Variance Analysis

Variance Analysis | Formula, Need, Importance, Limitations, Types (efinancemanagement.com)

Table of Contents
1. What is Variance Analysis?
2. Variance Analysis Formula
3. Need and Importance of Variance Analysis
4. Limitations of Variance Analysis
5. Forms of Variances
1. Sales Quantity Variance
2. Sales Mix Variance
3. Sales Price Variance
4. Raw Material Price Variance
5. Raw Material Usage Variance
6. Raw Material Mix Variance
7. Labour Rate Variance
8. Labour Efficiency Variance
9. Fixed Overhead Expenditure Variance
10. Variable Overhead Expenditure Variance
6. Conclusion

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What is Variance Analysis?
Variance Analysis deals with an analysis of deviations in the budgeted and actual financial
performance of a company. The causes of the difference between the actual outcome and the
budgeted numbers are analyzed to showcase the areas of improvement for the company. At
times, it is also a sign of unrealistic budgets; therefore, budgets can be revised in such cases.

In other words, variance analysis is a process of identifying causes of variation in the 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 adverse variance. This eventually helps in
better budgeting activity.

A variance in management accounting may be favorable (costs lower than expected or revenues
higher than expected) or adverse (costs higher than anticipated or revenues lower than
expected). Either positive variance or negative variance reflects negatively on the budgeting
efficiency unless caused by extreme events.

Variance Analysis Formula

Variance = Actual Income/Expense – Budgeted Income/Expense

Now, 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 significant deviations on
essential items helps the company know the causes, and it allows management to look into
possible ways of how much deviation can be avoided.
 Variance analysis facilitates assigning responsibility and engages control mechanisms in
departments where required. For example, suppose labor efficiency variance is seen to be
unfavorable, or procurement of raw material cost variance is unfavorable. In that case, the
management can enhance control of these departments to increase efficiency.

Limitations of Variance Analysis

The variance analysis is of immense 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 that may affect the remedial action-taking
ability to a certain extent. Also, not all sources of variance may be available in accounting
data, which makes acting upon variances difficult.
 Suppose the budgeting is not made, considering the detailed analysis of each factor. In that
case, the budgeting exercise may be loosely done, which is bound to deviate from the
actual numbers—after that, analyzing variances may not be a useful activity.

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Forms of Variances
Variances could occur due to changes in one or many items of the budgeted list, and hence we
can have various types of variance to be analyzed. Let us look at some of the common types of
variances as tabulated below:

Forms of
Variance in Special Note / Formula
Variance
(Actual Quantity Sold – Budgeted
Quantity) X Profit per Unit
Sales Quantity
1 The quantum of sales. This is directly affected by a sudden
Variance rise/fall in demand for the products or
services offered by the company.

The proportion of various products This may happen due to shifts in the
2 Sales Mix Variance demand curve.
sold, i.e., the sales mix.

The selling price of the products.

This may happen due to higher (Actual Selling Price – Standard Selling
3 Sales Price Variance Price) X Quantity Sold
competition/ achievement of higher
market share.

(Standard quantity Of Raw Material *

Standard Cost Per Unit) – (Actual
Quantity Of Raw Material *Actual Cost
Raw Material Price The direct cost of raw materials
4 Per Unit)
Variance used. This may happen due to changes in
external factors, e.g., cheaper imports
due to changes in taxation, etc.

(Budgeted Quantity – Actual Quantity) *

Raw Material Usage The quantity of raw materials used Standard Price
5 Many reasons could cause this
Variance up.
deviation, including sales volume.

The cost of the standard proportion

Raw Material Mix
6 of raw materials used by the
Variance company to produce goods.

Costs of labor paid to produce the Labour rate variance helps the
Labour Rate goods. This may happen due management in optimizing labor cost,
7 which is one of the key components of
Variance to economies of scale or due to
unplanned recruitments. direct cost

(Standard/Budgeted Hours –Actual

Labour Efficiency The number of hours utilized by
8 Number of Hours) * Budgeted Hourly
Variance the labor resource of the company. Rate

Usually, these do not deviate much

Fixed Overhead Fixed cost expenditure incurred by unless expansion plans come up or
expansion plans which were planned
9 Expenditure the company like rent, electricity, get delayed or halted due to some
Variance machinery, land, etc. problem, some unplanned losses
happen, or natural calamity occurs.

Deviation in this measure could be on

Variable Overhead the favorable side if costs reduce due to
Variable costs like indirect material economies of scale or could be on the
10 Expenditure unfavorable side due to reasons such
cost
Variance as an increase in idle time, reduction in
sales, etc.

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Conclusion
The widely used types of variances that are analyzed 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 calendar variance, and 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 the industry profile.

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