What Is An Acceptable Variance?

Sep 11, 2015

One of the most common issues we observe in our cost work involves companies which are producing very large variances related to direct costs or overhead, without much interest related to how those can be controlled or, for that matter, what they even mean.

Many systems utilize their own cost information for inventory valuation which can lead to large variances in materially misstated inventories. If your variances are offsetting and similar in proportion, then the risk of your inventory being significantly over or under- valued is reduced. This is especially true given the presumption that the only number which really matters in the scenario is the total cost as computed by the costing system. Only if it actually equates to the total cost of the product. For these purposes, it does not matter that one cost category is grossly understated and another cost category is grossly overstated, as long as those two approximately net out to the same result. This resolves to maintain inventory values in a reasonable range.

Unfortunately, this scenario is very rare. It is far more likely that there are very large variances (sometimes over 20%) with little concern from management relative to how it will affect any other part of the operation. In my view, if you have a fully functioning cost system (used to value inventory, determine product, customer, or plant profitability and/or used for managing operations), then variances of this magnitude cannot be tolerated and must be investigated and resolved as quickly as possible.

As I think about this fact pattern, it is obvious that large variances indicate the cost to produce them are materially in error and will result in introducing inaccurate or incomplete information. If the variances are left to continue without any attempt to analyze or investigate, then management is not doing their job.

I don’t believe cost systems should operate without any variances. In fact, I believe a properly functioning cost system will always produce variances in relationship to actual operations. This is true simply because there is not a single operation so dependable that it functions 100% at all times on all problem products. However, large, reoccurring, uninvestigated variances indicate a fundamental problem in the costing system. Such dilemma must be investigated and resolved before any true reliance can be placed on those numbers, no matter what the intended use.

When questioned about what is an acceptable variance, I have always used this rule of thumb: when total variances considered cumulatively exceed 10% of the cost of sales, then actions must be taken to investigate and correct those problems.

I have had managers say 1% per month positive or negative will be acceptable and their goal is to keep the cumulative variances under the average of 1% per month for the entire year. Regardless of what your company goals are for the tolerance of variances, it is my suggestion when cumulative variances exceed 10% for the entire year, they must be investigated and resolved before beginning the next year. Doing this will be very crucial, specifically so that any known deficiencies are corrected before beginning the next accounting cycle.

Categories: Cost Accounting