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What does purchase price mean in simple terms?
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What Is Purchase Price Variance
The purchase price variance is an important metric used by procurement teams to measure how much variance they are seeing in the purchase price of goods and services.
Essentially, purchase price variance refers to the difference between the actual price paid for goods and services and the base purchase price for the same thing.
In other words, the actual purchase price is how much money the company actually spent buying goods and services whereas the baseline purchase price is how much the company will pay for the same goods and services.
Typically, a company’s standard price is set to be the price they paid for their material and purchases during the prior year or prior accounting period.
If the prices for the last period do not properly reflect what the company considers it should be paying for the material and items purchased, it will use another method to establish its standard price representing a more optimal price it should pay for items purchased.
The actual price is how much the company actually paid to purchase items.
The actual price is typically obtained by consulting the invoices received and paid by suppliers for the material.
In many cases, the actual price for the current period will serve as the standard price for the next period assuming that no other variables affect the pricing of the items.
Why Purchase Price Variance Is Important
Calculating and understanding purchase price variance is important for most businesses, particularly those in manufacturing and producing goods.
Companies that are required to purchase a lot of materials and services to produce their goods have to make sure that their cost of goods sold remains low to maximize their profitability.
In some industries, the costs of direct material purchase can go as high as 70% of all the company’s costs.
Having a deep understanding of how much material is costing your company to purchase and comparing it to your annual budget is a crucial function in allowing companies to boost their profitability.
Comparing standard purchase price and actual standard price is something most procurement departments and finance professionals do on a regular basis to track the variance in their expenses.
The main reason why companies, procurement and finance professionals are interested in purchase price variance is to have better control over their manufacturing, procurement costs, and other supply chain costs.
Causes of Purchase Price Variance
What causes purchase price variance?
There are many factors impacting a company’s purchase price leading to a variance in relation to its standard price.
When your purchase price variance calculation shows that you have been saving money in your spending, it could be due to:
- More favorable procurement contracts negotiated
- A decrease in market prices for the items purchased
- Ability to get larger discounts
- Swapping items purchased for other similar ones at lower price
On the other hand, when you spend more on things you purchase in relation to your standard price, it could be caused by:
- Procurement contracts provide for price increases
- There’s an overall increase in market prices for things purchased
- You have less bargaining power due to a reduced volume of purchases
- You cannot get larger discounts from vendors
- Inefficient procurement processes
There may be other causes for variance in the purchase price as well, such as:
- Cost layering issues
- Material shortages
- Issues with new suppliers
- Higher costs for rush orders
- Poor volume purchase planning
Purchase Price Variance Formula
What is the purchase price variance formula?
Here is the formula you need to calculate the purchase price variance:
PPV = (AQ X SP) – (AQ X AP)
The formula can be written in another way as well:
PPV = (AP – SP) X (AQ)
- PPV = Prive Purchase Variance
- AQ = Actual Quantity
- SP = Standard Price (or Baseline Price)
- AP = Actual Price
The purchase price formula consists of taking the result of the actual quantity purchased multiplied by the standard price and subtracting by the result of the actual quantity purchased multiplied by the actual price.
How To Calculate Purchase Price Variance
How do you calculate purchase price variance?
To better understand how to calculate the purchase price variance, let’s look at an example.
Let’s consider the following parameters for our example:
- You need to purchase 1,000 laptops for your company (actual quantity)
- Your company will pay up to $2,000 per laptop as the baseline purchase price (or standard price)
- You end up paying $1,500 per laptop when you actually purchase it
In this example, we take 1,000 laptops (actual quantity) multiplied by $2,000 (standard price) giving you $2,000,000.
Then you calculate how much you actually paid for the laptops (1,000 X $1,500 = $1,500,000).
In this example, the purchase price variance is $500,000 ($2,000,000 – $1,500,000).
This means that you have saved $500,000 in the purchase of your laptops in relation to what your company was willing to pay for them as a standard price.
Interpreting Purchase Price Variance
How do you interpret the value obtained when calculating purchase price variance?
Calculating the purchase price variance and understanding the output of your calculation is important.
For companies to be successful, they need to have good control over their expenses and their cash outflow.
To keep things in check, companies go through a budgeting process where they identify their needs and allocate a budget for their spending.
The amount a company is willing to spend per unit of item purchase then becomes the company’s standard price.
When you look at your actual spending and compare it to your standard price, you’ll be able to tell if you are saving money or spending more than you should.
When the actual purchase price is lower than your standard price, it means that you are saving money and spending less than what the company was willing to pay.
However, if your actual purchase price is higher than your standard price, it means that you are spending more than you had anticipated.
How To Decrease Purchase Price Variance
Reducing purchase price variance can help companies better control their supply chain costs and have less variance impacting their bottom line.
The more certainty you have in keeping your costs stable or predictable, the more you can make better and more informed business decisions.
There are many ways companies can reduce purchase price variance helping them keep costs in control.
One method is to negotiate procurement contracts with suppliers where you can lock your prices for a long period of time and where you can contractually set how much your supplier can increase prices over time.
Another way you can reduce variability in purchase prices is to implement a more efficient procurement process where you access real-time and accurate data driving your decisions.
In many companies, not having a proper procurement process and strategy can lead to many basis points reduction in their overall profitability leading to significant financial losses over time.
Investing in the right procurement software, hiring the right procurement professionals, and having your finance team track the actual price and standard price will help you control costs and manage your profits.
Variance In Purchase Price Takeaways
So there you have it folks!
What Does Purchase Price Variance Mean
In essence, in cost accounting, purchase price variance refers to the difference between the actual price you pay to purchase things versus the standard price you had established multiplied by the actual number of units purchased.
When your actual purchase price variance is below your standard price, it means that you are saving money on the things you buy.
On the other hand, when your actual purchase price variance is higher than your standard price, it means that you are losing money or spending more.
It is crucial for every company to ensure that they are tracking their expenditures tightly allowing them to better achieve their profitability targets and KPIs.
It is even more crucial for companies that buy a lot of material to produce their products as all increases in their material cost will directly reduce their overall profitability.
Now that you know what purchase price variance means and how it works, good luck with your procurement process!
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