What Is Variance Analysis - Assignment Example

What Is Variance Analysis? The operating statement presented above plays a vital role in the identification of variances and explaining the reasons behind their occurrence. By preparing such operating statements, the management scrutinizes variances in order to, first of all, identify why they occurred in the and what remedial action can be taken in order to eliminate the situation. The variance analysis also assists the managers in rewarding efficient and effective performance of the labor force of the manufacturing concern. The role of supervision cannot be disregarded in such cases but variance reporting provides an aid to the supervisor in carrying out the control responsibilities. But it is of prime importance that management; especially the supervisors acquire full explanations of the reasons for these variances otherwise such variance analysis would be no good for control purposes. Variances are of two types, favorable and unfavorable. The favorable variance means that the budgeted and the actual costs and revenues are the same as forecasted by the budgeting department of the company, whereas unfavorable means the opposite of it. In any manufacturing concern, the variable cost comprises of direct material, direct labor and variable production overhead cost. Responsibility of material price variance lies with the purchasing department. If the material price variance is unfavorable, then it should be an indication for the managers the prices of the raw materials have increased or the purchasing department has carelessly overstocked the inventory level during the current operational year. The adverse material price variance could also be due to change in material standard. The managers while analyzing the budgeted and actual profit should take care of the aforementioned factors. On the other hand, material usage variance usually occurs due to defective material and excessive waste of the material during the production. It has also been observed generally that material usage variance also occur due to fault in allocation of materials to jobs. The managers should ensure that materials of higher quality are used during the production process and allocation of materials to all the jobs is done prudently. Other important direct cost is the direct labor cost. Labor rate variances tend to be fairly minor because usually the labor rates are agreed with the labor unions and there is a minor chance that these rates changes after the agreement is entered into. [Accountingtools.com. "What is variance analysis? ] Labor rate variance however may occur because of the use of a single average rate for a department, operations, or craft, while several different rates exist for the individual workers. On the other hand, the labor efficiency can occur for number reasons. The first and foremost reason could be the lack of materials or faulty materials, inexperienced workers and due to the learning curve effect. Learning curve can be defined as the time taken by the worker to understand the procedures of the operation through which a particular product is produced. These procedures are fairly repetitive and thus labor is expected to take less time in production after producing first batch or first unit. Thus, if there is lack of learning curve, labor efficiency variance is likely to occur. The manager should analyze these variances and ensure that the labor force of the company is utilized appropriately during the production process. [Small Business - Chron.com. "When Should a Manager Use Variance & Sensitivity Analysis] Factory overheads are of two types; fixed factory overheads and variable factory overheads. Variable overhead variance can be due to the difference between the budgeted and actual no. of units produced. Variable overhead variance can also arise due to the difference between the overhead rates. It usually happens that the company needs to revise the overhead from its initial estimate in order to include all the relevant variable cost into the production cost of the product. Other causes of increase in the overhead are increase in cost of services, excess use of services and change in type of services used. Variance in fixed factory overhead usually occurs due to the difference in the budgeted and actual fixed cost of the company. For example increase in the depreciation expense, rent expense and insurance cost causes an adverse fixed factory overhead variance. A variance is a symptom. Every significant variance, whether favorable or unfavorable, should be investigated and critically analyzed, either because performance has evaded from the standard or the standard itself is wrong. For example, a manufacturing process may change thus changing physical standards, or rapidly rising materials prices may cause monetary standard to be out of date. Perhaps a favorable variance is more than off-set by a related unfavorable variance (e.g. low cost materials of poor quality), or necessary activities such as maintenance of equipment are being neglected, causing low expenditures and a favorable variance. Off course, management should use the occurrence of desirable favorable variances as an opportunity to recognize the efficient performance of responsible managers and workers. (c) The traditional cost accumulation system of absorption costing was development in a time when most organization produced only a narrow range of product. And overhead cost were only a very small fraction of total cost, direct labor and direct material cost accounting for the largest proportion of the costs. The benefit of more accurate systems for overhead allocation would probably have been relatively small. In addition, information processing cost was high. IN recent years, however, there has been a dramatic fall in the costs of processing information. And, with the advent of advance manufacturing technology (AMD) overheads are likely to be far more important and in fact direct labor may account for as little as 5% of a product’s cost. It therefore now appears difficult to justify the use of direct labor or direct material as the basis for absorbing overheads or to believe that errors made in attributing overheads will not be significant. Many resources are used in non-volume related support activities, such as setting up, production scheduling, inspection and data processing. These support activities assist the efficient manufacture of the wide range of products and are not, in general, affected by changes in production volume. They tend to vary in the long term according to the range and complexity of the products manufactured rather than the volume of output. The wider the range and the more complex the products, the more support services will be required. Consider, for example, factory X which produces 10,000 units of one product, the Alpha, and factory Y which produces 1,000 units of each of 10 slightly different versions of the Alpha. Support activity costs in the factory Y are likely to be lot higher than in factory X but the factories produce an identical number of units. For example, factory X will only need to setup once whereas factory Y will have to setup the production run at least ten times for the ten different products. Factory Y will therefore incur more setup costs for the same volume of the production. Traditional costing systems, which assume that all products consumes all resources in proportion to their production volumes, tend to allocate too grade a proportion of overheads to high volume products (which cause relatively little diversity and hence use fewer support services) and too small a proportion of overheads to low volume products (which cause greater diversity and therefore use more support services). Activity based costing (ABC) attempts to overcome this problem. [Investopedia.com. "Activity-Based Costing (ABC) Definition] The information provided by analyzing activities can support the management functions of planning, control and decision making, provided it is used carefully and with full appreciation of its implications. Before an ABC system can be implemented management must analyze the organization’s activities, determine the extent of their occurrence and establish the relationships between activities, products/services and their cost. The information produced from such an exercise can then be used as a basis of forward planning and budgeting. For example once an organization has set its budgeted production level, the database can be used to determine the number of times that activities will need to be carried out, thereby establishing necessary departmental staffing and machines level. Financial budgets can then be drawn up by multiplying the budgeted activity levels by cost per activity. This activity based approach may not produce the final budget figures but can provide the basis for different possible planning scenarios. The information database also provides an insight into the way in which costs are structured and incurred in service and support department. Traditionally it has been difficult to control to control the cost of such departments because of the lack of relationship between the departmental output levels and departmental costs. With ABC, however, it is possible to control or manage the costs by managing the activities which underlie them by monitoring a number of key performance measures. If the ABC costing method is adopted by Mr. Ash, the variable production overhead rate is likely to change and thus it will the variance calculation. Works cited Accountingtools.com. "What is variance analysis? - Questions & Answers - AccountingTools." n.d.. Web. 16 Mar 2013. <http://www.accountingtools.com/questions-and-answers/what-is-variance-analysis.html>. Investopedia.com. "Activity-Based Costing (ABC) Definition | Investopedia." 2013. Web. 16 Mar 2013. <http://www.investopedia.com/terms/a/abc.asp#axzz2NiPPA61d>. Small Business - Chron.com. "When Should a Manager Use Variance & Sensitivity Analysis?." 2003. Web. 16 Mar 2013. <http://smallbusiness.chron.com/should-manager-use-variance-sensitivity-analysis-15694.html>. Read More