance?
Organizations can reduce unfavorable PPV by employing strategic procurement practices such as effective negotiation with suppliers, multi-year contracts, bulk purchasing, and fostering strong supplier relationships to secure stable pricing.
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.
