What is Variance Analysis? What are the possible reasons for different Cost Variances ?

What is Variance Analysis?

Variance Analysis is the process of calculating and analyzing the differences between actual costs and budgeted or standard costs. These differences, known as variances, are then investigated to determine the underlying causes. Variances can be favorable (actual cost is less than the standard cost) or unfavorable (actual cost is more than the standard cost). The analysis helps in identifying inefficiencies, improving operational performance, and making informed business decisions.

Types of Cost Variances and Their Reasons

1. Material Cost Variance

Material Cost Variance is the difference between the standard cost of materials used and the actual cost of materials used. It can be further broken down into:

• Material Price Variance: (Standard Price – Actual Price) x Actual Quantity Purchased. Reasons for this variance include:
  • Changes in market prices due to supply and demand.
  • Ineffective purchasing practices (e.g., not negotiating favorable prices).
  • Changes in supplier.
  • Currency fluctuations (for imported materials).
• Material Usage Variance: (Standard Quantity – Actual Quantity Used) x Standard Price. Reasons for this variance include:
  • Inefficient production processes leading to wastage.
  • Poor quality materials requiring more input.
  • Lack of proper training for workers.
  • Substandard specifications for materials.

2. Labour Cost Variance

Labour Cost Variance is the difference between the standard cost of labour and the actual cost of labour. It comprises:

• Labour Rate Variance: (Standard Rate – Actual Rate) x Actual Hours Worked. Reasons include:
  • Changes in wage rates due to union negotiations.
  • Overtime payments.
  • Hiring of more skilled (and expensive) labour.
• Labour Efficiency Variance: (Standard Hours – Actual Hours Worked) x Standard Rate. Reasons include:
  • Lack of worker skill or training.
  • Machine breakdowns causing idle time.
  • Poor supervision.
  • Inefficient work methods.

3. Overhead Cost Variance

Overhead Cost Variance is the difference between the standard overhead cost and the actual overhead cost. It is often more complex to analyze due to the diverse nature of overhead costs. It can be divided into:

• Fixed Overhead Variance: (Budgeted Fixed Overhead – Actual Fixed Overhead). Reasons include:
  • Changes in production volume affecting fixed overhead absorption.
  • Unexpected repairs or maintenance costs.
• Variable Overhead Variance: (Standard Variable Overhead – Actual Variable Overhead). This can be further broken down into:
  • Variable Overhead Material Variance: Similar reasons to Material Cost Variance.
  • Variable Overhead Labour Variance: Similar reasons to Labour Cost Variance.

The following table summarizes the variances:

Variance Type	Formula	Possible Reasons
Material Price Variance	(SP – AP) x AQ	Market fluctuations, poor purchasing, supplier changes
Material Usage Variance	(SQ – AQ) x SP	Wastage, poor quality, lack of training
Labour Rate Variance	(SR – AR) x AH	Wage rate changes, overtime, skilled labour
Labour Efficiency Variance	(SH – AH) x SR	Lack of skill, machine breakdowns, poor supervision
Fixed Overhead Variance	(Budgeted FO – Actual FO)	Production volume changes, unexpected costs
Variable Overhead Variance	(Standard VO – Actual VO)	Material/Labour variances impacting overhead

Note: SP = Standard Price, AP = Actual Price, AQ = Actual Quantity, SQ = Standard Quantity, SR = Standard Rate, AR = Actual Rate, AH = Actual Hours, SH = Standard Hours, FO = Fixed Overhead, VO = Variable Overhead.