What is Purchase Price Variance (PPV) and How to Calculate it?

• Procurement

Introduction

Gardner, (1954) and Huntzinger, (2007) define Purchase price variance (PPV) as a metric used to measure the effectiveness of cost-saving efforts by calculating the difference between the planned cost (standard pricing) allocated for purchasing activities and the actual cost incurred.

Purchase Price Variance (PPV) can be tracked monthly, quarterly, biannually, or annually for a specific item or the overall spending over a given period. The metric results in either a favorable or unfavorable variance, influenced by internal or external factors. A favorable variance indicates that the company is spending less than planned, whereas a positive outcome means the company is spending more than the planned budget.

Why is Purchase Price Variance (PPV) Important?

Every business aims to increase its profit margin, and one effective way to achieve this is by cutting costs. To develop cost-saving strategies, a company must first identify where it is falling short and where it has an advantage in savings. This is where Purchase Price Variance (PPV) plays a crucial role and as per Emiliani, (2010), helps strategy makers evaluate spending and create well-structured cost-saving strategies.

1) Controlling Costs

Purchase Price Variance (PPV) helps track spending and ensures that estimated costs align with planned costs. By using PPV, managers can identify inefficiencies in cost-saving strategies by detecting cost overruns and underruns, allowing them to take corrective actions.

2) Planning & Budgeting

Planning is a crucial part of any business activity. During the planning phase, managers do not have an exact estimate of the costs they will incur for purchasing. They planned the estimated cost as best as they can which then serves as a standard for purchasing. PPV helps assess the accuracy of these estimates by measuring the variance between the estimated and actual costs.

3) Supplier Evaluation

Purchase Price Variance (PPV) assists in evaluating supplier relationships and managing supplier selection. It helps determine the accuracy of supplier pricing. Suppliers whose prices fluctuate significantly over time may not be suitable for long-term partnerships, whereas those who consistently provide products at estimated costs can be considered for future contracts.

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How is Purchase Price Variance (PPV) calculated and How to Interpret the Results?

Purchase Price Variance (PPV) can either be categorized as Favorable PPV or Unfavorable PPV. Let’s take a look at which scenarios result in favorable and unfavorable PPV. 

The formulae for the PPV is:

PPV= (Standard Price – Actual Price) *actual quantity

Let’s understand this with some examples:

Example # 1:

A FMCG company plans to purchase 20,000 units of packaging material at an estimated cost of $6 per unit, setting a total budget of $120,000. However, due to bulk purchasing negotiations, the company secures a discount and purchases the material at $4.50 per unit, reducing the actual cost to $90,000.

PPV Calculation:

PPV= (Standard Price−Actual Price) ×Quantity

PPV = ($6.00 – $4.50) *20,000

PPV = $30,000 (Favorable)

Since the actual purchase cost was lower than the planned cost, this results in a $5,000 favorable PPV,

Example # 2:

A car manufacturing company plans to purchase 5,000 kg of a raw material for tyre production at $120 per kg, expecting a total cost of $600,000. However, due to environmental policies, the actual purchase price increases to $142 per kg, leading to an actual cost of $710,000.

PPV Calculation:

PPV= (Standard Price – Actual Price) * 5000

PPV = ($120.00 – $142.00) *5,000

PPV = -$110,000 (Unfavorable)

Favorable PPV:

Favorable PPV occurs when the standard price or estimated cost is higher than the actual price or purchase cost, resulting in cost savings. This positive variance is achieved through effective negotiations, efficient internal management, and leveraging market opportunities.

Unfavorable PPV

Unfavorable PPV occurs when the actual price or purchase cost exceeds the standard price or estimated cost, leading to higher expenses. This negative variance can result from bypassing defined procurement processes, Internal mismanagement, or ineffective price negotiations with suppliers.

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What Causes Favorable Purchase Price Variance (PPV)?

Negotiations:

The most visible factor in negotiation is a favorable PPV, which can be attained when the negotiation is conducted efficiently, and the supplier agrees to deliver at a price lower than the planned cost. This can be achieved by securing discounts on agreement terms related to delivery, quantity, early payments, and the benefits of a long-term relationship with the supplier.

Strategic Sourcing:

Strategic sourcing involves managing suppliers, while their selection is done through Request for Quotation (RFQs) forms from multiple suppliers to compare and evaluate them based on pricing, quality, and delivery speed. Ordering in bulk from the same supplier can result in better bulk pricing and a long-term cost advantage.

Bulk Purchases and Volume Discounts:

Ordering costs increase the overall cost for the supplier. To reduce this, suppliers prefer selling in bulk, which benefits organizations by allowing them to secure discounts and increase profit margins through lower per-unit costs, ultimately leading to a favorable PPV. This approach helps managers align estimated costs with actual costs.

Market Conditions:

PPV can be favourable for the companies who monitor the market trends actively as it can give the advantage of the commodities declining prices and seasonal fluctuation due to change in the market trends.

What Causes Unfavorable Purchase Price Variance (PPV)?

Market Fluctuations and Inflation:

External factors such as inflation, rising raw material costs, and global supply chain disruptions have a significant impact on procurement costs. Inflation has always been a top concern for higher management, as it is beyond the control of both suppliers and buyers. However, its impact is typically greater on the buyer than on the supplier.

Unpredictable and Ad-Hoc Spend:

Uncontrolled, off-contract purchases as opposed to a structured procurement through a defined process. However, when the purchasing department deviates from this process by prioritizing fast delivery and convenience over cost efficiency, it results in a positive PPV, indicating that the company is spending more than the planned cost. This type of spending also eliminates potential discounts from preferred suppliers.

Internal Mismanagement:

Internal factors include employee mismanagement, such as failing to keep up with market trends, which can result in missed opportunities like bulk discounts and seasonal discounts. Additionally, poor management in identifying specific needs and required quantities can lead to higher-than-expected costs. Implementing better forecasting models and procurement planning can help businesses avoid these inefficiencies.

Loss of Special Pricing or Discounts:

Supplier contracts should be reviewed continuously over time, as expired contracts or changes in supplier policies related to discounts and delivery terms can lead to higher costs. If a supplier stops offering volume-based pricing or promotional rates, businesses may face unexpected price hikes This all negatively impacts PPV, resulting in an unfavorable variance.

How to Manage Purchase Price Variance (PPV)

Aligning Procurement and Finance Goals:

A company’s financial objectives should always align with every department’s decision. This can be achieved through communication among departments, which helps build an understanding that resources are limited and should be respected when setting purchasing goals.

Continuous Monitoring and Reporting:

To manage PPV, the company should regularly monitor variances to identify inefficiencies and take corrective action at the right time.

Negotiating with Suppliers:

Supplier relationships are a key factor in managing PPV, as they enable the company to track price variances from suppliers and stay informed about any contract changes regarding discounts, delivery terms, and conditions. Negotiating favourable terms with suppliers helps in reducing costs.

Industry Benchmarks:

In the market, a company is never the sole player. Therefore, it should always monitor competitors’ operations and what they are paying for the same items. This helps in setting a benchmark. Failure to do a market analysis, may lead to overspending on products.

Technology Integration:

PPV depends on effective planning and therefore better planning results in a smaller cost variance. This leads to a favorable PPV and business growth. To plan accurately one has to rely on real-time data analysis, through software solutions or excel based templates.

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References

Garnder, S. (1954), Evolution of Cost Accounting to 1925, University of Alabama Press, University, AL.

Huntzinger, J. R. (2007). Lean cost management: accounting for lean by establishing flow. J. Ross Publishing.

Emiliani, M. L. (2010). Historical lessons in purchasing and supplier relationship management. Journal of Management History, 16(1), 116-136.