8.5 Describe How Companies Use Variance Analysis
3 min read•june 18, 2024
compares actual costs to standard costs, revealing performance gaps. It's a powerful tool for managers to identify efficiency issues, control costs, and drive continuous improvement in their operations.
has pros and cons. While it aids budgeting and , setting accurate standards can be challenging. Calculating variances for materials, labor, and overhead helps pinpoint areas needing attention and supports data-driven decision-making.
Variance Analysis and Standard Costing
Use of variance reports
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- compare actual costs to standard costs to identify differences between expected and actual performance
- Favorable variances indicate actual costs were lower than standard costs suggesting efficiency or cost-saving measures were effective (using less raw materials than expected)
- Unfavorable variances indicate actual costs exceeded standard costs suggesting inefficiencies, waste, or unexpected cost increases (higher labor rates than budgeted)
- Management uses variance reports to identify areas of strong and weak performance, investigate causes of significant variances, take corrective actions to address unfavorable variances, reinforce practices leading to favorable variances, and monitor trends in variances over time
- helps in continuous improvement efforts by highlighting opportunities for cost reduction and process optimization
- Supports performance evaluation by providing quantitative measures of departmental or individual achievements against set standards
Pros and cons of standard costs
- Advantages of standard costing:
- Facilitates budgeting by providing a benchmark for expected costs
- Allows for performance evaluation by comparing actual to standard costs
- Supports by highlighting deviations from standards
- Enables management by exception, focusing on significant variances
- Provides a basis for pricing decisions and profitability analysis (setting prices based on standard costs plus desired margin)
- Disadvantages of standard costing:
- Setting accurate standards can be challenging and time-consuming
- Standards may become outdated due to changes in processes or environment (new technology, supplier price changes)
- Overemphasis on meeting standards may lead to dysfunctional behavior (cutting corners to meet cost targets)
- Variances may not always provide clear insights into root causes
- May not be suitable for companies with highly variable or custom products (job order costing)
Calculation of cost variances
- Direct materials variances:
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- Direct labor variances:
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- Overhead variances:
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- Interpreting variances:
- Favorable variances have a positive impact on profitability (actual costs lower than standard)
- Unfavorable variances have a negative impact on profitability (actual costs higher than standard)
- Use to visualize the breakdown of variances into price/rate and quantity/efficiency components
- Investigate significant or recurring variances to identify root causes and take appropriate actions (renegotiate supplier contracts, provide additional training to workers)
Advanced Applications of Variance Analysis
- : Adjusts budgeted costs based on actual activity levels, allowing for more accurate variance calculations
- Cost control: Uses variance analysis to identify areas of excessive spending and implement corrective measures
- : Assigns variances to specific managers or departments responsible for controlling those costs
Key Terms to Review (28)
Cost Control: Cost control is the process of managing and regulating the costs incurred by an organization in order to maximize profitability and efficiency. It involves monitoring, analyzing, and taking corrective actions to ensure that costs are kept within predetermined budgets or targets. Cost control is a critical responsibility of management across various business functions and is particularly important in the context of managerial accounting.
Direct labor rate variance: Direct labor rate variance measures the difference between the actual hourly wage paid to workers and the standard hourly wage expected, multiplied by the actual hours worked. It helps in assessing whether labor costs are being controlled effectively.
Direct materials price variance: Direct materials price variance is the difference between the actual cost of direct materials and the standard cost, multiplied by the quantity purchased. It measures how much more or less was spent on direct materials than expected based on standard costs.
Direct Materials Price Variance: The direct materials price variance is the difference between the actual cost of direct materials purchased and the standard or budgeted cost of direct materials, based on the quantity of materials used in production. It measures the impact of paying more or less than the expected price for the direct materials consumed.
Favorable variance: A favorable variance occurs when actual costs are less than standard costs or actual revenues exceed standard revenues. It indicates better performance than expected and can result from cost savings, higher efficiency, or increased sales.
Favorable Variance: A favorable variance refers to a situation where the actual cost or performance is less than the standard or budgeted amount, indicating that the organization has spent less or performed better than expected. This term is particularly relevant in the context of materials variances, overhead variances, and overall variance analysis within a company's operations.
Fixed Overhead Spending Variance: The fixed overhead spending variance is a type of variance analysis used to measure the difference between the actual fixed overhead costs incurred by a company and the budgeted or expected fixed overhead costs. This variance provides insights into how effectively a company is managing its fixed overhead expenses in the context of its operations and production activities.
Fixed Overhead Volume Variance: The fixed overhead volume variance is a variance analysis tool used to measure the difference between the actual fixed overhead costs incurred and the fixed overhead costs that should have been incurred based on the actual level of production or activity. It helps companies understand the impact of production volume on their fixed overhead costs.
Flexible Budgeting: Flexible budgeting is a budgeting approach that adjusts the budgeted amounts based on the actual level of activity or volume, rather than using a static, predetermined budget. It allows managers to better align budgeted costs with the organization's changing needs and circumstances, providing more accurate and relevant information for decision-making.
Labor Efficiency Variance: The labor efficiency variance is a measure of the difference between the actual hours of labor used and the standard hours of labor that should have been used for the work performed. It indicates how efficiently a company is utilizing its labor resources in the production process.
Labor Rate Variance: Labor rate variance is a measure of the difference between the actual labor rate paid and the standard labor rate established for a specific task or production process. It helps organizations understand and manage the costs associated with labor, a crucial component of overall production expenses.
Materials Quantity Variance: Materials Quantity Variance is the difference between the actual quantity of materials used in production and the expected or standard quantity of materials that should have been used, multiplied by the standard price of the materials. It measures the efficiency of materials usage in the production process within the context of variance analysis.
Performance Evaluation: Performance evaluation is the process of assessing and measuring an individual's or organization's progress towards achieving specific goals or objectives. It is a critical component in both financial and managerial accounting, as it helps organizations identify areas for improvement, allocate resources effectively, and make informed decisions about future strategies.
Responsibility accounting: Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility to assess performance. It allows for accountability by holding managers responsible for the financial results of their specific segments or units.
Responsibility Accounting: Responsibility accounting is a management accounting system that assigns revenue and cost items to the individuals or departments responsible for their incurrence. It is a crucial component of managerial accounting, as it enables organizations to track and evaluate the performance of various responsibility centers within the company.
Standard Costing: Standard costing is a cost accounting technique that establishes predetermined cost estimates for the production of goods or services. It serves as a benchmark to evaluate and analyze the actual costs incurred, allowing for the identification of variances and the implementation of cost control measures.
Total Labor Variance: Total labor variance is a metric used in variance analysis to measure the difference between the actual labor costs incurred and the expected or standard labor costs for a given production or service output. It provides insights into the efficiency and productivity of a company's labor force and helps identify areas for improvement in labor management.
Total Materials Variance: The total materials variance is a measure of the difference between the actual cost of materials used in production and the standard or expected cost of those materials. It is a key component of variance analysis, which companies use to understand and control their manufacturing costs.
Total Overhead Variance: The total overhead variance is the difference between the actual overhead incurred and the budgeted overhead for a given period. It represents the overall deviation between the planned and realized overhead costs, providing insight into how effectively a company has managed its overhead expenses.
Tree Diagrams: Tree diagrams are a visual tool used to represent and analyze the possible outcomes or decision paths in a problem or process. They are particularly useful in the context of variance analysis, as they can help companies understand the different factors contributing to variances in their financial performance.
Unfavorable variance: Unfavorable variance occurs when actual costs exceed standard costs, indicating higher expenses than planned. It signals inefficiencies or higher resource consumption in production or operations.
Unfavorable Variance: An unfavorable variance is a type of variance that occurs when the actual cost or performance of a business activity exceeds the expected or budgeted cost or performance. It indicates that the actual outcome is less favorable than the planned outcome, signaling potential inefficiencies or issues that need to be addressed.
Variable overhead efficiency variance: Variable overhead efficiency variance measures the difference between the standard variable overhead cost allocated for the actual hours worked and the standard variable overhead cost allowed for the actual production achieved. It helps in assessing the efficiency in utilizing labor hours related to variable overheads.
Variable Overhead Efficiency Variance: The variable overhead efficiency variance is a measure of the difference between the actual variable overhead costs incurred and the variable overhead costs that should have been incurred based on the actual level of activity. It reflects the efficiency with which a company utilizes its variable overhead resources in the production process.
Variable Overhead Spending Variance: The variable overhead spending variance is a measure of the difference between the actual variable overhead costs incurred and the variable overhead costs that were budgeted or expected to be incurred based on the actual level of production or activity. This variance is an important tool used in variance analysis to understand and manage a company's overhead costs.
Variance analysis: Variance analysis is the process of comparing budgeted financial performance to actual financial performance to identify discrepancies. It helps managers understand why variances occur and how to address them for better future planning.
Variance Analysis: Variance analysis is a management accounting technique used to identify and evaluate the differences between actual and expected or budgeted performance. It provides insights into the causes of these variances, enabling managers to make informed decisions and take corrective actions to improve operational efficiency and financial performance.
Variance Reports: Variance reports are financial documents that compare a company's actual performance to its budgeted or standard performance, highlighting any differences or variances. These reports are used in variance analysis, a key management accounting tool that helps organizations identify and understand the reasons for deviations from planned targets.