©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 10 Variance Analysis – A Tool for Cost Control & Performance Evaluation

Introduction Control decisions include questions of how to evaluate performance, what measures to use, and what types of incentives to use. Managers can use the budget as a control tool by comparing budgeted sales, budgeted production, and budgeted manufacturing costs with actual sales, production, and manufacturing costs. These comparisons are typically made through a process called variance analysis.

Standard Cost A budget for a single unit of a product or a service is known as its standard cost. Just as the cost of a product consists of three components—direct materials, direct labor, and manufacturing overhead —a standard cost will be developed for each component.

Standard Cost Components There are two separate cost components for each part of a product cost: A standard quantity or amount of materials, labor or overhead. A standard or budgeted price of materials, labor or overhead.

Setting Standards Historical Data Task Analysis Standards can be determined in a couple of ways.

Ideal Versus Practical Standards Most managers would agree that practical standards encourage employees to be more positive and productive. An ideal standard is one that is attained only when near-perfect conditions are present. An ideal standard assumes that every aspect of the production process, from purchasing through shipment, is at peak efficiency. A practical standard should be attainable under normal, efficient operating conditions. Practical standards take into consideration that machines break down occasionally, waste occurs in materials, etc.

Flexible Budgeting with Standard Costs

Flexible Budget Variance

Breaking Down the Variable Manufacturing Cost Variance The flexible budget variance may show that actual variable manufacturing costs are higher than budgeted, but what is the true cause? Incurred more labor cost than usual?? Spent more than budgeted on electricity or supplies?? Spent too much on materials??

The Basic Variance Analysis Model Price variance = Actual X Actual - Standard quantity (AQ) price (AP) price (SP) [] Usage variance = Standard X Actual - Standard price (SP) quantity (AQ) quantity (SQ) [ ]

Interpreting and Using Variance Analysis Stable Rapid Change Reduced non- value added Continuous Improvement Heavily Automated - Reliance on Direct Labor Mature Standard costs and variance analysis are useful for diagnosing organizational performance in companies that are stable, mature, and reliant on direct labor. They are not very helpful in rapidly changing companies.

Information from variance analysis is typically too aggregated for operating managers to use. Drawbacks of Variance Analysis Summary Reports Information from variance analysis is usually not timely enough to be useful to managers. Traditional variance analysis of variable and fixed overhead provides little useful information for managers. Traditional variance analysis focuses on cost control instead of performance measures.

Using and Interpreting Variances Identifying management’s objectives is vitally important in deciding how to use and interpret variances. Understand management’s primary objective. Is it cost control or producing a high-quality product is important? Once managers are sure of the root cause(s) of a variance and have considered their own objectives in utilizing variance analysis, they can intelligently consider options available to deal with the problem.

Behavioral Considerations Dysfunctional behavioral examples include: The use of ideal standards can lead to resentment as managers always face unfavorable variances. Too much emphasis on direct material usage variance causes managers to increase production while causing inventories to rise unacceptably. Purchasing manager evaluations linked to price variances can cause purchases of inferior materials.

End of Chapter 10