In variance analysis, the total direct materials variance may be split into: price variance and quantity variance. Direct materials price variance refers to the variance that arises due to the difference in the actual and standard purchase price of raw materials used in production.
The formula for direct materials price variance is:
DM price variance = (AP - SP) x AQ
where: AP = actual price, SP = standard price, and AQ = actual quantity.
Example: Based on market quotes, XYZ Company has established a standard price of $5 per kilogram of raw material. Each unit of its product requires 2 kgs. Last month, XYZ used 20,000 kgs. of raw material costing $105,000 to produce 9,600 units. Compute for the direct materials price variance.
|DM price variance||=||(AP - SP) x AQ|
|=||($5.25 - $5) x 20,000 kgs.|
|DM price variance||=||$5,000 unfavorable|
If actual price is greater than standard price, the variance is unfavorable since the company paid more than what it has set. If actual price is less than standard price, the variance is favorable.
A favorable DM price variance occurs when the actual price paid for raw materials is less than the estimated standard price. It could mean that the firm's purchasing department was able to negotiate or find materials with lower cost. This is generally favorable to the company; however, further analysis is needed since lower price is often attributed to lower quality. Lower quality of materials results to lower quality of finished products, or excessive use of materials (resulting to an unfavorable DM quantity variance).
Also, a higher standard price may simply mean that the general prices in the industry have fallen and that the standard needs to be revised.
The DM price variance is unfavorable if the actual price of the materials is higher than the standard price. The purchasing department bought materials that cost too much. While this is usually treated as undesirable, higher actual prices may simply indicate a normal rise of prices in the industry. In such case, the standard price needs to be revised.
Generally, the purchasing department of the company is responsible for direct materials price variance since it has control over the acquisition of materials, including the selection of suppliers.