How Should Variances Be Used by a Company for Accounting Purposes?
Variance analysis is a technique used by companies to break overspending and underspending during production into price and quantity variances. Price variances occur when a company pays more for a production input, such as materials or labor, than expected, where quantity variances occur when the company uses more of the input than expected. Understanding how to use variance analysis information in your small business can help you figure out where to focus your time to address problems as they come up.
Variance analysis allows small-business owners to manage by exception. This means company managers will spend most of their time working to determine how to improve variances and the least amount of time monitoring processes that are working smoothly. For example, an owner of a furniture factory may notice that his product costs for lumber seem too high. By breaking the variance in cost into price and quantity variance components, he might determine that the price variance is unfavorable but the quantity variance is favorable. This tells the small-business owner that higher materials costs for lumber are causing the unfavorable variance, not overusing product or excess scrap.
Some small businesses use the variance analysis framework to simplify bookkeeping. These companies record transactions using standard cost techniques. The company accountants will record purchases of materials, payments to workers and other costs of production at the typical cost for the company, regardless of what the actual cost is. Then the company will make separate accounting entries to adjust these amounts to the actual dollar value. This makes the initial accounting entries simpler and allows the company to track when costs are abnormal.
Variance analysis helps small-business owners determine which department is responsible for cost overruns. For example, a company that overspends on the materials used to build basketball hoops can overspend in two ways. The company may overspend on the price of the materials or use more materials than are actually needed to produce the hoop. Usually, these activities are the responsibility of different people. The purchasing department is often in charge of securing prices for raw materials. However, the effectiveness of production workers is often the responsibility of the production manager. When small-business owners use variance information to determine which workers are responsible for cost overruns, this is known as responsibility accounting.
One of the drawbacks to using the variance analysis framework is that it offers no room to track continuous improvement. When calculating variances, the small-business owner determines whether a variance is favorable or unfavorable. This information does not tell management whether variances are improving or getting worse. In addition, favorable variances often are ignored, and this isn't always a good business practice. For example, a favorable labor quantity variance occurs when a company uses fewer labor hours than it expected to use. But if this is achieved by not allowing breaks or by employees working off the clock, the favorable variance is not actually indicating good business. Management should be investigating significant favorable variances just as often as significant unfavorable variances.