VARIANCE ANALYSIS

Definition of Variance Analysis

In accounting, a variance is the difference between an actual amount and a budgeted, planned or past amount. Variance analysis is one step in the process of identifying and explaining the reasons for different outcomes.

Variance analysis is usually associated with a manufacturer’s product costs. In this setting, variance analysis attempts to identify the causes of the differences between a manufacturer’s 1) standard or planned costs of the inputs that should have occurred for the actual products manufactured, and 2) the actual costs of the inputs used for the actual products manufactured.

Example of Variance Analysis

Assume that a company manufactured 10,000 units of product (output). The company’s standards indicate that it should have used $40,000 of materials (an input), but it actually used $48,000 of materials. The variance analysis may include the following:

  • There is an $8,000 unfavorable variance which needs to be analyzed
  • The $8,000 variance can be separated into a price variance and a quantity variance
  • The price variance identifies whether the actual cost per pound of the input was more or less than the planned or standard cost per pound
  • The quantity variance identifies whether the actual quantity of the input used was more or less than the planned or standard quantity for the actual output

The variance analysis of manufacturing overhead costs is more complicated than the variance analysis for materials. However, the variance analysis of manufacturing overhead costs is important since these costs have become a large percentage of manufacturing costs.

 Types of Variances

There is a need of knowing types of variances before measuring the variances. Generally, the variances are classified on the following basis.

  1. On the basis of Elements of Cost.
  1. Material Cost Variance.
  2. Labour Cost Variance.
  3. Overhead Variance.
  1. On the basis of Controllability
  1. Controllable Variance.
  2. Uncontrollable Variance.
  1. On the basis of Impact
  1. Favorable Variance.
  2. Unfavorable Variance
  1. On the basis of Nature
  1. Basic Variance.
  2. Sub-variance.

A brief explanation of the above mentioned variances are presented below

1. Material Cost Variance

It is the difference between actual cost of materials used and the standard cost for the actual output.

2. Labour Cost Variance

It is the difference between the actual direct wages paid and the direct labour cost allowed for the actual output to be achieved.

3. Overhead Variance

Overhead variance is the difference between the standard cost of overhead allowed for actual output (in terms of production units or labour hours) and the actual overhead cost incurred.

4. Controllable Variance

A variance is controllable whenever an individual or a department or section or division may be held responsible for that variance.

According to ICMA, London,

Controllable cost variance is a cost variance which can be identified as primary responsibility of a specified person.

5. Uncontrollable Variance

External factors are responsible for uncontrollable variances. The management has no power or is unable to control the external factors. Variances for which a particular person or a specific department or section or division cannot be held responsible are known as uncontrollable variances.

6. Favourable Variances

Whenever the actual costs are lower than the standard costs at per-determined level of activity, such variances termed as favorable variances. The management is concentrating to get actual results at costs lower than the standard costs. It shows the efficiency of business operation.

7. Unfavorable Variances

Whenever the actual costs are more than the standard costs at predetermined level of activity, such variances termed as unfavorable variances. These variances indicate the inefficiency of business operation and need deeper analysis of these variances.

8. Basic Variances

Basic variances are those variances which arise on account of monetary rates (i.e. price of raw materials or labour rate) and also on account of non-monetary factors (such as physical units in quantity or time). Basic variances due to monetary factors are material price variance, labour rate variance and expenditure variance. Similarly, basic variance due to non-monetary factors are material quantity variance, labour efficiency variance and volume variance.

9. Sub Variance

Basic variances arising due to non-monetary factors are further analyzed and classified into sub-variances taking into account the factors responsible for them. Such sub variances are material usage variance and material mix variance of material quantity variance.

Likewise, labour efficiency variance is subdivided into labour mix variance and labour yield variance. At the same time, variable overhead variance is sub-divided into variable overhead efficiency variance and variable overhead expenditure variance.

Advantages of Variance analysis

The following are the merits of variance analysis.

  1. The reasons for the overall variances can be easily find out for taking remedial action.
  2. The sub-division of variance analysis discloses the relationship prevailing between different variances.
  3. It is highly useful for fixing responsibility of an individual or department or section for each variance separately.
  4. It highlights all inefficient performances and the extent of inefficiency.
  5. It is used for cost control.
  6. The top management can follow the principle of management by exception. Only unfavorable variances are reporting to management.
  7. Sometimes, the variances can be classified as controllable and uncontrollable variances. In this case, controllable variances are taken into consideration for further action.
  8. Profit planning work can be properly carried on by the top management.
  9. The results of managerial action can be a cost reduction.

10. It creates cost consciousness in the minds of the every employee of business organization