ENGINEERING MANAGEMENT VARIANCE ANALYSIS

VARIANCE ANALYSIS
Definitions and purpose of variance analysis; The mechanics of variance analysis; The interpretation of variance analysis.

Definitions of Standard Costing and Variance Analysis

Standard costing: A standard is a normal or usual level established in advance of an activity; A yardstick for comparison when the activity takes place and the actual level is known;
Standard cost is the planned unit cost of the products, components or services produced in a period.

Definitions of Standard Costing and Variance Analysis

Purposes of a standard costing system is:To provide management with a yardstick for the evaluation of performance.

Definitions of Standard Costing and Variance Analysis

Variance analysis: A variance is the difference between a planned, budgeted or standard cost and the actual cost incurred. Variance analysis is the evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action.

Definitions of Standard Costing and Variance Analysis

Purpose of variance analysis: To give information on those aspects of business operations which are not proceeding according to plan. Recognizes the importance of controlling both actual results and planning procedures.

Definitions of Standard Costing and Variance Analysis

Purpose of variance analysis: To generate information which may be useful for future planning (e.g.for the setting of future standards). Important in a changing environment, for example in times of rapid technological change or high inflation.

Setting Standard Costs

The preparation of standard costs requires great care and attention.

The information produced by a standard costing system will be virtually worthless if the RESULTING variances are caused by inefficient standard setting.

Setting Standard Costs

An activity level should be chosen that is capable of being achieved. It would be possible to choose a standard that was ideal:one that represented a performance that could be achieved only under the most favorable of conditions.

Such a standard would be unrealistic, because it is rare for ideal conditions to prevail.
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Setting Standard Costs

A more realistic standard is defined as an attainable standard. An attainable standard is one that a business can expect to achieve in reasonably efficient working conditions. In other words, it accepts that some delays and inefficiencies (such as normal losses, waste and machine downtime) will occur.

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Setting Standard Costs

The standard cost of a particular unit comprises four main elements: direct materials;

direct labour;
variable overhead; fixed overhead. In turn, each element comprises two factors, quantity;

price.
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Setting Unit Standard Cost

Firstly establish the standard costs of 1 unit of production, referred to as Z units. The is done to allow for and control the difference between budgeted and actual output. This is known as a flexible budget, as compared to the fixed budget that is a given.

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Setting Unit Standard Cost

The standard unit cost is calculated firstly on the basis on total absorption costing.

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Setting Unit Standard Cost

Example:
Assume that the total cost of production is 18 per unit, and the IDEAL or TARGET selling price would be 20 per unit. For an annual production run of 120,000 units, the monthly production (and predicted sales) is 10,000 units.

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Setting Unit Standard Cost

Considering the actual profits for a 1 month period enables a comparison between the Standard cost and actual costs incurred.

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Interpreting actual profit

Assuming the actual figures to be equal to one twelfth of the standard actual figure: In a 1 month period the standard sales target would be 10000 units of Z; The sales revenue would be 200,000 the costs are 180,000; The profits would be 20,000.

This is summarised in the control profit budget for 1 control period.

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Interpreting actual profit

The actual profit statement is straightforward.

Profit is equal to the units produced minus the costs of producing those units.

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Considerations
Profits Sales Materials Labour - ???
TAXES, Inflation and currency variations.

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Stock Variance
If stocks of materials are left over at the end of the period: Part of the variance in costs would be transferred to the next period if the stocks were valued at their actual rather than standard value.

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Stock Variance
Consequently, stocks are valued at the standard cost rather than the actual cost of production.
Therefore any difference in costs directly effects current months profit statement and allows the difference in profits to be directly compared with the variances.

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Operating profit variance.

In any one month the difference between the actual profit and the standard profit can be either:NEGATIVE or ADVERSE POSITIVE or FAVOURABLE
The difference between the standard profit and the actual profit can be broken down into its different elements. These are broadly defined as sales and cost variances.
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Sales Variances
Example: The standard projections of Z units allows for sales of 10,000 units @ 20 per unit. But actual monthly sales are only 7,000 units. Lower profits can be expected because of the 3,000 shortfall in sales.

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Sales Variances
Price also has an impact if it is lower than the standard budgeted figures, i.e. 19.50 rather than 20. Taking into consideration both divergences from set standards, what will be the total sales variance?

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Sales Variances.
The fall in profit from the reduced price on the actual units sold,
Plus The profit that would have been made on the 3,000 units not sold.

The total sales variance is an adverse 9,500

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Direct Materials Variance

Areas of interest: How the ACTUAL QUANTITY of the materials used to produce 10,000 units of Z compares with the standard amount we anticipate to produce 10,000 units of Z. How much we ACTUALLY PAID for the material compared to what we should have paid according to the standard (market) price .
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Labour Variance
Labour variances are considered in an identical manner to material variances. Two elements are examined: Wages; Productivity.

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Labour Variance

Example:
The set standard wage is 5 per hour and it is estimated that 0.4 hours of labour is needed for each unit. However, if labour is 6 per hour and each unit takes 0.5 hours of Labour, the impact will be?

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Labour Variance
Then standard cost for 10,000 units would be:Standard costing 0.4 x 5 x 10,000 = 20,000
Actual costing 0.5 x 6 x 10,000 = 30,000

Variance is ????

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Variable Overhead Variance

If less units are produced than were expected, would variable overheads be lower? Simple answer = yes However this figure must be quantified. The total non-production variable overhead variance is:Difference between the standard cost of the standard hours required to produce 10000 units and actual costs incurred.
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Variable Overhead Variance

It must be established if this extra cost reflects inefficiency in terms of labour or in terms of extra variable cost spending. The expenditure variance will indicate an overspend compared to planned spend for the given number of labour hours. The efficiency variance is adverse identifying the cost of labour inefficiency.
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Variable Overhead Variance

However, in the case of non-production variable overheads the total costs are lower.
Therefore it can be determined which areas are affected by falling production levels and by extrapolating this data an ADVERSE or POSITIVE variance can be assigned to each unit of production.

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Fixed Cost/ Overhead Variance

Two issues require investigation when considering fixed costs from a control perspective:Firstly, what is the total fixed cost variance of the business in terms of monetary value. Secondly what is the cost, or importance, of fixed costs when variances in production or sales occur.

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Fixed Cost/ Overhead Variance

1. Total fixed cost variance:Is variance in fixed costs a large sum of money over the fiscal period?; if so why?

Budgeted fixed costs must be compared to actual fixed costs, as fixed costs do not vary with the output level.
This identifies the change in fixed costs for all parts of the business.

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Fixed Cost/ Overhead Variance

2. The cost, or importance, of fixed costs when variances in production or sales occur. Has under or over recovery of the cost of producing less than budgeted occurred

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Fixed Cost/Overhead Variance.

Other fixed cost variances will indicate the costs/benefits of under/over-performance in the areas already considered. Original standard costs must always be used to establish how actual costs have changed from those anticipated. The original standard cost are not changed as the process moves forward.
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Operating Profit Statement

This statement relates the individual variances to the overall profit variance. This is useful because it shows how important each variance is in the context of overall profits. The operating profit serves as a check that variances identified are correct.

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Operating Profit Statement

Lower output and lower sales combined with a lower price mean that profits are considerably lower than expected. This is compounded by the spreading of fixed costs over a smaller output which further reduces profits. The assumption is therefore of underperformance throughout!!!

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Operating Profit Statement

It is not just sales variances that can push a company into a loss; When materials, labour and variable costs are all higher than they should be they also contribute to lower profit.

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The Interpretation of Variances

Actual costs may differ from planned costs at the predicted level of activity or the level of activity differs from the planned level.
Because of:-

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The interpretation of variances

Inefficiency in operation: 1. Failure to obtain a reasonable standard in the prevailing circumstances, through inability in one form or another, or through lack of motivation; 2. When budgeting (and in decision making) the interdependence of departments has not been taken into account;
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The Interpretation of Variances

3. Action taken by one department may cause variances elsewhere within the business;
4. Random fluctuations around standards and goals which are more likely to be average targets;

5. Finally, and quite commonly, the reality that an inflexible plan has proved to be unrealistic in the light of changed circumstances.
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The Interpretation of Variances

How should the sales volume variance be evaluated? Sales variance does not appear to be caused by charging higher prices because prices have fallen; The problem may be incompetence or lack of motivation on the part of salesmen.

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The Interpretation of Variances

The drop in sales may be caused by poor products, thus the fault of production rather than the sales department; It could be due to seasonal demand;

It could be due to external changes in the market place which are beyond the control of the company such as changing consumer preferences and changing competition.

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The Interpretation of Variances

If demand in the market has declined rapidly since standards were set, the sales department may have done well to sell any units at the decreased price. Highlights the importance of accurate standards. A simple examination of the variance does not enable us to blame any department. Instead, it identifies that further review may be required.
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The Interpretation of Variances

If this completed and it is found that poor performance by salesmen is to blame, action can be taken to change their incentives; If consumer preferences are to blame, either the product may have to be changed or the company may have to leave the industry as reduced sales result in a financial loss.

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How should the sales price variance be evaluated?

This Depends largely on whether the company can influence the prevailing market price. If the company has no control over price: sales price variance is largely uncontrollable; no advantage to be gained in holding the sales force responsible for the difference, favorable or otherwise.
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How should the sales price variance be evaluated?

In this case, the information derived from the review of sales price variance will only be of use as an aid to future planning;
If the sales price variance is controllable, it should be used in conjunction with the volume variance (based on contribution lost or gained) in evaluating management.

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How should the sales price variance be evaluated?

For example a fall in price may be caused by charging a price which is too low in an attempt to increase sales (LOSS LEADER); Fall in sales price may be caused by a decrease in costs (SEASONAL); Could be caused by a downturn in the market.

Once again, it is unclear if the adverse variance is company or circumstance specific.

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How should the sales price variance be evaluated?

Materials variance can be attributed to:USAGE PRICE Does this mean that the buying manager should be congratulated for paying lower materials prices? or, the production manager should be criticized for inefficient use of raw materials?

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How should the sales price variance be evaluated?

Usage variance, may be less effected by outside factors and more under the control of the production manager.

It may due: to the wrong standards of work; untrained employees; inefficient machinery; efficiency of machine operators; changes in the material mix and non-standard production scheduling.

All lead to waste if different to the specified standards.

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How should the sales price variance be evaluated?

How should the material price variance be evaluated? By accurate comparisons in quality and quantity. OR????? Labour Rate Variance

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How should the labour rate and efficiency variances be evaluated?

The adverse labour rate variance may reflect inefficiency on the part of the personnel department;

It may reflect higher bargaining power on the part of workers unions;

Overtime may be paid too highly or may be unsupervised; Changes in incentive schemes may have an impact.
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How should the labour rate and efficiency variances be evaluated?

Labour rate variances may be due entirely to external uncontrollable factors such as national and local wage awards for individual skills and grades. In this case, the personnel department cannot be held responsible for any rate changes; Alternatively it may reflect employment of higher skilled workers, although it might not appear so from the materials usage figures.
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How should the labour rate and efficiency variances be evaluated?

Labour efficiency is less likely to be effected by outside factors such as the economy.
If more hours than necessary were used for production, this may be due to lack of supervision, poor training, or changes in working methods.

Responsibility for these variances depends partly upon the conditions prevailing in the labour market.
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How should the labour rate and efficiency variances be evaluated?

Use of less skilled labour due to shortage of skilled labour may cause standard time for the job may be lengthened to permit meaningful evaluations. If the standard time for the job is representative of the actual conditions during the period, any labour efficiency variance may be fairly attributed to the production methods.
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Keeping standards up to date

Clearly a fundamental issue in interpreting variances is whether the standards (or standard plan) are up to date. Situations exist in which management MUST review and update standards during the working/budget period. May not be necessary if no significant changes in the budgeted costs of input factors occur and if budgeted sales prices do not change during the budget period In latter case, if managers have properly anticipated price changes in setting standards.
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Keeping standards up to date

If costs or sales prices do change, due to unanticipated inflation, it becomes a matter of great importance for management to ensure that budgets and standards remain at a realistic level; One of the basic purposes of the control exercise is to assess managerial effectiveness.

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Keeping standards up to date

To measure effectiveness in a meaningful it is vital to compare like with like;

to measure managerial effectiveness,

the actual costs and revenues must be compared with the realistic standards existing at the time of incurring the costs and revenues;

If this is not done, individual managers may be unfairly advantaged or disadvantaged by being assessed on the basis of obsolete standards.
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How useful is Variance Analysis?

Variances provide an indication that something is not going as planned; They will not indicate whether there is definitely a problem or not; In order to establish this, further investigation is required.

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Investigating variances
One aspect of good management is knowing when to investigate a variance. The need to know when to investigate a variance is not always clear;
An important point to bear in mind is the cost of any investigation. Although it may be possible to quantify with reasonable accuracy the costs of investigation, it is far less easy to put a value on the benefits.

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Investigating variances
The importance of investigating only material or significant variances is frequently stressed. This presents measurement problems.

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Summary
Standard cost = planned cost of a particular unit or process and is based on what is reasonably attainable. In variance analysis actual costs are compared with standard costs, and corrective action is taken if there are any unplanned trends. Variance analysis enables differences between actual and standard costs to be broken down into cost elements and thus measure performance. VARIANCE is always expressed as a %age of the standard:e.g. + or 5%
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Summary
The degree of analysis will vary, but a total cost variance will be examined in terms of: direct material; direct labour; variable overhead; fixed overhead variances. In turn, these will be scrutinised in terms of quantity and expenditure variances.
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Summary
Sales variances will also be calculated. There are two principal types:

sales variances based on profit;

sales variances based on contribution.

The former are based on total absorption costing whereas the latter is based on marginal costing.

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Summary
The variances help in tracing the main causes of differences between actual and budgeted results. They do not explain what has actually happened.

Managers should investigate variances when: benefits of investigation outweigh the costs; the variances are significant.
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Summary
VARIANCE ANALYSIS IS BEST ILLUSTRATED AS A PERCENTAGE DEVIATION FROM NORMAL. FOR EXAMPLE:PLANNED EXPENDITURE = 10,000 ACTUAL EXPENDITURE = 15,000 VARIANCE = ? NEGATIVE OR ADVERSE 50%.
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Summary

VARIANCE ANALYSIS IS USUALLY THE FIRST ITEM DISCUSSED AT ANY MANAGEMENT MEETING, WITH THE EMPHASIS ON ANY PERCENTAGE CHANGES.

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Summary
It is important to realise that all aspects of a business to have a competitive focus;

Any changes from the NORM must be recognised immediately, evaluated and where necessary acted upon;
Management must have good knowledge and understanding of competitors and their strategies for a competitive focus to be effective; The companys own strengths and weaknesses must be critically evaluated in relation to the strengths and weakness of your competitors.

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Summary
A company must try to know as much about its competitors strategy as it does about its own! It must be established why they have made certain moves, predict what they are planning for the future and estimate the likely reactions to the companies strategy. In this way a winning strategy can be developed.

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ANALYSIS OF COMPETITORS
The information required includes: WHO ARE THEY? WHAT ARE THEIR OBJECTIVES WHAT ARE THEIR STRATEGIES? HOW SUCCESSFUL ARE THEY? WHAT ARE THEIR STRENGTHS? WHAT ARE THEIR WEAKNESSES?
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CONCLUSION
FINANCIAL COMPETITION IS WARFARE.
The strong and ruthless survive and prosper. The weak and badly organised wither and perish.

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