What is Variance Analysis?
Variance analysis is a process used by companies to identify any inefficiencies or deviations from a plan or budget. They do so by first establishing a budget and then comparing actual performances with it. By doing so, companies can identify any deficiencies in their operations and, sometimes, the budgets. This process can be helpful for companies.
The process of variation analysis comes from management and cost accounting. Both of these relate to monitoring and controlling costs. Similarly, these areas include making decisions about the future. Variance analysis can help in all these three aspects. Firstly, by providing a basis for comparison, variation analysis can help with monitoring and control. Once companies identify any deficiencies, they can make decisions about the changes to make.
Variance analysis can be useful to companies. It can allow companies to identify significant deviations and investigate them. Similarly, it establishes a basis for management accountability. By understanding the costs and process better, companies can also enhance their operational and planning efficiency. On top of that, variance analysis can be helpful in increasing profitability and decreasing costs.
Despite its many advantages and usages, however, variance analysis may not always be useful. It is mainly because variance analysis comes with some limitations. Therefore, it is crucial to understand these limitations.
What are the Limitations of Variance Analysis?
The process of variance analysis, while useful, may not be for every company. While it can be highly beneficial for companies to use variance analysis, they must also understand the limitations that they will face. These are as below.
Use of standards
The first limitation of variance analysis comes from its use of standards. As a part of standard costing, companies must establish standards for each cost or income they incur. However, this process can be lengthy, and any problems within the process can cause significant deficiencies during variance analysis. Similarly, companies need to revise their standards continuously to account for any changes.
Lengthy process
The process of establishing standard costs can be lengthy in itself. However, companies still need to perform variance analysis on actual performance. The process can become complicated and lengthy, which is a limitation of variance analysis. Companies need to consider the time and effort it requires to perform variance analysis when using the tool.
Costly process
As mentioned, variance analysis requires companies to go through a lengthy process. It can translate to higher costs for companies. The process of calculating variances, investigating and then reporting them is complicated. Companies must use professional employees to complete the process and come back with results. It can, therefore, increase costs, which can be higher than the benefits that companies receive from the process.
Subjective interpretation
Once companies calculate variances, they need to investigate them to reach a conclusion. However, this process may result in subjective interpretations. Similarly, companies need to establish thresholds for the variances that they want to investigate. This judgement can also be subjective and may result in substantial variances to be overlooked or missed.
Reactive approach
Unlike some other tools in management accounting, variance analysis takes a reactive approach. Therefore, this tool cannot be useful in preventing any problems. Variance analysis can only detect deficiencies or problems once they have occurred. While it is still beneficial for companies to do so, it can also result in significant losses before companies catch the deficiencies.
Manipulation of data
Variance analysis works through establishing standards that departments within a company must follow. The problem arises when companies enforce variance analysis strictly. It can result in data manipulation from departmental managers who would want to show a favourable variance. Some companies may also associate bonuses with favourable variances, which can further motivate managers to manipulate information.
Service businesses
Variance analysis works best for production-based companies. For companies in the service sector, variance analysis provides limited results. While it can still be useful, companies cannot apply the same variances with services. It is because the structure for service-based businesses significantly differs from a manufacturing business.
Short-term approach
Companies use variance analysis to identify any deficiencies in their processes after every period. However, this approach may promote a short-term approach towards goals and objectives rather than a long-term one. While companies want to avoid adverse variances, they are also necessary for the long-term sometimes. By avoiding these variances, companies can curb their future growth.
Limited scope
Variance analysis allows companies to examine specific areas separately. However, some companies may have complex processes. For example, one product may require input from various departments. In that case, variance analysis fails to provide meaningful results. Furthermore, it can also create internal conflicts between managers in case of any adverse deficiencies.
Conclusion
Variance analysis is a tool that companies use to compared budgeted and actual performances. Variance analysis is significantly critical for companies to monitor and control their costs. Similarly, it can help in decision-making as well. However, variance analysis comes with several limitations, some of which are mentioned above.
