One of the dilemmas, or maybe I should say conflicts, inherent with cost accounting metrics is that managers are always torn between doing what is best for the organization (e.g. maximizing throughput and cash flow) versus doing what is best for their own local performance improvement (e.g. maximizing local efficiency). This is always the quandary between cost world thinking and the throughput world. In this posting I want to discuss another of the more well-known cost metrics, purchase price variance.
Purchasing managers are typically measured on their capacity to generate favorable purchase price variance, but exactly what is Purchase Price Variance (PPV)? PPV is the difference between the actual price paid to purchase an item and its standard budgeted price, multiplied by the actual number of units purchased. If you like formulas,
PPV = (Actual price – Standard Price) x Quantity Purchased
A positive PPV means that actual costs have increased while a negative PPV means that costs have decreased. The standard price is typically developed by a group of engineers in a company and it’s what they believe that a company should pay for any item given a predetermined quality level, quantity to purchase and delivery speed. In effect, the PPV is really an “opinion” of some of your employees based upon assumptions that may or may not match your company’s purchasing situation. Here’s an example of how PPV might not be a good metric for your company.
I know of a Department of Defense MRO contractor responsible for part’s acquisition needed to repair military aircraft. Because buying in bulk always gives companies a better price per part, the purchasing Director decided to get the minimum cost so he purchased five times the number of parts that were necessary to fulfill what was needed for the guaranteed life of the contract (3 years plus 2 years if performance met requirements). In so doing, he was able to receive a price that was significantly better than the budgeted price in the contract. What a hero he was and his PPV looked really great!! In order to maximize the performance of this key metric, it is really common practice for those responsible for part’s acquisition to do this, but there is a potential down side to these actions. Most of these long-term contracts also have a provision for delivery performance and if a company is failing to deliver enough maintained aircraft, they could lose the contract to a competitor. So if they lose the contract, then what happens to the excess inventory they ordered to get a favorable PPV? The answer is, they’re stuck with it!
As you might have guessed this particular contractor did not perform well and failed to deliver the contracted daily number of aircraft so the contract with them was canceled and given to one of the competitors after only two years. Remember, the purchasing director had purchased 5 times the required amount just to get the best price he could, thinking he was saving his company loads of money. But when the contract was lost, he was forced to either sell the excess inventory to the competitor or write it off. They sold it to the competitor for pennies on the dollar. So did PPV save this contractor money or did it cost them big time? In the long run, it cost them hundreds of thousands of dollars. All of this happened because of another cost accounting metric….Purchase Price Variance.
In my next posting, we’ll continue to explore cost accounting and some of the more ridiculous metrics that drive the wrong behaviors.