In its 2021 survey of Chief Procurement Officers, Deloitte found a significant change. For the first time in a decade, cost reduction had dropped to second place among CPOs’ priorities. Taking first place was having procurement drive operational efficiency. Technology is the key to achieving both of these targets, and CPOs know it. That’s why digital transformation placed third in the list of priorities. All three of these CPO priorities are reflected in a key KPI: purchase price variance (PPV).
PPV just might be the most critical metric when it comes to measuring the effectiveness of an organization’s procurement team. In this post, we explore what purchase price variance is, why it’s important, how to calculate PPV, and how to reduce PPV.
What is Purchase Price Variance (PPV)?
When your procurement team needs to source something, a standard or baseline price is used in setting the budget. The data for setting this baseline price is usually historical—for example, the price paid the last time the team placed an order for the product. As part of this baseline price, it’s assumed that the quality remains the same, the quantity is the same, and the delivery speed is the same.
The purchase price variance is the difference between that baseline price and the price the organization actually pays for the product or service. PPV can be positive or negative. When PPV is negative, that means the actual price paid is less than the baseline. That’s a good thing. When PPV is positive, the procurement team had to pay more for the product than the budgeted baseline price, which is a situation organizations would rather avoid.
You can see already that PPV is a key measurement in achieving cost reduction.
Why is PPV Important?
Input costs like raw materials and services make up a big part of any company’s overall product costs. In manufacturing—where there are significant outlays for raw materials and components—that can be upwards of 70% of the total cost.
Budgeting and tracking costs are critical, especially when a company is working hard to reduce costs. PPV is arguably the most important metric in determining whether cost reduction is being achieved. It is also a vital measurement of the effectiveness of the procurement team.
How to Calculate PPV
When calculating PPV, you need two key numbers: the baseline cost and the actual cost. This is where digital transformation and operational efficiency come into the mix.
To get an accurate baseline price, you need to know historical costs for the same product. Having this information available digitally makes it much faster and more accurate for the procurement team to come up with that baseline price.
To calculate PPV, use the following formula:
PPV = Actual Quantity x Baseline (or Standard) Price—Actual Quantity x Actual Price
If you end up with the actual costs decreasing compared to the baseline costs, the results will be a negative PPV. On the other hand, if the actual costs have increased, you end up with a positive PPV.
It sounds counter-intuitive, but a negative PPV is considered to be a favorable outcome. It means the procurement team has come in under budget. A positive PPV is what companies want to avoid. That means they are paying more for a product than they have in the past, and they are now over budget.
What Causes Variance in Purchase Price, and How to Reduce PPV
Multiple factors can result in a variance in the purchase price, some good and some bad.
A favorable (negative) PPV outcome is good news for the procurement team. They have managed to get better-than-expected pricing from their suppliers—which means they are contributing toward that high priority of cost reduction. How does this happen? Suppliers don’t just give discounts for no reason, although it’s possible that lower material prices are being reflected or improved currency exchange rates. There may also be a volume discount in play.
However, In many cases, a favorable PPV outcome means that the procurement team has become more effective at negotiating pricing. That is often attributable to digital transformation and improved operational efficiency. Through an advanced procurement software solution, that combination can make the procurement team much more effective at assessing bids from multiple suppliers. AI-powered software like Arkestro can automate many tasks, including the bidding process (with Intelligent First Bids) and exception warnings that get a procurement team member involved in an issue immediately. Arkestro even offers real-time purchase price variance KPI reporting.
An unfavorable PPV means there is room for improvement. There could be factors at play over which the procurement team has little or no control.
For example, the business owner may have required a smaller order this time, resulting in the loss of a volume discount. Maybe the supplier is improving quality and hiking prices as a result. More often than not these days, demand for a product or material is raising its market price.
The bad news for the procurement team is that no matter the reason, it’s seen as a failure on the organization’s part. They not only failed to achieve cost savings but ended up spending more. Real-time purchase price variance KPI reporting can help to prevent these unfavorable outcomes. Even when there is no way around it, the reports are invaluable in explaining what happened and helping to devise a strategy to avoid a repeat.
Procurement teams can be proactive about reducing PPV. One of the best ways is through advanced forecasting and predictive procurement. When you combine digitization with AI that can process massive amounts of data, the odds of being caught off guard by an unfavorable PPV are significantly reduced.
Take The Next Step
Now that you understand the importance of PPV, it’s time to take the next step. Book an Arkestro Ops demo and see first-hand how AI-powered predictive procurement software makes it easy to track purchase price variance while supporting the top priorities of CPOs in 2021.