8.5 Describe How Companies Use Variance Analysis

Variance analysis 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.

Standard costing has pros and cons. While it aids budgeting and performance evaluation, 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

Top images from around the web for Use of variance reports

• 

  6.3 Comparing Absorption and Variable Costing | Managerial Accounting View original

  Is this image relevant?

• 

  Material Cost Variance | Accounting for Managers View original

  Is this image relevant?

• 

  Labor Rate Variance | Accounting for Managers View original

  Is this image relevant?

• 

  6.3 Comparing Absorption and Variable Costing | Managerial Accounting View original

  Is this image relevant?

• 

  Material Cost Variance | Accounting for Managers View original

  Is this image relevant?

1 of 3

Top images from around the web for Use of variance reports

• 

  6.3 Comparing Absorption and Variable Costing | Managerial Accounting View original

  Is this image relevant?

• 

  Material Cost Variance | Accounting for Managers View original

  Is this image relevant?

• 

  Labor Rate Variance | Accounting for Managers View original

  Is this image relevant?

• 

  6.3 Comparing Absorption and Variable Costing | Managerial Accounting View original

  Is this image relevant?

• 

  Material Cost Variance | Accounting for Managers View original

  Is this image relevant?

1 of 3

• Variance reports 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
• Variance analysis 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 cost control 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:
  1. Materials price variance = $(Actual price - Standard price) × Actual quantity$
  2. Materials quantity variance = $(Actual quantity - Standard quantity) × Standard price$
  3. Total materials variance = $Materials price variance + Materials quantity variance$
• Direct labor variances:
  1. Labor rate variance = $(Actual rate - Standard rate) × Actual hours$
  2. Labor efficiency variance = $(Actual hours - Standard hours) × Standard rate$
  3. Total labor variance = $Labor rate variance + Labor efficiency variance$
• Overhead variances:
  1. Variable overhead spending variance = $(Actual rate - Standard rate) × Actual quantity$
  2. Variable overhead efficiency variance = $(Actual quantity - Standard quantity) × Standard rate$
  3. Fixed overhead spending variance = $Actual fixed overhead - Budgeted fixed overhead$
  4. Fixed overhead volume variance = $(Actual quantity - Budgeted quantity) × Standard fixed overhead rate$
  5. Total overhead variance = $Variable overhead variances + Fixed overhead variances$
• 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 tree diagrams 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

• Flexible budgeting: 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
• Responsibility accounting: Assigns variances to specific managers or departments responsible for controlling those costs