The material variances can be split in several types of variances, depending on the setup of your manufacturing or ERP system. Typically we consider:
Material Price Variances (MPV)
The concept behind Material Price Variance is simpel: #difference between std cost and po price. You set your purchasing standards once a year by freezing your current purchasing prices into a “frozen period” and we call those “Standard Costs (STD)”. During the year whenever you raise a Purchase order with a price agreed (PO price). In an ideal world there is no difference between the price you paid at the beginning of the year (STD) and the price you pay during the year (PO price). However you will understand that is not always the case. Lets look at some factors that influence differences between STD and PO Prices:
- Standard Costs may have been based on average purchase volume from a supplier. If you buy less or more than you agreed in a contract, or if you want an expediated delivery for a single unit, your PO price may be different than the standard.
- Material surcharges may apply because of inflationary reasons. E.g. the price of copper may increase dramatically during the year forcing your suppliers pass on the price increase to your location, well above your standard. In case these inflationary conditions are permanent in nature and are due to economic or technologic reasons you may need to bring this variance into your inventory valuation (debit Inventory, credit MPV). It is wise to keep these type of specific price increases (surcharges) visible in a separate MPV #account so when the price comes down again you can force your suppliers to reduce the price back to its orginal level.
- Foreign exchange (FX) may be a factor in creating differences when you buy products in foreign currency. Although it may not always be possible but you may want to try select suppliers that do not have a curency risk. Hedging your payables position may help in reducing the effect. Ideally, if your ERP system permits, you should record the FX entries into a separate account so it is clear that your purchasing team cannot be held accountable for this variance.
- Contract ends in the new year requiring the purchasing department to renogiate. Obviously this will have an impact on your PO price (versus the STD set early in the year). This variance needs to be well understood as this is an indicator of a well functioning purchasing function and the leadership of the site may want to hold them accountable for this number.
- Other reasons for differences may be due to unforeseen price increases from your supplier, Bill of Material of material changes, customer spec changes, or Engineering Change notices driving the use of new parts in the production process.
As mentioned, you can see that the main drivers of MPV are coming from your Purchasing (or Supply Chain department). Having the ownership lie with this deparment is critical as making them responsible for the variance amount will drive better purchasing decisions. If you would see positive MPV trend you know that your purchasing department has managed to negotiate better prices. (Note: price is only one factor in a contract and should not be pursued as a stand-alone item, also consider payment terms, discounts, etc — these items are often given away without fully uderstanding the costly impact).
The MPV is generated upon receipt of the goods and should be automatically calculated by your ERP system taking STD Cost -/- P.O. Price and posting this to your MPV account.
There are varying degrees of types of costs you can include into your Material STD cost but for the simplicity of this example lets assume we only have material cost to consider. Other items that can be included in your Material STD cost would be a markup for Freight, Packaging, Insurance, Customs/duties, Material Overhead.
Purchase Prices Variance (PPV)
Where with MPV the variance is generated at the time of receipt, this variance is generate at the time of recording the invoice by #accounting. The variance is nothing more than the P.O. Price agreed (on the purchase order sent to the supplier) and the Invoice Price (INV Price). It may seem strange that this type of variance exisits right? Why would one agree a PO price X today and receive an INV Price Y tomorrow. Indeed, this is a control account, also known as the three-way-matching principle. You compare the P.O., Receipt and Invoice, and only if they match you pay the invoice.
So who is responsible for the PPV account. That depends! Most companies have a system called “invoice matching”, any invoice that does not match the purchase order will put the invoice on payment hold. In absence of such a system the #accountant will refuse to pay an invoice with a price descrepancy and needs approval. The invoice would only be paid when the purchasing manager agrees to accept the higher invoice price (as said this is often automated through an email workflow within your ERP).
Some reasons why you may have a purchasing price different from the purchasing price:
- Purchase order terms did not forsee in material price increases between placing the order and the #actual delivery, resulting in differences on the actual invoice. Typically this can be covered by having good terms and conditions in place and contractually defined.
- The purchase order price was open to interpretation. As an example you may have agreed an hourly rate but depending on the person who performs the activity this may change, e.g. a nightly rate that is different than a daily rate or a Senior versus a Junior consultant.
- You may be hitting on a discount or premium by buying a certain quantity. E.g. if your minimum order quantity is 10 but you order 9, some suppliers are charging you additional fees resulting in a difference between P.O. price and Invoice price.
- Items on the purchase order, like packaging or insurance were not included and now need to be separately approved may be causing a variance between PO and INV price.
The PPV is the ownership of the accounting department with approval for any discrepancies between PO and INV price by Purchasing or Supply Chain Management.
- Monitor both accounts monthly
- Split the variances by root cause (surcharges, price increases, FX, etc.)
- Make purchasing responsible for material price variances they can control
- Include these items in the goal setting process (personal and company goals)
- Ensure you have the proper controls to avoid unauthorized purchase price variances
- Make sure your accounting system is setup properly to be able to split these variances into the right accounts. Lumping all these variances together is not desirable.
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