PPV–Hidden money in outsourced manufacturing

There are three letters that anyone who outsources manufacturing should know.

P. P. V.

Stands for Purchase Price Variance.  It’s an accounting term actually, used to account for the difference between the the actual price paid to the vendor(s) and standard cost of a purchased component or assembly.  PPV is a balance sheet item and accumulates debits and credits of these differences.  Eventually PPV is “emptied” to the P&L, either for good or bad. See  http://www.accountingtools.com/purchase-price-variance for example for more on the accounting aspects.

In the outsourced manufacturing world, specifically for turnkey contract manufacturing where the price paid to the contract manufacturer for an assembly is based on the cost of the BOM (Bill of Materials, another important acronym) plus a value add or transformation cost, which may be a fixed price or a percentage of the BOM or often a very complex calculation.  But in this case the amount paid equal to the BOM cost is based on the standard cost (see above), agreed upon between the customer and the contract manufacturer.

So this is where PPV comes in.  Because it is now in the contract manufacturer’s interests to buy the components within the assembly at a cost less than standard. This number is typically low, only a percentage or two, but in the contract manufacturing world this is huge.

This game, however, is not exactly stacked in the contract manufacturers favor.  Savvy customers know all about PPV and the most ruthless among them negotiate pricing so low such that the only profit that the contract manufacturer makes is in the PPV.  And there is extreme effort put in ferreting out any latent savings and forcing that into the standard.  But unsavvy customers can get taken on this, badly in some cases, especially in product classes where component costs routinely go down over time (e.g. consumer electronics).

There is no right or wrong here, but it pays to know how the game is played before sitting at the table.

Chuck

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