Variance analysis is a technical jargon used to explain a situation where actual result or outcome of an event significantly and materially differs from planned, expected or targeted results or outcomes.
Note the emphasis on the words significant and materiality. In accounting, materiality is defined as a situation where the omission or inclusion of an item will influence the action of a decision maker(s) or anybody that relies on the information so provided. Significant can be said be the same thing as materiality in this context.
The process of variance analysis is simple. It is just an act of comparing standards with actual. Companies usually set standards on which actual performance will be judged. The area of standard setting is one aspects of budgetary control that management accountants express their professional care and skill in order not to cause more harm than good using the budgeting process. The preparation of variances analysis sheet is one of the duties / roles of accountants in business. That makes the importance of accounting in decision making very vital.
ACCLAIMED ADVANTAGES OF VARIANCE ANALYSIS
- PERFORMANCE MEASUREMENT: the less sophisticated managers and other users of accounting information will simply see adverse variance as bad and favourable variance as being good. Though variance analysis is a good tool to assess the performance of managers but care should be taken when using this so as not to make costly mistakes and assumptions.
- RESPONSIBILITY ACCOUNTING: responsibility accounting is yet another technically coined phrase used to describe how managers are held accountable for what they do. Companies are usually structured in segments (by functions or by division) and made accountable for resources reposed in their care. The fact that variance analysis is done on item/ departmental basis makes it very easy for managers, departments or divisions to be held accountable for any material deviation from planned activity. Again, great care should be exercised when using variance analysis for responsibility accounting.
- MANAGEMENT BY EXEMPTION: significant or material variance draws the attention of managements to areas where planned activities are different from actual outcomes.
In general, great care need to be exercised when using variance analysis as management tool so as not to use variances too dogmatically. For example, consider the following variances relating to material below;
Material price variance $10,000
Material usage variance $7,000
It is obvious from the above that what this means is that materials were bought for less than standards and that more materials were used than standard.
What this variance result fails to do is that it did not tell us the causes of the discrepancies and requires further investigation, which may lead managers to make suboptimal decision(s). Decision makers’ first reaction might be to praise the buyer who is responsible for buying the materials from a cheaper source than anticipated and reprimand the manager who is responsible for using the material.
ANY OF THE FOLLOWING COULD HAVE CAUSED THESE VARIANCES TO BE REPORTED:
- Market forces making materials prices to fall
- Wrong standard material prices being set
- Purchase managers buying inferior goods that eventually led to the use of more materials than planned.
- Wrong standard material usage being made, etc
The above points makes it become a DISADVANTAGE when the raw information (data) from variances is applied to decision making process without researching further into the cause(s) of the variance in the first place.
Variance analysis when used properly and correctly is a tool which helps decision makers of all level identify where assets are not fully utilized or where adjustment is required.
Again, an adverse variance of a maintenance department that is seen as a cost center may as well be caused by any of the following or any combination of the following
- Urgent request from the sales department as a result of unanticipated order.
- Poor maintenance department management
- Poor maintenance performed last year under a different manager
- Poor or no training given to staff members of the maintenance department, etc
There has never been a time when variances analysis alone tells the whole story, i.e. variance analysis cannot tell you the cause(s) of something. It only draws your attention to areas that needs further investigation.