In any manufacturing company Purchase Price Variance (PPV) Forecasting is an essential tool for understanding how price changes in purchased materials affect future Cost of Goods Sold and Gross Margin. This helps business stakeholders to make more informed pricing decisions and finance functions to give more accurate forward-looking statements on overall future profitability.
But before we jump in more details on how to forecast PPV, let’s shortly explain what PPV is. And to do that we need to discuss how corporate financial budgeting is done.
Purchase Price Variance in Budgeting
Direct material purchases can add up to 70% of all the costs in manufacturing companies. Hence, budgeting and following up material prices is a key job of any finance function in this type of business. When a financial budget is created the exact actual price of materials is unknown, so a best estimate needs to be used. In accounting this best estimate price is called Standard Price.
Now, later when the budgeted costs realize companies have an accurate measure for the Actual Price and Actual Quantity of units bought.
Purchase Price Variance is the difference between the Actual Price paid to buy an item and the Standard Price, multiplied by the Actual Quantity of units purchased. Here is the formula:
Purchase Price Variance = (Actual Price – Standard Price) x Actual Quantity
A Positive Variance means the actual costs are higher than the budgeted, whereas Negative Variance means that costs are lower. Thus, positive variance can usually be considered as a bad thing and negative variance as a good thing.
Purchase Price Variance and Performance Measurement
PPV can be used to quantify the efficiency of a company’s procurement function. Negative PPV is consider as savings and thus good performance from the procurement organization. This is, however, a very simplistic approach as commodity price volatility is often outside the control of buyers. In the worst cases, PPV as a performance measure can lead to politics around Standard Price setting instead of providing a motivating KPI for the procurement team.
On the other hand, PPV is valuable for financial planning. It explains how material price changes have affected your gross margin compared to your budget. This is a key component in understanding the development of overall business profitability and thus a vital financial performance indicator. And it is usually readily available from your finance systems where PPV calculations should happen automatically.
Forecasting Purchase Price Variance
As described above PPV is a historical indicator telling you what has happened in the past. Imagine, however, how powerful a forward-looking PPV indicator would be. Enter Forecasted PPV, a performance indicator that can highlight future risk to your gross margin and overall profitability.
The math needed to calculate Forecasted PPV is straight-forward and similar to the Realized PPV formula:
Forecasted PPV = (Forecasted Price – Standard Price) x Forecasted Quantity
With the aid of Forecasted PPV business units gain the much-needed visibility on how material price changes are expected to erode gross margins and thus they can proactively take needed actions to protect those margins. And finance teams can confidently adjust their forecasts and forward-looking statements; and explain the effect of material price changes in these.
So, if Forecasted PPV is such a great performance indicator and simple to calculate, why are not all companies using it? The problem is that Forecasted PPV can’t be automatically calculated by your ERP or finance system. Your SAP contains your Standard Prices but coming up with reliable data on Forecasted Prices and Quantities is a much more complex exercise.
Forecasted quantities should be based on expected market demand (and thus production volumes), but often this information is not accurate or available for all business units and regions. Thus, quantity forecasts are usually result of combining
- Data from demand planning and MRP systems
- Extrapolated historical quantities and previous forecasts
- Manual entry and adjustment by persons who best understand demand
In the same way forecasted prices can come from purchasing systems when there is long enough visibility to contracted prices, but often procurement people need to manually estimate at least the key materials based on their view of the supply market and with the help of cost structure models.
In a large enterprise where there are usually multiple source systems for forecast data, tens of thousands of material numbers to be forecasted and a score of plants and business units involved in the process, building and maintaining a regular Purchase Price Variance Forecast is not a task to be taken lightly.
Sievo Spend Forecasting – PPV Forecasting made easy
Sievo’s Spend Forecasting solution is a purpose-built solution for all purchase related forecasting needs. And if you are looking for a system for Purchase Price Variance Forecasting, we got you covered. But don’t take our word for it, hear what Chris from Becton Dickinson has to say about Sievo Spend Forecasting:
Intrigued? Request a personalized demonstration from our website.