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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Materials variance The total materials variance is £2,200 unfavourable, as shown in Table 15.7.

However, we need to consider the price and usage variances for each type of material, because the reasons for the variance and the corrective action may be different for each.


–  –  –

−2,200 80,000 72,000 74,200 Materials usage variance Using the above formula we can calculate the usage variance for each of the three materials. This is shown in Table 15.8. In each case, while holding the (standard) price constant, there has been a higher than expected usage of materials. This is an

efficiency variance, which may be the result of:

ž poor productivity;

ž out-of-date bill of materials;

ž poor quality materials.

Materials price variance Using the formula, the price variance for each of the three materials is shown in Table 15.9. While holding the (actual) quantity constant, we can see the effect of price fluctuations. Both plastic and wood have been bought below the standard price, while metal has cost more than standard. These variances may be the

result of:

ž changes in supplier prices not yet reflected in the bill of materials;

ž poor purchasing.

–  –  –

£1,000 price), which needs to be investigated as a matter of priority – while there may be a trade-off between the price and usage variances for plastic and wood, as sometimes quality and price can conflict with each other. The total materials variance is shown in Table 15.10.

Similarly, we need to analyse the usage and price variances for both skilled and semi-skilled labour.

Labour variance The total labour variance is an unfavourable £21,250, as shown in Table 15.11.

Similarly, we need to look at the usage variance (which is a productivity or efficiency measure) and the price variance (which is a wage rate variance) for each of the two types of labour.

Labour efficiency variance Using the same formula, the efficiency variance for labour is shown in Table 15.12.

The adverse variance is a result of 1,000 additional hours being worked for skilled labour and 1,000 hours less being worked by unskilled labour. This may have been

the result of:


–  –  –

−2,200 ž poor-quality material that required greater skill to work;

ž the lack of unskilled labour that was replaced by skilled labour;

ž poor production planning.

–  –  –

1,033,750 −21,250 1,125,000 1,012,500

–  –  –

ž unplanned overtime payments;

ž a negotiated wage increase that has not been included in the labour routing.

The total labour variance is an unfavourable £21,250. This is a combination of efficiency and rate variances, but it is all in relation to skilled labour. The total labour variance is shown in Table 15.14.

Variable production costs also need to be analysed.

Variable overhead variance The overhead variance is an adverse variation of £13,250, as shown in Table 15.15.

There are two types of overhead variance, the efficiency variance and the spending variance.

The overhead efficiency variance is £5,000 adverse, as shown in Table 15.16.

The variance has occurred because an extra 1,000 hours have been worked. The efficiency variance is typically related to production hours and often follows from variances in labour (see Chapter 11). The reason may be that as more hours have


–  –  –

been worked this has consumed more variable costs, e.g. the more machines running, the more electricity may be consumed.

The overhead spending variance is £8,250 adverse. This is shown in Table 15.17.

This variance is due to extra spending for each hour worked. The reason for this variance may be a higher cost per hour, e.g. the rate per kilowatt used paid to the utility provider may have increased.


–  –  –

The total variable overhead variance is an adverse £13,250, which is a combination of both efficiency and rate variances. The total variable overhead variance is shown in Table 15.18.

Fixed cost variance The fixed cost variance is straightforward. As changes in quantity cannot influence fixed costs (which by definition are constant over different levels of production), the variation must be the result of a spending variance.

In this case the variance is an adverse £5,000, because costs of £130,000 exceed the budget cost of £125,000.

Reconciling the variances

The difference between the original budget profit of £70,000 and the actual result of £53,800 can now be reconciled, as in Table 15.19.

While the example used here is a manufacturing example, variance analysis is equally applicable to service businesses, although there will, of course, be no


Table 15.19 Reconciliation

–  –  –

Note The difference between the original budget and the flexed budget is £19,500 adverse (the quantity variance). The difference between the flexed budget and the actual is £3,300 favourable. Together, the adverse variance is £16,200. However, it is important to remember that the individual variances for each type of material and labour need to be investigated and corrected as the total material, labour and overhead variances of £41,700 adverse are ‘disguised’ by the favourable price variance of £45,000.

need for a materials price variance. Differences in the volume of activity, sales variances, labour variances and overhead variances will constitute the difference between actual and budgeted profit.

Once variances have been identified, managers need to investigate the reasons that each occurred and take corrective action. This is part of the management control cycle – the feedback loop – described in Chapter 4.

Criticism of variance analysis Standard costing, flexible budgeting and variance analysis can be criticized as tools of management, because these methods emphasize variable costs in a manufacturing environment. While labour costs are typically a low proportion of manufacturing cost, material costs are typically high and variance analysis has a role to play in many manufacturing organizations.

However, even in manufacturing the introduction of new management techniques such as just-in-time is often not reflected in the design of the management BUDGETARY CONTROL 239 accounting system. Just-in-time (JIT) aims to improve productivity and eliminate waste by obtaining manufacturing components in the right quality, at the right time and place to meet the demands of the manufacturing cycle. It requires close co-operation within the supply chain and is generally associated with continuous manufacturing processes with low inventory holdings, a result of eliminating buffer inventories – considered waste – between the different stages of manufacture. Many of these costs are hidden in a traditional cost accounting system.

Variance analysis has less emphasis in a JIT environment because price variations are only one component of total cost. Variance analysis does not account, for example, for higher or lower investments in inventory. Purchasing managers should therefore consider the total cost of ownership rather than the initial purchase price.

In the non-manufacturing sector, overheads form the dominant part of the cost of producing a service and so price and usage variance analysis has a limited role to play. However, organizations can use variance analysis in a number of ways to support their business strategy, most commonly by investigating the reasons for variations between budget and actual costs, even if those costs are independent of volume. These variations may identify poor budgeting practice, lack of cost control or variations in the usage or price of resources that may be outside a manager’s control.

We have already described approaches to total quality management (TQM) and continuous improvement in Chapter 9 and the implications of these processes for cost management. It is important to recognize that reducing variances based on standard costs can be an overly restrictive approach in a TQM or continuous improvement environment. This is because there will be a tendency to aim at the more obvious cost reductions (cheaper labour and materials) rather than issues of quality, reliability, on-time delivery, flexibility etc. in purchased goods and services. It will also tend to emphasize following standard work instructions rather than encouraging employees to adopt an innovative approach to re-engineering processes.

Using a case study of the Portables division of Tektronix, Turney and Anderson (1989) found that accounting systems were obsolete, reporting information that was no longer used, but that the role of accounting changed ‘from being a watchdog

to being a change facilitator’ (p. 41). They described how:

the accounting function has failed to adapt to a new competitive environment that requires continuous improvement in the design, manufacturing, and marketing of a product. (p. 37) The traditional focus for cost collection was labour, material and overhead for a work order, but shifted to the output of a production line based on standard costs.

This moved improvement from individual worker performance to overall process effectiveness. Variance reports were replaced by a system of stopping production

when a defect was found. Overhead was ‘bloated’ due to:

the enormous complexity of the production process... long production runs tended to produce large inventories of the wrong product... [in which the]


additional cost of unique components was not fully reflected in the standard cost of the product. (p. 44) and the low-volume and tailored products consumed significantly more support services per unit than did the high-volume, mainline products. (p. 45) Turney and Anderson described how Tektronix Portables introduced new measures of continuous improvement and a new method of overhead allocation that ‘shifts product cost from products with high-volume common parts to those with low-volume unique parts’ (p. 46) that ‘has influenced product design decisions, encouraging a simpler product that is less costly and easier to manufacture’ (p. 47).

Variance analysis is therefore a tool that can be used in certain circumstances, but is not one that should be used without consideration of the wider impact on improvement strategies being implemented by the business. Nevertheless, neither accountants nor non-financial managers should overlook the importance of cost control.

Cost control Cost control is a process of either reducing costs while maintaining the same levels of productivity, or maintaining costs while increasing levels of productivity through economies of scale or efficiencies in producing goods or services. For this reason cost control is more accurately considered as cost improvement. Cost improvement needs to be exercised by all budget holders in order to ensure that limited resources are effectively utilized and budgets are not over-spent. This is best achieved by understanding the causes of costs – the cost drivers.

For example, the cost of purchasing as an activity can be traced to the number of suppliers and the number of purchase orders that are required for different activities. The more suppliers and purchase orders (the drivers), the higher will be the cost of purchasing. Cost control over the administration of purchasing can be exercised by reducing the number of suppliers and/or reducing the number of purchase orders. This is an example of the application of activity-based costing, described in Chapter 11.

Cost control can also be exercised by undertaking a review of horizontal business processes, i.e. crossing organizational boundaries, rather than within the conventional hierarchical structure displayed on an organization chart. Such a review aims to find out what activities people are carrying out, why they are carrying out those activities, whether they need to be carried out at all, and whether there is a more efficient method of achieving the desired output. This is called business process re-engineering (BPR, see Chapter 10).

Understanding cost drivers and reviewing business processes can be used as

tools to help in controlling costs such as:

ž projects: why are they being undertaken?

ž salaries and overtime: what tasks are people performing, and why and how are they performing those tasks?

BUDGETARY CONTROL 241 ž travel: what causes people to travel to other locations and by what methods?

ž IT and telecommunication costs: what data is being processed and why?

ž stationery: what is being used and why?

The questions that can be asked in relation to most costs are: What is being done?

Why is it being done? When is it being done? Where is it being done? How is it being done?

We have already mentioned both activity-based costing (ABC, Chapter 11) and activity-based budgeting (ABB, Chapter 14). Kaplan and Cooper (1998) defined

activity-based management (ABM) as:

the entire set of actions that can be taken, on a better informed basis, with activity-based cost information. With ABM, the organization accomplishes its outcomes with fewer demands on organizational resources. (p. 137) Kaplan and Cooper differentiated operational and strategic ABM. The former is concerned with doing things right: increasing efficiency, lowering costs and enhancing asset utilization. Strategic ABM is about doing the right things, by attempting to alter the demand for activities to increase profitability.

Strategic ABM can be used in relation to product mix and pricing decisions.

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