Direct material price variance definition
/What is the Direct Material Price Variance?
The direct material price variance is the difference between the actual price paid to acquire a direct materials item and its budgeted price, multiplied by the actual number of units acquired. This information is needed to monitor the costs incurred to produce goods.
How to Calculate the Direct Material Price Variance
The direct material price variance formula is to subtract the budgeted price from the actual price, and multiply the difference by the actual quantity acquired. The formula is as follows:
(Actual price - Budgeted price) x Actual quantity = Direct material price variance
The direct material price variance is one of two variances used to monitor direct materials. The other variance is the direct material yield (or usage) variance. Thus, the price variance tracks differences in raw material prices, and yield variance tracks differences in the amount of raw materials used.
The budgeted price is the price that the company's purchasing staff believes it should pay for a direct materials item, given a predetermined level of quality, speed of delivery, and standard purchasing quantity. Thus, the presence of a direct material price variance may indicate that one of the underlying assumptions used to construct the budgeted price is no longer valid.
Example of the Direct Material Price Variance
The purchasing staff of ABC International estimates that the budgeted cost of a chromium 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 direct material price variance of $2.50 per pound, and a variance of $62,500 for all of the 25,000 pounds that ABC purchases.
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What Causes a Direct Material Price Variance?
Here are several possible causes of a direct material price variance:
Discount application. A discount is to be retroactively applied to the base-level purchase price at the end of the year by the supplier, based on actual purchase volumes. This is under an arrangement with the supplier, who must approve it.
Materials shortage. There is a raw material shortage, which drives up its cost. This assumes that the demand level exceeds the supply, possibly over an extended period of time.
New supplier. The company has changed suppliers, and the replacement supplier charges a different price. This commonly happens when the current supplier’s offerings prove to be of low quality, while the replacement supplier’s offerings are of higher quality, and therefore more expensive.
Rush basis. The company needed the materials on short notice and paid overnight freight charges to obtain them. This is especially common in the absence of a rigorous production planning system.
Volume assumption. The company now buys in different volumes than it originally planned for. This may be caused by an incorrect initial sales assumption regarding the number of units that will be sold, or perhaps a shift in market conditions that has significantly altered the number of units sold.
As you can see from the list of variance causes, different people may be responsible for an unfavorable variance. For example, a rush order is probably caused by an incorrect inventory record that is the responsibility of the warehouse manager. As another example, the decision to buy in different volumes may be caused by an incorrect sales estimate, which is the responsibility of the sales manager. In most other cases, the purchasing manager is considered to be responsible.
Problems with the Direct Material Price Variance
The direct material price variance can be useful, but it also has several important limitations and potential problems; they are as follows:
It may encourage purchasing the wrong materials. A purchasing manager may focus on obtaining a lower price, even if the materials are of lower quality and create production or spoilage problems.
It ignores total cost considerations. A favorable purchase price may be offset by higher freight, storage, handling, inspection, or rework costs, so the overall cost may not actually improve.
It can reflect market conditions rather than performance. Changes in supplier pricing, inflation, shortages, or commodity swings may drive the variance, even when the purchasing staff performed well.
It may create conflict between departments. Purchasing may buy cheaper materials to improve its variance, while production may face more waste, downtime, or inefficiency as a result.
It can be based on outdated standards. If the standard price is no longer realistic, the variance may highlight old assumptions rather than actual operating performance.
It may not show timing effects clearly. A favorable variance can arise from buying materials in bulk or at a temporary discount, even though this may increase carrying costs or create future obsolescence risk.