This section describes how material, labour and overhead variances are calculated and what causes each of those variances. A chart is also provided to describe how the variances add up to translate to a profit variance.
In a typical organization, the planning process starts with a budget followed by actual performance. The budget will usually be based on standard costs of the desired output units. But how does a budget actual performance relate?
- Budgets are followed by performance
- Performance leads to preparation of a performance report, which compares the budgeted performance and the actual performance, and therefore determines whether there is a favourable (F) or unfavourable (U) variance. These variances are exceptions, thus the performance report (Variance report) is an exceptions report.
- Variance signals those areas that require managerial attention and these are usually areas with problems. These variances lead to investigation in those problems areas and the appropriate corrective action is determined, recommended and later on implemented.
Variance reporting concentrates on both favourable and unfavourable variances. Usually, unfavourable variances are punished on the responsible persons while favourable variances are rewarded. However, this is a rule of thumb but not always the case. Remember that an unfavourable variance might arise due to factors beyond the employee’s or manager’s control, in which case you can’t punish that person: rather, you need to explain the unfavourable variance in terms of the uncontrollable factor of alternatively adjust the standard to incorporate the changed circumstances. The same case can be argued for favourable variances.
- Variance Analysis Defined
Variance analysis can simply be defined as the process of analyzing the difference between the standard cost and the actual cost (this difference is called the variance) into its constituent parts. The causes of variances are determined and management can take appropriate measures.
- Why Perform Variance Analysis?
Variance analysis is aimed at obtaining practical pointers to the causes of off-the –standard performance so that management can improve operations, increase efficiency, utilize resources more effectively and reduce costs. For this to be achieved, the following need to be met:
- A simple standard costing system that is easily well understood by everyone in the organization.
- Fast and timely reporting of variances at the point of incidence so as to attach responsibility for favourable or unfavourable variance.
- Rapid management action to correct adverse (unfavourable) variances and encourage favourable variances.
- Utmost commitment to the process of setting standards and performance evaluation by all managers and employees.
However, not all variances are identified and acted upon. Only those types of variances, which fulfill the cost control needs of the organization and meet performance evaluation purposes of the entity are identified, calculated and acted upon. Thus, the only criterion for the calculation of a variance is its usefulness to the organization: if it is not useful for management purposed, then it should not be calculated!
- Attaching the Variance to Responsible Persons
In calculating variances, the calculations need to be detailed enough so that the responsibility for the variance can be assigned to a particular individual. This is necessary because it would be almost impossible to control costs if the responsibility for a certain variance is spread between many managers since each of them will “pass the buck” or refuse to accept personal responsibility for the variance.
For example, the material cost variance can be analyzed into usage variance and price variance. The usage variance is the responsibility of the foreman or production manager using those materials, while the price variance is the responsibility of the purchasing manger.
The above example illustrates how variance analysis is utilized to attach responsibility for cost variances to individuals. Such individuals cannot claim that they are not responsible for the variances arising. However, to be able to attach such responsibility, the costs must be controllable by the concerned individuals!
Due to tendency of budgetary control and standard costing variance analysis responsibilities to individuals, it is usually referred to as responsibility accounting. But where departments are interdependent, then responsibility accounting may not be straight forward due to inefficiencies or efficiencies brought in from other departments.
- Relationship between variances
We cannot over emphasize the central aim of variance analysis as outlined in the above paragraphs: i.e. To assign responsibility for a particular variance to a specific individual, assuming there is adequate independence between departments and the managers have full control of their departments so that they can be held fully responsible for the resulting variances.
Variance analysis subdivides the total difference between the budgeted profit and actual profit for the period into the detailed difference. This is illustrated in the figure below. Each of the managers responsible for each of the detailed variances can then he held responsible. But remember that only those variances useful for management controls are calculate.
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