BackToBasics
Understanding variances
Nick Craggs breaks down how to treat variances and the different methods used to measure them.
Words Nick Craggs, First Intuition
Variances are a key tool in a management accountant’s toolbox to understand why we spent more or less than we anticipated. Knowing that we did spend more or less than we budgeted isn’t as useful as knowing why. If you know the reason, maybe you can do something about it.
Labour variance
If you have spent more on labour than you budgeted on, it can be due to either you using more labour hours per unit of production, and/or you paid your staff more per hour than you intended.
The labour rate variances investigate if we spent more or less per hour than we budgeted on and puts into monetary terms how much the difference in the rate per hour we spent cost us or saved us. We calculate this as the actual number of hours we used at the actual amount we paid per hour, compared to the actual number of hours valued at the standard rate per hour.
Variance insight
You might find that the causes of these variances can be linked: for example you might find you have a favourable labour rate variance because you paid your cheap labour less per hour, but if they work much slower, you might find that you actually spend more money on labour as you get a greater adverse labour efficiency variance.
Likewise, an adverse material price variance might be linked to buying better-quality material, which in turn lead to a great reduction in wastage and an even greater favourable variance in the material usage variance.
Or they might not be linked at all! Alternatively, it might also be linked to things that you cannot do anything about, like a global price rise, but at least you know how much it cost you and you can continue to monitor it and, where possible, take steps to improve your overall performance and mitigate the price rise’s effects.
Material variance
The other major cost in a manufacturing company is material, and this is split into the material usage variance and the material price variance.
The material usage variance is similar in concept to the labour efficiency variance as this shows the monetary value of difference in the amount of material per unit we used. Here I use kilos, but it could be litres or grams depending on what you are making. To calculate the material usage variance, we compare the actual amount of material we did use to the actual number of units produced multiplied by the budgeted amount of material per unit. This gives us the difference in kilos between what we did use for what we produced to what we budgeted on using for the level of production we achieved. But if we want to express this as a monetary term we multiply it by the standard amount per kilo we budgeted on paying. This the extra cost or saving in pounds of using more or less material per unit of production than we thought we should.
The material price variance is akin to the labour rate variance as it shows the extra cost or cost saving due to the difference in the amount per kilo you paid. To calculate the material price variance, we compare the actual amount of material we used at the actual price per kilo compared to the actual amount we used valued at the standard price per kilo. The difference is due to what we paid per kilo.
