Variance Analysis

19 May No Comments

Variance analysis is used as a tool to evaluate performance. Consider your professional experiences as well as your review of the Required and/or Optional Resources and determine what type of variances might be the most alarming to see. If cost variance is high, is that an indication of a priority for a firm? Provide an instance in which favorable variances are just as important to understand as unfavorable variances. What type of inventory control considerations do you think are occurring with the use of variance analysis?

In budgeting or managerial accounting, a variance is the difference between a budgeted, planned or standard cost and actual amount incurred/sold. Variances are computed for both costs and revenues. Concept of variance is intrinsically connected with planned and actual results and effects of the difference between those two on the performance of the entity/company.

Variances are divided according to their effect or nature of underlying amounts. When effect of variance is concerned, there are two types of variances:

1) When actual results are better than expected results given variance is described as favourable variance. In common use, favourable variance is denoted by letter F- usually in parentheses (F).

2) When actual results are worse than expected results given variance is described as adverse variance or unfavourable variance. In common use, adverse variance is denoted by letter U or letter A-.

Second typology (based on nature of underlying amount) is determined by needs of users of variance information and may include:

Variable cost variances:

Direct material variances

Direct labour variances

Variable production overhead variances

Fixed production overhead variances

Sales variances

Variance analysis, in budgeting or management accounting, is a tool of budgetary control by evaluation of performance by means of variances between budgeted amount, planned amount or standard amount and actual amount incurred/sold. Variance analysis is carried out for both costs and revenues.

Variance analysis is associated with explaining the difference (or variance) between actual costs and standard costs allowed for the good output. For example, difference in materials costs can be divided into a materials price variance and a materials usage variance. Difference between actial direct labour costs and standard direct labour costs can be divided into a rate variance and an efficiency variance. Difference in manufacturing overhead can be divided into spending, efficiency and volume variances. Mix and yield variances can also be calculated. Variance analysis helps management to understand present costs and then to control future costs.

Variance analysis is also used to explain difference between actual sales dollars and budgeted sales dollars. Examples include sales price variance, sales quantity variance and sales mix variance. A difference in relative proportion of sales can account for some of the difference in a company’s profits.

If one finds out early enough that the project schedule is slipping or costs are blowing beyond the budget, one can take corrective action to bring project back on track. Many of the objectives boil down to how long will it take and how much will it cost. So, project managers keep an eye on how actual project cost and schedule compare to associated plan. Differences between actual and planned values are called variances. Variance values which would doom one project may barely ripple the surface of a gargantuan effort. Take time out during project planning to decide how much variance the project can handle. By setting thresholds for cost and schedule variances, one can know when to take corrective action.

By the time stakeholders sign off on a project plan, one has a complete picture of project performance. From estimated work, duration and costs of individual tasks to budget and proposed schedule for entire project, baseline values are the standard against which one compares actual performance. But, as soon as one begins to execute project plan, actual values start rolling in and reality is rarely same as baseline all envisioned. Cost and schedule variances help to determine if tasks or the entire project are over budget or behind schedule.

If a variance value is positive, scheduled value is greater than baseline value and the project is either over budget or behind schedule. Negative variances represent an under-budget or ahead-of-schedule situation. Variances of zero or less are good; those greater than zero may cause concern.

Variance values which spell trouble not only vary from project to project but also from task to task. Each project is unique and achieves different objectives. Business objectives like time to market, a strict budget or scarce resources can lead to different thresholds for cost and schedule variances. Discuss priority for project objectives to determine variance thresholds.

If cost variance is high, is that an indication of a priority for a firm?

A cost variance is the difference between a cost’s actual amount and its budgeted or planned output. For example, if a company had actual repairs expense of $950 for May but budgeted amount was $800, the company had a cost variance of $150. Since actual cost was more than budgeted amount, cost variance is said to be unfavourable. When an actual cost is less than budgeted amount, cost variance is said to be favourable.

Cost variances are a key part of standard costing system used by many manufacturers. In such a system, cost variances explain difference between1) standard, predetermined and expected costs of good output and 2) actual manufacturing costs incurred. These cost variances send an early signal to management that company is experiencing actual costs which are different from company’s plan. Standard costing systems will report a minimum of two cost variances for each of following manufacturing costs: direct materials, direct labour and manufacturing overhead.

Standard costing is an important subtopic of cost accounting. Standard costs are associated with a manufacturing company’s costs of direct material, direct labour and manufacturing overhead. Rather than assigning actual costs of direct material, direct labour and manufacturing overhead to a product, many manufacturers assign expected or standard cost. This means that a manufacturer’s inventories and cost of goods sold will begin with amounts reflecting standard costs, not actual costs, of a product. Manufacturers still have to pay actual costs. As a result, there are always differences between actual costs and standard costs and those differences are called variances. Standard costing and related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard costs.

If actual costs are greater than standard costs, variance is unfavourable. An unfavourable variance tells management that if everything else stays constant the company’s actual profit will be less than planned.

If actual costs are less than standard costs, variance is favourable. A favourable variance tells management that if everything else stays constant the actual profit is likely to exceed planned profit.

Sooner the accounting system reports a variance, sooner that management can direct its attention to difference from planned amounts.

If we assume that a company uses perpetual inventory system and that it carries all of its inventory accounts at standard cost, then standard cost of a finished product is the sum of standard costs of the inputs. Usually there will be two variances computed for each input:

Input for Product Variance #1 Variance #2

————————- ——————- ——————-

Direct material Price (or cost) Usage (or quantity)

Direct labour Rate (or cost) Efficiency (or quantity)

Manufacturing overhead-variable Spending Efficiency

Manufacturing overhead-fixed Budget Volume

Cost variance (CV) is a very important factor to measure project performance. It indicates how much over or under budget the project is.

Cost Variance can be calculated using the following formula:

Cost Variance (CV) = Earned Value (EV) – Actual Cost (AC)

OR

Cost Variance (CV) = BCWP- ACWP

Formula mentioned above gives the variance in terms of cost that will indicate how less or more cost has been used to complete the work as of date.

Positive Cost Variance indicates that project is under budget.

Negative Cost Variance indicates that project is over budget.

Cost Variance %

Cost Variance % indicates how much over or under budget the project is in terms of percentage.

Cost Variance % can be calculated using following formula:

CV % = Cost Variance (CV) / Earned Value (EV)

OR

CV % =CV / BCWP

Formula mentioned above gives the variance in terms of percentage which will indicate how much less or more money has been used to complete work as planned in terms of percentage.

Positive Variance % indicates % under Budget

Negative Variance % indicates % over Budget.

Cost Performance Indicator (CPI):
Cost Performance Indicator is an index showing efficiency of utilization of resources on the project. Cost Performance Indicator can be calculated using the formula:

CPI = Earned Value (EV) / Actual Cost (AC)

OR

CPI = BCWP / ACWP

The formula mentioned above gives efficiency of utilization of resources allocated to the project.

CPI value above 1 indicates efficiency in utilizing resources allocated to the project is good.

CPI value below 1 indicates efficiency in utilizing resources allocated to the project is not good.

To Complete Cost Performance Indicator (TCPI):

To Complete Cost Performance Indicator is an index showing efficiency at which resources on the project must be utilized for remainder of the project. This is calculated using the formula:

TCPI = (Total Budget –EV) / (Total Budget –AC)

OR

TCPI = (Total Budget BCWPEV) / (Total Budget –ACWP)

The formula mentioned above gives the efficiency at which the project team should be utilized for the remainder of the project.

TCPI value above 1 indicates utilization of project team for remainder of the project can be stringent.

TCPI value below 1 indicates utilization of project team for remainder of the project should be lenient.

Cost Variances may be either positive or negative figures. Negative figures happen if you spend more on a project than you are allowed in your budget. Positive figures result if you spend less on a project than the budget predicted. Negative cost variance figures are a bad thing for a business as companies cannot always guarantee that they can come up with funds to cover excess cost. However, positive cost variances are not always good for a company, either. For instance, if you come out in the black on your project budget by sacrificing customer service or quality parts, you may not sell as many of products or may lose clients. One must examine any cost variance figures one gets in context of the business to determine true impact those numbers will have.

Regardless of whether variance is positive or negative, it means one of these two things: First is that, due to insufficient or inappropriate data or human error, you over-estimated or under-estimated expenses. Second possibility is that events arose which altered costs, like a supplier being unable to come through on your order and necessitating expedition of materials from another, more expensive supplier. Sometimes, these events are preventable, in which case, risk management strategies can help but this is not always the case because it is difficult to foresee every possible or scenario that could play out.

Cost variance allows you to monitor financial progression of whatever it is you are doing in your business. When cost variances are low, you know that you have controlled risks well. You also know that you have retrieved and analyzed data related to operations sufficiently. Actual costs should match what you budgeted and your cost variance should be zero but in practice, this is difficult to achieve.

If a board requires less than the budgeted amount of activity, the variance is described as favourable. Terms favourable and unfavourable can be thought of in terms of variance’s effect on net income. If a variance is favourable, variance will have positive effect on net income. If unfavourable, variance will decrease net income.

Variances exist for primarily three different causes:

1. Budget may have errors in its creation. This can be due to math computations, relying on wrong data, failing to consider inflation, etc.

2. Conditions may have changed. Economic conditions impact consumer demand, cost of materials, competitive pricing of goods, etc.

3. Manager’s job performance may have been very good or very bad. Favourable variances may not always indicate ‘good’ situations.

The ‘management by exception’ approach requires that only budget variances which are ‘material’ in amount are investigated. Material is a term which means number is large enough to impact someone’s decision. Both favourable and unfavourable variances are investigated if they exceed materiality ‘threshold’. The threshold is measured in dollars as a percentage of budgeted cost. For instance, assume a budgeted cost of $50,000 for labour with a materiality threshold of 1%. The 1% indicates level for which all variances exceeding that amount must be investigated. Company using this threshold would investigate all favourable and unfavourable variances which exceed $500. Amount used will vary by company. Companies determine the cause of the variance so that it can be fixed if needed.

Provide an instance in which favourable variances are just as important to understand as unfavourable variances.

Mike manages a production facility for his business. Under him are the following departments: purchasing, production, warehousing and shipping, maintenance and security. Mike gets a bonus each year, depending on how well he manages production facility. He also has authority to give bonuses to employees working under him when they meet or exceed performance goals.

Mike and his management team use a standard cost system. They determined the possible quantities and cost components of their products under normal conditions. Costs are divided into following categories: Direct Materials, Direct Labour and Factory Overhead. The factory incurs no Selling or general and administrative expenses. All their costs relate to producing products.

A product’s standard cost is what it should cost to make the product. At start of each month, a production budget is prepared, using standard costs and estimated production quantities. At end of each month, a variance report is prepared to compare production budget with actual quantities and costs of production.

Variance report tells Mike and his managers how well they did at achieving their budgeting goals. A favourable variance shows that actual costs are less than budgeted costs. An unfavourable variance is just the opposite – actual costs are greater than budgeted costs.

By using a budget, management team can estimate their future costs and cash needs, plan production, schedule employees, co-ordinate materials purchases, reduce waste, increase production efficiency and meet shipping deadlines. Variances help managers identify specific areas where they came in over or under budget. They will try to repeat their successes and eliminate their failures. Each month, they hope to become a little more efficient.

Budgets will be used to evaluate Mike and his managers. Their annual bonuses will depend on how well they meet budget goals. Managers who produce unfavourable variances will be replaced. Suppose few questions were asked from them by using relevant variances. How well did managers do:

Buying and using materials to make products?

Scheduling employee time and motivating them to be efficient?

Controlling factory overhead costs?

Variances:

1. Total Materials Variance

a. Materials Price Variance

b. Materials Quantity Variance

2. Total Labour Variance

a. Labour Rate Variance

b. Labour Efficiency Variance

3. Variable Overhead Variance

4. Fixed Overhead Variance

Variances and Standard Costs are entered into accounting records using journal entries. Use of standard costing systems simplify accounting procedures. Standard Costs are entered weekly/monthly. Variances are calculated and entered. Monthly production and income reports are prepared. Managers use current information to prepare budgets for coming months.

Actual Costs <-difference = variance-> Standard Costs

$1200 <-$50 favourable variance-> $1250

Actual costs are less than standard =favourable variance.

By breaking total variance down into its component parts, managers can pinpoint cause of variance. Sometimes, a favourable variance in one area causes an unfavourable variance in another area. For example, there may be a favourable materials price variance because lower cost materials were purchased. If materials were from an inferior grade, there could be increase in waste, giving rise to an unfavourable materials quantity variance. More labour could be required to handle and deal with inferior materials, giving rise to an unfavourable labour efficiency variance. Small total variance shows large favourable and unfavourable variances offsetting each other which is not a sign of effective management.

—————————————————————————————————————————————

Quantity Variance $1000 favourable

Price Variance 950 unfavourable

Total Variance $50 favourable

Variances can arise for a large number of reasons:

Errors in estimating

Mis-management of resources

Unforeseen price changes

Equipment breakdown

Labour problems

Poor planning

Shortage of raw materials

Budgeting and Variance accounting presume that managers must fix problems, not bury or hide them. It also presumes that these problems are short term problems and can be effectively controlled in the future. Sometimes, there is a change in actual costs which necessitates a change in standard costs. For example, a new labour contract could increase total labour costs by predictable amount. Standard labour costs must be re-calculated to reflect new actual labour costs. Once new standard cost is calculated, future variances will be correctly reflected in monthly variance report. If standard costs are not updated, monthly reports may show unrealistic favourable or unfavourable variances.

Purpose of variances and budgeting is to give management an effective tool for controlling costs. But system must be reviewed and kept up to date. This is important as standard costs and variances are entered into books as journal entries, so they must be based on reliable underlying assumptions. These assumptions must pass critical eye of company’s certified auditors, so they must be current and accurate.

What type of inventory control considerations do you think are occurring with the use of variance analysis?

Inventory management is pivotal in efficient organization. It is also vital in control of materials and goods which have to be held for later use in case of production or later exchange activities in case of services. Principal goal of Inventory management involves having to balance conflicting economies of not wanting to hold too much stock, thereby, having to tie up capital so as to guide against incurring of costs like storage, spoilage, pilferage and absolescence and desire to make items available when and where required so as to avert cost of not meeting such requirement.

Inventory management has become highly developed to meet rising challenges in most corporate entities and this is in response to the fact that inventory is an asset of distinct feature. A company’s inventory management situation will attain a greater height if, firstly, emphasis is placed on economic order quantity model since it is seen to be in best interest of manufacturing companies to maintain an optimal level of materials in store, level that minimizes total cost of investment in inventory. To achieve this successfully, different costs, that are associated with inventory, must be segregated and accumulated in a way that EOQ can be easily determined.

Secondly, there is a positive relationship between inventory and sales and between inventory & production cost. It shows that inventory levels can be a useful indication of what level of sales to expect. It is recommended that sales and marketing department of the company must pay more attention to growth pattern of inventory usage and incorporate it in sales forecasting technique.

Finally, materials management unit should also pay attention to sales growth over years and take into consideration, apparent relevance of sales and production cost in making decision with regards to inventory.

For a manufacturing company, inventory may consist of raw materials, work in process and finished goods. Raw materials are components that are processed into a final product. Work in process consists of goods that are under production. Finished goods are completed units awaiting sale to customers. Each category requires special consideration and control.

Failure to properly manage any category of inventory can be disastrous. Overstocking raw materials or overproduction of finished goods will increase costs and obsolescence. Out-of-stock situations for raw materials will silence production line. Failure to have goods on hand may result in lost sales. Just-in-time inventory management and EOQ (economic order quantity) are popular techniques.

Techniques must be utilized to capture cost of quality or cost of a lack of quality. Finished goods that do not function as promised cause warranty costs including rework, shipping and scrap. There is an extreme long-run cost associated with a lack of customer satisfaction.

When inventory is purchased, it constitutes an asset on balance sheet. This inventory remains an asset until goods are sold, at which point inventory is gone and cost of inventory is transferred to cost of goods sold on income statement. By analogy, a manufacturer pours money into direct materials, direct labour and manufacturing overhead. Business managers must rely on systematic monitoring tools to maintain awareness of where business is headed. Managerial accounting provides monitoring tools and establishes a logical basis for making adjustments to business operations.

Economic order quantity is the order quantity which minimizes total inventory holding costs and ordering costs.

One must determine optimal number of units to order so that total cost associated with purchase, delivery and storage of product. Required parameters to the solution are total demand for the year, purchase cost for each item, fixed cost to place order and storage cost for each item per year.

Underlying assumptions are:

Ordering cost is constant.

Rate of demand is known and spread evenly throughout the year.

Lead time is fixed.

Purchase price of item is constant.

Replenishment is made instantaneously; whole batch is delivered at once.

Only one product is involved.

Q = order quantity, Q* = optimal order quantity, D = annual demand quantity, S = fixed cost per order, H = annual holding cost per unit.

Single-item EOQ formula finds minimum point of following cost function:

TC =PD + DS/Q + HQ/2

Total Cost = purchase cost + ordering cost + holding cost

To determine minimum point of total cost curve, partially differentiate total cost with respect to Q and set to 0:

0 = -DS/Q^2 + H/2

Solving for Q gives Q*:

Q* =

When ordering inventory, two of the biggest issues are quality and cost. When all else are equal, choosing one supplier over another comes down to which supplier offers best price break for largest order. Buy stock eventually runs low and negotiations begin again. Multiply that by number of supplies you use and picture how much time purchasing agents spend trying to cut better deals. Just-in-Time inventory management is designed to help streamline the operation, ensure consistent quality and reduce on-site inventory.

JIT is an inventory management system based on placing smaller, more frequent, inventory orders. JIT can quickly reveal areas which need improvement, improve efficiency and productivity, free up additional workplace and free up working capital.

Switching between suppliers to secure lowest price is fine when you have extra storage and won’t suffer if order is a day or two late. Problem is, when faced with overlapping deadlines, suppliers have to put their best customers first, so if you are a first-time customer, you could get caught short.

Hence, JIT relies on long-term contracts with reliable suppliers, ordering several parts from same supplier, even if parts may be cheaper through other vendor. By working closely with suppliers, they are in tun with your immediate needs and can provide smaller, frequent shipments designed to meet your current requirements. This collaboration results in:

Consolidation of efforts on part of supplier

Long-term contracts securing lowest prices possible

Freeing up purchasing-and-receiving employees to work on other things.

For JIT to work, you need to have reliable suppliers who provide consistent-quality products, with warehouses close enough to your location to make speedy deliveries.Cutting-edge automated equipment and high-tech inventory management systems are making JIT easier to implement.




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