As a business owner, employing all metrics possible to understand how efficiently your procurement processes and spending are faring with the constantly changing pricing structures and market conditions is essential.
Doing so lets you formulate better procurement strategies, make informed financial decisions, and streamline your company’s purchasing spend like never before.
Purchase Price Variance (PPV) is one such forecasting metric that, despite being simple to compute, is robust enough to measure your procurement performance and improve your corporate budgeting accurately.
If you are unclear about the question ‘What is PPV?’, don’t worry; you are not alone. We are here to guide you. This article will walk readers through PPV, its importance, how its calculated, how to reduce it, and a modern solution that can transform the effectiveness of your procurement function.
In this article, we will cover the following topics:
- What is purchase price variance?
- Why is purchase price variance important?
- How do you calculate purchase price variance?
- Why does purchase price variance happen?
- How can you reduce purchase price variance?
- Forecast Purchase Price Variance with Zapro Spend Analytics
What is purchase price variance?
Purchase Price Variance is a forecasting metric that allows business stakeholders to track the price of procurement items and their price fluctuations over predefined periods. It measures the effectiveness of the procurement group or department based on their total monthly, quarterly, or annual procurement expenditure.
In simple mathematical terms, purchase price variance is the baseline or standard price of the goods or services you must procure, subtracted from the actual price you paid.
Why is purchase price variance important?
In the procurement world, the value of materials and services often fluctuates for various factors. Ultimately, what you pay for a product may not always reflect its cost, which is why procurement groups must follow the right strategies to achieve the best prices.
Often businesses following standard pricing and benchmarks to evaluate bids lack clarity on the extent of their strategy’s success. Purchase price variance helps assign a metric that can be used to measure the initiatives of the procurement group easily.
How do you calculate purchase price variance?
To understand purchase price variance, let us first look at its formula:
Here, the standard price refers to the amount that the procurement experts of a company estimate they will pay for a specific material or service during budgeting. You can estimate the standard price based on factors such as the first purchase price (FPP), the last purchase price (LPP), or any other valid metrics.
However, considering that budgeting typically occurs months before the actual procurement, the actual price the organization will end up paying for the item may be different. The difference in price upon procurement depends on the factors the product or service was subject to that drove its price up or down after budgeting. This amount is known as the actual price.
Now that we understand the formula, let us look at a real-world scenario to understand purchase price variance and how it may either be a positive or negative sign for your procurement strategy and budgeting. In this scenario, the procurement group of your organization is tasked with securing ten new chairs for a bunch of newly appointed employees.
During your budgeting, you and other organizational stakeholders determined from the previous year’s last purchase price (LPP) that the standard price for each chair is $200. However, the actual price you end up paying for each unit is $180, which is $20 less than your initial budget plan.
Actual Quantity = 10 unitsStandard Price = $200Actual Price = $180
Applying these values to the purchase price variation formula, we get:
PPV = 10 units x $200 – 10 units x $180PPV = $2000 – $1800PPV = $200
The calculated PPV here implies that you have saved $200 on the purchase of the 10 Chairs. Since the actual price is lower than the standard price, it is a favorable purchase price variance, indicating that you are saving money for your company.
On the contrary, if the actual price were higher than the standard price, it would mean that your PPV is unfavorable and your procurement team exceeded the expected purchase budget by $200.
Why does purchase price variance happen?
Let us explore some of the factors why a favorable or unfavorable purchase price Variance can occur.
Favorable purchase price variance:
- When your procurement group gathers multiple competitive bids from numerous suppliers to achieve the best price.
- Your procurement group is enforcing the right strategies and negotiating better supplier deals.
- Your organization may be receiving higher discounts due to increased order quantities.
- Your organization is ordering cheaper items with reduced quality and price.
- There has been a drop in the cost of the material due to lessened demand or other factors.
Unfavorable purchase price variance:
- Your organization may be purchasing an item of higher quality.
- Your order quantity has dropped, resulting in you paying a higher price per unit.
- Your procurement strategies and processes may have inefficiencies.
How Can You Reduce Purchase Price Variance?
However, here are some factors you can look into to reduce your purchase price variance:
- New materials or products
- Tiered pricing
- Spot buying
- Customer pricing cycles
- Inventory levels
- Purchase order negotiations
- Regularly negotiating with your suppliers
When materials are harder to obtain, their price may increase due to the shortage.
The item’s price may fluctuate due to its market demand. When demand increases, it is most likely that the item cost will, too, and vice versa.
3. New materials or products
When purchasing a product or material for the first time or a new entry into the market, gather as much data as possible to determine its standard or baseline price accurately. This will make calculating PPV easier and more accurate.
4. Tiered pricing
Suppliers often charge a lesser price for their products per unit for those who buy a larger volume. An unfavorable purchase price variance frequently happens when companies procure products in lower volumes or below the supplier’s minimum order quantity.
5. Spot buying
Opportunistic buying is looking for the right deals and discounts. There may be lucrative opportunities where a supplier is, looking to offload their stock at a discounted price quickly. By identifying these situations, you can purchase a higher product volume at a better price reducing your purchase price variance.
6. Customer pricing cycles
Based on the nature of your customer and market, you can periodically reset standard pricing levels, especially in a B2B (Business-to-Business) environment. It can be a great opportunity to reduce negative purchase price variances.
7. Inventory levels
Your inventory levels, consumption disciplines like FIFO(First-In, First-Out), weighted average costing, cycle counting variances, and more all influence the amount of inventory you have on hand and how it was costed. Properly managing and controlling these factors can help considerably reduce the purchase price variance.
8. Purchase order negotiations
An excellent strategy to reduce purchase price variance is frequently negotiating with suppliers to reduce costs and achieve the best deals.
9. Regularly negotiating with your suppliers
Locking the lowest possible prices with your suppliers is a smart strategy to enhance your revenue generation.
In conclusion, now that it is clear how vital purchase price variance is in driving the performance of your procurement function. A noteworthy suggestion to derive better results from your procurement group is to use an E-procurement tool that can integrate directly with your financial ERP systems.
Forecast purchase price variance with Zapro Spend Analytics
Zapro is an E-procurement solution that provides excellent spend analytics and spend automation, allowing seamless data exchange and accurate accounting without compromising your budget.
Engaging in Zapro’s spend analytics software will enable you to accurately identify, gather, clean, categorize, and analyze the data derived from your business’s various sourcing and procurement functions.
Our software will make forecasting purchase price variances effortless and provide you with all the information through robust dashboards and KPIs to drive the PPV down.