Price variance

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What is a Price Variance?

Price variance is the actual unit cost of a purchased item minus its expected purchase cost. The presence of a variance tells management when to investigate into situations where purchase prices appear to be too high. This is a key cost management tool

How to Calculate Price Variance

To calculate price variance, subtract the standard cost of a purchased item from its actual purchase price, multiplied by the quantity of actual units purchased. The price variance formula is:

(Actual cost incurred - Standard cost) x Actual quantity of units purchased = Price variance

If the actual cost incurred is lower than the standard cost, this is considered a favorable price variance. If the actual cost incurred is higher than the standard cost, this is considered an unfavorable price variance. However, achieving a favorable price variance might only be achieved by purchasing goods in large quantities, which may put the business at risk of never using some of its inventory. Conversely, the purchasing department may be committed to having very little inventory on hand, and so buys materials in very small quantities, which tends to result in unfavorable price variances. Thus, the operational plan of a business tends to drive the types of price variances that it incurs.

Related AccountingTools Course

Cost Accounting Fundamentals

Standard Costs and Variance Analysis

Advantages of Using a Price Variance

There are several advantages associated with using a price variance, of which the following are the most important:

  • Identifies cost savings and overspending. Using price variances helps to detect cost fluctuations, so that you know where to take corrective action. For example, if raw materials cost more than expected, managers can negotiate better supplier contracts.

  • Improves budgeting and forecasting. Using price variances enhances the accuracy of financial projections by analyzing past cost patterns. This helps companies set more realistic budgets and cost expectations for future periods. For example, if actual supplier costs have been consistently higher than budgeted, then future budgets can be adjusted accordingly.

  • Detects fraud and errors. Using price variances can uncover potential fraud, billing errors, or inefficiencies in procurement and financial reporting. For example, if a supplier consistently charges more than the agreed-upon price, it could indicate fraud or errors in invoicing.

Problems with Price Variance

There are several problems with the price variance, which are as follows:

  • Standard cost basis. The price variance is based on a standard cost, which is essentially the opinion of someone within the organization. If the standard cost is set at an unrealistic level, then there will always be a misleading price variance associated with it.

  • Incorrect behaviors. If he purchasing staff is evaluated based on the price variance, then they are more likely to purchase in bulk in order to improve the variance. This can result in an excessive investment in inventory.

Types of Price Variances

The price variance concept can be applied to any type of cost. For example, there is the labor rate variance for labor costs, the purchase price variance for materials, the variable overhead spending variance for variable overhead, and the fixed overhead spending variance for fixed overhead.