Purchase price variance definition
/What is the Purchase Price Variance?
The purchase price variance is used to discover changes in the prices of goods and services. It can be used to spot instances in which the purchases being made differ in price from your planning levels. By using the variance, you can identify cases in which it can make sense to look for a different supplier, or to start pricing negotiations with an existing one. The variance can also indicate areas on which to focus when you want to reduce costs.
How to Calculate the Purchase Price Variance
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.
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Causes of a Purchase Price Variance
There are a number of possible causes of a purchase price variance, which are noted below.
Cost 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 Issue
There is an industry shortage of a commodity item, which is driving up the cost. A possible resolution is to reconfigure your products, so that they no longer use the commodity that is in short supply. Another option is to enter into a contract with a supplier to obtain a fixed proportion of its capacity; this can be expensive, but ensures that you have access to a sufficient quantity of the necessary materials.
New Supplier Issue
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 Order Issue
The company incurred excessive shipping charges to obtain materials on short notice from suppliers. These fees can substantially increase the price of a product.
Faulty 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.
When the Purchase Price Variance Does not Apply
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.
Example of a Purchase Price Variance
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.
Terms Similar to Purchase Price Variance
The purchase price variance is also known as the material price variance.