Cost Management Using Variance Analysis
Variance = Actual Cost - Budget (Standard) Cost
Cost Variance = Actual Cost - Budget (Standard) Cost
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
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.
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.
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.
Direct Material and Direct Labor Variance
|Standard - for one unit||Unit Cost
|DM 1lb. Material $26.00 per lb.||=||26.00|
DL 12 hrs. labor @ $12.00 per hour
Produced 3,600 units
Bought and used 4,000 lbs. of material
Used 50,400 hours of direct labor
Another Word on Setting of Standards
They have to be realistic to be effective and useful.
Say in a production department you have 40 machines - what should be the number of production hours available?
Theoretically = 40 machines x 8 hours/day x 250
= 80,000 hours/year
Practically they only work 80% of the time due to downtime, Personnel HB Sense
.8(80,000) = 64,000
that would be 100% capacity utilization on one shift. (i.e. currently attainable standards).
Chances are you will be working at 80% of capacity or .8(64,000)=51,200.
The flexible budget will allow you to determine what the costs should be at that production level.