The Importance of Purchase Price Variance in the Budget
In any sector of a company, when it comes to expenses, the lowest price is an additional attraction, both to gain competitive advantages and outline the best strategies and to ensure greater profit and business growth. Hence, the importance of saving and promoting cost savings when needed.
As the name of the indicator suggests, the Purchase Price Variance (PPV) refers to the difference between two variables: the actual price of the product purchased and its standard price, always related to the number of units purchased. This is one of the main indicators used to measure the variation in the price of goods and services purchased, being a tool capable of telling how effective the purchasing team is.As a tool to understand how changes in the price of indirect materials can affect the future cost of products sold and also the gross margin, PPV assists in making price decisions by providing accurate forward-looking statements about future overall profitability.
When talking about PPV, the assumption is that the quality of the product is the same and that both the quantity of items purchased, the place of purchase, and the speed of delivery do not impact the price.
We go deeper to differentiate the variables: the actual price of the product purchased is how much the company actually spends on that item, whereas the standard price refers to what purchasing experts believe the company will pay to purchase the item during the planning or budgeting process.
The standard price is usually based on the last purchase price of the previous year, the first purchase price of the current year, or a price developed based on the best available scenario when the standard was created.
How it is calculated
As we have already seen, the Purchase Price Variance is the difference between the actual price paid to purchase an item and its standard price. To calculate it, just multiply these two variables by the actual number of units purchased.
- The formula looks like this: (Actual price – Standard price) x Actual quantity = PPV.
When the result is a positive variation, it means that the real costs have increased and the opposite, that is, a negative variation, means that the real costs have decreased.
See an example of purchase price variation
In its annual budget, a purchasing team decides that the standard price for a piece should be set at $5, based on a purchase volume of 10,000 pieces for the following year.
However, when the next year arrives, this team buys only 8,000 pieces and ends up paying $5.50 for each unit. A price variation of $0.50 per piece and a variation of $4,000 were created for all purchased parts.
However, it is important to assess the risks: a company can obtain a favorable PPV when buying products in larger quantities, however, if it is not assertively calculated, such a purchase can bring the risk of excessive inventory.
On the other hand, if a company’s purchasing department insists on buying in small quantities, it can result in an unfavorable price change. Therefore, it is necessary to plan carefully, preferably using data analysis, to effectively control price changes and make sure that the stock is at a good level.
Creating a budget
As a key performance indicator, Purchase Price Variance is critical for purchasing teams, as substantial value can be saved by using it as an indicator.
Materials tend to represent most of the costs of manufacturing companies, which is exactly why PPV is important, as it is a tool to assess and control expenses.
When the standard price is precisely defined, it is possible to develop historical data so that, at the end of the year, the full impact of the variations can be used as a KPI by the purchasing team – so the objective must be to accurately predict which will be material costs for the current year and the following year, to ensure accurate margins.
For the construction of the budget, the PPV target must be zero, since an unfavorable variation tends to grow more and more if it is not adjusted. Showing what is yet to come, the Purchase Price Variance is a leading indicator, making it an important gross margin KPI.
Forecasting the Purchase Price Variation
Using PPV metrics to look at the future is an effective tool for managing overall profitability and gross margin.
- The formula for calculating PPV Forecasting is: (Estimated Price – Standard Price) x Estimated Quantity.
With the Forecasting Purchase Price Variance, companies gain greater visibility into the prices of materials that are expected to impact gross margins, allowing for a proactive approach. From this information, finance teams can adjust their forecasts and forward-looking statements with more confidence.
Reducing the Purchase Price Variance
Keeping data on contract prices up to date when products are purchased is essential to reduce PPV. Therefore, its effectiveness can be improved by sharing the company’s historical data, with the costs and margins of the suppliers being passed on to the buyer. In this way, negotiations take place around a common price reference point.
Talking about price changes with suppliers can be essential, not only to neutralize pressures, but also to highlight the value the team has reached through purchasing decisions – such an attitude can help maintain prices and stabilize costs.
Another important point is that when using prices from independent markets in negotiations, the buyer is in a better position to influence the supplier to reduce prices.
The Benefits of Purchase Price Variance
- It is an accurate measure of the Actual Price and the Actual Quantity of the units purchased, a fundamental value for the purchasing team to project savings
- Can quantify the efficiency of a company’s purchasing team
- It is a valuable tool for making annual financial planning
- Explains how material price changes affect gross margin compared to budget
- Helps to understand the development of overall business profitability
- Assists in adjusting forecasts and forward-looking statements
- Creates an environment that continuously pushes the supplier’s price down
- Keeps prices lower and stabilizes business costs
- Increases efficiency and helps negotiate a fair market price
One of the objectives of any company is to be able to acquire indirect materials at a price lower than budgeted – and as we have seen so far, there is always a price variation in the budget, since it is thought of months before the purchase happens.
Under these conditions, a favorable variation means that real costs may be less than budgeted, while an unfavorable variation means that real costs are greater than budgeted.
Thus, PPV becomes an important metric when it comes to effective decision-making for business profitability. To learn more about other metrics that impact industry behavior, continue reading our blog.