Variance Analysis


Definition

Variance Analysis, in managerial accounting, refers to the investigation of deviations in financial performance from the standards defined in organizational budgets.

Explanation

Variance analysis typically involves the isolation of different causes for the variation in income and expenses over a given period from the budgeted standards.

So for example, if direct wages had been budgeted to cost $100,000 actually cost $200,000 during a period, variance analysis shall aim to identify how much of the increase in direct wages is attributable to:



Types of Variances

Main types of variances are as follows:

Click on variances listed above to view their explanations, formulas, calculations & examples


Basis of Calculation

Variance analysis highlights the causes of the variation in income and expenses during a period compared to the budget.

In order to make variances meaningful, the concept of 'flexed budget' is used when calculating variances. Flexed budget acts as a bridge between the original budget (fixed budget) and the actual results.

Flexed budget is prepared in retrospect based on the actual output. Sales volume variance accounts for the difference between budgeted profit and the profit under a flexed budget. All remaining variances are calculated as the difference between actual results and the flexed budget.

Following is a graphical illustration of how variances are calculated using the flexed budget approach:


Flexed budget is prepared using actual output. As actual quantity is the 1.5 times of budgeted quantity, sales and expenses have been 'flexed' to 1.5 times of the original budget with the exception of fixed overhead which remains the same under the marginal costing basis.
Budget
(Original)
Budget
(Flexed)
Actual
Result
Output(10,000 units)(15,000 units)(15,000 units)
Sales$1,000,000
The difference of
$300,000 represents
Sales Price Variance
$1,500,000$1,800,000
Direct Materials($100,000)
The difference of
$50,000 represents
Direct Material Total Variance
($150,000)($200,000)
The total variance can be analyzed into
material usage variance & material price variance
Direct Labor($200,000)
The difference of
$50,000 represents
Direct Labor Total Variance
($300,000)($350,000)
The total variance can be analyzed into
labor efficiency variance & labor rate variance
Variable Overheads($300,000)
The difference of
$50,000 represents
Variable Overhead Total Variance
($450,000)($500,000)
The total variance can be analyzed into
variable Overhead Rate & Efficiency variance
Fixed Overheads($75,000)
The difference of
$25,000 represents
Fixed Overhead Total Variance
($75,000)($50,000)
The total variance can be analyzed into
Fixed Overhead Expenditure & Volume variance
Total$325,000$525,000$700,000
The difference between budgeted profit and profit under flexed budget ($200,000) represents the Sales Volume Variance. Sales Volume Variance can be further analyzed into Sales Mix Variance & Sales Quantity Variance

As you may have noticed, all variances other than the sales volume variance are basically calculated as the difference between actual and flexed income & expenses. The difference between flexed budget profit and the fixed budget profit is accounted for separately in a single variance, i.e. sales volume variance.

This approach to calculating variances facilitates comparison of like with like. Hence, we can compare the actual expenditure incurred during a period with the standard expenditure that 'should have been incurred' for the level of actual production. Similarly, actual sales revenue can be compared with the standard revenue that 'should have been earned' for the level of actual sales during a period in order to determine the effect of

Functions and Importance

Variance analysis is an important part of an organization's information system.

Functions of variance analysis include:

Planning, Standards and Benchmarks

In order to calculate variances, standards and budgetary targets have to be set in advance against which the organization's performance can be compared against. It therefore encourages forward thinking and a proactive approach towards setting performance benchmarks.

Control Mechanism

Variance analysis facilitates 'management by exception' by highlighting deviations from standards which are affecting the financial performance of an organization. If variance analysis is not performed on a regular basis, such exceptions may 'slip through' causing a delay in management action necessary in the situation.

Responsibility Accounting

Variance analysis facilitates performance measurement and control at the level of responsibility centers (e.g. a department, division, designation, etc). For example, procurement department shall be answerable in case of a substantial increase in the purchasing cost of raw materials (i.e. adverse material price variance) whereas the production department shall be held responsible with respect to an increase in the usage of raw materials (i.e. adverse material usage variance). Therefore, the performance of each responsibility centre is measured and evaluated against budgetary standards with respect to only those areas which are within their direct control.