Table of Content:-
- Meaning of Variance Analysis
- Definition of Variance Analysis
- Uses of Variance Analysis
- Forms of Variances
- Disposition of Variances
- Classification of Variances
Meaning of Variance Analysis
Variance is commonly defined as the difference between the expected amount and the actual amount of costs or revenues. Variance analysis is a tool that compares the standard or expected amount with the actual amount to evaluate performance. The analysis includes an explanation of the difference between actual and expected figures along with an assessment of the potential reasons behind the variance. The purpose of this detailed information is to assist managers in determining what may have gone right or wrong and to help in future decision making.
Definition of Variance Analysis
According to the Terminology of CIMA, Variance is “The difference between planned, budgeted or standard cost and actual costs (similarly in respect of revenue)”.
Sometimes actual results are just equal to planned results, the situation is known as Zero Variance.
According to C.L.M.A. London, Terminology, variance analysis is “The process of computing the amount of variance and isolating the causes of variance between actual and standard”.
Thus, variance analysis is used to observe how well a business is performing and also how close actual costs and revenues are to expected costs and revenues.
Applications/Uses of Variance Analysis
It must be remembered that mere calculation of variances is not sufficient but their proper analysis and finding out the reasons for the variances is the ultimate object to control costs. The following are the important uses of variance analysis:
1) It is a main tool for cost control and cost reduction.
2) Management by exception is possible in this analysis.
3) It helps in making future planning programmes.
4) A cost consciousness is created within the organisation.
5) It helps the management to maximise profits by analysing the variances into controllable and uncontrollable.
6) Through variances analysis, inefficiency is analysed and immediate action is taken by management. Thus, it can be said that variance works like a barometer.
Forms of Variances
Normally, variance can take two forms, namely:
1) Positive/Favourable Variance
A variance can be put into the favourable category when than the standard cost. There may be two conditions:
i) Revenues were more than the expected amount, and
ii) Costs were below the budgeted amount.
In accounting practice, a favourable variance is shown by noting a letter F (Fav), For positive (+pos) reports. A favourable variance might earn a bonus for a manager, or perhaps a move up the corporate ladder.
2) Adverse/Negative/Unfavourable Variance
In contrast, the variance can be judged as unfavourable when the actual cost exceeds the standard cost.
There may be two conditions:
i) The revenues were below expectations, and
ii) If the costs exceed the standard, the variance would be termed unfavourable or adverse.
This would be denoted on the reports with the letter A (Adv.), with a negative sign (-) or U (unfavourable). Consistently creating an unfavourable variance might result in a manager being reprimanded or losing their job. However, the analysis is typically used to help managers prevent a negative situation from recurring by providing information about what went wrong.
Disposition of Variances
The disposition of variances is detailed as follows:
1) Transfer to Profit and Loss Account
The standard cost variances are closed by transfer to the Profit and Loss Account. The advantages of this method are:
i) The stocks and work-in-progress can still be shown valued at the standard cost.
ii) Standards remain intact and they can be compared with each other during different periods, for cost control.
iii) Variances transferred to the Profit and Loss Account attract the greater attention of the management and so the executives try hard to see that adverse variances are minimized as far as possible.
iv) Prompt inventory valuation is facilitated, and it can be done at any time as the valuation is done on standard cost.
2) Allocation to Finished Stock, Work-in-Progress, and Cost of Sales
The variances are distributed to the Finished Stock, Work-in-Progress, and Cost of Sales in proportion to their values of closing balances. As a result of this method, the Finished Stock, the W.L.P., and the Cost of sales are shown at their actual values. The standard value plus or minus variance is the actual value. So when the variances are merged into these three items, they are shown at their actual values. From the audit point of view, the actual values are preferred. Another argument given for this method and against the Profit and Loss Method is that the variances are not the items of profit or loss but are part of costs, and therefore, they should not be transferred to the Profit and Loss Account but absorbed in the Stock, W.I.P. and Cost of sales.
3) Transfer to Reserve Account
Under this method, carry forward the variances to the next financial year for setting off in the subsequent year or years. The adverse and favourable variances may cancel each other in the course of reasonable time and thus be disposed of. Therefore, the variances are transferred to Reserve Accounts and the unwritten-off accounts are shown in the Balance Sheet of the year.
Classification of Variances
The main objective of Standard Costing is to compute and analyze variances. The variance is the difference between the standard performance and the actual performance. Where variances recorded are unfavourable, the concerned departmental head is held responsible for it, and he is asked to take corrective action in the matter.
For adverse Material Price Variance, the purchase manager is sounded; and similarly, for Material Usage Variance, the production manager is asked for control over the same.
For the purpose of classification and computation variances can be explained under the following headings as shown below:
Material Cost Variance (MCV)
Direct Materials Cost Variance can be defined as the difference between the standard costs of direct material specified and the actual cost of direct material used.
According to the Terminology of CIMA defines Material Cost Variance as “The difference between the standard direct material cost of the actual production volume and the actual cost of direct material”.
The term “total variance” refers to the overall fluctuation resulting from variations in material prices, usage or mix, yield, and other contributing factors.
Material cost variances are sub-divided into the following:
- Material price variance, and
- Material usage variance.
Material cost variance are calculated as follows:
Materials Cost Variance = Standard Material Cost – Actual Material Cost
Standard Material Cost = Standard price per unit * Standard quantity of materials
Actual Material Cost = Actual price per unit * Actual quantity of materials
If the standard cost is more than the actual cost, the variance will be favourable. On the other hand, if the actual cost is more than the standard cost, the variance will be unfavourable or adverse.
Material Price Variance (MPV)
The difference between the standard price of material and the actual price of material used for production is known as the material price variance.
The material price variance is stated as:
Materials Price Variance = Actual Quantity (Standard Price – Actual Price)
The possible causes for material price variance may be:
- Due to changes in the market price of materials,
- Inefficient purchasing,
- Change in the quantity of material used,
- Change in the specification of materials, and
- Change in the amount of taxes and duties, etc.