Variance analysis is concerned with comparing performance against the short-term business targets. Short term performance is very important as it contributes to the business strategic long-term objectives.
We know that forecasting and budgeting should set realistic expectations, but we can also expect that differences will arise between the planned and actual performance. Budgetary systems should ensure that information is regularly communicated and evaluated by key decision makers in the organisation. They should provide a fast reporting of performance, quick response and remedial actions as well as timely revision of forecasts.
Standard costing
Standard costing allows to determine costing estimates. A standard cost is the planned unit of costs of products, components or services produced in a period. It is used to measure business performance, control processes, valuate the inventory and establishment of selling prices.
Standards of performance may be set on different basis:
* estimate of the expected performance,
* estimate of attainable performance,
* estimate level of performance by the same organisation,
* level of performance achievable by comparable organisations,
* level of performance to meet organisational objectives.
Standards may be set assuming efficient level of operation but including allowances for normal loss, waste and machine downtime or at ideal level which assume no allowance for losses.
Standard product specification costs
A standard product specification is a statement containing a full breakdown of the cost elements which are included in a standard cost of a product or service. For each cost element (direct labour, materials and overheads) a standard unit input costs are shown as well as standard cost per unit of output produced.
A bill of material is a detailed specification for each product produced of the sub-assemblies, components and materials required, distinguished between those which are purchased externally and those which are purchased in house. Having established the quality and materials specifications, the purchasing department estimates costs based on supplier prices, inflation, availability of bulk-discounts to establish direct material unit costs.
The standard direct labour cost is the planned average cost of direct labour, based on the standard time and standard performance. A standard hour is the amount of work achievable, at standard efficacy level, in one hour. A standard time for a job, is the time in which the task should be completed at standard performance.
Standard performance is the level of efficacy which employees can achieve. Time to achieve specific level of output will reduce over time as the employees are trained. This is called the learning curve effect, until it gets to the straight line. The straight line is the standard performance of activity. The standard direct labour cost is then calculated by multiplying the standard labour hour by the standard hourly rate. Direct labour rates per hour are determined with reference to the type of skill to be used, union agreements, inflation and market rates.
A typical standard cost is presented in figure below:
Source: Davies, T. 2011, "Business accounting and finance"
There are several advantages of using the standard cost system:
* it is a basis for budget preparation,
* it may be used in planning and control,
* it highlights the areas of strengths and weaknesses,
* it is used for evaluation of performance by comparing actual costs with standard costs,
* it should result in the use of best resources and best methods for increasing efficacy,
* it may be used as a basis for inventory valuation,
* it may be used for determination of pay incentives,
* it can be in decision making for estimation of future costs,
* it fits with management by exception, where only significant variances are investigated, thus making an effective use of management time. It allows for immediate action.
There are also disadvantages of the standard costs:
* difficulty in establishing standard overheads rate if standard absorption costing is used as opposed to standard marginal costing,
* standard costing requires a great deal of input data which can e time consuming and expensive as the maintenance of the cost database,
* the amount of detail required including the lack of historical detail, lack of experience and training add to this administrative burden,
* standard costing is generally used in organisations where jobs are repetitive, it is important to set accurate standards, otherwise it may be meaningless,
* it is difficult to set balance in setting accurate standards so that they both motivate employees and achieve organisational goals,
* There may be difficulties in determining which variances against standards are significant.
There is a great deal of uncertainty when setting standard cost that can be influenced by inflation or economic factors. These must be continuously updated and once a year is often not enough.
Types of standards
There are three types of standards that can be used for costing systems:
* Basic standards - these generally remain unchanged, but generally these do not reflect the current situation.
* Ideal standards - these are standards expected for perfect performance in perfect conditions. They assume no waste and no inefficiencies. These may be hard to achieve and are poor motivators.
* Attainable standards - these are results expected under normal working conditions, having some allowance for wastage and inefficiencies. There should be challenging and motivational.
Flexed budgets
Budgets need to be revised in line with actual levels of activity and be realistic. The standards chosen for use in budget are also used in revised flexed budget to provide comparison. We measure the difference between the planned outputs and actual outputs and plan for actions to modify future performance. The variance analysis of budgets can be far-reaching.
If we are planning production at, for example 600 unit per month and the production costs include direct materials, direct labour, variable production overhead, fixed production overhead we come out with a total production cost, lets say: £12,600. But the actual output might of been 650 units with manufacturing cost £12,200.
This data can be used to prepared flexed budget and must be prepared for 650 unit output and a standard cost for 650 pieces (not actual output).
Then, if we have compared the performance and production costs, we would see that the performance was good as the production costs were lower. The analysis of the details variances contributing to better actual cost performance (amount of materials used, material prices, direct labour hour, direct labour rates and overheads) needed to be performed. This is called the 'analysis of detailed variances' to determine conclusions for achieved performance.
Variance analysis
Variance analysis is the difference with the planned, budgeted or standard cost and the actual cost incurred. Timely reporting should give opportunity for timely action. These variances would be either favourable or adverse. Favourable performance may inform of a poor standard. Different variances can also be misleading due to measurement errors, out of date standards or out of control operations. A decisions should be made on whether those variances should be investigated or not. Sometimes it might not be cost effective to carry out those investigations.
The simplest way to start examine differences is to present the original budget, flexed budget and the actual results in 3 different columns.
If we have achieved reduced cost, as per example above for 650 units produced, we can try and explain the cost variance against the budget. We would do the comparison against the flexed and actual budget across the costs of direct materials, direct labour, variable overhead and fixed overhead. We need to prepare it for the flexed budget as it will give us a better view of the performance. Against each actual cost we can define of whether the performance was (F) favourable or (A) adverse. We might find out that the number of units produced may fe favourable (F) as the budget was 600 items and the actual was 650. Total materials may be found favourable as well as direct labour may be found favourable and the adverse performance may be found in fixed overheads.
Majority of differences come from:
* differences in prices (price variance, rate variance, expenditure variance)
* differences in quantities (usage variance, efficacy variance)
In terms of fixed production variance the difference may come from:
* the actual cost and fixed overhead efficacy variance (the difference between actual and flexed hours and standard overheads absorption rates)
* fixed production overhead capacity variance (the difference between the actual and budgeted hours and standard overhead absorption rate). It measures the amount of which the overheads have been over- or under-absorbed caused by the actual hours worked.
The figure below presents different variances that can be measured based on the marginal costing:
Source: Davies, T. 2011, "Business accounting and finance"
We can also measure variance based on the absorption costing:
Source: Davies, T. 2011, "Business accounting and finance"
Generally, these variances would be calculated by accountants, but managers can understand them and appreciate their significance, investigate reasons and take appropriate corrective actions. Most budget holding managers would be responsible for the explanation of the variances.
Operating statements
The comparisons of the budgets and the actual performance is generally presented to managers. This can be done either on a daily, weekly or monthly basis. It is called the "operating statement" . This statement will also include information on why the differences have occurred or possible reasons for variances. Generally key variances are shown relating to:
* sales revenue - used by sales and marketing department,
* labour - used by managers and human resources,
* materials - used by purchasers with possibility of looking on new sources
* overheads - for senior management
Selling prices, recession, changes in demand, increased competition or bad operational planning can be some reasons for revenue variances.
Changed market conditions, foreign currency exchange, supplier increased prices or discounts, changes in the quality of materials, invoicing errors, improved inventory control, labour skills, production methods variances can affect material cost.
Wage rate negotiations, changes in the skills of the labour force, learning efforts, machinery level of maintenance changes changing level of quality may impact the direct labour variances.
Related direct labour variances or changes to the overhead rates may impact the variable production overheads variances.
Changes to fixed overheads may affect the variable overheads variances.
Possible reasons for variances
The list of possible reasons for variances is not exhaustive but the most common variance reasons within manufacturing are:
* direct material prices: skills of purchasing department, quality of materials, price inflation, supplier discounts, foreign currency exchange or invoicing errors,
* direct materials usage: quality of materials, labour efficacy, inventory control, quality control,
* direct labour rate: use of higher or lower skilled labour, quality of materials, efficacy of plant and machinery, learning curve performance, inaccurate time allocation during learning process,
* overhead expenditure: inflation, wastage, resource usage savings, changes in services through outsourcing,
* overhead efficacy: labour efficacy, efficacy of plant and machinery, technological changes,
* overhead capacity: idle time, over-usage or under-usage of plant capacity.
Planning and operational variances
When examining variances we generally ask the following questions:
* What did it cost and what should it have cost?
* How long it did take and how long it should have taken?
This was we can determine the reasons for actual and planned performance.
Operational variances based on flexed budgets can help with reflection of actual conditions in the reporting period and define remedial actions.
The decision models can be based on:
* percentage - which prompts investigation against percentage achieved against relating standards,
* statistical significance - investigates unusual occurences,
* statistical control charts - with warning limits and action limits.
References: Davies, T. 2011, "Business accounting and finance"
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