Variance analysis is a major management accounting technique whereby the organization will be able to look through its financial performance by comparing the actual outcome against the budgeted figure.
With this, the business organization would be able to reveal any discrepancies, trace the causes, and thereby make relevant decisions to enhance operational efficiency.
This tutorial will cover what variance analysis is, the types of variances, the importance of variance reports, and business examples to demonstrate how it works.
What is Variance Analysis?
Variance analysis refers to the quantification and investigation of variances between projected financial outcomes and actual performance.
Essentially, it looks at variances in cost and revenue to derive meaningful insight into the financial health status of the corporation concerned.
This practice allows managers to identify instances of performance that are not meeting expectations and thus take essential action.
Why is Variance Analysis important?
Variance analysis is very important on several counts:
- Performance Measurement: Comparison between actual performance with budgeted figures shows the level of efficiency of a particular organization. It provides insight into whether goals are met and where an organization needs to concentrate for improvement.
- Budgetary Control: The variance reports are an essential tool in budgetary control. They enable an organization to keep its financial resources under control by ensuring that expenditure is channeled per the planned budgets.
- Strategic Planning: Understanding the causes of variances will help an organization to make the right decisions regarding their future budgets and operational plans. This would enable the managers to change their plans in front of actual performances in order to get better strategic planning.
- Cost Management: The analysis of variance is manufactured and operational cost information and thus could help an organization to understand any inefficiencies and thereby manage costs. It could enhance the overall profitability of any organization and improve cost efficiency.
- Performance Motivation: Variance reports exposed to teams will help management in creating accountability and a culture of continuous improvement. People are more prone to ownership of the performance when they can understand how their work has affected the bottom line in the financial results.
Types of Variance Analysis
Variance analysis, depending on the context and application in which it is made, can be divided into many types. In simple terms, the following types can help the efforts focus on those aspects of the operations where the organization needs to have a greater emphasis.
- Budget variance
Budget variance refers to the differences between the figures you projected in your budget and your business’s actual performance It considers the actual financial performance against the budgeted figures. Two categories of variances are:
- Positive Variance: This occurs when budgeted revenues are exceeded by actual revenues, or when the actual costs are less than the budgeted costs. It is a positive variance that indicates the operation of an organization is better than expectations.
- Negative Variance: This occurs when actual revenues are lower than the budget figures, or actual costs exceed budgeted costs. A negative variance allows for warnings that issues have to be identified.
- Variance in Manufacturing
Manufacturing variance only deals with production costs and consists of a few subheadings as follows:
- Direct Material Variance: This aspect of variance deals with the difference between the actual cost of materials used against the estimated cost of such material at standard prices.
- Direct Labor Variance: This determines the deviation in the actual labor cost incurred from that considered to be the standard labor cost for production.
- Overhead Variance: This variance studies the deviation in manufacturing overhead, which may be classified into two broad categories: fixed and variable.
- Sales Variance
Sales variance looks into the deviation between actual sales figures against budgeted sales. It can also give an organization a sense of prevailing market trends, pricing strategy, and sales performance to reshape its sales strategy.
- Cash Variance
Cash variance looks at the deviation of actual cash inflows and outflows from that which was budgeted. It is important to control the liquidity in any organization for it to have adequate cash flow to meet the operational requirements.
- Operating Variance
Operating Variance: It identifies the operational efficiency of the business, which can be a comparison between actual performance metrics and standard performance metrics. This measures how well an organization leverages the resources that it already has. Examples might include productivity comparisons, efficiency comparisons, and overall comparisons in operational effectiveness.
- Profit Variance
It means the difference between the actual profit and the budgeted profit. It looks into revenue and expense variance, hence allowing an in-depth view of the causes for the bottom line. Analysis of profit variance allows any organization to determine which areas to improve both in revenue generation and cost control.
Formulas for Variance Analysis
It’s essential to grasp several key formulas that could be applied while carrying out variance analysis. Here are a few core concepts:
- Formula of Budget Variance: This formula helps in estimating the variance between actual and budgeted amounts.
- Direct Material Variance: The consumption of materials utilized against the expected cost by standard prices is considered.
- Direct Labor Variance: The labor cost incurred is highlighted against the standard labor cost of production.
- Overhead Variance: Actual manufacturing overhead costs against applied overhead costs are considered.
- Sales Variance: It would calculate the variance between actual sales and projected sales, considering the pricing strategies involved.
- Cash Variance: This will work out the actual cash inflow and outflow against the budgeted ones.
While such formulas provide the basis for analysis, it must be recalled that variance analysis is pretty much more than numbers; interpretation and context need to be added to get relevant insights.
Practical Examples of Variance Analysis
The following examples indicate how this type of variance analysis could be implemented in practical cases.
Example 1: Budget Variance for a Retail Business
A retail company makes an annual budget by estimating revenues based on its past sales figures and expected market conditions. In the closing days of the year, the company conducts a variance analysis and identifies that the revenues generated were considerably higher than the revenues budgeted earlier.
This favorable variance is therefore investigated to find its causes by the management team. They find that an unexpected surge in consumer demand, together with effective marketing campaigns, contributed to higher sales. The insight derived here thus leads this team to adjust future budgets by exploiting this demand trend.
Example 2: Manufacturing Variance in a Factory
An organization in the manufacturing business continuously acts in this regard with a cost of production through a variance analysis. They estimate actual and compare raw material and labor costs to the budgeted figures.
The management immediately catches, upon review, an unfavorable direct material variance of a big amount. Their follow-up investigation realizes that these increased prices by suppliers coupled with inefficiency in the process resulted in higher material costs.
The company will have to renegotiate contracts with suppliers and improve processes in order to reduce future variances.
Example 3: Cash Variance in a Service Organization
A service-based organization would budget its cash inflows based on forecasted client engagements. In this case, a service-based organization had actual cash inflows in a quarter come in lower than budget, which is determined through a cash variance.
Upon close variance analysis, the management team identifies delays in client payments and a reduction in the number of new contracts as the causes for the unfavorable variance.
They act by strengthening their processes of accounts receivable and finding new marketing strategies to attract more clients.
Example 4: Sales Variance in a Software Company
A software development company predefines sales targets based on the forecasted market demand for its products. In one quarter, the sales variance analysis reveals that the actual sales generated are far less than expected.
In order to understand this negative variance, the management team conducts market research and takes valuable insights from the sales team. It finds that their competitors’ new features were not part of their product.
Through this valuable insight, the company updates the priorities of development and invests in upgrading its product suite to recapture market share.
Advanced Variance Analysis Techniques
Organizations desirous of better variance analysis can avail themselves of several advanced techniques to find deeper insights:
Multi-Factor Variance Analysis
This methodology decomposes variances into a variety of contributing factors that allow organizations to appreciate the complexity underlying performative discrepancies. By examining various variables, managers can identify root causes more effectively.
Rolling Forecasts
Organizations utilize rolling forecasts to keep up with the dynamism of the market environment. By continuously updating forecasts on the basis of recent performance, companies will minimize variances and ensure that their strategies remain informed by current realities.
Benchmarking
This puts variance analysis into context, as it benchmarks against the industry standard or competitor. Comparing a business’s performance against other similar organizations allows them to identify better ways of conducting its operations.
Root Cause Analysis
The root cause analysis enables organizations to investigate further why the variance has occurred. Other than addressing symptoms this methodology seeks to understand the root causes and apply corrective actions that achieve sustainable benefits.
Integrated Reporting
Incorporating variance analysis into larger performance management systems helps to make links between financial data and operational metrics. Integrated reporting means that all the dimensions of performance align, hence giving an expanded view into the health of the organization.
Scenario Planning
Use scenario planning to enable the organization to plan for multiple scenarios at once using different assumptions. Anticipating variances with contingency plans against each scenario moves the business one step ahead by developing mitigation strategies in advance.
Conclusion
Variance analysis is an essential tool in management accounting that permits organizations to analyze their financial performance, disclose variances, and base decisions on facts. The use of the concept of different types of variances, appropriate techniques of analysis, and interpretation in the right context will enable business enterprises to develop operational efficiency and be more strategically focused.
In fact, the importance of variance analysis does not stop at the level of number evaluation but provides a sustainable continuous improvement framework that allows ownership by teams and forces the organization towards profitability and sustainability.
The role of variance analysis will continue to be important as it guides the financial management and strategic decisions that businesses make in these increasingly complex and dynamic times.
Do follow us on Facebook and LinkedIn, to stay connected with us.
