Making Variance Analysis More Meaningful

To make variance analysis a useful aid to management is the main objective of variance calculations. But this can only be done if we investigate the variances and the data used to calculate them. Typical questions that could be asked include:

  1. Is there any relationship between the vacancies e.g. did we report an unfavourable material usage variance because we reported a favourable material price variance as a result of purchasing low quality materials?
  1. Can further information than merely the variance be provided by the management as to what could have resulted in the variance? E.g. did the budget use an unrealistic overhead absorption rate leading to capacity and efficiency variances?
  1. Is the variance significant and worth reporting? (Materiality). It is no point concentrating on very small variances. Normally the management sets a significance level of variances e.g. variances are only investigated only if they beyond 20% of the expected value. Thus, a variance of between 1% and 19% would not be investigated.
  1. Are the variances being reported quickly enough, to the right people, in sufficient or too much detail, with explanatory notes and is follow-up done to ensure correction of the situations leading to variances occurring?

What Causes Overhead Variances?

Overhead variances arise mainly due to the conventions of the overheads absorption process. The overhead absorption rates utilized in this process are calculated form two main estimates:

  1. Estimates of expenditure levels.
  2. Estimates of the activity levels during the budget period.

Since the two elements are mere estimates, they hardly coincide with reality, and therefore will almost certainly cause a favourable or unfavourable variance in any given accounting period.

Overhead variances are also caused by efficiency variations. Because overheads are frequently absorbed into production by means of labour hours, overhead variances arise when labour efficiency is greater or less than planned.

How are Overhead Variances Useful for Control Purposes?

Overhead variances are essentially a book balancing exercising providing an arithmetic reconciliation between the standard costs and actual costs. Apart form the expenditure variance, the calculation of the other overhead variances provides little real control information, since they are related more to the conventions of overhead absorption than to the organization’s operational reality.

However, the information used in calculating the efficiency and volume variances, (i.e. the budgeted labour hours, the actual labour hours and the standard labour hours), can be used to calculate various ratios which provide clear information on important aspects of the firm’s operations.

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