Managerial Accounting 10.3: Direct Materials Variance Analysis - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how standards are  used to evaluate our direct materials variances.  

There are two different variances that we will  talk about in just a second that are associated  

with direct materials in a manufacturing setting  and we're going to take a look at those variances.  

But we are going to start by talking about the  standard costs that are used to first of all  

establish the flexible budget. In a separate video  we described how these standards are established  

and in particular how the standard cost per unit  is established. So here we are just going to review  

this and indicate that the flexible budget is  calculated by taking the standard cost per unit  

of product that we are manufacturing, times the  actual number of units produced. So remember the  

flexible budget is prepared after the period has  gone by where we take the actual units produced,  

we know that number, and multiply it by what we  expected the standard cost per unit to be. We  

then compare the flexible budget to actual costs.  And when we do that we break out any differences  

into two variances. And in the materials setting  these two variances are the materials price  

variance and the materials quantity variance.  So we are going to take a look at that in this  

lecture. Let's start with the materials price  variance. The materials price variance focuses  

on the price that we paid for materials. And  it really answers the question, it is right here,  

this is the key, it answers this question, did we  spend more or less on the direct materials than  

we expected to spend. And the way to calculate  this is to take, I am going to go right to the  

bottom, it is described in the third bullet point  in detail but I am going to go right here to this  

bottom formula. The materials price variance is the  actual quantity of materials purchased, and that is  

AQ, with the P as the postscript,  and we multiply that by the actual price.

Then we subtract from that the actual quantity  purchased again times the standard price per  

quantity of material per unit of measure, I should  say of that material. So if it is measured in  

pounds it would be the standard price per pound.  If it was measured in ounces, it would be the standard price  

per ounce, or yards would be the standard price per  yard. And the same idea over here with the actual  

price. It would be the actual price per pound,  or per ounce, or per yard. So this is trying to  

figure out or this is how to calculate the  materials price variance, and what we are doing is  

taking the actual quantity purchased. And if you  want to look at this in more detail, the actual  

quantity purchased, we are holding that constant,  and we are really looking at what was the actual  

price that we paid relative to the standard price  that we paid. And so that is what comes out of  

this, that's where we get the price variance. We  were evaluating the price variance. How much did  

we pay versus how much do we expect to pay. The  next variance to look at related to materials  

in production, used in production, is the quantity  variance. And so what is the quantity variance and  

then how do we calculate it. The materials quantity  variance focuses of course on the quantity of  

materials that we use in production. We are not worried here about the price that we paid, we are  

really just focusing on the quantity of materials  that we used in production. And it answers the  

question, the very important question, did we use  more or less direct materials in production than  

we expected to use. If we go right to the bottom of  this slide you'll see the formula that is needed  

to figure out the materials quantity variance.  And it is described in detail in the third bullet  

point right here. The materials quantity variance  at the very bottom is the actual quantity used  

in production. So we have the U postscript, actual  quantity used, not purchased, but used in production,  

times the standard price per unit of measure.  And again if it's in ounces it would be the  

standard price per ounce, if it's in yards it would  be the standard price per yard, if it's in pounds  

it would be the standard price per pound. And  then we subtract from that, so that is the  

actual quantity used, times a standard price, what we  expected to pay per quantity measure, we subtract from  

that the standard quantity that we expected  to use, times the standard price that we expected  

to pay per unit of measure. So once we calculate  the variance how do we know if the variance is  

favorable or unfavorable. And this does not, this  is not just for direct materials, this goes for  

all variances related to direct materials, direct  labor, and variable manufacturing overhead. In the  

first bullet point here we describe a favorable  variance. And a favorable variance has a positive  

impact on operating profit. So if a variance  is labeled as a negative number, it is actually  

favorable at least in the direct material setting  because that means that the actual cost was lower  

than expected cost. And if the actual cost is  lower than the expected cost our profits are  

higher than expected. So a favorable variance  in a cost setting, direct materials, direct labor,  

variable manufacturing overhead is a negative  number. That sometimes causes confusion with  

students. They think that it should be a positive  number, but no if it's a negative number that means  

that again the actual costs that we incurred are  lower than our expected costs and that's

generally a good thing, and that means that our  profits are higher. An unfavorable variance then  

has a negative impact on operating profit. So if  a variance in the direct materials, direct labor,  

and variable manufacturing overhead setting is  a positive number, it is unfavorable because the  

actual cost is higher than the expected cost. And  if the actual cost is higher than the expected  

cost, that means that our profits are lower than  expected and the variance is unfavorable. I have  

a separate lecture on how to record variances  on the books, so this is just a precursor to that  

this last bullet point. Companies use a standard  cost system, that do use the standard cost system,  

credit favorable variances and debit unfavorable  variances to income statement accounts. So much

more on that in a separate lecture. Let's go  to the next slide which gives us the detailed  

calculations related to the two direct materials  variances. There is a lot of information on this slide, but so  

I'll try to summarize the information that  you see here and then you can pause at any  

point take a look at the footnotes to get the  detailed information and where that comes from.  

But let me give you at least to start the broad  view. We are looking at, with these white boxes  

here, the two variances that are associated with  direct materials. So with the box on the left we  

are looking at the materials price variance and  this is the price variance. And with the box on  

the right, we are looking at the materials quantity  variance. Remember from the previous slide a couple  

slides back that the materials price variance  looking at the left here materials price variance,  

is the difference between this calculation and  this calculation. So we have already gone through  

that calculation in general now we're going to  apply some numbers to it. So let me dive a little  

more into the detail and we'll focus on this  right here the price variance. The calculation  

from left to right here, the calculation is the  actual quantity purchased, the actual quantity  

of materials purchased, and we are measuring those  materials in pounds, and this information was given,  

the actual quantity purchased. So let's assume  that we purchased 440,000   

pounds of material, now that's the actual quantity  purchased, times the actual price and the actual  

price here let's assume is $1.20 per  pound. Sometimes we have to figure out the actual  

price per pound because maybe we know the total  cost of those materials that we purchased and  

the total quantity but perhaps we don't know the  price per pound. If that is the case we take the  

total cost of $528,000 and just simply divide it  by the number of pounds, the actual quantity purchased  

440,000 here, and that would give us this $1.20 per  pound. So we know that our actual price for the  

materials that we purchased in total is $528,000.  Now let's go to the middle column and let's take a  

look at what we expected to pay given the actual  quantity we purchased. Well we expected to pay $1  

per pound and we paid $1.20. So we paid more than  we expected. We have an unfavorable variance, we  

know that but now we have to figure out what the  total dollar amount is. So we are going to take  

the actual quantity purchased, and that is 440,000  pounds, and multiply it by our standard price that  

we established per pound of $1, and that  gives us the total of $440,000. The difference  

then between the 440,000 and the 528,000 that you see over  here is $88,000. So our variance is unfavorable,  

we paid more than we expected by $88,000. And it  should say more specifically our materials price  

variance is $88,000 unfavorable. Now let's look at  the quantity variance. And again a few slides back  

we talked about how to calculate the quantity  variance and it is this calculation actual  

quantity of materials used not purchased but used  in production, times the standard price, and we then  

subtract from that the standard quantity expected  to be used, times the standard price. Let's start  

with this calculation here. Actual quantity  used times the standard price. We are given that we  

used 399,000 pounds of materials in production,  and our standard price as I mentioned before is  

$1 per pound. So that total becomes $399,000 now  we go to the far right. So we are over here, and  

we want to know by the way this is our flexible  budget, I indicate that here, this is the flexible  

budget. We want to know what the flexible budget  amount is. So to find that we take the standard  

quantity allowed given actual production, that is  an important statement. Standard quantity allowed  

given actual production. So please take a look  at that footnote down below to see where that  

420,000 pounds comes from. I'll say it quickly  here. It is the standard of 2 pounds per unit,  

times actual units produced of 210,000. And so that  equates to 420,000 pounds and  

that I can tell you right now is where students  often go astray. So take a close look at that  

footnote. And then multiply that simply by the  standard price per pound which was already  

mentioned, is $1 pound. And that gives  us a flexible budget amount of $420,000. So now  

we take the 420,000, the difference between the 399,000  down here and the 420,000 up here, and that gives  

us a favorable materials quantity variance. So  let's take a look at why it's favorable. Well  

we actually used 399,000 pounds and we expected  to use 420,000 pounds. So that is good news. We  

used less than we expected to use and therefore  we have a favorable materials quantity variance.  

And I described on a previous slide why that  is in brackets when it's favorable and why it's  

not in brackets when it's unfavorable. So these  are the two variances that are associated with  

direct materials. This slide describes some of  the possible causes for the variance that we saw  

in the previous slide. Remember, we on the previous  slide saw an unfavorable materials price variance  

and a favorable materials quantity variance.  So why might we have an unfavorable materials  

price variance. Now in a real-life setting we'd  go out and investigate. Let's find out, let's talk  

to the purchasing agents and find out why we  had an unfavorable materials price  

variance. I am simply providing some possible  causes here, but we would want to investigate  

to find out assuming that it's a significant  enough dollar amount, we want to investigate  

why we have that unfavorable price variance. So  there are many different potential causes of  

this unfavorable materials price variance. I'm  just going to go through a couple of these and  

you can read through all of these on your own and  get a better sense. But the first two, I'll  

go through the first two. Maybe we had high demand  for materials in the industry as a whole and that  

caused our suppliers to raise prices, just a  simple supply and demand issue and there's  

more demand than supply and prices went up. Or  perhaps a key supplier of those materials shut  

down and now we have shortages and again that  will drive higher prices. You can take a look at  

the other two as well. Then moving over here to the  favorable, not unfavorable, favorable materials quantity  

variance why might that have happened. Well we had  perhaps higher quality materials that reduced the  

waste and the spoilage that we typically incur.  Maybe we have an employee training program and  

that program resulted in more efficient use of  materials and much less waste. So just to give  

you two examples. But again we want to go out  and investigate why those variances occurred.  

And then the most important part of this is  take action accordingly. And maybe we  

would continue training because we really saw  some benefits to that. Maybe we would go  

look for some other suppliers to try to prevent  that unfavorable materials price variance from  

occurring in the future. So that is where the real  value comes out when we perform variance analysis.