Pricing strategies play a crucial role when a business introduces a product to the market or responds to a competitor’s marketing strategy. If you are a marketing or sales executive, a businessman or an entrepreneur, understanding the role of product pricing, price changes and price adjustment strategies is very important for marketing success. Learn more about product pricing strategies with this course. We shall look at one such aspect of pricing, called the Purchase Price Variance (PPV), its role in determining the product price and its benefits in our discussion here.
What is Purchase Price Variance?
Any company that is engaged in selling products has to take care of the manufacturing or production cost of the products, the distribution and other costs involved in the entire supply chain. Purchase Price Variance (PPV) can be defined as the price difference between the amount that is paid to a supplier to buy a product and the actual cost of the product. If the actual cost has increased, it is known as positive variance and on the contrary, if the actual cost has declined, it is called as negative variance. The actual price is the amount, which the manufacturers want the company to pay for the item by considering the quality, quantity and delivery. Purchase Price Variance is entirely based on the standard price, which in turn is based on various factors that do not match the purchasing situation of the company. The ultimate goal of any business is to purchase the materials for a cost that is below the budgeted amount.
The difference between the actual amount paid per product and the budgeted amount per product multiplied by the number of purchased products is known as purchase price variance. The production cost of the company is highly influenced by the purchase price variance of the materials; therefore, it’s also called as material purchase price variance. To learn more about these concepts and how to actually manage them, check out this introductory course on accounting.
How to Calculate Purchase Price Variance
Purchase price variance is calculated to know the efficiency of a purchasing department in buying the raw material at low cost. An increased value of PPV means that the material is purchased for a lesser amount than the standard price. A negative value of PPV means that the material is purchased for a higher amount than the standard price fixed by the company. It is not always good to have a positive or favourable PPV, as the quality of the materials might affect your product; hence, PPV should be analyzed with direct material quantity variance. Sometimes, your purchasing department might purchase the materials for a very low price than the standard price, which will be offset by the direct material quantity variance due to the compromised material quality. Find out more about standard prices and raw material cost implications in our this course on financial accounting.
Purchase price variance = (actual price – standard price) X quantity.
Let’s understand how to calculate purchase price variance by way of the following example:
Say for example, the manufacturing and purchasing staff of XYZ Company decides that the standard cost should be set to $3.00, which is based on the volume of 5,000 that is being purchased for the coming year. During the year, if the company buys 4000 products, it can take advantage of a purchasing discount and ends up paying $3.50 per product. This creates a purchase price variance of $0.50 per product, resulting in a variance of $1,500 for all the 4000 products.
How is Purchase Price Variance Reclassified?
Your purchase department would have measured the PPV at the time of purchasing of raw materials. If there is a significant price variance, it should be reclassified into the inventory of raw materials, inventory of work-in-process, the cost of the products and inventory of the finished products. The reclassification of purchase price variance is also known as ‘allocating the variance’. If the amount of PPV is very small, then with higher inventory turnover rates the entire amount of PPV should be reclassified to the price of the products. Also, the reclassification should be based on the location of the raw materials that created the price variance in the first place.
Causes of Purchase Price Variance
Purchase price variance is not mandatory in a manufacturing environment, wherein the raw materials are purchased from the suppliers and delivered to the company when required. There are a number of reasons for purchase price variance, some of which are listed below:
- Layering issue – The cost of the product is taken from the layering system of the inventory such as first-in-first-out. As a result, the actual cost varies by a substantial margin from the present market price.
- Shortage of materials – The shortage of commodity items increases the cost of the product.
- On the basis of demand – Companies often incur excess shipping charges to get materials from suppliers on short notice.
- Assumption of the volume – The cost of the product is derived on the basis of purchasing volume than the amount at which the company buys.
Benefits of Purchase Price Variance
There are a number of possibilities that cause price variance of a product. PPV can help you measure the effectiveness of your company’s product spending. If you are in the business of commodity selling, you should undertake the developing standards for purchasing materials. Once you have formulated the pricing of the purchased material and received approval for the budget from the management, you can update that price as standard price of those materials at the beginning of the financial year. You will be able to recognize the purchase price variance, as you start receiving the inventory in the warehouse.
In short, most businesses have a standard costing system that simplifies the inventory valuation. However, the main problem with these standards is that they trigger unintended consequences down the supply chain. Get more insights into accounting principles, to better understand it’s impact on your business, with this course.
Purchasing has a role to play in adjusting the cost of the materials and drive for high quality materials. The key is to understand the relation between the actual cost of the product, standards and variances with their potential consequences for better supply chain management.