Using Variance Analysis to Evaluate Performance
A standard cost is a predetermined cost of manufacturing, servicing, or marketing an item during a given future period. It is based on current and projected future conditions.
The norm is also dependent on quantitative and qualitative measurements. Standards may be based on engineering studies looking at time and motion.
The formulated standard must be accurate and useful for control purposes.
Variance analysis compares predetermined standard to actual performance. It could be done, by division, department, program, product, territory, or any other responsibility unit.
When more than one department is used in a production process, individual standards should be developed for each department in order to assign accountability to department managers.
Variances may be as detailed as necessary, considering the cost/benefit relationship Opens in new window.
Evaluation of variances may be done yearly, quarterly, monthly, daily, or hourly, depending on the importance of identifying a problem quickly.
Because actual figures (e.g., hours spent) are not known until the end of the period, variances can be determined only at this time.
A material variance requires notifying the person responsible and taking corrective action.
Insignificant variances need not be looked into further unless they recur repeatedly and/or reflect potential difficulty.
Generally, a variance should be investigated when the inquiry is anticipated to result in corrective action that will reduce costs by an amount of exceeding the cost of the inquiry.
When the production cycle is long, variances that are computed at the time of product completion may be too late for prompt corrective action to be taken.
In such a case, inspection may be undertaken at key points during the processing stage. This allows for spoilage, labor inefficiency, and other costs associated with problems to be recognized before product completion.
One measure of materiality is to divide the variance by the standard cost.
A variance of less than 5 percent may be deemed immaterial. A 10 percent variation may be more acceptable to a company using tight standards compared to a 5 percent variation to a company employing loose standards.
In some cases, materiality is looked at in terms of dollar amount or volume level. For example, a company may set a policy looking into any variance that exceeds $10,000 or 20,000 units, whichever is less.
Guidelines for materiality also depend on the nature of the particular element as it affects performance and decision-making. For example, where the item is critical to the future functioning of the business (e.g., critical part, promotion, repairs), limits for materiality should be such that reporting is encouraged. Further, statistical techniques can be used to ascertain the significance of cost and revenue variances.
An acceptable range of tolerance should be established for managers (e.g., percent). Even if a variance never exceeds a minimum allowable percentage or minimum dollar amount, the manger may want to bring it to upper management’s attention if the variance is consistently close to the prescribed limit each year.
This may indicate the standard is out of date and proper adjustment to current levels is mandated to improve overall profit planning. Because of the critical nature of costs, such as advertising and maintenance, materiality guidelines are more stringent.
Often the reasons for the variance are out-of-date standards or a poor budgetary process and not actual performance. By questioning the variances and trying to find answers, the manager can make the operation more efficient and less costly. It must be understood, however, that quality should be maintained.
If a variance is out of the manager’s control, follow-up action by the manager is not possible. For example, utility rates are not controllable internally.
Standards may change at different operational volume levels. Further, standards should be appraised periodically, and when they no longer realistically reflect conditions, they should be modified.
Standards may not be realistic any longer because of internal events, such as product design, or external conditions, such as management and competitive changes.
For instance, standards should be revised when prices, material specifications, product designs, labor rates, labor efficiency, and production methods change to such a degree that current standards no longer provide a useful measure of performance.
Changes in the methods or channels of distribution, or basic organizational or functional changes, would require changes in selling and administrative activities.
Significant favorable variances should also be investigated and should be taken advantage of further. Those responsible for good performance should be rewarded. Regression analysis may provide reliable association between costs and revenue.
Variances are interrelated, and hence the net effect has to be examined.
For example, a favorable price variance may arise when lower-quality materials are bought at a cheaper price, but the quantity variance will be unfavorable because of more production time to manufacture the goods due to poor material quality.
In the case of automated manufacturing facilities, standard cost information can be integrated with the computer that directs operations. Variances can then be identified and reported by the computer system and necessary adjustments made as the operation proceeds.
In appraising variances, consideration should be given to information that may have been, for whatever reason, omitted from the reports.
- Have there been changes in the production processes that have been reflected in the reports?
- Have new product lines increased setup times that necessitates changes in the standards?
Standards and variance analyses resulting from them are essential in financial analysis and decision making.
Advantages of Standards and Variances
- Aid in inventory costing
- Assist in decision making
- Sell price formulation based on what costs should be
- Aid in coordinating by having all departments focus on common goals
- Set and evaluate divisional objectives
- Allow cost control and performance evaluation by comparing actual to budgeted figures. The objective of cost control is to produce an item at the lowest possible cost according to predetermined quality standards.
- Highlight problem areas through the “management by exception” principle
- Pinpoint responsibility for undesirable performance so that corrective action may be taken. Variances in product activity (cost, quality, quantity) are typically the production manager’s responsibility. Variances in sales orders and market share are often the responsibility of the marketing manager. Variances in prices and methods of deliveries are the responsibility of purchasing personnel. Variances in profit usually relate to overall operations. Variances in return on investment relate to asset utilization.
- Motivate employees to accomplish predetermined goals
- Facilitate communication within the organization, such as between top management and supervisors
- Assist in planning by forecasting needs (e.g., cash requirements)
- Establish bid prices on contracts
Standard costing is not without some drawbacks, such as the possible biases in deriving standards and the dysfunctional effects of establishing improper norms and standards.
When a variance has multiple causes, each cause should be cited.
- Research data for this work have been adapted from the manual:
- Budgeting Basics and Beyond By Jae K. Shim, Joel G. Siegel.