Not-So-Significant Variance

The Purchase Manager of a manufacturing plant was very unhappy with the unfavorable price variance although not very significant. He then expressed his uneasiness to VP-Operations saying that price variance does not measure the purchasing department's performance any longer. He said that his department has worked hard to obtain price concessions and purchase discount from the suppliers. He pointed out that engineering changes have been made in several parts, increasing their prices whereas part identification remaining same.

Similarly, the Manufacturing Manager also had approached VP-Operations saying that responsibility for unfavorable quantity variance should be shared. He was of the opinion that his department should not be made liable for quality problems associated with the use of obsolete or less expensive parts. He said that they had to use substitute materials of low quality to make up with engineering changes and to use up obsolete stock. In spite of all these problems he has reduced his other assembly costs and improved efficiency of the department.

The VP-Operation then approached Accounts Manager worried about the cost of investigating these not-so-significant variances to understand the problems more clearly. The Accounts Manager was smart Management Accounting Graduate; he first wanted to review the standards before investigating these not-so-significant variances. He was clear that the problems are due to incorrect management accounting practices.

He found out that the evaluation of the purchase manager was based on direct materials price variances. This created incentive for him to build inventory. Price discounts were granted for large purchases. Thus, one way to generate favorable variance was to purchase raw materials in lot sizes larger than necessary for production and to hold these inventories until they are needed. However, it was proving costly to hold inventory due to warehousing, material handling, and obsolescence etc.

Accounts Manager found that firm is purchasing in excess of production requirement to get a huge price discounts and the Purchase Manager had taken necessary permission from VP-Operations for this. He thought that to curb these practices, the purchase department should be charged with the hidden cost of holding inventories.

He thought that instead of sharing the quantity variance as suggested by the Manufacturing Manager, to offset the purchasing manager's incentive to purchase low quality raw materials, purchases should be inspected when received thus purchasing should not be allowed to buy materials that deviate from the engineering specifications.

Frequent engineering design changes should properly be incorporated in the variance analysis to identify the actual performances.

He thought that new Key Performance Indicators and Standards will recognize the existence of all these problems, so the managers will no longer be responsible for the variance that is considered too costly to fix or investigate.

Standard costing method although traditional is still used by many organizations. One needs to understand the issues pertaining to the system in its entirety to discover any cost saving advantage.

Accounts Manager then calculated the impact of changes in the management accounting system and found out that the organization can save up to Rs. 20 Million in each period.