The difference between the actual cost of direct material and the estimated or standard cost of direct material used is termed as direct material price variance.
The concept can be clearer with the help of formula:
Material Price Variance = (Standard Price-Actual Price) × Actual Quantity
The formula has 3 main components, ie
• Standard Price
• Actual Price
• Actual Quantity
Standard price is the estimated amount or cost set by the management on the basis of their past experience. Accurate estimates are important to get the desired results from calculations.
Otherwise, if you ignore some important points in the formation of your budget, you may not get the true image at the time comparison.
The importance of direct material variance is high like all the other variances. As it gives the information about the actual material price compare with the budgeted or estimated material price.
1) Helps in Controlling Cost:
The material price variance is a very effective management tool for controlling the cost of direct materials. Direct materials are a major part of the overall cost. C
ontrolling direct material cost means, lower cost of goods sold and higher profits margins.
If the actual price is less than budgeted price, it means that the company’s employees are motivated to meet the standards set by management.
And there is only a chance of little improvements. But if the actual price is higher than the estimated price, it gives an unfavorable result.
Unfavorable results mean that the company loses more money than expected. So it gives a hint to the management to take some decisive actions to control the price.
2) Helps in Decision Making:
The direct material price variance gives full information about the total difference between expected cost and the actual cost of direct material incurred to produce one unit.
On the basis of results obtained, the company’s management has to decide whether to continue with the current supplier or gets some different quotations from other suppliers also.
But for all these things basis for making budgets should be actual or near to actual.
3) Performance Measurement:
Direct material variance can give you an idea about the performance of the purchasing department.
If the price variance is favorable it means that purchase department is working hard and meeting the standards but if all the other factors remain unchanged and results show an unfavorable amount then management will have to think about the performance of purchase department.
Limitations Direct Material Price Variance:
1) Change in Supply and Demand:
The change in demand and supply of any commodity eventually affects the price.
And this change will disturb all the calculations done by organizations and they should have changed their calculations also.
If there is an unexpected change in supply and demand of the direct material used by the company and the company did not upgrade their estimations according to the new change.
Then the information you will get from direct material variance may not be accurate as it should be.
It is the limitation of standard costing that in the course of any unexpected change you have to update your system. Otherwise, you will not get the true picture of your business.
2) Change in Government Rules:
The formation of new rules and regulations by the government, from time to time to accommodate the new scenarios greatly affects the prices of raw material used by companies.
The expected changes are taken into consideration by management when preparing budgets and estimations.
But if the changes are immediate and uncertain, then for accurate information, you should have updated your estimates. So, in the end,, you will be updated estimates with the actual data.