Purchase Price Variance
Purchase Price Variance Overview
The purchase price variance is the difference between the actual price paid to buy an item and its standard price, multiplied by the actual number of units purchased. The formula is:
(Actual price - Standard price) x Actual quantity = Purchase price variance
A positive variance means that actual costs have increased, and a negative variance means that actual costs have declined.
The standard price is the price that engineers believe the company should pay for an item, given a certain quality level, purchasing quantity, and speed of delivery. Thus, the variance is really based on a standard price that was the collective opinion of several employees based on a number of assumptions that may no longer match a company's current purchasing situation. The result can be excessively high or low variances that are really caused by incorrect assumptions.
There are a number of possible causes of a purchase price variance. For example:
- Layering issue. The actual cost may have been taken from an inventory layering system, such as a first-in first-out system, where the actual cost varies from the current market price by a substantial margin.
- Materials shortage. There is an industry shortage of a commodity item, which is driving up the cost.
- New supplier. The company has changed suppliers for any number of reasons, resulting in a new cost structure that is not yet reflected in the standard.
- Rush basis. The company incurred excessive shipping charges to obtain materials on short notice from suppliers.
- Volume assumption. The standard cost of an item was derived based on a different purchasing volume than the amount at which the company now buys.
The purchase price variance may not be necessary in a "pull" manufacturing environment, where raw materials are only purchased from suppliers in small increments and delivered to the company as needed; in this situation, management tends to be more focused on keeping the investment in inventory as low as possible, and on the speed with which customer orders can be filled.
Purchase Price Variance Example
During the development of its annual budget, the engineers and purchasing staff of Hodgson Industrial Design decide that the standard cost of a green widget should be set a $5.00, which is based on a purchasing volume of 10,000 for the upcoming year. During the subsequent year, Hodgson only buys 8,000 units, and so cannot take advantage of purchasing discounts, and ends up paying $5.50 per widget. This creates a purchase price variance of $0.50 per widget, and a variance of $4,000 for all of the 8,000 widgets that Hodgson purchased.
The purchase price variance is also known as the material price variance.
Episode 111 of the Accounting Best Practices podcast discusses variance analysis. Listen now.