Variance and Ratio Anaysis

Costing - Phase (I & II) Basics of Cost Control and Analysis

Variance Analysis

In reality, it is rare that the costs of the firm will exactly match the set standards. Management cannot insist that every time the performance must match the rigid standards. Limits of these deviations from the set standards which are called tolerance limits. The deviations are of two types: Random and significant. Random deviations are those which arise purely due to chance and are therefore uncontrol- lable. Significant deviations are those that have assignable causes and are therefore largely subject to control of the management. Cost control must be based on some measure of importance of these significant deviations.

If variances exist, their causes have to be determined for taking the corrective actions.

There are many causes for these variations which are listed below:

Due to union negotiations, policy decision or changing composition of work force, labour rates or salary levels may change.
The product mix may change in a multi-product industry.
The improvements in systems can bring about reduction in costs.
Changes in productivity can alter the cost levels.
Changes in product design will change cost.
Investment in new capital and replacement of old equipments can have immediate effects on both operating costs and overheads.
Policy decisions of various kinds may affect cost levels. (viii)Changes in hours of working time will have its influence on costs.

The amount of idle hours will vary depending on the extent of lock-outs and lay-offs.
Changes in the value of money.

If variance is significant, it signals the need for managerial investigation. An important thing about variances is that the causes of variance be personalised. So the variance analysis operates in accordance with the principles of responsibility accounting.

Computation and Analysis of Variances:

Once the standard costs are determined, the next step is to ascertain the actual cost. Finding variances cannot itself lead to control. Each of these variances is analysed to know the reason leading to the variance.

A detailed analysis of variances, particularly controllable variances, helps the management to ascertain the following:

The magnitude of variation.
Reasons for the occurrence of the variance.
The factors responsible for it.
The department on which the responsibility of the variance can be laid.
The corrective measure for reducing the variance.

Kinds of Variance:

These are four kinds of variance:

Material cost variance
Labour cost variance
Sales variance
Overhead variance

(i) Material Cost Variance:

Material cost variance is the difference between the standard cost of materials and actual cost of materials used.

Material cost variances are analyzed in terms of:

Materials price variance,
materials usage variance,
materials mix variance, and
Materials yield variance.

Materials price variance is the difference between the standard prices specified and the actual price paid.

Materials usage variance is the difference between the standard quantity specified and actual quantity used.

Materials mix variance is that portion which is due to change in the composition of materials mix. Materials yield variance is the difference between the standard yields specified and the actual yield obtained.

(ii) Labour Cost Variance (Direct WageVariance):

It is the difference between the standard direct wages specified and the actual wages paid for an activity.

The labour cost variance is analyzed into two separate variances:

Wage rate variance, and
labour efficiency. Wage rate variance arises due to difference between the standard and actual rate of wages. Labour efficiency variance is the difference between the standard labour hours specified and the actual labour hours spent.

(iii) SalesVariance:

It is the difference between the standard cost of sales specified and actual cost of sales.

There are four kinds of sales variances:

MixVariance
QuantityVariance,
Volume Variance, and
PriceVariance.

Mix Variance is due to the difference between the actual contribution of the sales mix and its standard contribution specified.

Quantity Variance is due to the difference between the standard sales mix and actual sales mix. Volume Variance is due to the difference between expected quantity of sales and the actual quantity of sales.

Price Variance is due to the difference between the actual price received and the standard price specified.

(iv) Overhead Variance:

It is the difference between the standard cost of overhead absorbed in the output achieve and the actual overhead cost.

The variable overhead variances are:

Overhead expenditure variance, and
Overhead efficiency variance.

The overhead expenditure variance is due to the difference between the standard allowance for the output achieved and the actual expenditure incurred. The overhead efficiency variance is due to the difference between the standard efficiency and the actual efficiency attained.

Ratio Analysis:

Ratio analysis is mainly used as an external standard, that is, for comparing performance with the other organisation in the industry. It can also be effectively used for comparing the performance of the firm over time. It is used to exercise cost control. Ratio is a yard stick which provides a measure of relationship between the two figures compared. The ratio may be expressed in percentage terms as a proportion or as a rate.

In the ratio analysis, an acceptable ratio is determined first and then it is compared with actual performance and the corrective measures can he resorted. The significant aspect in this analysis is that the management can take a greater interest in relative as opposed to absolute figures.

A particular ratio can be chosen depending on the need. It is possible to calculate different ratios relating to aspects like liquidity, profitability, capital structure, etc. But for a programme of cost control and cost reduction, one need to concentrate only on the operating cost ratios.

Ratio analysis is used as an instrument of cost control in two ways:

Ratios can be used to compare the performance of a business firm between two periods. It helps to identify areas which need immediate attention.
Besides, standard ratios are used to compare actual areas. Standard ratios are averages of the results achieved by several firms in the same line of business.

If these comparisons reveal any significant differences, the firm can take suitable action to eliminate the causes responsible for increase in costs.

Some of the most commonly used ratios for cost comparison are listed below: