Variance analysis is the study of deviations of actual behaviour from predicted or planned behaviour in budgeting or management accounting. If you are an accounting student or someone pursuing business studies, you may need to learn about these deviations and how they impact the performance of a business.
The purpose of variance analysis is to exercise cost control as well as cost reduction. The variances are linked with efficiency. An efficient team of people often brings a company favourable variance, while the unfavourable variances require remedial action.
The Definition of Variance Analysis
A lot of people have defined variance analysis differently based on their understanding of the study. However, the most comprehensive definition of variance analysis is as follows:
“Variance analysis is the measurement of variances, location of their root causes, measuring their effect and their disposition.”
In other words, variance analysis can be defined as the segregation of total cost variances into different elements in a way to identify or indicate the cause for such variances and people responsible for them.
In accounting, variance analysis is typically associated with explaining the difference between actual costs and the standard costs permitted for the expected output. The study of such variances allows a company to understand the present costs and have more control over future costs.
Imagine that a company is planning to produce 1,000 units of a product. The standard manufacturing cost of the company indicates that the production needs $50,000. However, it turns out that the company has spent $63,000 on production. So, the variance analysis should include the following details:
- There is a $13,000 unfavourable variance to be analysed.
- The $13,000 variance can be divided into a price variance and a quantity variance.
- The price variance shows whether the actual cost per unit was more or less than the estimated cost per unit.
- The quantity variance shows whether the actual quantity of the input used was more or less than the estimated quantity for the actual output.
The variance analysis can help understand the root cause behind such deviations from the standard figures and find out how they can influence the performance of a business.
What Are the Common Reasons Behind Variances?
There can be several reasons behind the variances in cost or behaviour in budgeting. The most common ones are:
- A significant change in market conditions (e.g. the recent pandemic, shortage in the supply of the raw materials, etc.) can impact the standard budgeting practices.
- A wrong idea of the budgeting standards can also lead to variance. For example: wrongly assumed output of a machine.
- The service delivery may not be as effective as assumed. For example, the company had planned to work 8 hours a day on the production but could actually perform 6 hours a day due to power cuts.
- In some cases, there may not be any basis for planning. For example, for creative activities, there’s no bar for a high level of accuracy.
There are plenty of other factors too that cause a variance of different types and not just the cost.
The Different Types of Variances
Before you go on to find the root causes behind the variances and try to measure them, you need to learn about the types of variances. You will be surprised to know that the variances are classified based on not just one but four (or perhaps more) elements.
On the basis of elements of cost:
i) Material cost variance:
When a company encounters a difference between actual costs of materials used in production and the standard (or estimated) costs of materials for the products, it is considered as material cost variance. This usually happens due to the difference in quantities consumed and the quantity initially allocated for production. This also happens when there’s a significant difference in price paid and price budgeted for materials used.
ii) Labour cost variance:
This happens when there’s a difference between the actual wage paid to the workers and the standard wage prevalent for the specified output. The variance is considered unfavourable when the actual labour costs are more than what the company has fixed in its budget.
iii) Overhead variance:
The overhead costs refer to the sum total of indirect material, labour and expense costs. The overhead variance happens when there’s a difference between the standard overhead costs that are budgeted and the actual overheads incurred.
On the basis of controllability:
i) Controllable variance:
A variance can be considered controllable when an individual or a department is held responsible for it. It happens when the person or the department responsible for looking out for such variances does not do the job properly. Such variances can be eliminated if the assigned people identify the cause beforehand and fix the issue.
ii) Uncontrollable variance:
The uncontrollable variances are generally influenced by external factors on which the management doesn’t have any command over. For such variances, no individual or department can be held responsible. The variance caused by the COVID-19 pandemic is a great example of an uncontrollable variance.
On the basis of impact:
i) Favourable variance:
When the actual costs are lower than the estimated or standard costs as per the determined level of activity, the difference can be termed as a favourable variance. Most businesses look for ways to get the actual results at lower costs than the standard costs. And when they succeed in doing so, it shows the efficiency of their business operations.
ii) Unfavourable variance:
When a company spends more money than the estimated amount based on the predetermined level of activity, the variance is termed as an unfavourable variance. Such variances clearly indicate the inefficiency of business operations and call for deeper analysis of the variances.
On the basis of nature:
i) Basic variance:
Basic variances usually happen due to differences in the monetary rates as well as on account of non-monetary factors. Such variances can be caused by a material price variance, labour rate variance, expenditure variance, material quantity variance, labour efficiency variance and volume variance.
The basic variances on account of non-monetary factors can be further analysed and classified into sub-variances as per the factors responsible for them. Material usage variance and material quantity variance fall under this type of variances. Similarly, the labour efficiency variance is segmented into labour mix variance and labour yield variance. The overhead variances are also sub-divided into variable overhead expenditure variance and variable overhead efficiency variance.
If you want to prepare an assignment on variance analysis of a business operation, knowledge of the types mentioned above of variances will be enough to get you started.
How to Perform a Variance Analysis?
Let us now understand how to perform such an analysis.
Step 1: Gather the necessary data:
Collect a similar set of data points that you are going to compare with the results. If you are analysing the cost variances, you need to collect budget-related data (the actual cost and the standard cost). Make sure you are comparing similar data sets. It means the data points should not only be of similar type but also represent the same business and the same period.
Step 2: Create a variance report:
Now, you need to create a variance report by comparing two different data points against one another, at the lowest level possible to help with variance research. A low-level comparison involves comparing results at a cost centre level, typically by a general ledger account. However, a lot of plans are often built at a higher level. So, if you use a plan as your comparison point, you need to create a variance report at a higher level and then research the material variances.
Generally, the favourable results are represented as a positive number, while the unfavourable results are represented as a negative number.
Step 3: Evaluate the variances:
Most companies focus on larger variances first, while others may have general ledger accounts that they monitor more thoroughly than others. Researching variances can become more intuitive when you have the information about how your company’s financials behave.
However, a good financial analyst will try to isolate the variances in question to the lowest possible level, even with an unfamiliar set of financials, to identify the root cause of the variance. You should also try to find out whether the variance was caused by a one-time event, or was it something that has become a trend.
Step 4: Compile an explanation of the variances and recommendations:
This is where you need to show the senior management that you have a complete understanding of the issue and have recommendations to either benefit from the favourable variance or correct an unfavourable variance. It may also come into the role of the analyst to fix the budget and forecast. If you are doing the variance analysis, you need to be aware of the variances that have happened throughout the year.
Step 5: Plan for the future:
While updating the plan, you need to consider that there is more to accounting for variances than capturing the immediate impact. You may need to make assumptions about how the new financial trends will act in the near future. This measure will help you prepare for the next variance analysis exercise.
Hopefully, now you have a good idea about the concept of variance analysis. So, work on your analytical as well as researching skills to perform successful variance analyses on your own. Good luck!
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