Describe how companies use variance analysis
Mitchell Franklin; Patty Graybeal; Dixon Cooper; and Amanda White
How businesses use variance analysis
Companies use variance analysis in different ways. The starting point is the determination of standards against which to compare actual results. Many companies produce variance reports, and the management responsible for the variances must explain any variances outside of a certain range. Some companies only require that unfavorable variances be explained, while many companies require both favourable and unfavourable variances to be explained.
Requiring managers to determine what caused unfavourable variances forces them to identify potential problem areas or consider if the variance was a one-time occurrence. Requiring managers to explain favourable variances allows them to assess whether the favourable variance is sustainable. Knowing what caused the favourable variance allows management to plan for it in the future, depending on whether it was a one-time variance or it will be ongoing.
Another possibility is that management may have built the favourable variance into the standards. Management may overestimate the material price, labour wage rate, material quantity, or labour hours per unit, for example. This method of overestimation, sometimes called budget slack, is built into the standards so management can still look good even if costs are higher than planned. In either case, managers potentially can help other managers and the company overall by noticing particular problem areas or by sharing knowledge that can improve variances.
Often, management will manage “to the variances,” meaning they will make decisions that may not be advantageous to the company’s best interests over the long run, in order to meet the variance report threshold limits. This can occur when the standards are improperly established, causing significant differences between actual and standard numbers.
Ethical considerations when using variance analysis over the long-term
The proper use of variance analysis is a significant tool for an organisation to reach its long-term goals. When its accounting system recognises a variance, a business needs to understand the significant influence of accounting not only in recording its financial results, but also in how reacting to that variance can shape management’s behaviour toward reaching its goals.1 Many managers use variance analysis only to determine a short-term reaction, and do not analyse why the variance occurred from a long-term perspective. A more long-term analysis of variances allows an approach that “is responsibility accounting in which authority and accountability for tasks is delegated downward to those managers with the most influence and control over them.”2 It is important for managers to analyse the reported variances with more than just a short-term perspective.
Managers sometimes focus only on making numbers for the current period. For example, a manager might decide to make a manufacturing division’s results look profitable in the short term at the expense of reaching the business’s long-term goals. A recognisable cost variance could be an increase in repair costs as a percentage of sales on an increasing basis. This variance could indicate that equipment is not operating efficiently and is increasing overall cost. However, the expense of implementing new, more efficient equipment might be higher than repairing the current equipment. In the short term, it might be more economical to repair the outdated equipment, but in the long term, purchasing more efficient equipment would help the business reach its goal of eco-friendly manufacturing. If the system use for controlling costs is not aligned to reinforce management of the business with a long-term perspective, “the manager has no organizational incentive to be concerned with important issues unrelated to anything but the immediate costs”3 related to the variance. A manager needs to be cognisant of their organisation’s goals when making decisions based on variance analysis.
Management can use standard costs to prepare the budget for the upcoming period, using the past information to possibly make changes to production elements. Standard costs are a measurement tool and can thus be used to evaluate performance. As you’ve learned, management may manage “to the variances” and can manipulate results to meet expectations. To reduce this possibility, performance should be measured on multiple outcomes, not simply on standard cost variances.
As shown in the table below, standard costs have pros and cons to consider when using them in the decision-making and evaluation processes.
Standard costing provides many benefits and challenges, and a thorough analysis of each variance and the possible unfavourable or favourable outcomes is required to set future expectations and adjust current production goals.
- 1 Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1026.5569&rep=rep1&type=pdf
- 2 Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1026.5569&rep=rep1&type=pdf
- 3 Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1026.5569&rep=rep1&type=pdf