MANAGEMENT ACCOUNTINGS - VARIANCE ANALYSIS I

This is second part of Management Accounting - Variance Analysis. In the previous chapter, theoretical background was discussed and a case-study  was introduced.

In this hub, calculation of various variances would be shown. Also some relevant topics would be covered like favorable and adverse variances, random and systematic variances and how to decided which variance is a serious one and what safeguards should be taken.

A TASTE OF CALCULATION OF VARIANCE

A video presentation would explain the way how "Material Price and Usage Variances" are calculated. This is a very simple example and one can find out difference without using the suggested sketches or formula. Please go through the video presentation before proceeding ahead.

If it is difficult to understand the various calculations, it is strongly advised to read the relevant chapters in the textbook relating to budgets, comparison between actual and estimate and passing judgement on the performance of a particular company.

VARIANCE ANALYSIS

Variance have been worked out from the information given in the earlier hub. Important variances are discussed as under:

SALE VARIANCE

Both Price and Quantity Variances were favorable which had a good impact on operation of the company. It not only shows good market conditions but also acceptance of the company's products as it could sold much more than its monthly budget or quota.

MATERIAL VARIANCE

Though the company is purchasing the term 'price' rather than 'cost' is being used for convenience. This is an accepted practice.

The price variance was adverse while usage variance was favorable. But magnitude of the latter was too small to make any material difference.

Was price variance avoidable? Was it due to mismanagement? Was this a case of over-invoicing? No, none of these since the owner himself handles all purchases. The reason was inflation which is one of the business risks.

We would advise the owner to study the trend and either buy in bulk or enter into a supply contract or make arrangement with suppliers for Just-in-Time inventory.

Since raw material constitutes nearly 80% of total cost, the price variance was the main reason for the losses sustained by the company in July 09.

LABOUR VARIANCE

Labor Rate Variance was adverse. As stated earlier, there was inflationary pressure in the country and labor demanded more wages or perks. However, its impact was off-set by efficiency variance. Many factors contributed to efficiency such as recruitment of good workers, quality of material and machines, good and conducive environment and friendly attitude of the owner who had served in the foreign countries.

Overheads are of two types. (i) Fixed Overheads which remain fixed regardless of production, (ii) Variable Overheads which varies with production just like direct material costs. The only difference is that Variable Overheads are Indirect costs like salaries of supervisors, electricity and fuel expenses. Such costs cannot be directly and conveniently traced to a particular product.

In our case, both Variable Overhead Expenditure and Efficiency Variances were favorable which showed a good control in the face of economic crisis.

FIXED OVERHEAD EXPENDITURE OR SPENDING VARIANCE

This is simply the difference between Actual Fixed Cost and Budget Fixed Cost which in our case was (Rs,91,635 minus Rs.100,800 = - 9,165), This is a good sign.

CONCLUSION

As stated earlier, the company sustained a loss of Rs.37,000 as against an estimated profit of Rs.126,980. In other words, there was a drop of Rs.163,980.

Just think of a situation that on July 1, 09 you had a balance of Rs.100,000 with your bank. On August 1,09 the same bank informed you that you had overdrawn Rs.100,000. How much you withdrew? Obviously, Rs.200,000. In the same way, we have calculated a drop of Rs.163,980.

All variance maybe studied one by one and a judgeent passed over them as shown below:

• Whether a variance is small or large depends upon it base. In our case, the base is Budget and variance as a % of budget is calculated and shown in one column.
• As a matter of policy, small variation, random in nature,  is acceptable (usually, it is 5-10%)
• If it exceeds the limit, it should be ascertained whether it was controllable or not.
• Any variance which is not controllable, should not be investigated but some precautions be taken to mitigate it outcome such as insurance, outsources or standby arrangements.

More by this Author

Kazi Huneef 7 years ago

Very informative, illustrave and simple discreption of a complicated subject.

hafeezrm 7 years ago from Pakistan Author

Thanks

Trsmd 7 years ago from India

what is the purpose of learning this variance analysis?

hafeezrm 7 years ago from Pakistan Author

Thanks Trsmd for your comments. Actually, this part is the second part. In the first part, purpose is given i.e. to find out difference (variance) between actual and estimated costs. While small variances are ignored, large variance are investigated to find out where they occur, when they occur, were these avoidable or controllable. Information gathered from such analysis are used as a feedback to upgrade estimation techniques and to reward and punish the concerned manager if there is a case. The purpose of the variance analysis to control the costs as per budget and it is a part of overall cost management technique.

Anu 6 years ago

This was very useful as it helped me to understand the concept of variance analysis clearly.Thank you sir for this informative article.

mega 5 years ago

what is the purpose of preparing variance analysis?

hafeezrm 5 years ago from Pakistan Author

Kindly go through the answer to Trsmd question

ika 5 years ago

1-what is the reasons/causes for favorable sales price

variance and sale margin volume variance?what are the

effects for the company?

2-what is the reasons/causes for unfavorable of fixed

overhead expenditure? what are the effects to the company?

hafeezrm 5 years ago from Pakistan Author

Thanks @ika for reading my article.

Favorable price variance is certainly due to increase in price which is directly reflected in profitability. Reasons could be :(i) quality premium, (ii) high demand and (iii) inflation.

Volume Variance could be high production due to better efficiency, change in technology or layout etc.

Fixed Overhead Variance (Adverse) may be due to (i) increase in tariff of utilities ( gas, power, water ), inflation or increase in pay of permanent officers and staff following strike settlement.

Any increase in price and quantity sold would increase the profit and goodwill of the company while increase in manufacturing would have an opposite effect.

Please consult some text books to have further info.