Understanding Variance analysis
The primary objective of variance analysis is to exercise cost control and cost reduction. Under standard costing system, the management by exception principle is applied through variance analysis. The variances are related to efficiency. The showing of efficiency leads to favorable variance. In this case, the responsible persons are rewarded. On the other hand, the showing of in efficiency leads to unfavorable variance. In this case, the responsible persons are enquired and find the root causes for such unfavorable variances. This type of findings are used for taking remedial action.
Meaning of Variance
A variance is the deviation of actual from standard or is the difference between actual and standard.
Definition of Variance analysis
“Variance analysis is the resolution into constituent parts and explanation of variances”.
“Variance analysis is the measurement of variances, location of their root causes, measuring their effect and their disposition”.
Thus, variance analysis can be defined as the segregation of total cost variances into different elements in such a way as to indicate or locate clearly the cause for such variances and persons held responsible for them.
Types of Variances
There is a need of knowing types of variances before measuring the variances. Generally, the variances are classified on the following basis.
A brief explanation of the above mentioned variances are presented below
1. Material Cost Variance: It is the difference between actual cost of materials used and the standard cost for the actual output.
2. Labour Cost Variance: It is the difference between the actual direct wages paid and the direct labour cost allowed for the actual output to be achieved.
3. Overhead Variance: Overhead variance is the difference between the standard cost of overhead allowed for actual output (in terms of production units or labour hours) and the actual overhead cost incurred.
4. Controllable Variance: A variance is controllable whenever an individual or a department or section or division may be held responsible for that variance.
According to ICMA, London,
“Controllable cost variance is a cost variance which can be identified as primary responsibility of a specified person”.
5. Uncontrollable Variance: External factors are responsible for uncontrollable variances. The management has no power or is unable to control the external factors. Variances for which a particular person or a specific department or section or division cannot be held responsible are known as uncontrollable variances.
6. Favourable Variances: Whenever the actual costs are lower than the standard costs at per-determined level of activity, such variances termed as favorable variances. The management is concentrating to get actual results at costs lower than the standard costs. It shows the efficiency of business operation.
7. Unfavorable Variances: Whenever the actual costs are more than the standard costs at predetermined level of activity, such variances termed as unfavorable variances. These variances indicate the inefficiency of business operation and need deeper analysis of these variances.
8. Basic Variances: Basic variances are those variances which arise on account of monetary rates (i.e. price of raw materials or labour rate) and also on account of non-monetary factors (such as physical units in quantity or time). Basic variances due to monetary factors are material price variance, labour rate variance and expenditure variance. Similarly, basic variance due to non-monetary factors are material quantity variance, labour efficiency variance and volume variance.
9. Sub Variance: Basic variances arising due to non-monetary factors are further analyzed and classified into sub-variances taking into account the factors responsible for them. Such sub variances are material usage variance and material mix variance of material quantity variance. Likewise, labour efficiency variance is subdivided into labour mix variance and labour yield variance. At the same time, variable overhead variance is sub-divided into variable overhead efficiency variance and variable overhead expenditure variance.
Advantages of Variance analysis
The following are the merits of variance analysis.
1. The reasons for the overall variances can be easily find out for taking remedial action.
2. The sub-division of variance analysis discloses the relationship prevailing between different variances.
3. It is highly useful for fixing responsibility of an individual or department or section for each variance separately.
4. It highlights all inefficient performances and the extent of inefficiency.
5. It is used for cost control.
6. The top management can follow the principle of management by exception. Only unfavorable variances are reporting to management.
7. Sometimes, the variances can be classified as controllable and uncontrollable variances. In this case, controllable variances are taken into consideration for further action.
8. Profit planning work can be properly carried on by the top management.
9. The results of managerial action can be a cost reduction.
10. It creates cost consciousness in the minds of the every employee of business organization.