Improving the Bottom Line with Variance Analysis
By Tony Della-Croce, Syosset, Technical Support

Manufacturers have been arguing for years over whether to use standard or actual costs as the basis for determining the cost of production. Although there is additional work involved in establishing standard costs, the biggest part of the job is actually determining the actual costs to base the standards on. And the time saved in costing sales outweighs the time spent in establishing the standard – proving that standard costing is the most profitable method. Accountants know that the process of determining the cost of production invokes about as much enthusiasm as watching paint dry. But manufacturers should realize that proper control of production cost has the same effect on a firm’s profitability as a 15-25% increase in sales. Decision-makers must keep in mind that the margin of sales over cost has the greatest effect on a firm’s financial growth and earnings per share. Moreover, improper control of cost has an inversely proportional effect on margin that can actually reduce earnings per share if permitted to continue for an extended period of time. And while and increase in sales could be, to a large extent, determined by market factors, cost is a management responsibility – which is much more controllable. Profit margins aside, the time saved by costing products at standard may be reason alone to establish a standard cost environment, especially since computerized MRP systems can reduce a firm’s inventory investment and make calculating standards more accurate and less time-consuming.  However, the most valuable aspect of a standard cost environment is that management has a tool to measure actual performance against what should have been accomplished based on the standard of performance. This management tool is the difference between actual cost and standard cost – called a variance. Variances allow you to evaluate performance against standards in a constantly evolving environment. This doesn’t mean that the standards are totally inflexible and cannot be altered. On the contrary, they are a rolling measure of performance to be established and interpreted based on the market conditions in which they exist. Variances are categorized by cost elements. There are three categories used in MANMAN – material,labor, and overhead.

Material Variances
There are three types of material variances recognized in MANMAN – purchase price, usage, and configuration.

Purchase price variance is the result of a difference between the price paid or a raw material and the price used as the standard. It can occur in two situations in MANMAN. First, if there is a difference between the quoted price and the standard price on a purchase order when it is received to MANMAN/MFG. Second, if there is a difference between the quoted price and the price stated on the vendor’s invoice when it is vouched in accounts payable.

Usage variance is the result of a difference between the actual amount of materials used in a process and the standard amount minus any scrap. Since scrap is taken out during the calculation, it’s important to note that unusually high material usage is an indication that scrapping is not occurring. This could mean that material is being left on the production line, or that you have improper yield factors on your raw material issues. Any of these conditions can result in production shortages, overpurchasing, inventory loss, or, ultimately, a valid production expense that is not being recognized – which can cause an increase in tax liability and a decrease in net margin and cash flow.

Configuration variance is generally the result of building an assembly with a different bill of material than was used to calculate the standard cost of the assembly. This could be caused by substituting components with the same engineering qualities but different costs, or changing the scheduled quantities of a component on a work order. If a configuration variance occurs, you must determine whether this situation is a result of some period abnormality or whether it represents a permanent change in the product structure. In the latter case, you might consider making an inventory standards change for that assembly and all affected upper level assemblies if the variance will substantially affect the income statement for more than one quarter.

These three variances comprise what is commonly referred to as total material variances, and should be evaluated on a periodic basis by both cost accounting and material control.

Labor Variances
The second category of variance is labor, which can be further divided into rate, efficiency, lot, and methods change.

Rate variance occurs whenever an employee’s labor rate differs from the standard rate in the work center where an operation is performed. Efficiency variance occurs when an employee works for a different  period of time than expected based on the standard earned time for a particular operation.

Lot size variance is actually a labor efficiency variance computed by operation and totaled on the work order. It is the result of a difference in set-up cost per unit when a non-standard lot size is ordered. For MANMAN users, the standard lot size is the average order quantity of source cod M or R parts. If the work order quantity does not equal the standard lot size, a variance occurs, since set-up cost (which is earned only once when the unit is completed through the operation) is applied to this new work order quantity. This means that the set-up cost distributed per unit on an actual basis differs from the set-up cost distributed per unit in the standard calculation.

The last labor variance is methods change, which, simply stated, means a different routing was used to build the assembly than was used to calculate the standard cost of assembly. This can be caused by using a routing other than the primary routing associated with the assembly, or by adding or deleting an operation from the Tracking Detail File record for that work order. Finally, MANMAN captures a residual value on all work orders. This variance represents any values that were not captured in the standard variances as outlined above. This can be caused by such things as production reporting more completed on a work order than was originally scheduled. Residual value is an indication of a problem elsewhere and should be carefully investigated.

Overhead Variances The last category is overhead, which can be interpreted as all costs that are not a visible part of the finished product. Overhead can be divided into two categories – direct factory overhead and all other administrative expenses.

Direct factory overhead consists of all cost of manufacturing other than direct material and labor – such as plant, equipment, and fuel expenses. These costs are allocated to manufacturing conversion cost as a rate per direct labor hour.

Factory overhead can be further classified as variable overhead – which is directly related to production volume and fixed overhead – which stays constant in a normal operating range of volume.
Both fixed and variable overhead are expressed as a rate per direct labor hour in the work center. They should be calculated using a combination of historical data and an estimated total direct labor
hour for the year. This facilitates the use of standard cost and permits manufacturing overhead to be capitalized into inventory cost based on the standard and actual direct labor reported. This ultimately
translates into a more accurate cost of goods sold and a better statement of non-production operating expense which attracts investors and increases the value of finished goods without significantly
increasing quantity on-hand.

Overhead variance then can be defined as a combination of actual manufacturing expense accumulated in a period and the standard overhead reported for production earned in the same period. If the overhead reported on an actual basis is significantly over- or under-applied for the year because of a change in volume etc., the rates should be corrected and the year-to-dateallocation corrected by a reallocation based on direct labor hours in goods-in-process, finished goods, and cost of sales. Every firm should know its approximate break-even point, which is determined by dividing the total fixed cost and expenses by the variable profit percent. This theory also applies to computing profit on a marginal bid contract, since any sale price that recovers all variable cost contributes towards increased profits.

Reporting and Posting Variances

Purchase price variances can be reported with the MANMAN/AP commands P.O./STANDARD COST VARIANCE REPORT (HP/AP,RE,375 VMS/AP,RE,440). The remaining variances can be reported on the CLOSED WORK ORDER COST REPORT (HP/MFG,RE,316 VMS/MFG,RE,332*). When reporting work order variances, if the actual reported is less than the “earned” standard, the variance is described as favorable and appears as a negative number on the report. If the actual is more than the standard, the variance is conversely called unfavorable and appears as a positive number. However, the terminology favorable or unfavorable is a somewhat unfortunate choice in describing variances. Whether a variance is favorable or not cannot be determined simply by comparing actual to standard. The underlying reason for the difference is most important and no variance, favorable or not, should be accepted as normal for a prolonged period of time. Purchase price variances (including VMS make vs. buy) can be posted automatically to the general ledger. All other variances must be posted manually. The basic rule of thumb for posting manually is to post any variances that appear on work order cost reports with a positive sign as a credit to work-inprocess and a debit to the proper periodic variance expense. All variances with a negative sign should be posted as a debit to work-in-process and a credit to the proper periodic variance expense. This ensures that positive (or unfavorable) variances reduce work-in-process and increase period expense, while negative (or favorable) variances do just the opposite. Failure to post variances manually will result in large discrepancies of inventory value reported on a perpetual basis in manufacturing and the general ledger balances. Variances should also be reported to management on a period product line basis, with actual performance measured against a realistic and achievable standard. It is useful to do this reporting on a percentage basis of actual to standard, which ensures that, unlike dollars, they will not be affected by a level of activity in a period-to-period comparison. In summary, a standard cost environment, with proper variance analysis, can significantly improve the net margin, expedite and streamline accounting practices, and ultimately increase operating income and provide for extended growth of the firm. *Repetitive environments report material & labor aggregates via Work Areas rather than Work Orders.

APICS International From the APICS 2007-2008 Annual Report Internationalization.

Based on the objectives set by international committees and staff, the new International Services division initiated a new business model for international expansion in 2007. New agreements were
developed and several new partners recently joined the network of international representatives. As a result, 2007 saw significant growth in the international membership base, as well as growth in
certification exams due to renewed energy and enthusiasm from the international representatives. Building on this foundation, 2008 will foster a new dynamic to provide for successes in this area.
Agreements that have been concluded to date (Authorized Education Providers):

• China – ASCMS
• China – SC-Lead
• Italy – Advance Operations Management School
• Middle East – Morgan International
• Netherlands – ATiM
• Singapore – SIMM
• South Africa – Kent Outsourcing Services
• Taiwan – Anser Consulting
• Tunisia - AB Consulting
• Turkey - ABCO Engineering
• Turkey - Eurosis Consulting

Agreements concluded to date (International Associates):
• South Africa – SAPICS
• Indonesia - IPOMS

India One of the highlights of APICS’ presence in the global arena was the 2007 Business Process Council World Conference & Exhibition in Mumbai, India. APICS leaders gave a presentation on
solutions to improve customer satisfaction and increase productivity. APICS is committed to increasing its presence in India. With its fast-growing business environment, India is a powerful force
in the economic landscape.

China APICS recently released a Chinese language APICS Dictionary. Our goals for advancing APICS’ international presence by 2010 include:
• Increasing the number of international members outside North America to 10,000.
• Increasing the number of certification exams outside of North America by 5 percent.
• Increasing representation of APICS with local associations in each of the identified markets outside of North America.