What is a possible reason for an Unfavourable direct materials price variance?

What is the Materials Price Variance?

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.

Causes of the Materials Price Variance

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

Example of the Materials Price 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.

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. 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.

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.

Materials Shortage

There is a raw material shortage, which drives up its cost.

New Supplier

The company has changed suppliers, and the replacement supplier 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.

Problems with the Direct Material Price Variance

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.

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.

Terms Similar to Direct Material Price Variance

The direct material price variance is also known as the purchase price variance.

What can cause an unfavorable material quantity variance?

What are possible reasons for a favorable direct materials price variance?

Why direct material price variance is unfavorable?

Which of the following Cannot be a reason for Unfavourable direct materials price variance?