MANAGEMENT ACCOUNTING - VARIANCE ANALYSIS
Variance means difference while analysis means breakdown. In Cost or Management Accounting, variance would relate to difference between Standard and Actual Costs. Analysis would break this difference into various parts like quantity, price and capacity. Any wide variation would be thoroughly investigated and persons responsible (purchase manager, human resource manager, factory manager or marketing manager) would be asked to explain. If it proved avoidable or controllable, someone would be penalized or reprimanded else measures would be taken to avoid in future as far as possible.
In short, variance analysis helps the management in decision-making. In addition (i) it is used in cost-control, (ii) gives early warning for corrective action and (iii) is useful in accountability.
What is a standard cost?
It is a planned cost or a target cost. It is a realistic estimate based on historical data or experiments like time and motion studies. Standard costs give an indication of probable cost of performing an operation or producing a good or service in normal conditions. Later, such estimates serve as a bench marks against which actual data is compared.
What is actual cost?
Actual amount paid or incurred, as opposed to estimated cost or standard cost.
Why compare Actual Costs with Standard Costs
- It gives an idea of efficiency. Other things remaining the same, if actual cost increases estimated cost, there may be either in-efficiency or dishonesty.
- It is used for accountability. Comparison may reveal weak areas and corrective action can be taken against the manager before it is too late.
- Since in-efficiencies or dis-honesties are revealed by comparison on regular basis, top managers can relax and intervene only when wide variations are highlighted. This is known as management by exception.
- It is help in cost control. Whenever the comparison reveals wide and persistent differences, the matter is investigated and efforts are made to avoid its repetition.
AN OPPORTUNITY IN CHAOS
Ahmed Kamal was happy to be in his hometown, Karachi (Pakistan) after having served in foreign country for about 15 years. His main mission was to explore possibilities of returning back to his country. He has enough savings to while away his time even if he could not find any job.
Within few hours, he became disappointed as suddenly the lights went off and the whole area turned dark. “What happened, what”, he enquired hysterically and was advised to calm down as it was a normal event lasting for 2-4 hours. Having lived in a developed country this was most un-acceptable to him and whole night he mulled over the problem. He saw an opportunity in chaos. He thought of making and selling UPS (also known as backup home-power). He felt relieved and went to sleep.
A SIMPLE PLAN
Next day he went to a well-stocked library, which had internet facilities on the side, and came up with a simple plan. By investing Rupees six million, he can setup a small workshop consisting of benches, drill machines, cutters, pliers, soldering iron, wire stripper and meters for quality-check.
Necessary parts would be purchased locally and assembled in the workshop. These mainly consist of transformers, printed circuits, switches, screws, wires, sockets, volt meters, battery lead and terminals.
Annual production would 6,600 units which can be sold @Rs.7,445 per unit earning an annual profit of Rs.1,148,000 enough to bring ROI (Return On Investment) of 20%.
Project Completion and initial Operations
He went ahead with the implementation and completed the project in about two months. Basically, it was a workshop or an assembling unit. Final cost was Rs.6,500,000 which shows a small variation from the estimate.
The project was put into operations in July 2009. Output in the first month was 700 units which were instantly sold @ Rs.9,000 per units. Despite this, the end result was a loss of about Rs.37,000 as against an estimated monthly profit of around Rs.126,980. This puzzled Mr. Kamal and tried to investigate the matter.
Necessary details are given in the following tables.
Raw Material with wastage
6,840 equivalent units @ Rs.5,700
Labour - annual
118,800 hours @ Rs.55 per hour
100% of labor hours @ Rs.11.20 per hour
Price Per Unit
Raw Material used
707 equivalent units @ Rs.7,695 per unit
11,000 hours @ Rs.65 per hour
PRODUCTION IN JULY 09
9,000 hours @ Rs.10 per hour
PRICE PER UNIT
Beginning Point of any Investigation
One must have an overall idea or a broad picture to spot patterns and trends. If an investigator comprehends such vital information, validation process of new information would be easy.
The side table clearly shows that the problems was on the cost side. As against 20.9% increase in sales, the costs increased by 24.6% resulting in overall decline in profit by 129.1%. Naturally, we should study in details all components of costs viz (i) Raw Materials, (ii) Labor and (iii) Overheads. Since Raw Materials consist of 80% of total manufacturing cost, we have identified the source for further investigation.
GUIDELINES on VARIATION ANALYSIS
The following guidelines may be kept in mind while analysing variations:
- Variations are natural due to time-lag between Estimating Standard Costs and Collection of Actual Costs.
- Small Variation should be ignored.
- Systematic or non-random variations, howsoever small, must be investigated since it is due some system error.
- Investigation would be more useful if the variation can be avoided or controlled.
- Cost of investigation and cost of not investigation may also be ascertained for a better decision.
- In case of investigation the following questions be asked: (i) Where did it occur, (ii) At what time did it occur, (iii) Why did it occur, (iv) Who is responsible and (v) What would be its implications.
In the next chapter, the above variations would studied in details after finding out:
- Material Price Variance
- Material Quantity Variance
- Labor Rate Variance
- Labour Efficiency Variance
- Variable Overhead Spending Variance
- Variable Overheads Efficiency Variance
- Volume Capacity Overhead