Developing standards for purchased items should be undertaken with careful analysis. Sources of this information include;
· Data from past periods.
· Negotiated Contracts with your suppliers.
· Survey of your suppliers pricing for the future periods.
· An understanding of commodity pricing on your supply chain.
Past data is generally available at a low cost; however, the data can have limitations that include inefficiencies that may not be evident in the data set. Factors for pricing your inputs items should include:
· Anticipated quantities required based on the Budgeted Sales Volume.
· Timing of when the material is needed to support the manufacturing process.
· Length of the Supply chain.
· Supplier Volume pricing.
· Anticipated inventory turns for the material.
· Inventory Storage Costs.
Simply utilizing the last purchase price paid to your supplier for the item is short sited and lacks good business judgment.
So you now have formulated your purchased item pricing and you have received approval for your budget from the Board of Directors. You then update the pricing as your standard costs for those items at the beginning of the operating year. As you begin receiving inventory into your warehouse, you begin to recognize purchase price variance (PPV). What does this measure?
There are a number of different possibilities causing this variance:
· Actual Negotiated Pricing was not reflected in the standards appropriately.
· Actual Quantities purchased were increased to obtain better pricing. This can have a positive impact on performance; however, if inventory turns slow and the carrying cost of the inventory exceed the favorable PPV, then this was a poor business decision.
· Material prices increased or decreased as a result of industry oversupply.
· Standards were set without careful analysis. This condition will have a likely negative effect on margins.
Root cause analysis should be conducted to determine the reason for the variance. This analysis will assist you in determining the appropriate business action to stem further margin erosion.
Andy Vitullo, CPA
Principal, Logan Consulting