Understanding Variance Analysis for Effective Cost Control
Variance analysis is a crucial tool for evaluating performance, cost control, and management by exception. It helps identify differences in costs between actual and desired performance, allowing for corrective actions to be taken. Key prerequisites include establishing accurate standards, controllable operating conditions, objective measures of performance, and assigning responsibilities. By distinguishing between controllable and uncontrollable variances, organizations can better assess their performance and make informed decisions.
- Variance analysis
- Cost control
- Performance evaluation
- Management by exception
- Controllable variances
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Variance analysis Objectives Performance evaluation Through variances, differences in costs shall be highlighted between attained performance and desired performance Also the causes and sources of the same can be dwelled upon and responsibility assigned accordingly Cost control Each element is analysed in detail to isolate the causes of variances individually Both favourable and unfavourable variances are analysed Depending upon the cause, appropriate corrective acton can be scheduled Management by exception Suitably prepared variance reports call top management s attention only to exceptional variances
Pre-requisites for a sound variance analysis system Meaningful and accurate standards Standards must be established scientifically Variance calculated from such standards show how closely actual costs correspond to costs of desired performance
Pre-requisites for a sound variance analysis system Controllable operating conditions Standards can be expected to be attained only when the operating conditions or production variables are controllable performances have to be evaluated by standards by those whose
Pre-requisites for a sound variance analysis system Objective measures of performance Objective criteria measuring both inputs and outputs must be established for
Pre-requisites for a sound variance analysis system Assignment of responsibilities Variances must responsibility centres set up in the organisation Important to distinguish between Controllable variances Uncontrollable variances be analysed w.r.t different
Pre-requisites for a sound variance analysis system Distinction between performance variance and forecast errors The degree of accuracy and precision with which standards can be established for various elements of costs may vary If individuals are held responsible for forecasting errors, it would not be appropriate
Pre-requisites for a sound variance analysis system Significance of variance must be considered Significance shall depend upon: Magnitude of variance Frequency of occurance Thus significance variance is large in amount and persistently occur over time would increase if the
Important questions At what point did the variance occur? Which cost elements were at variance with standards and by what amount? What were the underlying causes? Who were responsible for the variances?
General model for variance analysis Different variances are divided into two parts: Price variance Quantity variance This is because control decisions relating to price paid and quantity used will generally fall at different points in time and place in the organisation
General model for variance analysis TOTAL VARIANCE = STANDARD ACTUAL
General model for variance analysis TOTAL VARIANCE = STANDARD ACTUAL PRICE QUANTITY PRICE QUANTITY
General model for variance analysis TOTAL VARIANCE = (SQ * SP) (AQ * AP)
General model for variance analysis PROFIT VARIANCE Sales & Total production cost variance Sales margin variance distribution cost variance
General model for variance analysis PROFIT VARIANCE Sales & Total production cost variance Sales margin variance distribution cost variance Overhead variance Material cost variance Labour cost variance
General model for variance analysis PROFIT VARIANCE Sales & Total production cost variance Sales margin variance distribution cost variance Overhead variance Material cost variance Labour cost variance Variable overheads variance Fixed overhead variance Material price variance Material usage variance Labour rate variance Labour hours variance
Basic assumption of variance analysis Standard price (SP) is used to calculate quantity variance (also known by names usage or efficiency) Actual quantity (AQ) is used to calculate price variance (also known by name rate) Standard quantity (SQ) is always for actual output
Total production cost variances Material cost variances Labour cost variances Overhead cost variances
Material cost variances MCV = (SQ * SP) (AQ * AP)
Material cost variances MCV = (SQ * SP) (AQ * AP) This is for actual output
Material cost variances MCV MPV MUV MMV MYV
Material price variance MPV = (SP AP) * AQ
Material price variance MPV = (SP AP) * AQ MPV = (SP * AQ) (AP * AQ)
Material price variance MPV = (SP AP) * AQ MPV = (SP * AQ) (AP * AQ) Here, price is the cause of variance The difference in standard and actual price is multiplied with the actual quantity to ascertain the amount of variance
Material price variance Causes for variation in prices Non-controllable factors Controllable factors
Material price variance Causes for variation in prices Non-controllable factors Controllable factors In such cases, variance occurs due to extraneous factors like frequently changing market price or demand pattern
Material price variance Causes for variation in prices Non-controllable factors Controllable factors In such cases, variance occurs due to extraneous factors like frequently changing market price or demand pattern Such factors cannot be predicted and thus may lead to forecasting errors
Material price variance Causes for variation in prices Non-controllable factors Controllable factors In such cases, variance occurs due to extraneous factors like frequently changing market price or demand pattern Here, variance occurs on account of such factors like uneconomical purchase lots, high transportation cost, unfavorable terms with suppliers, failure to avail discount etc. Such factors cannot be predicted and thus may lead to forecasting errors
Material price variance Responsibility for material price variance
Material price variance Responsibility for material price variance Unfavourable Favourable
Material price variance Responsibility for material price variance Unfavourable Favourable May be caused due to failure of other departments Generally that of the purchase manager May be caused due to extraneous factors
Material price variance Responsibility for material price variance Unfavourable Favourable May be caused due to failure of other departments Generally that of the purchase manager May be caused due to extraneous factors Indicative of inefficiency of purchase function
Material price variance Responsibility for material price variance Unfavourable Favourable May be caused due to failure of other departments Generally that of the purchase manager May be caused due to extraneous factors Indicative of inefficiency of purchase function Purchase manager not to be held accountable
Material price variance Responsibility for material price variance Unfavourable Favourable May be caused due to failure of other departments Generally that of the purchase manager May be caused due to extraneous factors Example sudden rush orders, unexpected change in production schedule etc. Indicative of inefficiency of purchase function Purchase manager not to be held accountable
Material price variance Responsibility for material price variance Unfavourable Favourable May be caused due to failure of other departments May not always be indicative of purchase department s efficiency Generally that of the purchase manager May be caused due to extraneous factors Example sudden rush orders, unexpected change in production schedule etc. Indicative of inefficiency of purchase function Purchase manager not to be held accountable May be due to use of sub standard material
Material usage variance MUV = (SQ AQ) SP
Material usage variance MUV = (SQ AQ) SP MUV = (SQ * SP) (AQ * SP)
Material usage variance MUV = (SQ AQ) SP MUV = (SQ * SP) (AQ * SP) USAGE is the cause for variance
Material usage variance Causes for variation in usage: Would be basically controllable as uncontrollable factors would already be accounted for while setting up standards Examples: mishandling of materials, abnormal wastage, using sub standard material, untrained workers, non standardization of production methods, obsolete machinery etc.
Material usage variance Responsibility for variance: Basically that of the production department
Relationship between MPV and MUV Example 1: Suppose SQ = 50 units, SP = Rs 4.50, AQ = 40 units, AP = Rs 5 Here, MPV = (4.5 5) * 40 = Rs 20 (Adverse) MUV = (50 40) * 4.5 = Rs 45 (Favourable)
Relationship between MPV and MUV AP = 5 SP = 4.5 AQ = 40 SQ = 50
Relationship between MPV and MUV AP = 5 SP = 4.5 QUANTITY VARIANCE AQ = 40 SQ = 50
Relationship between MPV and MUV PRICE VARIANCE AP = 5 SP = 4.5 QUANTITY VARIANCE AQ = 40 SQ = 50
Relationship between MPV and MUV Example 2: Suppose SQ = 50, SP = Rs 4.5, AQ = 55, AP = Rs 5 Here, MPV = (4.5 5) * 55 = - Rs 27.5 (Adverse) MUV = (50 55) * 4.5 = - Rs 22.5 (Adverse)
Relationship between MPV and MUV AP = 5 SP = 4.5 SQ = 50 AQ = 55
Relationship between MPV and MUV Pure price variance Joint price usage variance AP = 5 SP = 4.5 MUV SQ = 50 AQ = 55
Material mix and yield variance Pre-requisites for sub division of MUV into MMV & MYV: Material may be combined in various ways to produce a product without much affecting its quality Thus in order to arrive at an appropriate mix, costs of substitutable materials may have to be considered Specifications are set for mixing different kinds of materials to manufacture the product A change in material mix may have an impact on the yield of the finished product
Material mix and yield variance Material mix variance (MMV): May arise when a different blend of material is used than what is initially specified in form of standards Material yield variance (MYV): Would occur if the output or yield obtained from the mix is different from what is expected in standard terms
