Variance analysis

A technique that is commonly used in monitoring and measuring performance against budget is variance analysis. A variance is the 'difference between actual and planned performance' and can be favourable or adverse.

An analysis and investigation of variances is an effective way of detecting the causes of our business trends. Effective variance analysis operates within a system of management by exception, i.e we will concentrate on those events that are significant and exceptions. We will not waste our time on sorting through a mass of figures: variations point to the root of any inefficiency.

Standard Costing and Variance Analysis

Management accountants are often heavily involved in setting budgets for an organisation. They are then involved in monitoring and reporting on actual performance, together with investigating differences between actual and budgeted performance.

Introduction and Overview

Definition: "A standard costing system is a control system established by the company's management."

At the heart of a standard costing system is the standard cost card, which fulfils a number of uses, namely;

• Planning – up to date standards make the preparation of forecasts and budgets much easier;
• Control – areas of inefficiency can be identified by comparing standards and actual results;
• Reporting – standards provide information for internal and external reporting;
• Recording – it is easier to record stock movements at standard cost.

We can also establish differing types of standard, these are:

Ideal standards

• Attainable under optimum conditions only, without allowing for human error, random fluctuations, etc.
• Should not be used for variance analysis but could be used as a long-term aim.

Basic standards

• Long-run underlying standards used as a basis to set standards for the period under review.
• Should not be used for variance analysis as variances will occur due to price level changes, fluctuating conditions, etc.

Expected standards

• Expected to apply to a specified budget period, they are based on normal operating conditions.
• Used as a basis for planning but may be inappropriate to use as targets.
• Variances may be used for routine reporting but will need further analysis before being used for performance evaluation.

Current standards

• The current attainable standards that reflect conditions applying in the period under review and determined by adjusting the expected standard.
• Should be used for performance evaluation but require complex data collection and administration.

A variance is effectively the financial difference between actual and expected outcomes, and are expressed either as adverse or favourable. An adverse variance, for example, indicates that costs and/or revenues are not as we expected, and that consequently profits will be less than planned;

Cost variances

• Adverse variances arise where actual costs exceed expectations
• Favourable variances arise where actual costs are less than expectations

Sales variances

• Adverse variances arise where actual revenue or sales volume is less than expectations
• Favourable variances arise where actual revenue or sales volume exceed expectations

Standard costing often forms the cornerstone of many budgeting systems, in which an expected cost per unit of output or service is calculated. This cost is then scaled up for the budgeted level of activity.

Once actual data are available, it becomes possible to report on differences (variances) between actual and budgeted performance.

It is worth noting that standard costing is not just about cost! It also involves setting a standard sales price from which it is then possible to calculate a standard unit profit or contribution, depending on whether absorption or marginal costing is being used.

At the heart of the standard costing system is the standard cost card. It is not particularly useful for management to know that a product is expected to cost $240 to make. An effective standard costing system should break total cost down into its individual components, this is one of the purposes of a standard cost card, and an example cost card is shown below:

There are a number of different ways that variances can be calculated; a more intuitive approach compared to a formulaic approach is to be (ideally) preferred. The following general points should be borne in mind.

Variances aim to show the financial difference between expectation (costs or revenues) and reality (actual costs and revenues). The expected costs for material, labour and variable overhead variances are based on the costs expected for the actual level of activity (the original budget is irrelevant).

Study aids

Variance Analysis: Example

General considerations and background to variances and standard cost.

Notice how each cost element has two components:

• Standard cost per unit of resource e.g. $20 per kg, $10 per hour.
• A standard rate of consumption per unit of product made e.g. 3kg per unit, 4hrs per unit.

For each cost item in a cost card it is possible to calculate three variances:

• A total cost variance – the difference between the total expected cost and the actual total cost for the number of units made.
• A price variance – arising because of differences between the standard and actual unit cost for the quantity of resources bought.
• A usage variance – arising because of differences between the actual and expected efficiency of resource use.

Variances can either be adverse or favourable.

• If a variance results in profit being lower than budgeted it is described as adverse (A)
• If a variance results in profit being higher than budgeted it is described as favourable (F)

Material Variances

Material price variance
This measures the effect on profit of paying a different price for materials to that expected, it is

• Calculated on quantity purchased if stocks are valued at standard cost; or
• Calculated on quantity used if stocks are valued on an actual basis.

Material usage variance
This measures the effect on profit of using a different quantity of materials than expected for the actual production.

The three basic materials variances are.

Total Cost
The difference between the standard material cost of actual output units and the actual material cost of the output units

Price Variance
The difference between the standard cost of materials bought and the actual cost of materials bought.

Usage Variance
The difference between the amount of materials that should have been used to make the output and the actual amount used, valued at standard cost.

Labour Variances

Labour rate variance
This measures the effect on profit of the actual labour rate/hour differing from that expected.

Labour efficiency variance
This measures the effect on profit of using a different number of hours than expected for the actual production

There are three basic labour variances:

Total Cost
The difference between the standard labour cost of actual output units and the actual labour cost of the output units.

Rate Variance
The difference between the standard cost of labour used and the actual cost of labour used.

Efficiency Variance
The difference between the amount of labour that should have been used to make the output and the actual amount used, valued at standard cost.

It is worth noting that the rate and efficiency variances, when added together, always equal the total cost variance.

Variable cost variances

The budget should always be flexed, i.e. adjusted onto a production (activity) basis that takes into account the actual volume of production (activity).

Variable overhead expenditure variance
This measures the effect on profit of the actual hourly rate differing from that expected

Variable overhead efficiency variance
This measures the effect on profit of the actual hours incurred of variable overhead differing from those expected for the actual production

There are three basic variable overhead variances:

Total Cost
The difference between the standard total variable overhead cost and the actual total variable overhead cost.

Expenditure Variance
The difference between the standard hourly overhead rate and the actual hourly rate for the hours worked.

Efficiency Variance
The difference between the amount of labour that should have been used to make the output and the actual amount used, valued at the standard variable overhead rate per hour.

It is worth noting that the expenditure and efficiency variances, when added together, always equal the total cost variance.

Fixed Overhead Variances

Fixed overhead variances are slightly more complex, as the exact variances calculated depend on the method of costing being used by a company.

Marginal Costing

If a company is using marginal costing, only an expenditure variance has to be calculated. This is the difference between budgeted total fixed cost and actual total fixed cost.

Absorption Costing

If a company is using absorption costing, two fixed overhead variances have to be calculated. The first of these is an expenditure variance, and is identical to that calculated for marginal costing. The second variance is a volume variance. This compares the expected and actual volumes of output and the effect it has on absorbed overhead.

Fixed overhead expenditure variance
This measures the effect on profit of the actual fixed costs being different to that budgeted

Fixed overhead volume variance
This measures the effect on profit of under or over absorbing fixed overhead costs because of a difference between the actual and budgeted production volume

Sales Variances

In addition to calculation of cost variances, it is also possible to calculate sales variances.

Sales variances can arise for two reasons:

• The unit sales price was different from that expected – a price variance
• The volume of sales was different to that expected – a sales volume variance

Sales price variance
This measures the effect on profit of the actual selling price differing form that budgeted

Sales volume variance
This measures the effect on profit of the sales volume differing from that budgeted

Whilst straightforward, care does have to be taken with these variances as their exact method of calculation varies according to the method of costing employed by a company.

• If marginal costing is used, volume variances are converted from units to money by multiplying by standard unit contribution.
• If absorption costing is used, volume variances are converted to money by multiplying by standard gross profit.

The price variance is identical under both marginal and absorption costing.

Operating Statements

Whilst it is useful to calculate individual variances, they have more value if they put together in an operating statement that reconciles actual and budgeted profits. This provides an at-a-glance summary of what is responsible for any differences between actual and budgeted (standard) profits.

The worked example that is contained in the Learning Zone contains an example of an operating statement.

Investigating Variances

Variances and operating statements are both useful management tools. However, they are the start rather than the end of the management control cycle.

Once a variance has been identified what should be done next?

Some companies set a tolerance level, values above and below where investigations will not occur e.g. if costs are +/- 1% of budget they are not investigated.

The cause of a particular variance may affect another variance in a corresponding or opposite way (interdependence of variance).

Some companies also have a tendency only to investigate adverse variances.

• Adverse variances reduce profit to below expectations and should be investigated
• Favourable variances increase profit and therefore do not need to be investigated

Variances only have value if they are backed up by a system of investigation. Unless the cause of a variance can be identified it is difficult for a company to take effective action to remove the variance and bring performance back in line with standard.

Causes of variances

Possible causes of the individual variances are:

• Material price variance
• Different sources of supply
• Unexpected general price increase
• Alteration in exchange rates (imported goods)
• Alteration in quantity discounts
• Substitution of a different grade of material
• Standard set at mid-year price

Material usage variance

• Higher/lower incidence of scrap alteration to product design
• Substitution of a different grade of material

Labour rate variance

• Unexpected national wage award
• Overtime/bonus payments different from plan
• Substitution of a different grade of labour

Labour efficiency variance

• Improvement in methods or working conditions
• Variations in unavoidable idle time
• Introduction of incentive scheme
• Substitution of a different grade of labour

Variable overhead variance

• Unexpected price changes for overhead items
• Labour efficiency variances, (see above)

Fixed overhead expenditure variance

• Changes in prices relating to overhead items e.g. rent increase
• Seasonal effects e.g. heat/light in winter with seasonal effects during the year

Fixed overhead volume

• Change in production volume due to change in demand or alterations to stockholding policy
• Changes in productivity of labour or machinery
• Production lost through strikes

Operating profit variance due to selling prices

• Unplanned price increase
• Unplanned price reduction e.g., to try and attract additional business

Operating profit variance due to sales volume

• Unexpected fall in demand due to recession
• Additional demand attracted by reduced prices
• Failure to satisfy demand due to production difficulties