Variance analysis is the practice of evaluating the difference between budgeted costs and actual costs within your business. Whether you’re assessing sales, employee efficiency or overhead costs, understanding discrepancies between expectations and outcomes is essential to maintain a steady cash flow.
Knowing that you missed your target budget is one thing, but you need to see more than the bottom line. You need a quantitative investigation into why your target budget wasn’t met so that you can make evidence-based decisions for the financial future of your business. That’s where variance analysis comes in.
In this article, we will explore the different types of variances and how analysing them can help you take control of your budget.
What is a variance analysis?
Before we dig into the specifics of this financial analysis technique, it’s important to understand what a variance is in the first place. The simplest definition of a variance is a discrepancy between what you planned to spend and what you actually spent.
Accordingly, a variance analysis is the practice of extracting insights from the variance numbers in order to make more informed budgeting decisions in the future.
What does analysis of variance tell you?
In statistics, analysis of variance is sometimes abbreviated to ANOVA. It can be applied to many different uses in science and engineering, but the main business objectives of conducting this kind of analysis are:
- Controlling costs
- Identifying trends
What is an example of variance?
Let’s say a mechanic anticipated $10,000 in profits for one month but actually generated $8,000; that would be a $2,000 unfavourable variance. If it’s determined through a variance analysis that the discrepancy in anticipated profits can be traced to rising costs of automobile parts, the mechanic can adjust their rates to make a more accurate budget or find a cheaper supplier.
Depending on your goals, you can analyse any of the following variances in order to optimise your operational performance.
Four types of variances analysis
Variances can be broadly classified into four main categories with corresponding sub-categories. Let’s break down each one and see how they can help businesses identify potential weak spots in their budgets.
1. Material efficiency variance
Calculating material variance helps you see how efficiently you are using your materials. Material cost variance, for example, is the difference between the standard cost of direct materials and the actual cost of direct materials that you use in your business.
Material quantity variance, on the other hand, measures the difference between the standard quantity of materials expected to complete a project and the actual amount you used.
Finally, there is material price variance, which is the actual unit cost of an item minus its standard cost. Say you manufacture clothes, and you paid $9 per unit of fabric. If the standard cost was $10, you have a favourable efficiency variance because you paid less than the standard.
2. Labour variance
If your business is labour intensive, it’s important to understand how your employees’ productivity compares to your labour costs. Calculating the direct labour efficiency variance determines whether your employees are spending time the way you anticipated. Say it takes four hours to sew a dress: If you budgeted five hours, that yields a favorable variance.
Another way to evaluate labour variance is by analysing your labour costs. The labour rate variance is determined by calculating how much you spent on labour hours and seeing how that number compares to your original budget. For example, if a contractor who makes a dress for you charges $30 per hour, but you budgeted $32 per hour, you would have a favorable variance.
3. Overhead variance
Overhead variance refers to the difference between actual overhead and applied overhead.
In some cases, this can be a variable overhead variance which occurs when there is a discrepancy between your actual variable overhead and the standard variable overhead. Furthermore, the difference between the actual time it takes to manufacture a unit and the time budgeted for it is called the “variable overhead efficiency variance”.
On the other hand, a “fixed overhead variance” occurs when there is a difference between the standard fixed overhead for actual output and the actual fixed overhead.
4. Sales variance
If your business exceeds, or comes up short of, its sales goals, this is called a sales variance. If you know how to calculate a volume variance, you can understand whether you reached your expected sales levels.
For example, if you anticipated selling 100 bicycles this year but only sold 92, your sales volume variance is the cost of the eight bicycles you didn’t sell. Because you didn’t sell quite as many bicycles as you budgeted for, this is an unfavorable variance.
Keep in mind: you only need to analyse the variances that are applicable to your business. For example, a service-based business like a law firm may need to analyse only its labour efficiency variance. A construction company, on the other hand, would want to keep close tabs on its material quantity variance.
Understanding relationships between variances
The above types of variances have relationships that can help you discover patterns in your business. Let’s say you spent $26,000 on raw materials in a year but only budgeted for $25,000. As mentioned earlier, it’s crucial to understand where that $1,000 unfavorable variance came from: higher prices? Did a project require more materials than you expected? A combination of both?
Performing a variance analysis gets to the root cause of budgeting inconsistencies so you can avoid them in the future.
Advantages and disadvantages of variance analysis
While financial variance analyses can give you a deeper level of understanding into the finances of your business, it’s important to weigh the advantages and disadvantages of this reporting tool before going all in.
Advantages of variance analysis
- Rather than relying on guesswork to determine why you’re missing your budget, a variance analysis can help you pinpoint the true cause, giving you peace of mind.
- A robust view of budget variances can direct you towards which products to make/sell, what suppliers to use and which customers to target, ultimately improving your cash flow and giving you a competitive advantage in the marketplace.
- By mitigating risks, discovering trends and identifying weak spots, variance analysis can build trust among team members working towards a common goal.
Disadvantages of variance analysis
- It takes time for your staff to conduct variance analysis and send results to the management accounting team, which can be a problem if your business operates at a fast pace and needs data on the spot.
- In order to conduct accurate analyses, your accounting team may need to track down additional data such as bills of material, labour routings and overtime records in order to do an accurate analysis.
- Comparing your actual results to arbitrary industry standards can cause confusion as to whether you’re on track or need to make changes.
Is variance analysis right for your business?
As we saw in the examples throughout this article, variance analysis can yield valuable financial insights across a myriad of industries.
From spotting bottlenecks in manufacturing to improving profit margins on construction projects, variance analyses can give your business the insight it needs to continually improve over time.
It can be tempting to keep pushing forward when results don’t meet expectations, but by diagnosing why things went amiss, your business can quickly make adjustments to get back on track.