Question

In two or three paragraphs explain the purpose of variance analysis and its benefits and drawbacks.

Answer 1

Variance Analysis

Variance Analysis deals with an analysis of deviations in the budgeted and actual financial performance of a company. The causes of difference between the actual outcome and the budgeted numbers are analyzed to showcase the areas of improvement for the company. At times, it is also a sign of unrealistic budgets and therefore in such cases budgets can be revised.

In other words, variance analysis is a process of identifying causes of variation in the income and expenses of the current year from the budgeted values. It helps to understand why fluctuations happen and what can / should be done to reduce the adverse variance. This eventually helps in better budgeting activity.

The variances are related to efficiency. The showing of efficiency leads to favorable variance. In this case, the responsible persons are rewarded. On the other hand, the showing of in efficiency leads to unfavorable variance. In this case, the responsible persons are enquired and find the root causes for such unfavorable variances. This type of findings are used for taking remedial action.

The following are the merits of variance analysis:

1. The reasons for the overall variances can be easily find out for taking remedial action.

2. The sub-division of variance analysis discloses the relationship prevailing between different variances.

3. It is highly useful for fixing responsibility of an individual or department or section for each variance separately.

4. It highlights all inefficient performances and the extent of inefficiency.

5. It is used for cost control.

6. The top management can follow the principle of management by exception. Only unfavorable variances are reporting to management.

Drawbacks of Variance Analysis:

1. Variance analysis as an activity is based on financial results which are released much later after quarterly closing; there may be a time gap which may affect the remedial action taking an ability to a certain extent. Also, not all sources of variance may be available in accounting data which makes acting upon variances difficult.

2. If the budgeting is not made taking into consideration the detailed analysis of each factor, the budgeting exercise may be loosely done which is bound to deviate from the actual numbers. Thereafter analyzing variances may not be a useful activity.

3. Problems arise when standard costing is applied to organizations involved in the production of small batches of customized products because of the lack of historical benchmark standards for the new custom products.

4. Standard costing and variance analysis may encourage short-termism due to their inherent tendency towards short-term, quantified objectives and results. A negative perception of an organization's standard costing and variance analysis process can also encourage other sub-optimal behavior among employees such as attempts to incorporate budget slacks.