A technique that is commonly used in monitoring and measuring performance against budget is variance analysis. A variance is the ‘difference between actual and planned performance’ and can be favourable or adverse.
An analysis and investigation of variances is an effective way of detecting the causes of our business trends. Effective variance analysis operates within a system of management by exception, i.e we will concentrate on those events that are significant and exceptions. We will not waste our time on sorting through a mass of figures: variations point to the root of any inefficiency.
Standard Costing and Variance Analysis
Management accountants are often heavily involved in setting budgets for an organisation. They are then involved in monitoring and reporting on actual performance, together with investigating differences between actual and budgeted performance.
Introduction and Overview
Definition: “A standard costing system is a control system established by the company’s management.”
At the heart of a standard costing system is the standard cost card, which fulfils a number of uses, namely;
- Planning – up to date standards make the preparation of forecasts and budgets much easier;
- Control – areas of inefficiency can be identified by comparing standards and actual results;
- Reporting – standards provide information for internal and external reporting;
- Recording – it is easier to record stock movements at standard cost.
We can also establish differing types of standard, these are:
- Attainable under optimum conditions only, without allowing for human error, random fluctuations, etc.
- Should not be used for variance analysis but could be used as a long-term aim.
- Long-run underlying standards used as a basis to set standards for the period under review.
- Should not be used for variance analysis as variances will occur due to price level changes, fluctuating conditions, etc.
- Expected to apply to a specified budget period, they are based on normal operating conditions.
- Used as a basis for planning but may be inappropriate to use as targets.
- Variances may be used for routine reporting but will need further analysis before being used for performance evaluation.
- The current attainable standards that reflect conditions applying in the period under review and determined by adjusting the expected standard.
- Should be used for performance evaluation but require complex data collection and administration.
A variance is effectively the financial difference between actual and expected outcomes, and are expressed either as adverse or favourable. An adverse variance, for example, indicates that costs and/or revenues are not as we expected, and that consequently profits will be less than planned;
- Adverse variances arise where actual costs exceed expectations
- Favourable variances arise where actual costs are less than expectations
- Adverse variances arise where actual revenue or sales volume is less than expectations
- Favourable variances arise where actual revenue or sales volume exceed expectations
Standard costing often forms the cornerstone of many budgeting systems, in which an expected cost per unit of output or service is calculated. This cost is then scaled up for the budgeted level of activity.
Once actual data are available, it becomes possible to report on differences (variances) between actual and budgeted performance.
It is worth noting that standard costing is not just about cost! It also involves setting a standard sales price from which it is then possible to calculate a standard unit profit or contribution, depending on whether absorption or marginal costing is being used.
At the heart of the standard costing system is the standard cost card. It is not particularly useful for management to know that a product is expected to cost $240 to make. An effective standard costing system should break total cost down into its individual components, this is one of the purposes of a standard cost card, and an example cost card is shown below:
There are a number of different ways that variances can be calculated; a more intuitive approach compared to a formulaic approach is to be (ideally) preferred. The following general points should be borne in mind.
Variances aim to show the financial difference between expectation (costs or revenues) and reality (actual costs and revenues). The expected costs for material, labour and variable overhead variances are based on the costs expected for the actual level of activity (the original budget is irrelevant).