Management accounting--performance evaluation: analysing cost variances is no easy task, because a single variance may contain four different elements. Falconer Mitchell offers his guide to interpreting them.

AuthorMitchell, Falconer
PositionPAPER P1

Standard cost variances provide feedback information designed to help managers control operations in accord with the plans they have set. They highlight the difference between the planned costs of a period--ie, the standard costs that are determined before the period starts--and the actual costs incurred over that time. Consequently, they are reported after costs have been incurred and are intended to prompt a managerial reaction if they show that things aren't going to plan.

It's the managers' job to analyse the cost variance information reported to them and decide whether any action is needed and, if so, the appropriate action to take.

Cost variances comprise several different elements that together make up the total reported variance. The factors causing variances can be divided into two broad categories. First, there are operational causes that relate to operational activity--ie, the purchase and use of resources. Where these causes are controllable, managers can use variance information to trigger corrective action. Second, there are non-operational causes that relate to problems in the administration of the standard costing system. They provide feedback to the accountants running the system and their identification and elimination focuses attention on operational causes. This makes variance interpretation difficult, because each of these potential elements in a variance can have a different significance. Non-operational causes provide feedback to those who set the standards and run the standard costing system, while some operational causes can be acted upon and are, therefore, of interest to managers. Panel 1 illustrates the four elements of a cost variance.

Element one: costing system errors

If the system itself malfunctions, variances may be reported wrongly. For example, the issue of material stock from stores at an erroneously high price would generate unfavourable material price variances. Likewise, inaccurate direct labour time recording can result in false labour efficiency variances.

Such variances are caused by errors and are signals that the way the standard costing system is being run needs to be improved. Eliminating the "noise" caused by this type of variance means that managers can assume that reported variances are attributable to the other three elements.

Element two: inappropriate standards

The standard cost that's set is one of the two figures from which variances are computed. Consequently, the level at which the standard has been set can directly influence the variances. For example, the...

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