Variance Analysis deals with an analysis of deviations in the budgeted and actual financial performance of a company. The causes of difference between the actual outcome and the budgeted numbers are analysed to showcase the areas of improvement for the company. At times, it is also a sign of unrealistic budgets and therefore in such cases budgets can be revised.
In other words, variance analysis is a process of identifying causes of variation in income and expenses of the current year from the budgeted values. It helps to understand why fluctuations happen and what can / should be done to reduce the variance. This eventually helps in better budgeting activity.
A variance in management accounting may be favourable (costs lower than expected or revenues higher than expected) or adverse (costs higher than expected or revenues lower than expected). Either positive variance or negative variance is reflected negatively on the budgeting efficiency unless caused by extreme events.
Variance Analysis Formula
Variance = Actual Income/Expense – Budgeted Income/Expense
Let us look at the need and importance of variance analysis:
Need and Importance of Variance Analysis:
- Variance analysis aids efficient budgeting activity as management wishes to have lower deviations from the planned budgets. Wanting a lower deviation usually leads managers to make detailed and forward-looking budgetary decisions.
- Variance analysis acts as a control mechanism. Analysis of large deviation on key items helps the company in knowing the causes and it helps management look into possible ways of how such deviation can be avoided.
- Variance analysis facilitates assigning responsibility and engages control mechanism on departments where it is required. For example, if labour efficiency variance is seen to be unfavourable or procurement of raw material cost variance is unfavourable, the management can enhance control of these departments to increase efficiency.
Limitations of Variance Analysis
The variance analysis is been of large use to corporations; however it comes with its own set of limitations as follows:
- Variance analysis as an activity is based on financial results which are released much later after quarterly closing; there may be a time gap which may affect the remedial action taking an ability to a certain extent. Also, not all sources of variance may be available in accounting data which makes acting upon variances difficult.
- If the budgeting is not made taking into consideration the detailed analysis of each factor, the budgeting exercise may be loosely done which is bound to deviate from the actual numbers. Thereafter analysing variances may not be a useful activity.
Variances could occur due to change in one or many items of the budgeted list and hence we can have various types of variance to be analysed. Let us look at some of the common types of variances as tabulated below:
|Sr. no||Type of Variance||Variance in||Special Note / Formula|
|1.||Sales Quantity Variance||The quantum of sales.
This is directly affected by sudden rise/fall in demand for the products or services offered by the company.
|(Actual Quantity Sold – Budgeted Quantity) X Profit per Unit|
|2.||Sales Mix Variance||Proportion of various products sold i.e. the product mix.
This may happen due to shift in the demand curve.
|3.||Sales Price Variance||Selling price of the products. This may happen due to higher competition/ achievement of higher market share.||(Actual Selling Price – Standard Selling Price) X Quantity Sold|
|4.||Raw Material Price Variance||The direct cost of raw materials used.
This may happen due to changes in external factors e.g. cheaper imports due to changes in taxation etc.
|(Standard quantity Of Raw Material * Standard Cost Per Unit) – (Actual Quantity Of Raw Material *Actual Cost Per Unit)
|5.||Raw Material Usage Variance||The quantity raw materials used up.
Many reasons could cause this deviation including sales volume
|(Budgeted Quantity – Actual Quantity) * Standard Price|
|6.||Raw Material Mix Variance||The cost of the standard proportion of raw materials used by the company to produce goods.|
|7.||Labour Rate Variance||Costs of labour paid to produce the goods. This may happen due to economies of scale or due to unplanned recruitments.||Labour rate variance helps the management in optimisation labour cost which is one of the key components of direct cost|
|8.||Labour Efficiency Variance||The number of hours utilised by the labour resource of the company.
|(Standard/Budgeted Hours –Actual Number of Hours) * Budgeted Hourly Rate
|9.||Fixed Overhead Expenditure Variance||Fixed cost expenditure incurred by the company like rent, electricity, machinery, land etc.||Usually these do not deviate much unless expansion plans to come up or expansion plans which were planned get delayed or halted due to some problem, or some unplanned losses happen, or natural calamity occurs.
|10.||Variable Overhead Expenditure Variance||Variable costs like indirect material cost||Deviation in this measure could be on the favourable side if costs reduce due to economies of scale or could be on the unfavourable side due to reasons such as an increase in idle time, reduction in sales etc.
The widely used types of variances that are analysed by management are given above. Apart from these, the management may also use the variance analysis on other variables like direct cost yield variance, fixed overhead efficiency variance, variable overhead efficiency variance, fixed overhead capacity variance, fixed overhead total variance among many others. However, it is important to understand that it is not necessary to track all variances; it may be sufficient to track a few important ones depending upon the nature of the company, the life cycle and industry profile.