How to Calculate Cost Variances [with Treatment and Methods]

The following article will guide you about how to calculate cost variances in accounts.

Treatment of Cost Variances in Accounts:

For firms that use standard costing system, accounting for variances in internal reporting at the end of the period is an important decision. The decision influences both inventory valuation and income measurement. Divergent views exist among accountants as to the methods of disposition of cost variances.

The following are the commonly used methods of accounting for variances:

(a) Transfer of Variances to Costing Profit and Loss Account:

Under this method, the stock of WIP and stock of finished goods and cost of sales are maintained at standard cost and variances are transferred to the profit and loss account. The underlying assumption is that standard costs are correct or real cost and variances represent abnormal costs arising out of inefficiencies or efficiencies, abnormal activity or inactivity, wastage, etc. It helps to bring to the attention of the management to weaknesses as reflected by variances. It also makes results of different periods comparable.

(b) Allocation of Variances to Cost of Sales and Year-End Inventory:

Under this method variances are prorated to the cost of sales and year-end inventory of WIP and finished stock on some equitable basis (e.g. units, values). As a result of this adjustment the cost of sales and inventory of WIP and finished stock are shown at actual cost.

In the costing profit and loss account, this adjustment is shown separately to draw the attention of management to the weaknesses reflected by the variances. The underly­ing assumption is that standard costs are only tools of control and do not represent correct or real costs.

(c) Controllable and Uncontrollable Variances:

Under this method controllable variances are transferred to costing profit and loss account and uncontrollable variances are allocated to cost of sales and closing inventory of WIP and finished stock. This method is a compromise between the methods discussed in paragraph (a) and (b) above.

It is most logical to transfer controllable variances to costing profit and loss account and to adjust the value of closing inventories for uncontrollable variance such as material price variances due to price fluctuations.

(d) Transfer of Variances to Reserve Account:

Under this method variances are carried over to the subsequent financial year by transferring these variances to the reserve account. Thus, both the favourable and the adverse variance may be set off against the variances in subsequent years. This method is suitable where variances are caused by seasonal fluctuations and get smoothened over a complete business cycle.

When to Investigate Variances?

In deciding when variances should be investigated, managers often use guidelines framed on the basis of subjective judgments, rules of thumb, guess, etc. For example, a guideline may require investigation into all variances exceeding Rs 50,000 or 25% of the standard cost whichever is lower.

These guidelines ignore the fact that the variance analysis is subject to ‘Cost-benefit analysis’ and statistical tools are available to answer the cost-benefit question. These statistical tools help to separate the variances caused by random events from those which are controllable. Managers decide the ‘range’ or ‘tolerance limit’ within which variances are expected to fluctuate randomly. A random variance is attributable to chance and, therefore, does not call for managerial actions.

Illustration below explains the ‘cost-benefit analysis’ associated with decision on investigation of variances.

Illustration:

The management of Mrignayani & Co. has to decide whether to investigate into the cost variances reported in a variance report.

(i) The cost of investigation into the variance- CU 120

(ii) The cost of correcting the cause of non-random variance- CU 50

(iii) The loss from failure to discover the cause of variance- CU 200

(iv) Probability of occurrence of random variance 25 %

Required:

(a) If the probability given at (iv) is ignored,

(i) Should the company investigate, if the variance is due to a random cause?

(ii) Should the company investigate, if the variance is due to a non-random cause?

(b) Should the company investigate, if the probability given at point (iv) in the question is considered?

(c) What is the point of indifference probability?

Solution:

(a) (i) If the variance is due to a random cause, it does not call for any corrective action and an investigation into causes would not result in any benefit. Therefore, the company should not investigate into the variance.

(ii) If the variance is due to a non-random cause, in the absence of corrective actions it would recur, causing a loss of CU 200. The total cost of investigation and corrective action would be (CU 120 + CU 50), i.e. CU 170. The company should investigate into the causes as that would result in a net benefit of (CU 200-CU 170), i.e. CU 30

(b) In deciding whether the company should investigate into the variance, expected value rule should be applied.

(i) Expected Cost of Non-Investigation:

Loss from random variance- Probability × Loss 0.75 × 0 = 0

Loss from non-random variance- Probability × Loss 0.25 × CU 200 = CU 50

Expected cost of non-investigation- CU 0 + CU 50 = CU 50

(ii) Expected Cost of Investigation:

Cost of investigation random variance- 0.75 × CU 120 = CU 90.00

Cost of investigation non-random- 0.25 × CU 170 = CU 42.50

Expected cost of investigation- 90.00 CU + CU 42.50 = CU 132.50

The expected cost of non-investigation (CU 50.00) is lower as compared to expected cost of investigation (CU 132.50). Therefore, the company should not investigate into the variance.

(c) The point of indifference probability is the one at which the expected net benefit from investigation would be equal to the cost of investigation.

Let ‘P’ the profitability

Hence, Expected value of net benefits is P × CU (200 – 50), i.e. CU 150 P

Cost of investigation CU 120

Therefore, CU 120 = CU 150P

Or P= 120/150 = 0.80

Probability of random variances = (1 – 0.80) = 0.20

If probability of non-random variance is greater than 80% the company would prefer to investigate into the variance.