After an accounting period is closed, managers evaluate operational results and compare them to budgeted projections. Companies that create products typically analyze the actual price they paid for raw materials compared to what they expected to pay. This comparison is referred to as a material price variance.
Calculating the Variance
To calculate material price variance, subtract the actual price per unit of material from the budgeted price per unit of material and multiply by the actual quantity of direct material used.
For example, say that a dress company used 1,000 yards of fabric during the month. The budgeted price for the fabric was $5 a yard, and the actual price was $3 a yard. The material price variance is $2 - $5 budgeted minus $3 actual - multiplied by 1,000 yards, for a price variance of $2,000.
Because the actual price was less than the budgeted price in this example, the variance is deemed to be favorable. Had the actual price per unit exceeded the budgeted price, the variance would result in a negative number, and the variance would be unfavorable.
Analyzing the Variance
The material price variance calculation tells managers how much money was spent or saved, but it doesn't tell them why the variance happened. One common reason for unfavorable price variances is a price change from the vendor. Companies typically try to lock in a standard price per unit for raw materials, but sometimes suppliers raise prices due to inflation, a shortage or increasing business costs. If there wasn't enough supply available of the necessary raw materials, the company purchasing agent may have been forced to buy a more expensive alternative. If the company bought a smaller quantity of raw materials, they may not have qualified for favorable bulk pricing rates.
If the company can negotiate a deal or a discount, a favorable price variance may occur. Favorable price variances can also happen if the purchasing agent buys a less expensive material alternative. Although the variance is dubbed favorable, this type of price variance can have a negative effect on the company. If the price is lower because the quality of raw materials is lower, it may take more material than usual to construct the product appropriately. For this reason, managers often investigate material quantity variances when they notice a material price variance.