Variance Analysis Explained

Variance analysis is a powerful management accounting technique that helps businesses understand and analyze deviations.

It’s the process of comparing planned or budgeted figures to actual results and investigating the differences - the variances.

By analyzing these variances, businesses can gain valuable insights into their performance, identify areas for improvement, and make data-driven decisions to stay on track.

This post will explain the role of variance analysis, why it’s crucial, the different types of variances, and how to effectively use it to drive better business outcomes.

What is Variance Analysis?

Variance analysis is essentially a performance measurement tool.

It’s the process of quantifying and explaining the difference between actual results and planned or expected performance.

Think of it as a financial detective process - investigating why actual results differed from the plan.

It compares a business’s planned or budgeted financial outcomes to its actual results. By measuring these differences—called variances—businesses pinpoint where they excelled or fell short. This process helps them understand the underlying reasons, spot trends, and make smarter decisions for future performance and budgeting.

Key Components of Variance Analysis:

1. Planned/Budgeted Figures: Financial targets or expectations set in advance through budgeting or forecasting.
2. Actual Results: The financial outcomes achieved during a specific period.
3. Variance: The difference between actual results and planned figures. Variances can be:
   • Favorable (F): Actual results are better than planned.
   • Unfavorable (U): Actual results are worse than planned.
4. Analysis and Investigation: Understanding why variances occurred by identifying root causes.

Why is Variance Analysis Important?

Variance analysis provides numerous benefits:

1. Performance Evaluation: Identifies areas where the business is excelling or falling short.
2. Control and Accountability: Highlights deviations from plans and holds individuals or departments accountable.
3. Early Warning System: Flags potential problems or inefficiencies early, allowing timely corrective actions.
4. Improved Decision-Making: Provides insights for better decisions about pricing, production, and resource allocation.
5. Enhanced Budgeting and Forecasting: Improves the accuracy of future budgets by identifying systematic biases.
6. Continuous Improvement: Drives operational and financial performance improvements by addressing root causes.

The Critical Role of Variance Analysis in FP&A

For Financial Planning & Analysis (FP&A) teams, variance analysis is the backbone of effective strategic management.

• Bridging the Gap: FP&A's core function is to bridge strategic goals with operational execution. Variance analysis directly supports this by highlighting where actual performance deviates from strategic plans, allowing FP&A function to pinpoint exactly what went wrong (or right) and why.
• Informing Forecasts & Budgets: Instead of just rolling over previous numbers, FP&A teams use variance analysis to understand the drivers behind past performance. This understanding is crucial for creating more accurate and realistic future budgets and forecasts. For instance, if material price variances were consistently unfavorable due to market shifts, FP&A can factor this into next year's cost projections.
• Strategic Resource Allocation: By understanding which initiatives or departments are generating favorable variances (e.g., higher-than-expected ROI) or unfavorable ones (e.g., cost overruns), FP&A can advise leadership on where to reallocate resources for maximum impact.

Types of Variances: Categorizing Deviations

Variances can be categorized in different ways:

1. Based on Financial Statement Element:

• Revenue Variances: Differences between actual and planned revenue.
  • Sales Volume Variance: Due to differences in the quantity sold.
  • Sales Price Variance: Due to differences in the selling price per unit.
• Cost Variances: Differences between actual and planned costs.
  • Direct Material Variances:
    • Material Price Variance: Due to differences in material prices.
    • Material Quantity Variance: Due to differences in material usage.
  • Direct Labor Variances:
    • Labor Rate Variance: Due to differences in wage rates.
    • Labor Efficiency Variance: Due to differences in labor hours used.
  • Variable Overhead Variances:
    • Variable Overhead Spending Variance: Due to differences in variable overhead costs.
    • Variable Overhead Efficiency Variance: Due to differences in variable overhead usage.
  • Fixed Overhead Variances:
    • Fixed Overhead Spending Variance: Due to differences in fixed overhead costs.
    • Fixed Overhead Volume Variance: Due to differences in production volume.

2. Based on Favorability:

• Favorable Variance (F): Actual results are better than planned.
• Unfavorable Variance (U): Actual results are worse than planned.

3. Based on Controllability:

• Controllable Variance: Can be influenced by a specific manager or department.
• Uncontrollable Variance: Outside the control of the manager or department (e.g., market changes).

Performing Variance Analysis: A Step-by-Step Approach

1. Calculate Variances:
   • Use formulas to calculate variances (e.g., Sales Volume Variance = (Actual Volume - Budgeted Volume) × Budgeted Price).
2. Identify Significant Variances:
   • Focus on material variances that are large enough to warrant investigation.
3. Investigate Variances:
   • Dig deeper to understand root causes by gathering data and conducting interviews.
4. Determine Causes:
   • Identify specific factors contributing to variances (e.g., operational inefficiencies, market changes).
5. Take Corrective Action:
   • Implement changes to address unfavorable variances or replicate factors driving favorable variances.
6. Document and Learn:
   • Document the analysis process, findings, and actions taken for future reference and continuous improvement.
7. Regularly Review and Improve:
   • Make variance analysis an ongoing process to continuously improve performance and budgeting accuracy.

Variance Analysis Is a Competitive Advantage

By utilizing variance analysis, businesses can move beyond reactive management and become proactive in identifying problems, seizing opportunities, and continuously improving operations and financial outcomes.