You already know benchmarking and price tracking are important activities for a successful procurement practice. The data these activities provide offers the best point of reference for understanding fair pricing on goods and services.
But as pricing structures and market conditions change, how can you know if your procurement spend is consistent and on target? How should these metrics be interpreted in terms of measuring procurement success?
Most finance teams look to the purchase price variance (PPV) metric for answers. It’s a simple metric, but it can have broad implications for your procurement team and its perceived performance.
Read on to get a closer look at the meaning of PPV and its cost-saving potential, including the following:
- The importance of properly calculating and tracking PPV
- Factors that affect purchase price (for better or worse)
- How to successfully use PPV to see the bigger picture
Understanding the importance—and limitations—of PPV metrics can improve cost outcomes for every purchase while keeping your numbers in the proper context.
What is purchase price variance?
Purchase price variance (PPV) is the difference between the standard cost (also known as baseline price) paid on a specific item or service and the actual amount you paid to acquire it. PPV can be either favorable or unfavorable and may be tracked for specific time periods (monthly, quarterly, yearly). It is often reported in terms of total procurement spend.
Purchase price variance is an important metric for understanding fluctuations in price for goods and services. When used correctly, it provides vital insight into the effectiveness of the procurement organization in delivering on cost savings goals.
Why is purchase price variance important?
Understanding the standard price for goods and services is an important starting point for negotiating new purchases. Often, procurement teams will use standard pricing or accepted benchmarks as a guidepost for evaluating bids.
Knowing the variance in goods and services pricing also provides visibility into the effectiveness of cost-saving strategies. With the right context, PPV highlights success in your procurement initiatives.
It’s important to note that unfavorable variance doesn’t always indicate procurement strategy issues. To understand the internal and external causes of variance, you need to contextualize the data around it. For instance, external market forces such as supply chain delays can impact pricing. In some cases, prices cannot be negotiated down to meet the last purchase price (LPP) in the presence of external market issues.
A word about PPV as a performance metric
Using PPV as the sole metric for cost efficiency may miss other components of procurement strategy, creating an incomplete picture of the value the procurement team delivers.
For example, procurement may engage in cost avoidance versus cost savings—spending money in the near term to avoid increased costs later. Buying a service contract on fleet vehicles may require an upfront cost to avoid increased maintenance expenses later.
Likewise some strategies may decrease PPV, but do so at the risk of incurring higher total costs in the long run. Keeping these impacts in mind paints a clearer picture of a procurement strategy’s effectiveness.
How is purchase price variance (PPV) calculated?
Calculating purchase price variance for goods is relatively simple. The PPV formula is as follows:
PPV = (actual price paid − standard price) × actual quantity
Let’s consider two real-world examples of PPV in action:
IT needs to upgrade laptops for several team members. The department purchases 10 new laptops from a known supplier in its preferred vendor network and receives a volume pricing discount that drops the price from $1,200 to $1,000 per unit.
Baseline cost: $1,200 × 10 units = $12,000
Actual cost: $1,000 × 10 units = $10,000
The PPV on the purchase is a favorable variance of $2,000 for 10 units.
Manufacturing requires a specific sensor for building a product. While the price had previously been $1 per unit, chip demand increases have caused the price to jump 50%.
Baseline cost: $100 × 100 units
Actual cost: $150 × 100 units
The PPV on the purchase creates an unfavorable variance of $50 for 100 units.
Why does purchase price variance happen?
Purchase price variance is a common aspect of acquiring goods. It happens for a number of reasons.
Here are some common factors that positively affect price purchase variance:
Successful negotiation: Favorable PPV is sometimes attributable to good negotiation practices between your purchasing team and suppliers. Cost savings is only one component of a deal, but it’s often the most visible factor in determining a successful negotiation. For cases where the price is not the sole consideration, negotiating other contract terms like delivery speed or contract length might result in less favorable PPV but better cost efficiency overall.
Strategic sourcing: A significant degree of cost savings is achieved with proactive supplier management. Streamlining your supplier list results in consolidated ordering, with the end result of improving product and material price. Order volume tends to increase when ordering from a smaller pool of suppliers, which leads to better pricing.
Multi-year pricing: Procuring high-volume items through a multi-year contract reduces the price per unit and staves off variance caused by inflation or future material price increases. Creating accurate capacity planning and forecasts makes it easier to commit to multi-year deals.
Some common factors that negatively affect price purchase variance are as follows:
Maverick spend: Uncontrolled spending is one of the biggest sources of unfavorable purchase price variance within an organization. When finance and procurement don’t have sufficient spending controls in place, stakeholders are left to fend for themselves in getting the goods and supplies they need to be successful. This results in purchasing the most readily available supplies—which often translates to the fastest delivery, not the most cost-efficient.
Material price increases (inflation): As mentioned earlier, not every pricing factor is within procurement’s control. When the cost of raw materials or components goes up, purchase price variances quickly follow. This is where securing strong supplier relationships and volume discounts can help defray the effects of rising commodity prices.
Changes in item quality: Increases in product quality may affect PPV metrics. For instance, if the laptops from our previous example get component upgrades, the result is a higher quality product. However, the improvement may cause a price increase. Paying close attention to product features and details can help procurement teams acquire comparable goods year after year.
Loss of volume pricing: Changes to programs or discount tier qualifications on the supplier side may sometimes result in unfavorable price fluctuations on goods. Strong negotiation may be able to mitigate price changes through supplier-side discounts as license volume increases.
How to improve purchase price variance
Race-to-the-bottom pricing is not the only way to improve the cost efficiency of your organization. In truth, organizations must balance cost savings with value creation in order to truly optimize spend.
Here are some of the best ways to improve your PPV metrics and outcomes:
Improve planning and budgeting: Accurate budgets and proactive planning are your best allies for improving PPV metrics. By using capacity planning as part of a well-aligned interdepartmental procurement strategy, teams can avoid many issues that drive up purchase prices.
Prioritize logistics: Shipping and warehousing costs play a big role in the total expense of any purchase. Looking ahead and creating contingency plans for shipping issues can reduce the impact on purchase price and mitigate unfavorable PPV.
Conduct spend analysis: Get line-level visibility into direct material purchases across your organization. Using data to contextualize your spending strategy will help your procurement team effectively implement cost accounting measures and negotiate for the best cost efficiency.
Implement spend controls: Getting tail spend under control will have an immediate impact on pricing. Putting controls in place can help your organization avoid maverick spending, tighten delivery timelines, and stick with pre-negotiated suppliers to ensure total spend optimization.
How Order improves purchase price variance metrics
Using procurement management software to streamline purchasing greatly improves the efficiency and cost effectiveness of ordering supplies and products. Procurement software enables many of the above-mentioned spend control practices and centralizes data for better decision-making.
Order can help improve your PPV in several ways:
Streamlining approval and purchasing: Creating a more efficient purchasing process empowers department heads, finance, and procurement with faster deal flow and better visibility.
Automating spending controls: Dynamic purchasing workflows assign guidelines and budgets by user, role, department, or category. These guardrails prevent uncontrolled tail spend that creates unfavorable purchase price variances.
Enabling detailed reporting: Our procurement software centralizes purchasing and supplier data. Robust reporting makes it easier to conduct future planning and benchmarking.
Want to control tail spend and improve cost-efficiency for your organization? Learn the most common issues affecting your purchasing metrics in this informative ebook: 5 Ways Your Purchasing Process is Leaking Cash (and how to fix it).