What Is Variance Analysis in Accounting?

Variance analysis is a management accounting tool that compares planned or budgeted financial performance against actual results. This process identifies deviations, or variances, and helps understand their underlying causes. It provides insights into operational efficiency and financial health for informed decision-making.

Understanding the Basics of Variances

A variance represents the difference between a standard or budgeted amount and the actual amount achieved. A standard or budgeted amount is established as a benchmark, representing expected cost or revenue under normal operating conditions.

Variances can be “favorable” or “unfavorable.” A favorable variance occurs when actual results are better than expected, such as lower costs or higher revenue. For instance, spending $18,500 on a $20,000 budgeted cost results in a $1,500 favorable variance. Conversely, an unfavorable variance arises when actual results are worse than anticipated, meaning costs are higher or revenues are lower than planned. Spending $22,000 against a $20,000 budget results in a $2,000 unfavorable variance.

Common Types of Variances

Common types of variances are tracked to pinpoint deviations from plans. These variances help management understand where and why differences occurred in operations. Each type measures a distinct aspect of performance against established benchmarks.

Direct Material Variances

Direct Material Variances assess differences in raw material costs. The Direct Material Price Variance indicates whether the actual price paid for materials was higher or lower than the standard price, identifying purchasing efficiency or market price changes. The Direct Material Quantity (or Usage) Variance measures if more or fewer materials were consumed than the standard amount for actual output, highlighting production efficiency or waste.

Direct Labor Variances

Direct Labor Variances examine discrepancies in labor costs. The Direct Labor Rate Variance shows whether the actual hourly wage differed from the standard hourly rate. This variance can signal changes in wage rates or employee skill mix. The Direct Labor Efficiency Variance indicates if more or fewer labor hours were used than the standard hours allowed for actual production, reflecting labor productivity.

Sales Variances

Sales Variances focus on deviations in revenue. The Sales Price Variance measures the difference between the actual selling price and the standard selling price. This variance helps understand the impact of pricing strategies or market conditions. The Sales Volume Variance indicates the impact on revenue from selling more or fewer units than budgeted, reflecting market demand or sales force effectiveness.

Variable Overhead Variances

Variable Overhead Variances relate to indirect costs that change with production level. The Variable Overhead Spending Variance compares actual variable overhead costs to the budgeted amount. This variance can highlight inefficient spending on variable overhead. The Variable Overhead Efficiency Variance measures the effect of using more or fewer activity units (like direct labor hours) than planned for actual output, indicating operational efficiency.

Fixed Overhead Variances

Fixed Overhead Variances are indirect costs constant regardless of production volume. The Fixed Overhead Spending (or Budget) Variance identifies whether actual fixed overhead costs differed from the budgeted amount. This variance reflects cost control over fixed expenses. The Fixed Overhead Volume Variance arises when actual production volume differs from budgeted production volume, impacting fixed overhead application to products.

Performing Variance Analysis

Performing variance analysis involves a process to identify, investigate, and report deviations from financial plans. It begins with calculating variances by gathering actual financial data and comparing it against standard or budgeted amounts for each cost or revenue category.

Once variances are calculated, the next step is to investigate the causes of deviations. This investigates the reasons behind differences, such as changes in material quality, unexpected increases in supplier prices, shifts in labor productivity, or fluctuations in market demand. For instance, an unfavorable material quantity variance might be due to production line inefficiencies or defective raw materials.

The final stage involves compiling and reporting variance analysis results to management. These reports should be clear and concise, highlighting significant variances and their identified causes. The objective is to provide actionable insights to help management understand financial performance and make informed decisions.

Using Variance Analysis for Business Decisions

Variance analysis helps management make informed business decisions and improve organizational performance. It provides insights into how different parts of the business are operating compared to expectations.

A key application is performance evaluation, where variances help assess the effectiveness of departments, individual managers, or operational processes. By analyzing variances, management can identify areas of strong performance or those requiring attention. For example, a favorable labor efficiency variance could indicate effective training programs or improved work methods.

Unfavorable variances often prompt corrective action. If an unfavorable variance is identified, such as high material costs, management can investigate the cause and implement measures like renegotiating supplier contracts, seeking alternative suppliers, or improving production processes to reduce waste. This helps bring operations back in line with financial goals.

Insights from past variances are valuable for strategic planning and budgeting. Understanding why previous budgets were missed or exceeded helps in setting more accurate and realistic financial targets for future periods. This continuous feedback loop refines forecasting and resource allocation. Variance analysis also supports responsibility accounting by linking specific variances to the managers or departments accountable for those costs or revenues, fostering accountability.