Simplifying cost variance analysis
In a standard cost system, often you will find three cost variance accounts: material, labor and overhead (burden). Having an understanding of these variances and what their root causes are enables management to make operational improvements leading to greater profitability. It is critically important to understand the variables that make up each of these variances.
In its simplest form, all costs break down into two variables, quantity used and price paid. Since these variances were generated in a standard cost system, we need to add two more variables to examine them against expected quantity to have been used and expected price to be paid.
With these four variables available to us, we can now break down the variance accounts into two separate subsections for analysis, usage variance and pricing variance.
Usage variance allows us to determine the economic value of over or under using the resource being measured (material, labor, overhead). It is calculated by taking the actual number of units used subtracting the expected number of units used and multiplying the result by the average standard price we expected to pay (standard cost). This can be done at the aggregate level as well as at the individual level (SKU, work center, employee).
Pricing variance allows us to determine the economic value of over or under paying for the resource being measured (material, labor, overhead). It is calculated by taking the average actual price paid (actual cost) subtracting the average expected price to have been paid (standard cost) and multiplying the result by the expected quantity to have been used. As with the usage variance, this can be done at the aggregate level as well as at the individual level (SKU, work center, employee).
In order to verify that the usage variance and pricing variance have been calculated correctly, they should when added together equal the total variance being analyzed. Therefore, material usage variance plus material pricing variance equals total material variance.
If we are confident in the standards that we have developed, we can then use these variance accounts to give direction to potential operational improvements, such as process, productivity, training, quality, scrap, sourcing, and material substitutions, to name a few examples.
Looking for more guidance on variance analysis? RSM’s management consulting practice has resources that can address issues in supply chain, operations, inventory management, and accounting. You can be in control of your costs even in the most challenging environments.