Midsize business

How to identify trends and control costs with variance analysis

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 deviations between outcomes and benchmark expectations are essential to maintaining steady cash flow.

Knowing that you missed your target budget is one thing, but you need to see more than what appears on your financial statements. You need a quantitative investigation into why your target budget wasn’t met so you can make evidence-based decisions for your business’s financial future. That’s where variance analysis comes in.

In this article, we’ll explore the different types of variances and how analyzing them can help you take control of your budget.

What is variance analysis?

Before we dig into the specifics of this financial analysis technique, it’s essential to understand what variance is in the first place. The simplest definition of variance is a discrepancy between what you planned to spend and your actual numbers. Accordingly, variance analysis is the practice of extracting insights from the variance numbers 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 generated $8,000, that would be a $2,000 unfavorable variance. Suppose it’s determined through a variance analysis that the fluctuation in anticipated profits can be traced to rising costs of automobile parts. In that case, the mechanic can adjust their standard prices to make up for variable costs or find a cheaper vendor.

Depending on your goals, you can analyze any of the following variances to optimize 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.

On the other hand, material quantity variance measures the difference between the standard quantity of materials expected to complete a project and the actual amount you used.

Finally, there’s 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 favorable efficiency variance because you paid less than the standard.

2.  Labor variance

If your business is labor-intensive, it’s crucial to understand how your employees’ productivity compares to your labor costs. Calculating the direct labor 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 labor variance is by analyzing your labor costs. The labor rate variance is determined by calculating how much you spent on labor hours and seeing how that number compares to your original budget. For example, if a contractor who makes a dress for you charges $20 per hour, but you budgeted $22 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 that occurs when there is a discrepancy between your actual variable overhead and the standard variable overhead. Furthermore, the variable overhead efficiency variance is the difference between the real time it takes to manufacture a unit and the time budgeted for it.

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 its sales goals or comes up short, this is called a sales variance. If you know how to calculate a volume variance, you can understand whether you have 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. This is an unfavorable variance because you didn’t sell quite as many bikes as you budgeted for.

Keep in mind; you only need to analyze the variances that apply to your business. For example, a service-based business like a law firm may only need to examine its labor efficiency variance. On the other hand, a construction company 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 of your business’ finances, it’s essential to weigh the advantages and disadvantages of this reporting tool before going all in.

Advantages of variance analysis

  1. Rather than relying on guesswork to determine why you’re missing your budget, a variance analysis can help you pinpoint the actual cause, giving you peace of mind.
  2. A robust view of budget variances can direct you towards which products to make/sell, what vendors to use, and which customers to target, ultimately improving your cash flow and giving you a competitive advantage in the marketplace.
  3. Variance analysis can build trust among team members working towards a common goal by mitigating risks, discovering trends, and identifying weak spots.

Disadvantages of variance analysis

  1. 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 quickly and needs data on the spot.
  2. To conduct accurate analyses, your accounting team may need to track down additional data such as bills of material, labor routings, and overtime records to do a precise analysis.
  3. Comparing your actual results to arbitrary industry standards can confuse whether you’re on track or need to make changes.

Is variance analysis right for your business?

As we’ve seen in the examples throughout this article, variance analysis can yield valuable financial insights across many industries.

From spotting bottlenecks in manufacturing to improving profit margins on construction projects, variance analyses can give your business the insights it needs to improve over time continually.

It can be tempting to keep pushing forward when results don’t meet expectations, but by diagnosing why things went awry, your business can quickly make adjustments to get back on track.

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