Variance analysis

What is variance analysis?

Variance analysis is a technique used in financial and managerial accounting to compare and analyze the differences between planned or budgeted figures and actual results. It helps businesses understand the reasons behind deviations from the expected performance and provides insights into the factors driving those differences.

By conducting variance analysis, businesses can identify areas where they performed better or worse than expected. It allows them to pinpoint the specific factors that contributed to the variations, such as changes in costs, revenues, production volume, or efficiency. This information is valuable for decision-making and helps managers take appropriate actions to address any discrepancies and improve future performance. Variance analysis is an important element in manufacturing accounting.

Types of variance analysis

Several types of variance analysis are commonly used in financial and managerial accounting. Here are four main types:

Price Variance:

Price variance focuses on the difference between the planned or budgeted price and the actual price of a product or service. It helps evaluate the impact of price changes on costs or revenues. For example, if the budgeted cost for the material was $10, but the actual cost turned out to be $12, the price variance would be $2.

Quantity Variance:

Quantity variance examines the difference between the planned or budgeted quantity and the actual quantity of a resource used or sold. It helps assess the efficiency and utilization of resources. For instance, if the budgeted quantity for a product was 100 units, but the actual production was 90 units, the quantity variance would be -10 units.

Sales Variance:

Sales variance analyzes the difference between the expected or budgeted sales revenue and the actual sales revenue achieved. It helps assess the performance of sales efforts and market conditions. For example, if the budgeted sales revenue was $50,000, but the actual sales revenue was $45,000, the sales variance would be -$5,000.

Cost Variance:

Cost variance compares the planned or budgeted costs with the actual costs incurred. It helps evaluate the efficiency of cost management and cost control. For instance, if the budgeted cost for a project was $10,000, but the actual cost incurred was $12,000, the cost variance would be $2,000.

Related terms

1. Budget: A budget is a financial plan that outlines the expected revenues, costs, and expenses for a specific period. It serves as a benchmark for comparison with actual results in variance analysis.
2. Actuals: Actuals refer to the real or actual results achieved during a specific period. These are the numbers obtained from financial statements, reports, or other sources and are compared to the budgeted figures.
3. Variance: Variance is the numerical difference between the planned or budgeted amount and the actual amount. It represents the deviation or gap between the expected and actual performance.
4. Favorable Variance: A favorable variance occurs when the actual results are better than the budgeted or planned figures. It indicates that the performance exceeded expectations and can be considered positive.
5. Unfavorable Variance: An unfavorable variance occurs when the actual results are worse than the budgeted or planned figures. It indicates that the performance fell short of expectations and can be considered negative.
6. Standard Cost: Standard cost is a predetermined cost per unit of a product or service based on anticipated inputs, such as material, labor, and overhead. It serves as a benchmark for cost comparison and variance analysis.
7. Actual Cost: Actual cost is the real cost incurred to produce a product or provide a service. It includes the actual expenses for materials, labor, overhead, and other relevant costs.
8. Variance Analysis Report: Variance analysis reports summarize and present the variances between planned and actual results. It typically includes explanations, calculations, and comparisons of different variances to provide insights into the performance of a business.
9. Flexible Budget: A flexible budget is a budget that adjusts or flexes based on changes in activity levels. It allows for a more accurate comparison between actual results and the budget by considering the impact of varying production volumes or sales levels.
10. Static Budget: A static budget is a fixed budget that remains unchanged regardless of the actual activity levels. It provides a benchmark for comparison but does not account for fluctuations in production or sales volumes.

Types of variances

Several types of variances are commonly analyzed in business and financial management. Here are some key types of variances:

Material Price Variance:

This variance compares the actual price paid for materials with the standard or expected price. It helps assess the impact of price changes on material costs.

Material Quantity Variance:

Material quantity variance compares the actual quantity of materials used with the standard or expected quantity. It helps evaluate the efficiency of material usage and identifies potential issues such as waste or overconsumption.

Labor Rate Variance:

Labor rate variance compares the actual labor rate paid per hour with the standard or expected labor rate. It helps analyze the impact of labor cost fluctuations and assess the efficiency of labor utilization.

Labor Efficiency Variance:

Labor efficiency variance compares the actual hours worked with the standard or expected hours required. It helps evaluate the productivity and efficiency of labor and identifies potential issues such as overstaffing or understaffing.

Variable Overhead Variance:

Variable overhead variance analyzes the difference between the actual variable overhead costs incurred and the standard or expected variable overhead costs. It helps assess the efficiency and utilization of variable overhead resources.

Fixed Overhead Variance:

Fixed overhead variance compares the actual fixed overhead costs incurred with the standard or expected fixed overhead costs. It helps evaluate the efficiency of fixed overhead allocation and utilization.

Sales Volume Variance:

Sales volume variance compares the actual quantity or volume of units sold with the budgeted or expected quantity. It helps assess the impact of sales volume fluctuations on revenue.

Sales Price Variance:

Sales price variance analyzes the difference between the actual selling price and the standard or expected selling price. It helps evaluate the impact of price changes on sales revenue.

Direct Cost Variance:

Direct cost variance combines the material and labor variances to assess the overall variance in direct costs. It provides a comprehensive view of the deviations in these key cost components.

Profit Variance:

Profit variance compares the actual profit earned with the budgeted or expected profit. It helps evaluate the overall financial performance of a business and identifies areas of improvement.

These are just a few examples of the types of variances that businesses analyze to understand the deviations from expected performance and make informed decisions for improvement. The specific variances examined may vary depending on the nature of the business and the industry.

Importance of variance analysis

1. Performance Evaluation: Variance analysis allows businesses to compare actual results with planned or budgeted figures. By identifying and analyzing the variances, businesses can assess their performance and understand where they are exceeding or falling short of expectations.
2. Decision Making: Variance analysis provides valuable insights into the factors driving the variances. It helps managers understand the root causes of deviations and make informed decisions to improve future performance. By addressing the underlying issues, businesses can optimize their operations and resource allocation.
3. Cost Control: Variance analysis helps identify cost overruns or savings opportunities. By analyzing the variances in costs, businesses can implement strategies to control expenses and improve cost efficiency. This enables effective cost management and helps maintain profitability.
4. Resource Allocation: By understanding the variances in different areas of the business, variance analysis helps managers allocate resources effectively. It enables them to prioritize investments, allocate budgets, and allocate manpower based on areas that require attention or improvement.
5. Continuous Improvement: Variance analysis supports the concept of continuous improvement. By regularly analyzing variances, businesses can identify trends, patterns, and areas for improvement. This allows them to implement corrective actions, refine processes, and enhance overall performance over time.
6. Accountability and Performance Measurement: Variance analysis provides a framework for measuring and tracking performance. It helps hold individuals and departments accountable for their responsibilities and enables the evaluation of their contributions to overall organizational goals.

Challenges for variance analysis

1. Data Accuracy: Variance analysis relies heavily on accurate and reliable data. If the data used for comparison is incorrect or incomplete, it can lead to inaccurate variances and misleading conclusions. Ensuring data accuracy through proper data collection and management processes is crucial for meaningful variance analysis.
2. Identifying Root Causes: Determining the underlying causes of variances can be complex. Multiple factors can contribute to a particular variance, making it challenging to isolate and identify the primary drivers. Careful analysis, investigation, and understanding of the business context are necessary to accurately identify the root causes.
3. Variance Thresholds: Setting appropriate variance thresholds or tolerances can be challenging. Businesses need to define acceptable levels of variance based on their industry, specific circumstances, and goals. Striking a balance between setting thresholds that are too narrow (resulting in excessive analysis) or too wide (overlooking important deviations) requires careful consideration.
4. Time Sensitivity: Variance analysis is most effective when conducted promptly. Delays in obtaining and analyzing data can reduce the relevance and impact of the analysis. Ensuring a streamlined and efficient process for data collection, analysis, and reporting is crucial to address time sensitivity challenges.
5. External Factors: Variance analysis may be affected by external factors that are beyond the control of the business. Market fluctuations, changes in regulations, or unexpected events can influence performance and result in significant variances. Recognizing and accounting for these external factors is important for a comprehensive understanding of performance deviations.
6. Subjectivity in Interpretation: Variance analysis requires interpretation and judgment. Different individuals or departments may have varying perspectives on the causes and implications of variances. Ensuring clear communication, collaboration, and alignment among stakeholders involved in the analysis process can help minimize subjectivity and promote objective decision-making.