Purchase Price Variance (PPV) is a procurement metric that’s designed to measure a procurement organization’s (or an individual procurement professional’s) effectiveness at meeting cost savings targets.
The thinking about PPV is simple. If you spend $1.10 on a widget, then try to get the exact same widget next year for $1.00. The better the price you get, the better your PPV. Many organizations reward their buyers on a PPV metric.
But here is why I maintain PPV is a stupid metric.
When a buyer’s goal is to continually push the price down it puts extreme pressure on the supplier. There are three routes the supplier can take:
– The easy route is to take the price cut, which will reduce its margins. However, this short term win can be a long term loss for the buyer because the supplier may cut corners and quality may suffer.
– A harder route is for the supplier to make investments to reduce the cost structure. While this makes good sense from the buyer’s perspective, it’s typically not in the supplier’s best interest to do this because by achieving efficiency gains to get the price down to $1.00, a win-lose situation is created. It got the savings, but actually LOST revenue and margin because your price = their revenue. If I were a supplier why would I invest in efficiencies on your (the buyer’s) behalf when I am just going to lose?
– The route most commonly taken by suppliers is to get creative on how they can maintain their margin. Here is a fun example from my days from when I worked for a software manufacturing service provider. In the early days of software manufacturing, most software came in a box. It was common for the box to consist of a “pretty box” (the outside packaging), the software manual, one or more CDs, and several marketing type brochures. As the service provider we would buy (or make) each of the components and assemble them into the “pretty box.” In those days the manual was actually the largest component. Print is considered a commodity and it was common for our clients to have a print commodity expert that was very focused on the “price per page.” So when they beat us up on PPV based on price per page, we simply looked to put our profit elsewhere, such as in the touch labor of assembling all of the components in the box. After all, as a supplier we were rewarded for hitting our profitability target and if there was a cut in one place, our job was to beef up margins in other areas. PPV savings just gave the impression there were savings, but the total costs stayed the same.
A better approach is to shift your thinking from price to a Vested pricing model. Here is how it works: Full transparency is needed from the outset. The supplier shares its actual costs AND its margin. The buyer agrees with the supplier on a fair market margin, and commits to not ever reduce the supplier’s margin.
Under the Vested approach, the buyer creates an incentive structure for the supplier to reduce its cost structure. The more the cost structure goes down, the more incentives the supplier earns that greatly increase the supplier’s margin. Now cost savings become a win-win.
Want to learn more? Download our free white paper on “Unpacking Pricing Models.”
Image by eric731 via Flickr CC