In cost accounting when you find a prediction error, you need to consider whether or not to take action. If your actual results differ from your plan, it may not be that big of a deal. You need to consider the size of the difference and how you use the data.
Say you manage a large chain of sporting-goods stores that sells a light windbreaker. The jacket is popular with runners and bikers. Here are your planned estimates for the month: Monthly demand is 10,000 jackets. The ordering cost is $70 per order. Carrying costs total $3 per unit. You calculate an economic order quantity (EOQ) of 683.13 units.
Consider the relevant total cost. You calculate relevant total cost as [(demand x ordering cost) ÷ EOQ] + [(EOQ x carrying cost per unit) ÷ 2]. Based on this, your relevant total cost is $2,049.40.
Say your actual ordering cost is $85 instead of $70. When the actual ordering cost is plugged into the formula, the prediction error is $208.93. Well, consider how large that difference is as a percentage of the original relevant total cost:
Prediction error as a percentage of relevant total cost = $208.93 ÷ $2,049.40
Prediction error as a percentage of relevant total cost = 10.19 percent
Most accountants would consider a 10 percent change to be meaningful. That means that difference should be investigated. If you can determine why the difference occurred, you may be able to reduce your costs and increase profit. At the least, you can use the new figure of $85 in future planning.
You need to find out why the ordering costs increased. Maybe you have a new person processing orders. Because that person is still learning his or her job, orders may be processed more slowly. When the new employee learns the process, he or she should work faster. Your ordering cost should go back down.
Consider the total dollar amount of the change as well as the percentage change. You might conclude that a $208 difference isn’t worth taking the time to investigate. The dollar amount is too small, regardless of the percentage change.
This analysis requires judgment. When you meet with other managers in planning, consider a scope amount. Auditors use the term scope to mean the dollar amount above which a difference must be investigated. Differences or exceptions below that amount won’t be analyzed.
Scope is usually based on a percentage of some total. If, for example, you’re analyzing accounts receivable, you might investigate any difference greater than 5 percent of the total receivable balance. If your receivables total $500,000, you investigate any exception over $25,000 (5 percent of $500,000).