As already mentioned, standard costs provide information that is useful in performance evaluation. Standard costs are compared to actual costs, and mathematical deviations between the two are termed variances. Favorable variances result when actual costs are less than standard costs, and vice versa.
The following illustration is intended to demonstrate the very basic relationship between actual cost and standard cost. AQ means the "actual quantity" of input used to produce the output. AP means the "actual price" of the input used to produce the output. SQ and SP refer to the "standard" quantity and price that was anticipated. As you will soon see, variance analysis can be conducted for each factor of productive input: material, labor, and overhead. For the moment, just focus on the major concept - variances are simply the differences between actual cost incurred and the standard cost that was appropriate for the achieved production:
Variance analysis is the logical examination of the deviations in an attempt to identify areas for improvement. Management is responsible for careful evaluation of variances. This task is an important part of effective control of an organization. While comparing total actual costs to total standard costs is interesting, it provides little useful information for pinpointing specific problem areas. Instead, management must perform a more penetrating analysis into the detailed variances relating to each factor of production.
Variances Relating to Direct Materials
The total variance for direct materials is found by comparing actual direct material cost to standard direct material cost. The top portion of the illustration at right demonstrates this point. However, the overall materials variance could result from any combination of having procured goods at prices equal to, above, or below standard cost, and using more or less direct materials than anticipated. Proper variance analysis requires that the Total Direct Materials Variance be separated into the:
• Materials Price Variance: A variance that reveals the difference between the standard price for materials purchased and the amount actually paid for those materials [(standard price - actual price) x actual quantity].
• Materials Quantity Variance: A variance that compares the standard quantity of materials that should have been used to the actual quantity of materials used. The quantity variation is measured at the standard price per unit [(standard quantity - actual quantity) x standard price].
If you carefully study the illustration, you will see there are several ways to perform the intrinsic variance calculations. You can very simply compute the values for the red, blue, and green balls; noting the differences. Or, you can perform the noted algebraic calculations for the price and quantity variances; adding them together gives you the total variance. In performing the math operations, be very careful to note that unfavorable variances (negative numbers) offset favorable (positive numbers) variances. But, don't get lost in the math and forget the importance of the analysis. Management's goal is to pinpoint problem areas. A total variance could be zero, resulting from the purchasing department having negotiated favorable pricing that was wiped out by waste in material usage. A good manager would want to take corrective action, but would be unaware of the problem based on an overall budget versus actual comparison. The moral of the story is to always look into the details for improvement opportunities.