You’re probably well aware that most aspects of business don’t go exactly as planned. This is a reality in all businesses, so much so that variance analysis comes into play. Variance analysis lets you investigate the difference between planned behavior and actual behavior.
When it comes to performance metrics, variance shows the difference between what you produce and what you budget. A valuable tool in managerial accounting, this method helps you understand fluctuations in sales performance and helps you find a way to improve your numbers. Numerous types of variances exist, though most small businesses prefer to focus only on the types relevant to their particular field. By the same token, the method has a few problems that keep some companies from relying on variance analysis.
Variance Analysis Metrics
Since variance analysis evaluates the difference between planned and actual figures, you can apply it to virtually any aspect of your business. This method provides insight into major project factors. Some examples include:
- Sales volume variance measures profit changes resulting from budgeted sales versus actual sales.
- Sales mix variance measures profit changes that stem from variation in products sold.
- Direct material price variance analyzes the difference between the actual cost of direct material and the standard cost of how much your business purchases.
- Direct labour rate variance spotlights differences between actual cost and the standard cost of labour you utilize.
- Fixed overhead volume capacity and efficiency variance measures the difference between budgeted and actual fixed production overhead.
Illustrating Variance Analysis
To get an idea of how to calculate variance, assume you’re reviewing two recently completed business projects. You want to determine the variance between the budgeted and actual number of employees needed for each of the projects. With Project A, you budget for 10 employees but, in the end, the project requires only seven employees. Project B budgets for eight employees but requires 12 workers. These calculations demonstrate the variance between both projects:
- Project A variance = ((budgeted – actual) / actual) = ((10 – 7) / 10) = 0.3 or 30%
- Project B variance = ((budgeted – actual) / actual) = ((8 – 12) / 8) = -0.5 or -50%
Project A has a positive variance, which indicates its actual performance requires less resources than its budgeted performance. Project B, however, has a negative variance, which shows it needs more resources than projected by the budget. In most cases, negative variances point to the need for further analysis and improvements to bring them over to the positive side.
Variance Functions and Importance
Variance analysis helps businesses plan, create standards, and employ benchmarks. Further, it acts as a control mechanism that highlights operational deviations. You should always perform variance analysis upon project completion, and this metric works best if you perform it on a regular basis so that you can correct course if your budget goes off the rails. Lastly, due to the accurate inputs this analysis requires, it helps ensure responsible and accurate accounting practices.
Some Causes of Variance
Common causes of variance include inappropriate procedures, poor working conditions, bad equipment, measurement errors, accidents, poor equipment maintenance, computer malfunctions, and even traffic, weather, or natural disasters. Your small business has control of some of these causes, making it important to figure out ways to affect change that boosts your bottom line. Variances due to events outside your company’s control, however, prove harder to anticipate and correct.
Issues With Variance Analysis
While variance analysis offers the potential to help you flush out problems in your small business that lead to negative outcomes, it also comes with its own issues that prevent some companies from relying on it extensively. Because you can’t perform an analysis until after the fact, the time lag also delays feedback and problem correction in fast-paced manufacturing and service-based settings. Likewise, this information doesn’t reside in accounting information but within bills, invoices, overtime records, and similar files. This means that employees must spend lots of time sorting through data to get to the root of key issues. Lastly, since variance analysis compares actual results to arbitrary standards, the resulting information might not be useful to your small business at all.
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