Final Draft For Varriance Analsys Report.docx

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The Importance of Variance Analysis for managerial decisions making ABSTRACT This review aimed at examining the importance of variance analysis for cost control in organizations. The study x-rayed the concept of variance analysis, types, sources, objectives and its significance. The study reported that variance analysis has significant influence in evaluating individual performance in organizations, assignment of responsibilities to individuals and assisting management to rely on the principle of management by exception and recommended among others, variances analysis should be based upon scientifically established standards. INTRODUCTION Analysis of variances is the most important job in the proper implementation of a standard cost system. Cost variances are just meaningless figures unless adequately analyzed and intelligently interpreted. It is only through the medium of this analytical device that the figures can tell the story of what is happening and point the way to improvement procedures. Here is where the standard cost system leaves the realm of technical accounting and dull debits and credits and enters the atmosphere of interpretive and creative analysis for management guidance. Variance is a term used for the difference between actual cost and standard cost. A favourable variance occurs if actual costs are less than standard cost. Ordinarily, favourable variance is assumed to imply efficient performance. An unfavourable variance arises if actual cost exceeds standard cost. An unfavourable variance is supposed to indicate inefficient performance. However, whether performance is really efficient or inefficient will be known only when variances are analyzed in detail by their causes. Arora (2006) states that variance analysis is the process of analyzing variances by sub-dividing the total variance in such a way that management can assign responsibility for any off standard performance. According to ICMA London, terminology, variance analysis is the resolution into constituent parts and the explanation of variances. An important aspect of variance analysis is the need to separate controllable from uncontrollable variances. A detailed analysis of controllable variances will help the management to identify the persons responsible for its occurrence so that corrective action can be taken. Idornigie (2005) International Journal of Economic Development Research and Investment Vol. 3, No 2, August 2012 22 views variance as the deviations of actual performance from standard performance. They are indicators of sub standard performance or super-standard performance. When the costs of actual activity are higher than the standard cost we have adverse variance. On the contrary, when the actual costs are lower than the standard (expected) cost we have favourable variance.

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Favourable variances point to efficiency while unfavourable or adverse variances point to inefficiency.

Types of varience Favourable and Unfavourable Variances: Where the actual cost is less than standard cost, it is known as "favourable" or "credit" variance. On the other hand, where the actual cost is more than standard costs, the difference is referred to as "unfavourable" or "adverse" or "debit" variance. In other words, any variance that has a favourable effect on profit is favourable variance and any variance which has an adverse or unfavourable effect on profit is unfavourable variance. Assuming that standard costs have been correctly set, favourable variance is a reflection of efficiency and unfavourable variance indicates inefficiency. Controllable and Uncontrollable Variances: If a variance can be regarded as the responsibility of a particular person with the result that his degree of efficiency can be reflected in its size, then it is said to be a controllable variance. For example, excess usage of material is usually, the responsibility of the foreman concerned. However, if the excessive usage is due to material being defective, the responsibility may rest with the Inspection Department for non-detection of the defects. If a variance arises due to certain factors beyond the control of management, it is known as uncontrollable variance. For example, change in the market prices of materials, general increase in the labour rates, increase in the rates of power or insurance premium, etc. are not within the control of the management of the company. Responsibility for uncontrollable variance cannot be assigned to any person or department. The division of variance into controllable and uncontrollable is extremely important. The management should place more emphasis on controllable variance as it is these variances which require investigation and possibly corrective action. The controllable variances, on the other hand, may be ignored. This follows the well known principle of exception whereby those matters which are going right are not given attention and any deviations from efficient performance are investigated. CAUSES OR SOURCES OF VARIANCES Variances will arise from the following sources: Materials Variances i. Price Variances ii Paying higher or lower price than planned. iii Gaining quantity discounts by buying larger order quantities than planned. iv Buying higher or lower grade/quality of materials than planned. v Buying substitute materials whose price is different from the planned. vi Panic buying Usage Variance i Quality of materials ii Substitute materials iii Technical efficiency iv Human efficiency or skill

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v Pilferage vi Difference in yield from that planned. Labour Variances 1. Rate Variance i Labour unionism and higher rates. ii Different grades of labour used. iii Change in labour remuneration method. iv Change in method of production which may require different grades of labour input. Efficiency Variance i Change in operation method facility used by labour which affects efficiency. ii Grade of labour used. iii Workshop organization. iv Adequacy of supervision. v Grade of materials used. vi Working condition. Outside the specific causes listed above, variances can generally arise from the inappropriate or incorrectly set standards, wrong implementation of standard set as when more or less is input than standard, and mis-measurement of actual results. OBJECTIVES AND SIGNIFICANCE OF VARIANCE ANALYSIS Arora (2006) lists three objectives of variance analysis as: performance evaluation, cost control and management by exception. A firm operating a standard cost system calculates variances for each element of cost for which standards have been set. Once variances have been calculated, they are analyzed to determine: 1. Where the variance occur? 2. Which cost elements were involved and by what amount? 3. What were the causes of the variances? 4. Who were responsible for the causes of the variances? Such an analysis thus brings out the significance of variances in terms of their source, cause and responsibility. i Variance analysis system helps in evaluating individual performances by highlighting the difference in terms of costs between attained performance and desired performance. ii Variance analysis helps in assigning responsibilities to individuals. Realistically set standards provide challenge to individuals and motivate them to achieve the performance targets. International Journal of Economic Development Research and Investment Vol. 3, No 2, August 2012 24 iii A variance analysis system, combined with an appropriate reporting mechanism helps management to rely on the principle of management by exception. Suitably prepared variance reports call top management attention only to exceptional variances. Variances ranging between certain limits are disposed off at lower levels of management. The variance reports are also

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condensed in such a way that management is able to understand its implications through a detailed and time consuming study of a number of facts and figures. The following points highlight the four major types of variance analysis. The types are: 1. Material Variances 2. Labour Variances 3. Variable Overhead Variances 4. Sales Variances. Variance Analysis: Type # 1. Material Variances:

Some Definitions: 1. Direct Materials Usage Variance: “The difference between the standard quantity specified for actual production and the actual quantity used at standard purchase price.” 2. Direct Materials Price Variance: “The difference between the standard price and actual price for the actual quantity of materials.”

3. Direct Materials Total Variance:

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“The difference between the standard direct material cost of the actual production volume and the actual cost of direct material.” How to find out?

Formulae: (i) Actual quantity used for production x Standard price Minus (ii) Standard quantity for production x Standard price Actual quantity purchased x Actual price Minus: Actual quantity purchased x Standard price Note: The actual usage is to be calculated as follows: Opening stock + Purchase – Closing stock = USAGE Causes of Material Variances: (i) Price Variances: (a) Buying lower or higher quality of materials than planned. (b) Losing or gaining quantity discounts by purchasing in smaller or larger quantity of materials than planned. (c) Paying higher or lower price than planned. (d) Close substitute materials are bought due to unavailability of planned material,

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(ii) Usage variance: (a) Buying of substitute materials because of unavailability of standard materials. (b) Greater or lower yield from materials than expected or planned. (c) Greater or lower rate of scrap than anticipated.

Alternative Approach: Material Cost Variance: 1. Actual Quantity x Actual Rate 2. Actual Quantity x Standard Rate 3. Standard Mix of Actual Quantity x Standard Price 4. Standard Quantity for Actual Output x Standard Rate. 1. Material Cost Variance: Standard Cost for Actual Quantity – Actual Cost Variance Analysis: Type # 2. Labour Variances: Labour variance analyses the variance of actual labour cost from standard labour cost due to the following factors: (a) Rate of pay; (b) Labour efficiency; (c) Labour mix; and (d) Idle time etc.

Labour Variance may be classified as follows:

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Some definitions: (i) Direct Labour Rate Variance: Definition: “The difference between the standard and actual direct labour hour rate per hour for the total hours worked” —Terminology.

(ii) Direct Labour Efficiency Variance: “The difference between the standard hours for the actual production and the hours actually worked valued at the standard labour rate”—Terminology. (iii) Direct Labour Total Variance: “The difference between the standard direct labour cost and the actual direct labour cost incurred for the production achieved”—Terminology.

Types: (i) Labour Cost Variance: Formulae: (i) (Actual Labour Hours x Actual Rate) Minus (Actual Labour Hours x Standard Rate)

Causes: Labour cost may arise due to changes in the following factors: (i) Actual Wage Rate may be more or less than Standard Wage Rate.

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(ii) Actual Labour Hours may be more or less than Standard Labour Hours. (iii) There may be some idle hours due to abnormal situation like strike, lockout, shortage of power which were not considered at the time of fixing the standard labour cost. (iv) There may be shortage of workers having standard level of efficiency. (v) Actual Output may be more or less than Standard Output or yield. (ii) Labour Rate Variance: According to I.C.M.A., London, Labour Rate Variance “is that portion of labour (wages) variance which is due to the difference between the Standard Rate of pay specified and Actual Rate paid.”

Labour Rate Variance: = (SR x AH) – (AR x AH) = (SR – AR) x AH Causes: Labour Rate variance may be caused by the following factors: (i) Employment of more skilled and efficient workers who demand higher wages. (ii) Scarce supply of labour might have raised the wage rates. (iii) On the contrary, excess supply of labour might have lowered down the wage rate. (iv) Overtime allowances, bonus and extra shift allowances might have been paid. (v) Change in method of wage payment. (vi) Due to government policy general wage rate might have gone up. (vii) Due to an agreement with the trade unions there may be modification of terms and conditions of wage payment and as a result the rate of wages may go up.

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(viii) Faulty recruitment and placement of workers. (ix) New workmen now paid though not included in the standards. (iii) Labour Time (efficiency) Variance: This is like Materials Quantity Variance. According to I.C.M.A., London “it is that ortion of labour (wages) variance which is due to the difference between standard labour hours specified for the output achieved and actual hours expended”. This variance reflects the efficiency or inefficiency of the workers. Labour Efficiency Variance = (SH x SR) – (AH x SR) = SR x (SH – AH) It is to be noted carefully that actual labour hours used in the formula should be labour hours actually taken for production. Causes: Labour Efficiency Variance may be caused by: (i) Go-slow tactics adopted by the trade unions. (ii) Absence of maintenance up to standard level. (iii) Poor quality of raw materials. (iv) Loss in waiting time. (v) Lack of proper and efficient supervision. (iv) Idle-Time Variance: Sometimes workers may remain idle in the factory due to strike, power failures, achine break-down, etc. The hours for which workers are not provided with work facilities are known as idle hours. They get wages for these idle hours. Obvious idle hours do affect the labour cost variance. This kind of variance is undesirable and that is why reasons for these variances are to be identified and measures should be taken to control them. Idle Time Variance = Idle Hours x S.R.

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(v) Labour Yield Variance: This variance arises on account of the difference between Standard Yield and Actual Yield : Labour Yield Variance = (AY – SY) x SLC per unit (vi) Labour Mix. Variance: Labour Mix. Variance = (Revised Hours – Actual Hours) x S.R. Revised Hours will be calculated: RH = Actual Hours x Standard Mix Ratio. Alternative Approach Labour Cost Variances Alternative Approach: 1. Actual Hours x Actual Rate 2. Actual Hours x Standard Rate 3. Standard Hours for Actual Output x Standard Rate Or, Earned Standard Hours 4. Standard Hours is Standard Mix. for Actual Output x Standard Rate : 1. Rate of Pay Variance = 2-1 2. Efficiency Variance = 3-2 3. Labour Mix. Variance = 4-2 4. Total Variance = 3-1

Variance Analysis: Type # 3. Variable Overhead Variances:

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Types: (i) Variable Overhead Variance: The difference between the actual overheads incurred and the variable overheads absorbed. This variance is simply the under-absorption of overheads. (ii) Variable Overhead Expenditure Variance: Definition: The difference between the actual overheads incurred and the allowed variable overheads based on the actual hours worked is known as Variable Overhead Expenditure Variance (VOEV). (iii) Variable Overhead Efficiency Variance: Definition: The difference between the variable overheads and the absorbed variable overheads is known as Variable Overhead Efficiency Variance. Formulae:

Variance Analysis: Type # 4. Sales Variances: A number of standard costing systems have been designed to present Material, Labour and Overhead cost variances as discussed earlier. No doubt, these variables are

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invaluable, but many accountants do think that a system will remain incomplete if sales variances are not included in the presentation of information to the management.

Methods of Sales Variances: There are two methods of calculating sales variances namely: (i) The Turnover Method: This method shows the effect of a change in sales on turnover. (ii) The Margin Method: This method shows the effect of a change in sales on profit margin. Both the methods are very useful and should be understood by management accountants for taking managerial decisions. Causes of Sales Variance: Sales variances are basically caused by two changes which may occur when comparing budgeted sales with actual sales: (i) Those due to price and (ii) Those due to volume. The change in volume may be caused by: (i) Changes due to a change in quantity and (ii) Changes due to a change in ‘mix’ of sales. Here, the price and quantity are as budgeted but the ‘mix’ of products has changed from A 50%, and B 50% to A 60% and B 40%.

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(i) Sales Value Variance: (Actual Value of Sales – Budgeted Vale of Sales) Actual Sales = Actual Quantity sold x Actual selling price. Budgeted Sales = Standard Quantity x Standard selling price. If actual sales are more than the budgeted sales, there is favourable variance and if actual sales < budgeted sales the variance will be unfavorable. (ii) Sales Price Variance: (Actual selling price – Budgeted selling price) x Actual Quantity If actual sales price < budgeted sales, the variance is favourable and vice versa. (iii) Sales Volume Variance: (Actual Quantity – Budgeted Quantity) x Budgeted selling price If the actual quantity sold exceeds the budgeted sales quantity then the variance is favourable and if the actual quantity sold is less than budgeted sales quantity, the variance is taken as unfavorable. (iv) Sales Mix Variance: (Actual mix quantity sold – Actual quantity in standard proportion) x standard selling price. (Budgeted price per unit of actual mix – Budgeted price per unit of budgeted mix) x Total actual quantity.

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(v) Sales Quantity Variance: (Total actual quantity – Total budgeted quantity) x Budgeted price per unit of budgeted mix. (b) Sales Volume Variance

The revised terminology of cost accounting published in 1966 by the Institute of Cost and Management Accountants favours this method of calculating sales variances. Managerial Uses of Variances: Analysis and Causes Managerial Uses of Variances: Analysis and Causes! Determination of variances is only the first step in the process of standard cost variance analysis. Mere computation of material, labour and overhead variances is useless for cost control and performance evaluation. The final objective of variance analysis is to determine the person(s) responsible for each variance and to pinpoint the cause(s) for incurrence of these variances.

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Properly used standard cost variances are useful tools in achieving effective cost control. That is, before management can take effective action for improving control over costs, it needs to know not only the amount of variances, but also where the variance originated, who was responsible for them, and what caused them te arise. Analysis of standard cost variances is, therefore, necessary by responsibilities and causes. Analysis of Variances by Responsibilities Control over cost must be applied at the place and time where the cost originates. Variances must be identified with the manager responsible for the costs incurred, who should be held responsible for the cost. The cost factors which are directly controllable by operating supervisors must be separated from those cost factors for which executive management is responsible. Specific titles of individuals who are responsible for each type of variance differ among business enterprises. Generally speaking, the following personnel are held accountable for variances noted against them:

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Analysis of Variances by Causes: Variances reflect the effect on costs which certain events or conditions have produced. Before management can decide whether or not action is called for and, if so, what should be done, it is necessary to know what caused the variance to arise. Reasons for the variance should be determined and plans for necessary corrective action made either by discussing possible causes with the supervisors or by examining underlying data and records. The analysis of variances by causes is, therefore, an important aspect of the use of standard costs to attain effective cost control. For any standard cost variance, there are many possible causes. The following list is not all inclusive but does indicate causes responsible for variances:

Possible Causes of Standard Cost Variances: Materials Price Variance: (1) Recent changes in purchase price of materials. (2) Failure to purchase anticipated quantities when standards were established resulting higher prices owing to non-availability of quantity purchase discounts. (3) Not taking cash discounts anticipated at the time of setting standards resulting in higher prices. (4) Substituting raw material differing from original materials specifications. (5) Freight cost changes and changes in purchasing and storekeeping costs, if these are debited to the materials cost. ,

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Materials Quantity Variance: (1) Poor material handling. (2) Inferior workmanship by machine operator. (3) Faulty equipment. (4) Cheaper, defective raw material causing excessive scrap. (5) Inferior quality control inspection. (6) Pilferage. (7) Wastage due to inefficient production method. Labour Rate Variance: (1) Recent labour rate change within industry. (2) Employing a man of a grade different from the one laid down in the standard. (3) Labour strike leading to utilisation of unskilled help. (4) Labour layoff causing skilled labour to be retained at higher rates, so as to prevent resignations and job switching. (5) Employee sickness and vacation time. (6) Paying a higher overtime allowance than provided for in the standard. Labour Efficiency Variance: (1) Machine breakdown, use of defective machinery and equipment.

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(2) Inferior raw materials. (3) Poor supervision. (4) Lack of timely material handling. (5) Poor employee performance. (6) Inefficient production scheduling — delays in routine work, materials, tools and instructions. (7) Inferior engineering specifications. (8) New inexperienced employees. (9) Insufficient training of workers. (10) Poor working conditions — inadequate or excessive heating, lighting, ventilation, etc. Overhead Volume Variance (Factors causing either idle time or overtime of plant and facilities) (1) Failure to utilise normal capacity. (2) Lack of sales order. (3) Too much idle capacity. (4) Inefficient or efficient utilisation of existing capacity. (5) Machine breakdown.

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(6) Defective materials. (7) Labour troubles. (8) Power failures. Overhead Efficiency Variance: They include all causes which are listed under labour efficiency variance. Analysis of Variances by Products: Since management usually wants current true costs when decisions are to be made with respect to pricing and related questions, variances are often analysed by products in order to arrive at current product costs. Companies producing non-standard goods according to customer’s specification may also help analyse variances by job orders. The analysis of variances by causes is useful in deciding whether or not cost variances should be allocated to products in arriving at product costs for pricing. Standard product costs should be reviewed periodically and revised when it is found that the standard product costs in use are no longer useful for the purpose.

How companies apply variance analysis? Most of the companies are concerned with business planning and meeting their financial commitments. Ultimately all want growth. Accordingly, they analyze the variances between: a. Previous-year actual results and current year’s budget, which helps them in planning and this is also a part of the budgeting process. b. Existing budget (current financial year) and current-year actuals, which helps them in meeting their commitments. This activity is performed at regular intervals throughout the year like at close of every quarter and at year-end. c. Previous-year actual and current-year actual for analyzing growth. This is done at year-end.

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Application of Variance Analysis a. Comparing Budget with Actual: Variance analysis helps in managing the annual budgets by monitoring the budgeted figures and comparing it with the actual revenue/cost. In case of companies which are project or program driven, the financial data are evaluated at key intervals such as month close, quarter end, ect. For example, the month end reports can just provide quantitative data with respect to revenue and expenses or inventory levels. However, variance analysis would help to understand the reasons behind the variances between planned and actual revenue/cost which could lead to adjustments in the business strategies and end objectives. b. Identifying Relationships: Relationship between a pair of variables/elements/items could also be identified with the help of variance analysis. Correlations (both positive and negative) are critical in business planning. For instance, variance analysis could reveal that when the sale for Product A rises there’s a correlated rise in the sales for Product B. Thereby, revealing a positive correlation between 2 products. c. Forecasting: Forecasting uses patterns of the past data for developing a theory about the future business performance. Variances are placed into the context which helps analysts in identifying factors. For example, seasonal change holidays could be a major cause of positive/negative variances.

Most commonly used variances a. Purchase price variance: Purchase Price Variance results when actual price which is paid for materials is different from the budgeted cost for such materials. It is usually used as a lagging indicator for quantifying the efficiency of the procurement function. (How efficiently can you procure/purchase required material) b. Labor rate variance: This variance shows the variance between the actual price which is paid for direct labor that is used in the process of production and its standard labor cost (the cost that is acceptable and usually a standard price). Unfavorable variances mean that cost of labor exceeds the budgeted value, while favorable variances mean that labor cost was less than planned. Such information could be used for the planning and budgeting for future periods, and also works as a feedback for employees responsible for direct labor component of the business. c. Material yield variance: This variance is the difference between actual quantity of material used and the standard quantity expected to be used in course of production, multiplied by the standard cost of such materials. d. Volume Variance: Volume variance measures the difference between actual quantities sold or consumed and budgeted quantity expected to be consumed or sold, multiplied by the standard price per unit. The volume variance is a general measure of whether the business is generating the volume of products that it had planned.

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Benefits of using variance analysis Using variance analysis in the decision-making process renders the following positive impacts: a. Competitive advantage: Variance analysis helps an organization to be proactive in achieving their business targets, helps in identifying and mitigating any potential risks which eventually builds trust among the team members to deliver what is planned. b. Identifying the changes required in the business strategy: In some of the cases, comparing budget with actual results may point out the requirement for re-evaluating the target customer base or product line of the company. Several assumptions go into developing a budget. In case those assumptions are blowing up the budget, it could be because the budget-related projections are wrong for a variety of reasons. It could also be due to changes in the economy or delays in getting the products/services sent to end customers. c. Identifying any managerial concerns : At times, variance analysis could also provide insight as to how well an organization is being managed. For instance in the case of purchasing, the inability to negotiate volume discounts or securing the competitive bids could indicate managerial problems within the purchasing department. Moreover, weak sales could also be an indication that the salespersons are not trained properly or they lack motivation. By addressing such issues, the variances could disappear as the organization gets on track. d. Managing risk: With the help of variance analysis, the finance heads gather insights which they require to understand the reasons for controllable and uncontrollable variances. Once they’re aware of such variance, they’re in a position to implement policies to mitigate such risks arising from such variances. e. Creating shareholder value: When an organization brings in proper internal controls, a cross-functional environment, efficient internal audit process, and the culture of meeting commitments, it increases the chances that the variances would be favorable which means that the business commitments would be met or even exceed the expectations. .

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CONCLUDING REMARKS This review examined the importance of variance analysis for cost control in organizations. The study notes the concept of variance analysis, types, sources, objectives and significance of variance analysis. It observed that variance analysis has significant influence in evaluating individual performance in organizations assignment of responsibilities to individuals and assisting management to rely on the principle of management by exception. Consequently, Variances must be based up scientifically established standards. If the standard of performance is not meaningful, variance can be a meaningful measure of performance. Objective criteria should be the yardstick for measuring inputs and outputs. This implies that costs should be classified and recorded in an unbiased and systematic manner. Variance analysis system should be designed to pinpoint the responsibility centre. Standards should be set and variances should be analyzed for each responsibility centre. The quantity of output should be clearly defined and the quantitative measurement of output should be as accurate as possible.