Question

Are favorable variances always good and unfavorable variances always bad? How should variances be interpreted?

Answer 1

The key concept in variance analysis is Favorable and unfavorable variances should not necessarily be interpreted as good or bad.

There is an unfavorable cost variance when the actual cost incurred is greater than the budgeted amount.

There is a favorable cost variance when the actual cost incurred is lower than the budgeted amount. Whether a variance ends up being positive or negative is partially due to the care with which the original budget was assembled.

If there is no reasonable foundation for a budgeted cost, then the resulting variance may be irrelevant from a management perspective

Not all unfavorable cost variances are bad. Spending more money in one area may create a favorable cost variance somewhere else.

For example, it might be necessary to spend twice as much on preventive maintenance to avoid a much greater total expense associated with replacing fixed assets more frequently. Thus, it is sometimes better to review cost variances from the level of an entire department, facility, or product line, rather than at a more detailed level. This higher level of analysis gives managers room in which to allocate funds in a manner designed to improve total profits.

An unfavorable direct material usage variance generally points to a problem in production.

However, further analysis might reveal that usage was high because of an unusual number of defective parts, and the large number of defective parts was a result of the purchasing manager buying materials of inferior quality.