Cost Accounting - Variance Analysis

TYS – Variance Analysis, An overview

This Teach your Self Session is drafted with an assumption that its readers have a good basic understanding of the cost accounting system.

What should you expect from this TYS?

An overall understanding of the Variance analysis concept and its application.

Skimming through the basics!

You are already familiar that a product rolling out of a factory is a result of different materials coming together, undergoing a change by the application of labour, machining and other services. These products incur the cost of selling and distribution before it’s ultimately sold to a costumer and pays back a return.

Let’s relate the above to an example of a furniture factory.

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Here Plywood and timber goes in as raw materials, labour is applied in the form of structuring and carving with the help of machinery, transported to the showroom incurring distribution cost, and ultimately sold to a customer for a price.

Understanding Estimates

Its quiet natural to expect something from what you do. Its human nature to do so. Since business and more importantly production is a human activity, it’s no surprise humans make expectations. Expectations concerning product costs and its realization are in the form of budgets and standards.

Budgets are those estimates made from what you expect from a certain envisaged market situation. There is a high degree of estimation involved and the chances of actual results varying from the budgets are quiet high. Examples are the units expected to be sold, selling price.

Standards are those derived from past experiences and technical surveys. They constitute informed judgment from past experiences. The degree of estimation is low. Examples are Amount of material required for I unit of product, purchase price of materials.

For further clarity, let’s relate to the earlier example!

For the table being made, from previous experiences the factory manager could have an estimation of the required Raw Materials as 10 cubic feet of Timber @ Rs. 5,000 per cubic feet and 2 Plywood Sheets @ Rs. Rs. 4,000 per sheet, labour in the form of 30 hours of Carving @ Rs. 150 per hour and 20hours Structuring @ Rs. 100 per hour, Variable Overhead @ Rs. 90 for 40 hrs of production, and Fixed Overhead @ Rs. 3,00,000 for 100 table produced.

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This means, tabling it up:

Production Standards

Facing the reality!

Standards are derived from past experiences and hence variations from actual figures are quiet natural. The more care and diligence given in preparing standard estimates, the less variation expected with actuality. The real case cost scenario changes from time to time with the changes in customer preferences, minor changes in the properties of the product, changes in factory floor discipline, market changes, environmental changes etc. and these leads to actual results varying with the standards set. The analysis of this variance is essential in analysing and understanding and if required correcting the deviations from the standards set.

The variances of Actuals from Standards are classified into Favourable and Adverse. Variances that increase profit get’s to be called Favourable (denoted by F) and those that cut down profits as Adverse(denoted by A).

Relating that to our example:

The Standards set by the production manager for one unit of table was 10 cubic feet of Timber at a cost price of Rs. 5,000 per cubic feet. If during the manufacture of table the timber prices fell to Rs. 4,000 per cubic feet then we have a favorable variance of actual from the standards. On the other hand if prices remained the same but 12 cubic feet was used instead of 10 cubic feet , the variance is adverse.

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Summing it all up

For a cost unit,

Cost Variance is broadly categorized and sub-divided into:

1. Total Material Variance

2. Total Labour Variance

3. Total Variable Cost Variance

4. Total Fixed Cost Variance

All the above categories will be dealt into in later TYS Sessions.

Sales Variance is analysed using either of the two approaches:

1. Total Sales Variance under Total Approach (Impact on Turnover)

2. Total Sales Variance under Marginal Approach (Impact on Profit)

All the above approaches will be dealt into in later TYS Sessions.

So, what after Variance analysis?

We do variance analysis to find out the variation of Actual results from our expectations (ie. Standards and budgets). We do deeper iterative variance analysis to reach the bottom and zero in on what factor did exactly bring about the deviation of actual from the standards. Then they are further analysed to find the reason and zero in on the responsibility centre responsible for the deviation. Actions are then taken if found necessary.

Relating and concluding from the earlier example:

We have discussed 2 scenarios where deviation of actuals were witnessed from the standards.

Analysing the first one, the prize for 1 cubic feet of timber as per standards was Rs. 5,000, while the actuals was Rs. 4,000 this has resulted in a favourable variance, though requires an in-depth analysis. The per cubic feet prize has fallen by Rs. 1,000, which could mean:

1. An inferior quality timber was chosen in place of the earlier quality.

2. The overall prize of timber has fallen down.

3. The earlier Timber prizes were inflated.

After finding out the reason for the fall in procurement prize, responsibility centres are fixed and actions which the situation demands are taken. My suggestion for the above three reasons should be:

1. Responsibility centre – Material procurement Department, Investigate the reason as to why an inferior quality timber was chosen and rectify if necessary.

2. No Action

3. Responsibility Centre – Material procurement Department, Find out the person in charge of Timber procurement earlier and demand from him an explanation for the abrasion.

The same kind of an analysis can be done for the second one also. The readers/self tutors are requested to come up with their own ideas on why the second variance could have occurred and your suggestions for corrective measures. Your ideas can be posted as comments to this TYS.