We have learnt that favorable and unfavorale variances are adjusted to Cost Of Goods Sold to derive the Gross Profit in a business operation. Eventhough favorable variances have positive and unfavorable variances have negetive impacts on the Gross profit, ultimately no variance can influance the Net Profit of business operation. Thus, no variance is desirable.
In this article, I would emphasise on Materials Price Variance and it’s impacts on Gross Profit. In the later articles, I would discuss the impacts of other variances associated with business operations.
A procurement manager may claim that he has saved his company a lot because he earned a huge favorable price variance. But the claim would be revesed from the point of view of the sales manager of that company. That means, two managers will be in the opposite position on the topic. But why and how? An example would be sufficient to understand their perpendicular position.
The procurement manager has purchased against the given standards of the materials. For example he bought the materials for $5 per kg against which $15 per kg has been set as standard. Now if he bought 100 kg of the said materials then $1000 is earned as favorable variance. Is it real savings? No! He ultimately raised the Cost Of Goods Sold or Manufacturing Cost of a product made out of that materials.
Now, the sales manager is not aware of this oversatated COGS. He always deals with his sales and its promotion. Had there a little COGS less, he could have sold some more quantities and which could have been beneficial to the company’s earnings. For over stated COGS, there is a chance that he already lost some sales because of Margin issue. For the same reason he might have failed to participate in promotional offers or other competitive advantages. This is a real loss. Selling can raise the company revenue rather than a buying can do.
Unrealistic standards create variances but have no positive impacts on the Net Profit under any circumstances. Unrealistic standards is tantamount to lack of efficiency. Over purchase than budgeted requirements has many other disadvantages. So, set realistic standards and buy optimum level always and let the company grow at harmony.