Standard costs (SC) are an indication of what costs should be for a unit of production. The difference between actual cost (AC) and standard cost (SC) is called a variance. Variances can be analyzed to determine why they exist and this analysis can provide a basis for taking corrective action. If the actual cost is greater than the standard cost, the variance is unfavorable, if actual cost is less than the standard cost, the variance is favorable.
AC > SC = Unfavorable
AC < SC = Favorable.
A system of variance analysis helps in identifying the difference in terms of costs between actual performance and desired performance and hence helps to pinpoint efficient and inefficient operating areas. It helps in assigning responsibility to individuals and also helps to motivate individuals to achieve the performance targets.
Variance Analysis Technique
The technique of variance analysis also helps to isolate the causes of differences between actual costs and standard costs. For proper control, both favorable and unfavorable variance should be analyzed. The causes for the occurrence of variances along with the individuals responsible for variance can also be identified and analyzed. Hence the system of variance analysis helps management to find answers to the following two question:
1) Is the variance due to loose or tight standards?
2) Have the standards been set scientifically?
The technique of variance analysis also helps management to rely on the principle of management by exception management is usually not concerned with analyzing all the performance reports. Rather, the management may decide that performance within ± 3 percent of budget or standards is acceptable when examining performance reports. The management only examines more cost areas where differences
exceed these limitations.
Types of Variance Analysis
Variances can be divided into three main types:
1. Material Variances.
2. Labour Variances.
3. Overhead Variances.