In your business, variance analysis helps you identify problem areas that require attention, such as poor productivity, poor quality, excessive costs, and excessive spoilage or waste of materials.

Identifying and working on these problems helps managers improve production flow and profitability. Managers and accountants often talk about management by exception — using variance analysis to identify exceptions, or problems, where actual results significantly vary from standards. By paying careful attention to these exceptions, managers can root out and rectify manufacturing problems and inefficiencies, thereby improving productivity, efficiency, and quality.

Interpreting variances in action

The following figure summarizes the variances of a fictional company, Band Book.

A complete analysis of Band Book’s variances provides an interesting story to explain why the company has a \$1,000 unfavorable variance. The following events transpire:

• The company pays less than expected for direct materials, leading to a favorable \$13,500 direct materials price variance.

• Perhaps because of the cheaper, lower-quality direct materials, the company uses an excessive amount of direct materials. This overage results in a \$20,700 unfavorable direct materials quantity variance.

• The company pays its employees a higher wage rate, resulting in an unfavorable direct labor price variance of \$3,600.

• The company saves money because employees work fewer hours than expected, perhaps because they’re more productive, higher-paid workers. The favorable direct labor quantity variance is \$4,800.

• The company saves \$5,000 in reduced overhead costs.

Focusing on the big numbers

Management by exception directs managers to closely investigate the largest variances. For example, the two largest variances are the direct materials quantity variance (\$20,700 unfavorable) and the direct materials price variance (\$13,500 favorable). Band Book’s managers should focus on how the company buys and uses its direct materials.

Here, the direct materials quantity variance resulted because the company should have used 28,000 pounds of paper but actually used 30,000 pounds of paper. Why? Here are a few possibilities:

• The paper was poor quality, and much of it needed to be scrapped.

• The company underestimated the amount of paper needed (the standard quantity needs to be changed).

• Someone miscounted the amount of paper used; 2,000 pounds of paper are sitting in the back of the warehouse (oops).

• A new employee misused the machine, shredding several thousand pounds of paper.

Management by exception directs managers to where the problem may have occurred so that they can investigate what happened and take corrective action.

Now take a look at the favorable direct materials price variance of \$13,500. How did the purchasing department come to purchase direct materials for only \$9.90 a pound, rather than the \$10.35 standard? Did the purchased materials meet all of the company’s quality standards? Should the company reduce its standard price in the future?

Consider setting control limits to determine which items are sufficiently large to investigate. A variance exceeding its control limit takes priority over less significant variances.

Tracing little numbers back to big problems

Be careful! Don’t focus exclusively on the big numbers and ignore the little numbers. Big problems can also hide in the small numbers. For example, although many frauds (such as stealing raw materials) may trigger large variances, a well-planned fraud may be designed to manipulate variances so that they stay low, below the radar, where managers won’t notice them.

For example, knowing the standard price of a raw material is \$100 per unit, a crooked purchasing manager may arrange to purchase the units for exactly that price — \$100 per unit — while receiving \$10 per unit as a kick-back gratuity from the supplier.

This scheme results in a direct materials price variance of zero, but it doesn’t reflect what should be the company’s actual cost of doing business. A more scrupulous purchasing manager would have arranged a purchase price of \$90, resulting in a large positive direct materials price variance.

To avoid these problems, managers should still investigate all variances, even while focusing most of their time on the largest figures.