A business planning a project may have to make costing assumptions at the start of the process; it may not know all actual costs until project end. Purchase price variance is an accounting tool that calculates the difference between these costs. This shows whether profits have met estimates, or are higher or lower than initial projections.
During the budgeting process, companies usually estimate certain costs, such as raw materials, labor and overhead. Employees may use the prior accounting period's data, public information or other resources to try and estimate the standard cost of each of these expenses. Often, in the manufacturing process, the cost of raw materials and labor fluctuates throughout the year depending on the availability of resources and supply and demand. This means that the actual cost may not be the same as the standard, or estimated, cost.
When the company receives the materials, or the employees or contractors perform the necessary labor, then actual costs are incurred and the accountant or bookkeeper can record them accurately. Actual costs for labor may be different because the company incorrectly estimated how many man hours it requires to make or build a good. The actual cost is recorded as an expense during the accounting process, whereas the standard cost is a liability.
Purchase Price Variance
The purchase price variance is the difference between the actual cost and the standard cost. The formula for determining the purchase price variance in a budget is: (standard price * number of estimated units) - (actual price * number of actual units). If the value is positive, then actual costs increased. If the value is negative, then there was a decrease in actual costs. Companies do not wish to experience great fluctuations in either direction. Recognizing a variance rather quickly is beneficial to management, which can then make any necessary changes to the budget to compensate for the increase or decrease in expenses and cash.
For example, on Jan. 1st, Sue, the accountant for ABC, Inc., created a budget and estimated the cost of steel that the company would need for the first quarter at $700 per ton and would use five tons. In April, upon reviewing the first quarter expenses, she sees that the price of steel as $650 per ton and the company used 5.25 tons. The purchase price variance for steel is ($700 x 5) - ($650 x 5.25), equaling $87.50 for the first quarter.