Standard costing allows comparison between actual costs incurred and budgeted costs based on standards.
In a manufacturing environment, variance analysis may be performed separately for the different components of costs, i.e. direct materials, direct labor, and factory overhead.
What are Direct Materials?
Direct materials, in contrast to indirect materials, refer to the materials that form an integral or major part of the finished product. Examples include wood in furniture, steel in automobiles, fabric in clothes, etc.
Indirect materials include nails, screws, glue, and other small or immaterial items. Indirect materials are included in factory overhead.
Computing Direct Materials Variance
The direct materials (DM) variance is computed by comparing the total actual cost and total standard cost of the raw materials.
Direct materials variance = Total actual DM cost - Total standard DM cost
The total actual direct materials cost and total standard direct materials cost may be computed as follows:
Total actual DM cost = Actual quantity used x Actual cost per unit
Total standard DM cost = Standard quantity for actual production x Standard cost per unit
Note: "Unit" may refer to count, weight (kilograms, gallons, etc.), length (meters, yards), area (square feet, square meters), or other applicable units of measuring the material.
Favorable and Unfavorable Variance
If the total actual cost is higher than the total standard cost, the variance is unfavorable since the company paid more than what it expected to pay. If the total actual cost incurred is less than the total standard cost, the variance is favorable.
According to ABC Company's annual budget of 120,000 production units, 360,000 units of raw material are to be used (3 units for every finished product). The total budget for raw materials is $900,000 ($2.50 per raw material). Last month, ABC produced 10,000 units of its product. The company used 32,000 raw materials costing $76,800.
The direct materials variance of the production last month is:
|Total actual cost||$76,800|
|Less: Total standard cost||75,000|
|Variance - DM||$ 1,800||unfavorable|
Total actual cost. The total actual cost is given – $76,800. If we compute for the actual price per raw material used, we would get $2.40; i.e. $76,800 divided by 32,000.
Total standard cost. $75,000 is computed as: 30,000 standard raw materials for the actual production (3 x 10,000), multiplied by $2.50 – the standard cost per raw material.
Price Variance and Quantity Variance
For further analysis, the direct materials variance may be split into: direct materials price variance and direct materials quantity variance. As the terms suggest, the price variance arises due to difference in the purchase price of the raw materials, while the quantity variance arises from the difference in the quantity of raw materials actually used and expected to be used.
DM price variance = (Actual price - Standard price) x Actual quantity
DM quantity variance = (Actual quantity - Standard quantity) x Standard price
|Price variance ($2.40 - $2.50) x 32,000||$3,200||favorable|
|Quantity variance (32,000 - 30,000) x $2.5||5,000||unfavorable|
|Total DM variance||$1,800||unfavorable|