Direct Costs in Standard Costing

4.1. Price variances

There are two types of price variances: direct materials price variance and direct labor price variance. The calculation of both variances applies the same type of logic: the difference between an actual and standard price is multiplied by an actual quantity of input. In the case of direct materials, the actual quantity of input represents the actual quantity of purchased materials, and in the case of direct labor, actual quantity equals the actual hours used.

Direct materials price variance (MPV) is the difference between the actual quantity purchased at the actual price and the actual quantity purchased at the standard price.

Its formula is provided below:

Direct Materials Price Variance
=
(Actual Price Standard Price)
x
Quantity Purchased

MPV = (AP SP) x AQ

Where MPV = Materials price variance; AP = Actual price; SP = Standard price; and AQ = Actual quantity.

Direct materials price variance is usually calculated at the time direct materials are purchased. It is important to note that companies using standard costing record direct materials in the raw materials inventory account at a standard price rather than at an actual one. This reduces bookkeeping complexity because there is no need to keep track of all different actual prices paid for direct materials. At the point of purchase, management has to calculate the direct materials price variance and record it in the books.

To illustrate an example, let's assume XLCoutureDresses Inc. manufactures evening dresses. The company usually pays $100 per yard of embroidered silk fabric. In March 20X0, the company purchased 200 yards of embroidered silk fabric for $95 a yard, and in April 20X0, it bought 60 yards of the same fabric for $110 a yard.

In March 20X0, the materials price variance was calculated as follows: MPV = ($95 - $100) x 200 yards = ($1,000). This is a favorable variance because the company paid $5 dollars less per each yard of the purchased fabric. Also, we can see that the $1,000 value has a negative sign, which in this case also indicates a favorable variance. We can abbreviate whether a variance is favorable or unfavorable by writing the letter "F" or "U" next to the dollar amount of a variance, accordingly. For instance, in this case we have the materials price variance of $1,000 F.

Let's continue our example. In April 20X0, the company had the following direct materials price variance: MPV = ($110 100) x 60 yards = $600 or $600 U. This is an unfavorable variance because the company paid $10 more than normal per each yard of the fabric. In addition, in this case, the positive sign of the dollar amount indicates an unfavorable variance. Note that positive and negative signs don't always indicate favorable and unfavorable variances, accordingly. The indication depends on the application of formulas: (Actual Price Standard Price) or (Standard Price Actual Price) will have the same absolute values, but different signs. Thus, be sure to carefully interpret each variance.

In April 20X0, the company made the following journal entry (journal entry for March 20X0 is omitted):

Account Titles

Debit

Credit

Raw Materials (60 yards x $100 per yard)

6,000

 

Direct Materials Price Variance

600

 

      Accounts Payable (60 yards x $110 per yard)

 

6,600

As stated earlier, direct materials are recorded in the raw materials inventory account at a standard price (in this case, the standard price is $100 per yard), while accounts payable are recorded at actual price (in this case, the actual price is $110 per yard). The difference is recorded as direct materials price variance: Dr Unfavorable Materials Price Variance and Cr Favorable Materials Price Variance.

Direct labor price variance (LPV) compares the actual price and standard price of direct labor, multiplied by the number of actual hours used in production.

Its formula is provided below:

Direct Labor Price Variance
=
(Actual Price Standard Price)
x
Actual Hours Used

LPV = (AP SP) x AQ

Where LPV = Labor price variance; AP = Actual price; SP = Standard price; and AQ = Actual quantity.

Standard and actual prices are sometimes called standard and actual rates. They are expressed in dollars per labor hour.

To illustrate an example, let's go back to our imaginary company XLCoutureDresses Inc., a manufacturer of evening dresses. The company's standard labor rate is $10 per hour. In April 20X0, the company paid $11 per hour for 100 hours of work. In this case, the direct labor price variance is calculated as follows: LPV = ($11 - $10) x 100 hours = $100 or $100 U. The direct labor price variance is unfavorable because the company paid $1 more than the standard rate.

In April 20X0, the company made the following journal entry:

Account Titles

Debit

Credit

Work-in-process Inventory (100 hours x $10 per hour)

1,000

 

Direct Labor Price Variance

100

 

      Wages Payable (100 hours x $11 per hour)

 

1,100

Note that we purposely omitted March 20X0 in this example of labor price variances discussion.

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