The positive impact of a favourable cost variance can be seen in the way it creates more profit for an organization. In order to achieve this, there are three important factors that need to be taken into account:
First, you need to make sure that your revenues exceed your costs by at least five per cent. This is because when revenue exceeds costs, then the company has room to reduce its selling price and still have higher net income than if they did not allow for this.
Second, you want to make sure that the projected amount of inventory on hand does not exceed what you will sell within one year of operation.
For example, if we know our average yearly sales volume is $1 million dollars and our annual ordering requirement is 20% of annual sales (i.e., $200,00), then there should be no more than four months worth of inventory on hand at any given time.
Third, you need to make sure that the projected amount of capital expenditures does not exceed what is needed for one year or operating cycle as well.
For example, if we know our average yearly spending on new equipment and buildings is $100,00 and our company operates with a five-year operating cycle period; then there should only be around two years worth of inflated assets ($200k) at any given time – in order to avoid large amounts of depreciation happening all at once when an asset reaches its end of life expectancy).
