Variance AnalysisVariance Analysis

Variance analysisVariance analysis

• Variance analysis is the evaluation of performance by Variance analysis is the evaluation of performance by means of variances, whose timely reporting increase the means of variances, whose timely reporting increase the opportunity for remedial actionopportunity for remedial action

• Variance analysis involves an investigation of the Variance analysis involves an investigation of the difference betweendifference between– Actual costs and standard costs orActual costs and standard costs or– Between actual costs/revenue and budget costs/revenueBetween actual costs/revenue and budget costs/revenue

• It enables mangers to identify problems which need further It enables mangers to identify problems which need further investigation with a view to implementing remedial actioninvestigation with a view to implementing remedial action

• The value of variance analysis lies in managers being able The value of variance analysis lies in managers being able to isolate where increased costs are actually occurring and to isolate where increased costs are actually occurring and take remedial action in that specific areatake remedial action in that specific area

Standards and budgetsStandards and budgets

• Standard costing and budgeting share one thing in Standard costing and budgeting share one thing in common - they are both concerned with the future common - they are both concerned with the future rather than what has happenedrather than what has happened

• But there is an important difference - budgets relate to But there is an important difference - budgets relate to aggregates (e.g. sales revenue and total costs) aggregates (e.g. sales revenue and total costs) whereas standards refer to per unit figureswhereas standards refer to per unit figures

• Variances can be calculated against both standards and Variances can be calculated against both standards and variance but for the sake of simplicity we will focus on variance but for the sake of simplicity we will focus on variances against budget figuresvariances against budget figures

• Instead of using terms like standard costs or standard Instead of using terms like standard costs or standard price we will use the terms budget price per unit or price we will use the terms budget price per unit or budget quantitybudget quantity

VarianceVariance

• A variance is the difference between the budgeted A variance is the difference between the budgeted level of costs and revenue and the actual levels of level of costs and revenue and the actual levels of costs and revenuescosts and revenues

• Positive/favourable variancePositive/favourable variance– A better than expected resultA better than expected result– Costs lower or revenue higher than expectedCosts lower or revenue higher than expected– Should led to higher than expected profitsShould led to higher than expected profits

• Negative/adverse/unfavourable varianceNegative/adverse/unfavourable variance– A worse than expected resultA worse than expected result– Costs higher or revenue lower than expectedCosts higher or revenue lower than expected– Should led to lower than expected profitsShould led to lower than expected profits

Steps to be takenSteps to be taken

• Construct a budgetConstruct a budget

• Monitor results against the budgetMonitor results against the budget

• Identify the varianceIdentify the variance

• Calculate the varianceCalculate the variance

• Analyse and explain the varianceAnalyse and explain the variance

• Evaluate the significance of the variance both Evaluate the significance of the variance both in absolute terms and in proportionate termsin absolute terms and in proportionate terms

• Attribute responsibility for the varianceAttribute responsibility for the variance

• Take action to correct the problemTake action to correct the problem

Basic variancesBasic variances

• Actual BudgetsActual Budgets• Sales revenue £9.7m £10mSales revenue £9.7m £10m• Total costs £9.5m £9mTotal costs £9.5m £9m• Profits £0.2m £1mProfits £0.2m £1m• Sales revenue was £300k down on the budget Sales revenue was £300k down on the budget

figure- this was an adverse variance of £300kfigure- this was an adverse variance of £300k• Costs were £500k up on the budget figure- Costs were £500k up on the budget figure-

again adverse variance but this time of £500kagain adverse variance but this time of £500k• Add the two together and there is £800k Add the two together and there is £800k

variance on profitsvariance on profits

Types of varianceTypes of variance

• Sales varianceSales variance - sales revenue different from expected - sales revenue different from expected

• Cost varianceCost variance - total costs different from expected - total costs different from expected

• Materials varianceMaterials variance - cost of direct materials different - cost of direct materials different from expectedfrom expected

• Labour varianceLabour variance - cost of direct labour different from - cost of direct labour different from expectedexpected

• Overhead varianceOverhead variance - overhead costs different from - overhead costs different from expectedexpected

• Profit varianceProfit variance - profits different from expected - profits different from expected

• These are the broad headings for variances but within These are the broad headings for variances but within each category there are sub varianceseach category there are sub variances

Quantity or price? Quantity or price?

• In all cases variances are caused by In all cases variances are caused by eithereither– A price which is different from that planned A price which is different from that planned – Volume which is different from that plannedVolume which is different from that planned

• Alternatively it is possible that a variance Alternatively it is possible that a variance might be caused by a combination of the might be caused by a combination of the twotwo

• The purpose of variance analysis is to The purpose of variance analysis is to separate out the two elementsseparate out the two elements

Saes revenue variance Saes revenue variance

Sales revenue variance Sales revenue variance

• This is where sales revenue is different from expected.This is where sales revenue is different from expected.

• It is the result of It is the result of

• Sales volume varianceSales volume variance - caused by the actual volume - caused by the actual volume quantity sold being different from the planned volumequantity sold being different from the planned volume

• A volume variance measures the impact on revenue of A volume variance measures the impact on revenue of the difference between actual and expected quantity soldthe difference between actual and expected quantity sold

And/orAnd/or

• Sales price varianceSales price variance – caused by a difference in the – caused by a difference in the price actually paid compared to that in the budgetprice actually paid compared to that in the budget

• A price variance measures the difference between the A price variance measures the difference between the planned price and the actual selling priceplanned price and the actual selling price

Sales revenue varianceSales revenue variance

• Actual BudgetActual Budget• Quantity sold 9m 10mQuantity sold 9m 10m• Price per unit £3.5 £3.6Price per unit £3.5 £3.6• Sales revenue £31.5m £36mSales revenue £31.5m £36m• There was an variance on sales revenue of There was an variance on sales revenue of

£4.5m.This was caused by a combination of a £4.5m.This was caused by a combination of a lower than planned level of sales and a price lower than planned level of sales and a price charged which was lower than plannedcharged which was lower than planned

• We can disaggregate the £4.5m by separating out We can disaggregate the £4.5m by separating out the quantity/volume variance from the price the quantity/volume variance from the price variancevariance

Formulae Formulae

• Sales revenue variance = Sales revenue variance = (AQ X AP) minus (BQ X BP)(AQ X AP) minus (BQ X BP)

• Price variance =Price variance =(AP- BP) x AQ(AP- BP) x AQ

• Volume/ quantity variance =Volume/ quantity variance =(AQ –BQ) x BP(AQ –BQ) x BP

• Where AP is actual price per unit and AQ is Where AP is actual price per unit and AQ is actual quantity soldactual quantity sold

• and BP is budget price per unit and BQ is and BP is budget price per unit and BQ is budget quantity soldbudget quantity sold

Sales revenue varianceSales revenue variance

• The overall variance is (9m x £3.5) minus (10m x 3.6) The overall variance is (9m x £3.5) minus (10m x 3.6) = £31.5m minus £36m. This is an variance of - £4.5m= £31.5m minus £36m. This is an variance of - £4.5m

• It can broken down into price and volume variancesIt can broken down into price and volume variances

• Price variance = (£3.5-£3.6) x 9m = - £0.9mPrice variance = (£3.5-£3.6) x 9m = - £0.9m

• Volume variance =(9m - 10m) x £3.6 = - £3.6mVolume variance =(9m - 10m) x £3.6 = - £3.6m

• Notice that the price and volume variances sum to -Notice that the price and volume variances sum to -£3.4.5m£3.4.5m

• Both variance are adverse although the volume Both variance are adverse although the volume variance was of greater significance than the price variance was of greater significance than the price variancevariance

Direct materials varianceDirect materials variance

Material variancesMaterial variances

• Variance on the cost of materials used as Variance on the cost of materials used as inputs can be attributed to: inputs can be attributed to:

• Materials price varianceMaterials price variance– Difference between planned cost and the Difference between planned cost and the

actual cost per unit of materials used.actual cost per unit of materials used.

• and/orand/or

• Materials usage varianceMaterials usage variance– The difference between the planned quantity of The difference between the planned quantity of

materials used and the actual quantity used materials used and the actual quantity used

Materials varianceMaterials variance

• Actual BudgetActual Budget

• Cost per unit £5 £4Cost per unit £5 £4

• Quantity in units 500 550Quantity in units 500 550

• Total costs £2500 £2200Total costs £2500 £2200

• There is an adverse variance of £300 on direct There is an adverse variance of £300 on direct materials used in productionmaterials used in production

• Notice that there was an adverse variance on price Notice that there was an adverse variance on price per unit but a favourable variance on quantity of per unit but a favourable variance on quantity of materials used. Clearly the adverse variance more materials used. Clearly the adverse variance more than cancelled out the favourable onethan cancelled out the favourable one

Formulae Formulae

• Direct materials cost variance =Direct materials cost variance =(AQ x AC) minus (BQ x BC)(AQ x AC) minus (BQ x BC)

• Direct materials price variance =Direct materials price variance =(AC – BC) x AQ(AC – BC) x AQ

• Direct materials usage variance =Direct materials usage variance =(AQ – BQ) x BC(AQ – BQ) x BC

• Where AQ is actual quantity used and AC is Where AQ is actual quantity used and AC is actual cost per unitactual cost per unit

• And BQ is budget quantity and BC is budget And BQ is budget quantity and BC is budget cost per unitcost per unit

Materials varianceMaterials variance

• The total variance is (£5 x 500) minus (£4 x The total variance is (£5 x 500) minus (£4 x 550) = £2500- £2200 = £300 (adverse)550) = £2500- £2200 = £300 (adverse)

• The variance on cost per unit of materials The variance on cost per unit of materials was (£5-£4) x 500 = £500 (adverse)was (£5-£4) x 500 = £500 (adverse)

• The variance on materials usage was (500-The variance on materials usage was (500-550) x £4 = £200 (favourable)550) x £4 = £200 (favourable)

• The adverse cost variance was greater than The adverse cost variance was greater than the favourable usage variance leading to an the favourable usage variance leading to an adverse variance overalladverse variance overall

Direct labour varianceDirect labour variance

Labour varianceLabour variance

• This type of variance is related to the cost of labour This type of variance is related to the cost of labour employed – both price of labour and/or its efficiencyemployed – both price of labour and/or its efficiency

• Total labour cost varianceTotal labour cost variance - this is the difference - this is the difference between what it cost to employ direct labour and what it between what it cost to employ direct labour and what it was expected to cost for the actual level of productionwas expected to cost for the actual level of production

• Labour rate (price) varianceLabour rate (price) variance - labour available at a - labour available at a price different from expected. The variance is the price different from expected. The variance is the difference between the wage rate that was expected to difference between the wage rate that was expected to be paid and the wage rate actually paidbe paid and the wage rate actually paid

• Labour efficiency varianceLabour efficiency variance - production required more - production required more (or less) labour than expected or planned. It is caused by (or less) labour than expected or planned. It is caused by labour being more (or less) efficient than was expectedlabour being more (or less) efficient than was expected

Labour varianceLabour variance

• Actual BudgetActual Budget• Rate per hour £9 £8Rate per hour £9 £8• Hours of labour required 50,000 40,000Hours of labour required 50,000 40,000• Total cost of labour £450,000 £320,000Total cost of labour £450,000 £320,000• There was an adverse variance on direct There was an adverse variance on direct

labour of £130,000labour of £130,000• It was caused by a combination higher than It was caused by a combination higher than

planned wage rate and higher than planned planned wage rate and higher than planned quantity of labour to complete the workquantity of labour to complete the work

• But which of the two was more important?But which of the two was more important?

Formulae Formulae

• Total labour cost variance=Total labour cost variance=(AR x AH) minus (BR x BH)(AR x AH) minus (BR x BH)

• Labour rate variance =Labour rate variance =(AR- BR) x AH(AR- BR) x AH

• Labour efficiency variance =Labour efficiency variance =(AH – BH) x BR(AH – BH) x BR

• Where AR is actual wage rate per hour and AH is Where AR is actual wage rate per hour and AH is actual number of hours needed to complete the actual number of hours needed to complete the job job

• And BR is budget wage rate per hour and BH is And BR is budget wage rate per hour and BH is budget hours to complete the jobbudget hours to complete the job

Labour variancesLabour variances

• The overall labour cost variance is = (£9 x 50k) The overall labour cost variance is = (£9 x 50k) minus (£8 x 40k) = £450k - £320k = £130kminus (£8 x 40k) = £450k - £320k = £130k

• The labour rate variance is (£9 - £8) x 50k = £50kThe labour rate variance is (£9 - £8) x 50k = £50k

• The labour efficiency variance is (50k-40k) x £8 = The labour efficiency variance is (50k-40k) x £8 = £80k£80k

• The high variance on labour costs was caused by The high variance on labour costs was caused by a rise in the rate paid per hour and an increase in a rise in the rate paid per hour and an increase in labour required over the quantity planned in the labour required over the quantity planned in the budget. Of the two variances the efficiency budget. Of the two variances the efficiency variances producer the greater impactvariances producer the greater impact

Overhead variancesOverhead variances

Fixed overhead expenditure Fixed overhead expenditure variancevariance• Formula: budgeted fixed overheads minus Formula: budgeted fixed overheads minus

actual fixed overheadsactual fixed overheads

• Caused by a change in price of fixed Caused by a change in price of fixed overheads e.g. rent, standing chargesoverheads e.g. rent, standing charges

• If expenditure is higher than expected it If expenditure is higher than expected it could mean the full costs of overheads is could mean the full costs of overheads is not being absorbed (covered) in the pricenot being absorbed (covered) in the price

• Over absorption occurs if actual overhead Over absorption occurs if actual overhead costs are less than standardcosts are less than standard

Variable overhead variancesVariable overhead variances

• Overall variance = budget cost of variable Overall variance = budget cost of variable overheads minus actual costs of variable overheads minus actual costs of variable overheadsoverheads

• or (actual production x budget variable overhead or (actual production x budget variable overhead rate per unit) -actual variable overhead cost rate per unit) -actual variable overhead cost

• Caused by Caused by – Changes in overhead costs e.g. changes in the cost of Changes in overhead costs e.g. changes in the cost of

water, gas, electricitywater, gas, electricity– Or changes in activity levels linked to labour or Or changes in activity levels linked to labour or

machine hours workedmachine hours worked

Overhead volume varianceOverhead volume variance

• This is cause by changes in activity levels This is cause by changes in activity levels linked to labour or machine hours workedlinked to labour or machine hours worked

• Formula: (budget quantity of input hours for Formula: (budget quantity of input hours for actual production-actual input hours) x variable actual production-actual input hours) x variable overhead rateoverhead rate

• If actual output is less than planned this will If actual output is less than planned this will cause a variance because overheads will not be cause a variance because overheads will not be fully absorbedfully absorbed

• Output/sales in excess of plans will lead to Output/sales in excess of plans will lead to over-absorptionover-absorption

Interdependence of Interdependence of variances (1)variances (1)

• The cause of a particular variance The cause of a particular variance may affect another variance in a may affect another variance in a corresponding or opposite waycorresponding or opposite way

• Workers trying to improve Workers trying to improve productivity (favourable labour productivity (favourable labour efficiency variance) might become efficiency variance) might become careless and waste more material careless and waste more material (adverse material usage variance)(adverse material usage variance)

Interdependence of Interdependence of variances (2)variances (2)• A new improved machine becomes A new improved machine becomes

available which causesavailable which causes

• An adverse fixed overhead expenditure An adverse fixed overhead expenditure variance (because this machine is more variance (because this machine is more expensive and depreciation is higher)expensive and depreciation is higher)

• Favourable wage efficiency and fixed Favourable wage efficiency and fixed overhead volume variances (higher overhead volume variances (higher productivity)productivity)

Interdependence of Interdependence of variances (3)variances (3)• If supplies of a specified material are not If supplies of a specified material are not

available, this may lead to available, this may lead to • A favourable price variance (cheaper material A favourable price variance (cheaper material

used)used)• An adverse usage variance (cheaper material An adverse usage variance (cheaper material

caused more wastage)caused more wastage)• An adverse fixed overhead volume variance An adverse fixed overhead volume variance

(production delayed while material was (production delayed while material was unavailable)unavailable)

• An adverse sales volume variance (unable to An adverse sales volume variance (unable to meet demand due to production difficulties)meet demand due to production difficulties)