The materials price variance is the difference between the actual and budgeted cost to acquire materials, multiplied by the total number of units purchased. The variance is used to spot instances in which a business may be overpaying for raw materials and components. The formula is:
(Actual price - Standard price) x Actual quantity used = Material price variance
The key part of this calculation is the standard price, which is decided upon by the engineering and purchasing departments, based on estimates of usage, probable scrap levels, required quality, likely purchasing quantities, and several other factors. Politics can enter into the standard-setting decision, which means that standards may be set so high that it is quite easy to acquire materials at prices less than the standard, resulting in a favorable variance. Thus, the decision-making process that goes into the creation of a standard price plays a large role in the amount of materials price variance that a company reports.
If the standard price is reasonable, then a materials price variance may be caused by such valid factors as the following:
- Rush deliveries
- Market-driven pricing changes, such as changes in the prices of commodities
- Bargaining power changes by suppliers, who may be able to impose higher prices than expected
- Buying in unusually large or small volumes in comparison to what was expected when the standard was created
- A change in the quality of the materials purchased
As an example of the variance, the purchasing staff of ABC Manufacturing estimates that the budgeted cost of a palladium component should be set at $10.00 per pound, which is based on an estimated purchasing volume of 50,000 pounds per year. During the year that follows, ABC only buys 25,000 pounds, which drives up the price to $12.50 per pound. This creates a materials price variance of $2.50 per pound, and a variance of $62,500 for all of the 25,000 pounds that ABC purchases.