P1 – Management Accounting CH9 – Variance analysis: discussion elements

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Chapter 9 Variance analysis: discussion elements Chapter learning objectives:

Lead Component Indicative syllabus content

A.1 Discuss costing methods and their results.

(d) Interpret material, labour, variable overhead, fixed overhead and sales variances.

• Interpretation of variances.

• The interrelationship between variances.

(e) Explain the advantages and disadvantages of standard costing in various sectors and its appropriateness in the contemporary business environment.

• Criticisms of standard costing including its use in the contemporary business environment.

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1. Reasons for variances • Standard cost is an average of costs over a period(s).

• Actual costs in any given period may be greater or less than the standard cost.

• Flawed budgeting may produce variances.

• Inaccurate cost recording or operational reasons may be responsible for variances.

• Identifying the reasons helps to control variances and hence promote efficiency.

Factors to consider before investigating variances • All variances do NOT need to be investigated.

• It would be too cumbersome to investigate all variances that occur.

• Some variances may be natural to a process, so there is no point wasting time and energy on them.

• Other factors include:

o Size: some variance is to be expected, but how high should a variance be to merit investigation?

o Standard: if the standard set is too low or high, it is natural to have a high variance.

o Cost: if the cost of investigation is too high, it would not be beneficial to investigate it to control that variance.

o Cause: if the cause is known, there is no need to waste resources on further inquiry.

o Interrelation: some variances may be inversely related so that both can never be favourable.

Variance investigation techniques • Exception reporting: flags up only the unusual variances for investigation.

• Cumulative variances: investigate variances only if they recur over several control periods (it would be wasteful to investigate every variance every month).

• Control limits: uses historical data to set a standard; the statistical normal distribution is identified so that variances falling outside the range are investigated.

• Once a reason can be associated with a particular variance, one of the following actions is taken:

o Stop the cause of the adverse variance from recurring,

o Repeat or make the cause for the favourable variance recur, or

o Make the results return to a level closer to the budget.

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3. Causes of variances

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Test Your Understanding 1 – Labour efficiency variance Company A has determined an adverse labour efficiency variance.

Which of the following could lead to an adverse labour efficiency variance? A. Improving work methods

B. A high amount of idle time during production hours

C. Use of experienced labour

D. Close supervision

4. Interrelation of variances • Using cheaper materials results in a favourable price variance, but if the material is of lower

quality, there might be greater wastage and hence an unfavourable usage variance, and vice versa.

• Using more experienced labour might result in better productivity and efficiency but would be costly and result in adverse labour rate variance, and vice versa.

• Workers trying to save time might use material carelessly, resulting in a favourable efficiency variance but an adverse usage variance.

• Lowering price would give you an adverse price variance, but greater demand would present a favourable volume variance.

5. Controlling variances • Each manager should only be responsible for the variances that he/she can control.

• Therefore, each variance should only be reported to the specific manager who can influence it.

• When a variance is affected by more than one factor, it is known as a composite variance.

• A composite variance should be reported to all of the managers who can control the factors influencing that composite variance.

6. Modern developments

Standard costing in today’s environment • Standard costing does not suit today’s dynamic environment.

• The environment is continuously changing, whereas standards, once set, remain static.

• More and more products are becoming customised for customers.

• Fast-changing trends and shorter product life cycles require frequent updates to standards, making it a costly system to operate.

• Where most systems and production processes are automated, trying to control workforce efficiency through standards is redundant.

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• The modern concepts of continuous improvement/TQM make standard costing are all but useless as they keep improving upon the standards set.

• Modern dynamic environments require control information faster than the traditional variance reports at the end of a control period.

Adapting in today’s environment • Even for customised products/services, some parts of the activity/production may be fairly

standard.

• Standards need to be updated regularly to be meaningful.

• Set more challenging standards to keep up with the continuous improvement philosophy.

• Put more emphasis on variances that are more relevant to modern systems, i.e. less focus on labour variances.

• Use information systems that report variances in real time so that control decisions can be taken more effectively.

Test Your Understanding 2 – Modern business environment Standard costing in the modern business environment is inappropriate, because:

A. Products tend to be standardised

B. Production is highly automated

C. Standard costs do not become out of date

D. Variance reports are now out of fashion

McDonaldization • An extreme process of rationalisation used successfully by

McDonalds to achieve efficiency.

• Breaks down each process into all of the tasks that make up that activity, down to the smallest possible task.

• All of these tasks are rationalised to find the one most efficient way to complete each of them.

• The time and cost for each task can then be standardised with more accuracy.

• Each activity is understood by the managers according to the number of tasks it requires to complete.

• This approach takes the view that standardised products mean less expense and better quality.

• It is based on the belief that customers like the familiarity of standardised procedures.

• George Ritzer identified four dimensions of this process:

o Efficiency: choosing the optimum method to achieve the task, i.e. in less time and with least effort.

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o Calculability: capability to produce large quantities without foregoing quality; automation tends to be used more than manual labour to reduce errors.

o Control: proper control procedures for this to be effective.

o Predictability: knowing what to expect at any outlet (customers and employees).

Diagnostic reference groups • This activity can be carried out in service industries to achieve standardisation.

• For example, in the healthcare sector, the medical conditions of the patients can be classified in such a diagnostic reference group.

• The treatment to be provided can then be standardised accordingly.

• This way, the standard cost of the treatment can be determined as well as the performance of the healthcare provider.

• However, this approach is criticised, as the varying nature of illnesses makes it difficult to standardise diagnosis and treatment.

• Even one type of problem may have different appropriate treatments depending on the severity of the complaint, e.g. all G.I. disorders do not merit the same treatment.

• A consultant might hesitate to prescribe a different treatment than the standard for fear of the standard cost and performance measurement issues.

• There is a need to be careful with this system so as not to prescribe an inappropriate standard treatment.

Test Your Understanding 3 – McDonaldization Which of the following is an impact of McDonalization?

A. Standards can be more accurately set and assessed.

B. Standardised products are developed.

C. Increase in the need for human input.

D. Effective controls exist for the employees only.

7. Solutions to Test Your Understanding

Test Your Understanding 1 – Labour efficiency variance Correct option: B A high amount of idle time during production hours may result in adverse labour efficiency variance.

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Test Your Understanding 2 – Modern business environment Correct option: B Standard costing in the modern business environment is inappropriate because production is highly automated, standard costs become out of date too quickly and products are not standardised.

Test Your Understanding 3 – McDonaldization Correct option: A

One impact of McDonalization is that standards can be set and assessed more accurately.

8. Chapter summary