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. The formula 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material price variance may indicate that one of the underlying assumptions used to construct the budgeted price is no longer valid.
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.
- Materials shortage. There is a raw material shortage, which drives up its cost.
- New supplier. The company has changed vendors, and the replacement vendor charges a different price.
- Rush basis. The company needed the materials on short notice and paid overnight freight charges to obtain them.
- Volume assumption. The company now buys in different volumes than it originally planned. This may be caused by an incorrect initial sales assumption regarding the number of units that will be 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.
The direct material price variance can be meaningless or even harmful in some circumstances. For example, the purchasing manager might have engaged in heavy political maneuvering to have the standard price set unusually high, which makes it easier to generate a favorable variance by purchasing at prices below the standard. Also, the variance can cause incorrect behavior by creating an incentive to purchase in bulk in order to obtain the lowest price, even though this means burdening the company with an inordinate amount of inventory that it does not immediately need.
Consequently, the variance should only be used when there is evidence of a clear price increase that management should be made aware of.
Direct Material Price Variance Example
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.
The direct material price variance is also known as the purchase price variance.