Variance Analysis in Management Accounting

Management accounting is a part of accounting that concerns a company’s internal matters. Usually, it consists of establishing costs for various products or services and preparing forecasts or budgets. The purpose of management accounting is to help companies with planning, controlling, and decision-making. There are no specific requirements for management accounting, unlike financial accounting, which makes it different.

The foundation of management accounting comes from cost accounting. Cost accounting usually includes establishing costs or analyzing them. For all profit-making companies, cost accounting plays a significant role in profitability. There are several areas of cost accounting, one of which includes standard costing. Standard costing is a concept that has existed for a long time and is crucial for companies.

What is Standard Costing?

Standard costing is an area within management and cost accounting that relates to establishing standards. For most companies, establishing and controlling costs is a significant factor in increasing profitability. However, these companies cannot manage their costs if they don’t have a benchmark against which to check. Therefore, standard costing helps companies in establishing those benchmarks.

Standard cost includes a planned unit cost for products or services that companies sell. It indicates how much a unit of product or service should cost in an ideal situation. Based on this, companies can establish targets for the costs that they must maintain for their products. Usually, standard costs come from a unit level, allowing companies to calculate the total costs for actual units produced.

There are different types of standards that companies may set. These include basic, ideal, attainable, or current standards. Usually, standards may differ depending on each type of standard cost. However, they are often close to each other. Once companies establish a standard cost for products or services, they can use it to control and monitor their operations. One technique they can use to do so is variance analysis.

What is Variance Analysis?

As mentioned, companies use standards as a benchmark for their costs. However, these costs usually do not translate to actual costs. The actual expenses incurred during production may differ due to several reasons. These include wastage, unforeseeable circumstances, inefficiencies, unrealistic standards, etc. However, companies must pinpoint the reason for any variance from standard costing.

Variance analysis is a process that companies use to identify the differences between standard and actual costs. Through this process, companies study the deviations of forecasted or planned behaviour with actual results. Once they do so, they can understand the causes of any variances and control them in the future. Therefore, companies can use it as a reactive tool to control costs.

READ:  How to Calculate Sales Mix Variance?

The variance analysis process consists of three steps. The first is for companies to establish various standards. After that, they can calculate their actual performance and calculate any variances from the set standards. Lastly, they can investigate these differences to identify the reasons behind them and control them in the future.

What are the types of Variance Analysis?

There are several classifications of the types of variance analysis. Companies usually use variance analysis to identify any deviations from standards in their costs. These include direct material, direct labour, and overhead costs. These are all areas where companies can set standards for their production and unit costs and easily control.

Some companies also calculate variances for forecasted and actual sales. When it comes to sales, companies cannot establish standard costs. However, they can calculate the expected selling prices and set them as a standard. Once they do so, they can easily perform variance analysis on their revenues and identify any weak areas.

Variance analysis does not apply to variable costs, though. Companies may also use variance analysis to calculate differences between fixed overhead expenses. For a marginal costing system, the variance is straightforward as it includes the difference between actual and forecasted fixed overheads. For an absorption costing system, the process is different.

When calculating the fixed overhead variances in absorption costing, companies must establish a standard absorption rate. Based on that rate, companies can calculate the differences between actual and expected absorbed overheads. This way, they can also account for over-or under-absorbed overheads. This process only applies to production overheads, though.

As stated, the idea for variance analysis is simple. For any cost that companies can establish a standard, they can also calculate variance analysis. This way, companies can set a benchmark for themselves and monitor their costs against a budget. Similarly, variance analysis can also help in more advanced analysis rather than limiting the process to a specific area.

Companies that produce various products can also use variance analysis to analyze their product mixes. Companies can also calculate yield variances, which measure how efficiently they convert their inputs into outputs. Similarly, companies can further divide these variances into several levels for a better understanding of the differences.

Lastly, companies can also use variance analysis for planning and operational variances. Planning variances show the difference between revised and original budgets. These are often uncontrollable variances that partly come due to the use of unrealistic budgets. Operational variances, in contrast, compare actual and revised budgets. These are controllable variances for which the management is responsible.

READ:  Dividend Coverage Ratio: All You Need to Know About!

What are the classifications of Variance Analysis?

The above process for variance analysis is straightforward. As mentioned, it includes establishing a standard cost and calculating any differences with actual results. However, these present a single-dimensional view of variances for companies. Some companies may also perform other types of variance analysis to pinpoint the reasons for any variances.

For most costs, companies can divide the variances into two categories. These include expenditure or price variances and usage or efficiency variances. Price variances come as a result of differences in the costs for material, labour, or overheads. Similarly, these may include the material or labour quality, skilled labour, bonuses/overtime, discounts, supplier rates, or forecasting issues.

On the other hand, usage or efficiency variances come due to the actual and anticipated production units being different. These can come from various sources, such as material or labour quality, usage efficiency, wastages, skilled labour, changes in products, incorrect budgeting, etc. Sometimes, usage variances or efficiency may be indirectly dependent on price variances. For example, cheaper materials may cause favorable price variances but may cause adverse usage variances as well.

However, variations in costs or prices and usage or efficiency only apply to variable costs or sales. For fixed overheads, the process may differ. It is because fixed overheads do not usually change with activity levels. For fixed overheads, therefore, companies can calculate expenditure and volume variances. They can further classify volume variances into capacity and efficiency variances.

Do companies investigate all variances?

When using variance analysis, companies may come across positive or negative variances. Positive variances, also known as favorable variances, are when the differences are in the company’s favour. On the other hand, adverse variances can cause harm to the company. For example, an increase in sale prices can result in a favorable sales variance. However, an increase in costs causes an adverse expenditure variance.

Regardless of whether a company gets a favorable or adverse variance, it is crucial to review it. However, there are several other factors that also play a significant role in determining whether companies should investigate an anomaly. These include the size of the variance, the costs involved, historical trends, seasonal effects, calculation reliability, etc.

READ:  What are the Limitations of Ratio Analysis?

The most critical factor among these is the size of the variance. Usually, companies determine a specific level for variances above which they do not investigate any differences. For most companies, the standard and actual costs will never align. Therefore, they can ignore small differences. But when it comes to larger variances, the stakes are also higher.

Usually, the higher the size of variance is, the more critical it gets. However, there is no set standard for how much the size should be before a company investigates it. Usually, the size will differ according to the company’s requirements. Companies may use a variable percentage or fixed rate to set a benchmark for variances that they should investigate.

What are the causes of variances?

As mentioned, variances come from several sources. These sources are different for each type of area that a company wants to investigate. For example, material variances can come as a result of a difference in material quality used. Usually, however, companies can categorize all variances according to the factor that causes these.

The most common cause of variances is operational factors. Every company’s operations differ from others. Therefore, there is an element of uncertainty that may cause standards to vary from actual results. Operational factors may come from wastages, inefficient processes, etc.

Some variances may also be random. These are usually uncontrollable factors for which companies may not have accounted. Random factors are also usually one-off variances that companies can ignore. However, it is crucial to investigate these if they are a regular occurrence.

Lastly, variances may also come as a result of errors. As mentioned, the use of an unrealistic budget or standards may cause differences. Similarly, measurement errors in variance analysis can result in differences.

Conclusion

Variance analysis is a process that companies use to calculate the differences between budgets and actual performances. These include establishing a standard first, which is a part of standard costing. Variance analysis in management accounting is significantly helpful for controlling and monitoring purposes. There are several types of variances that may exist. However, companies do not investigate all of these.

Scroll to Top