Management Accounting-Performance Evaluation: Analysing Cost Variances Is No Easy Task, Because a Single Variance May Contain Four Different Elements. Falconer Mitchell Offers His Guide to Interpreting Them
Mitchell, Falconer, Financial Management (UK)
Standard cost variances provide feedback information designed to help managers control operations in accord with the plans they have set. They highlight the difference between the planned costs of a period--ie, the standard costs that are determined before the period starts--and the actual costs incurred over that time. Consequently, they are reported after costs have been incurred and are intended to prompt a managerial reaction if they show that things aren't going to plan.
It's the managers' job to analyse the cost variance information reported to them and decide whether any action is needed and, if so, the appropriate action to take.
Cost variances comprise several different elements that together make up the total reported variance. The factors causing variances can be divided into two broad categories. First, there are operational causes that relate to operational activity--ie, the purchase and use of resources. Where these causes are controllable, managers can use variance information to trigger corrective action. Second, there are non-operational causes that relate to problems in the administration of the standard costing system. They provide feedback to the accountants running the system and their identification and elimination focuses attention on operational causes. This makes variance interpretation difficult, because each of these potential elements in a variance can have a different significance. Non-operational causes provide feedback to those who set the standards and run the standard costing system, while some operational causes can be acted upon and are, therefore, of interest to managers. Panel 1 illustrates the four elements of a cost variance.
Element one: costing system errors
If the system itself malfunctions, variances may be reported wrongly. For example, the issue of material stock from stores at an erroneously high price would generate unfavourable material price variances. Likewise, inaccurate direct labour time recording can result in false labour efficiency variances.
Such variances are caused by errors and are signals that the way the standard costing system is being run needs to be improved. Eliminating the "noise" caused by this type of variance means that managers can assume that reported variances are attributable to the other three elements.
Element two: inappropriate standards
The standard cost that's set is one of the two figures from which variances are computed. Consequently, the level at which the standard has been set can directly influence the variances. For example, the standard may be deliberately set tightly at a level above what is considered attainable in order to motivate employees. All variances will be unfavourable as a result, but this will not indicate that corrective action is needed.
Alternatively, the standards may become obsolete if they were set some time ago and have not been recently revised. If this is the case, the standard may well represent a technology that no longer exists or supply conditions that have altered or a workforce that has become more experienced. Variances are likely to be favourable under these circumstances, but they will be attributable to a loose and obsolete standard rather than good operational performance. Because these variances result from inadequacies in the standard they represent feedback to the planning function to set more current standard costs.
Standards are static in nature, as they are set at one level and applied to a period in which costs may act in a dynamic way. This mismatch may also give rise to variances. If inflation is a feature of costs, the standard may be set to represent expected cost levels at the midpoint of the accounting period. Assuming that inflation accrues evenly over the period, this is likely to mean that favourable variances will be produced in the first half of the period and unfavourable variances in the second hall simply because one static estimate cannot adequately represent the dynamic change inherent in inflation. …