Cost Management Using Variance Analysis

          Cost Variance = Actual Cost - Budget (Standard) Cost

          Variance Analysis is a technique used for: 

a.      Cost Control   - Monitor Actual Expenditures against, should cost. 

b.     Profit Control - Which a large part is facilitated by cost control.

To be able to do Variance Analysis you need:          

1.     A cost accounting system that records the costs in the format that allows matching against planned cost. 

2.     Budgeted costs that are realistic, doable and accepted by those responsible for meeting them.

3.     The best way to develop "should" cost is through defining standard through actual measurement (engineers costs).  When this is done for the whole company, it is called Standard Costing. 

4.     Standard Costing is very expensive (i.e. must develop and keep standards up-to-date).  Pay for mass production companies where due to low profit margins cost must be carefully controlled (i.e. Proctor & Gamble, McDonalds, Medical Centers). 

5.     Where acceptable historical costs (cost database) are used to specify a should cost: 

a.      Last years actual cost plus adjustment for change.

b.     Statistically derived cost function.

The most widely used technique by management to maintain cost and profit control is

                    The Budget

--

Usually each of these sectors has specific individual budget that cover areas that management wants to monitor. 

     Sales Revenue - By individual product, sales office, customer 

     Factory Overhead - Maintenance, Quality Control, Engineering 

     General + Administrative - Legal Dept., Human Relations, Public Relations

 What Budget Does

1.     Communicates Goal

2.     Defines Constraints

3.     Provides Accountability

4.     Sets Targets to be Met

5.     Provides Systems Perspective

Necessary for Budgets to Work

1.     People have confidence in the budget system being used and budget figures set to be met

2.     Is utilized by management

3.     Management does not use to set blame, but as an indicator for possible action to be taken

4.     Fast feedback of performance to the managers so they can take corrective action

5.     They are not too administratively burdensome

Variance Analysis Involves

1.     Defining the gap between the budget goal and actual performance

2.     Investigating to determine cause

3.     Identifying potential responses

4.     Taking action

Typical variance that are calculated to explain why profit target is not met. 

Can either be sales revenue lower, costs higher or a combination of both.

 -----

Flexible Budgets

Flexible Budget is one that provides standards that are

relevant to evaluate performance at any activity level. 

This is necessary to make a meaningful evaluation of performance.

Usually used to develop the “should” cost.

For example you do not know at what operating level you are going to run.  What you know is that there is a fixed cost and variable cost.  

Say the fixed is $10,000 and variable cost is $5.00 per hour. 

The "Should" Cost if

          10,000 hrs. is  $10,000  + 10,000(5) =   $ 60,000 

          25,000 hrs. is  $10,000  + 15,000(5) =      75,000 

            20,000 hrs. is  $10,000  + 20,000(5) =    100,000 

So if in one month 10,000 hours are worked, the budget is $60,000.   If 20,000 hours were worked, $100,000 is the amount that should have been spent.

Example Problem

 Direct Material and Direct Labor Variance 

Actual 

          Produced 3,600 units

          Bought and used 4,000 lbs. of material

           Costing $108,000

          Used 50,400 hours of direct labor