Accounting for Variances
Accounting for variances refers to the process of identifying, recognizing, analyzing, and reporting differences between actual financial results and budgeted or standard financial results. Variances can arise in various aspects of a company’s operations, including revenues, expenses, production costs, and overhead costs. The primary purpose of analyzing variances is to identify the factors causing deviations from the expected results, allowing management to take corrective actions or make informed decisions.
Under U.S. Generally Accepted Accounting Principles (GAAP), accounting for variances is not explicitly governed by a specific accounting standard. However, it is an essential part of management accounting and internal reporting processes.
Here are the key aspects of accounting for variances:
- Identification: Determine the areas where variances exist. Variances can be identified by comparing actual financial results with budgeted or standard financial results for a specific period.
- Classification: Classify variances into different categories, such as sales variances, production cost variances, and overhead cost variances. Further, variances can be classified as favorable or unfavorable. A favorable variance occurs when the actual financial results are better than the expected results (e.g., higher revenues or lower costs), while an unfavorable variance occurs when the actual results are worse than the expected results (e.g., lower revenues or higher costs).
- Analysis: Analyze the underlying causes of the variances, which may involve investigating changes in market conditions, pricing strategies, production processes, or cost structures. This analysis is crucial for understanding the reasons behind the variances and taking appropriate corrective actions.
- Reporting: Present the variance analysis in internal management reports or financial statement disclosures, highlighting significant variances and their underlying causes. This information helps management and other stakeholders to evaluate the company’s performance and make informed decisions.
- Action: Based on the variance analysis, management may decide to take corrective actions, such as revising budgets, adjusting pricing strategies, improving production processes, or implementing cost control measures.
By accounting for variances, a company can better understand the factors affecting its financial performance, allowing management to take appropriate actions to address deviations from expected results and improve the company’s overall performance.
Example of Accounting for Variances
Let’s consider an example of a manufacturing company accounting for variances in production costs.
Example: Company XYZ produces and sells widgets. The company has budgeted for the production of 10,000 widgets during a specific month, with a standard cost per widget of $5 for direct materials and $3 for direct labor. However, at the end of the month, the company finds that it produced only 9,500 widgets, with actual direct materials costs of $48,000 and actual direct labor costs of $29,000.
Here’s how Company XYZ would account for the variances:
Step 1:
Identification: Company XYZ identifies variances in both direct materials and direct labor costs.
Step 2:
Classification: The company calculates the standard costs for the actual production volume (9,500 widgets) as follows:
Standard Direct Materials Cost: 9,500 widgets × $5/widget = $47,500 |
Standard Direct Labor Cost: 9,500 widgets × $3/widget = $28,500 |
The company then classifies the variances as favorable or unfavorable:
Direct Materials Variance: $48,000 (actual) – $47,500 (standard) = $500 (unfavorable) |
Direct Labor Variance: $29,000 (actual) – $28,500 (standard) = $500 (unfavorable) |
Step 3:
Analysis: Company XYZ investigates the underlying causes of the unfavorable variances. For direct materials, the company finds that the price of raw materials increased unexpectedly during the month. For direct labor, the company identifies that overtime was necessary due to a temporary labor shortage.
Step 4:
Reporting: Company XYZ includes the variance analysis in its internal management reports, highlighting the unfavorable direct materials and direct labor variances and their underlying causes.
Step 5:
Action: Based on the variance analysis, Company XYZ’s management decides to take corrective actions. For the direct materials variance, management may explore alternative suppliers or renegotiate pricing with existing suppliers. For the direct labor variance, management may consider hiring additional workers or adjusting production schedules to avoid overtime costs in the future.
By accounting for variances, Company XYZ can better understand the factors affecting its production costs, allowing management to take appropriate actions to address deviations from expected results and improve the company’s overall performance.