What Is Variance Analysis?

  • By AFP Staff
  • Published: 7/3/2024
What Is Variance Analysis

Variance analysis is a quantitative method used to assess the difference between planned and actual financial outcomes.

Variance analysis is commonly used in accounting and finance to understand “what” the actual deviations from the budget or forecast are, with the goal of determining “why.” The deviation can be favorable (better than expected) or unfavorable (worse than expected).

Favorable vs. Unfavorable Variance

“Favorable” and “unfavorable” are used to describe variances rather than “higher” and “lower” or “positive” and “negative.” While a higher or positive revenue is favorable, a higher or positive expense can be unfavorable. Using the terms “favorable” and “unfavorable” helps avoid confusion.

Favorable variances are beneficial to the organization. They result from one of two things:

  1. Actual revenue or income measures surpassing what was budgeted.
  2. Actual costs or expenses coming out lower than what was budgeted.

When a variance is detrimental to the organization, it is classified as unfavorable. Unfavorable variances result from one of the following:

  1. Actual revenue or income measures are below budget.
  2. Actual costs or expenses exceed what was budgeted.
Favorable Unfavorable
Revenue Actual > Budget Actual < Budget
Expense Actual < Budget Actual > Budget

By understanding the root causes of variances, FP&A professionals can make informed decisions, adjust forecasts and develop strategies to optimize financial performance.

Types of Variance Analysis

Master Budget Variance

A master budget shows expected income-generating activities, expenses, assets, sources of financing and liquid resources. It is developed for only one level of activity (e.g., sales volume) and is inflexible (or static) in nature. Think of it like a fixed star by which you can measure the distance you have traveled toward your goal.

Master budget variances are the degree to which actual results vary from the master budget; price and volume variances can be used to identify whether a master budget variance is attributable to variation in price or sales volume.

  • Price variance: Holds any variation in sales volume constant and allows the FP&A professional to isolate the effects of any change in pricing. To figure out the price variance, take the actual unit price minus the budgeted value multiplied by the actual sales volume.
  • Volume variance: Holds any variation in sales price constant and allows the FP&A professional to isolate the effects of any variation in sales volume. To figure out the volume variance, take the actual sales volume minus the budgeted sales volume multiplied by the budgeted sales price.

Flexible Budget Variance

Identical in format to the master budget, flexible budgets are prepared using various (any) levels of sales volume. Whereas the master budget is a fixed point, the flexible budget is a sliding scale that recalculates the period after close to establish spend levels based on actual sales.

The value of the flexible budget lies in the fact that it can be used to prepare a new budget when the actual sales volume doesn’t match the numbers in the master budget. Since the flexible budget is prepared using the actual sales volume, any variances are attributable to pricing or cost control.

  • Sales activity variances result from differences between the flexible budget and the master budget. They serve as a solid measure of the effectiveness of management in meeting sales objectives.
  • Price variances occur when the actual input cost surpasses the standard cost. An unfavorable variance indicates inefficiency in sourcing production inputs.
  • Usage variances measure production efficiency. When the actual quantity of inputs used exceeds the standard, an unfavorable usage variance occurs.

Multiproduct Sales Volume Variance

A multiproduct sales volume variance is a combination of the variance in actual total sales volume and actual sales mix. Here we are moving from what the variance was to why. The product mix (what was sold) has a huge impact because most products have different price and profitability points. Analyzing sales performance in the market can go a long way toward explaining variance to budget.

Figuring out this variance allows FP&A professionals to determine whether the variance in operating profitability is due to a deviation in sales activity or the mix of sales across the organization’s product lines.

Sales-Quantity Variance vs. Sales-Mix Variance

  • Sales-quantity variance is the difference between the expected sales volume and the actual sales volume, measured in terms of the impact on profit.
  • Sales-mix variance is the difference between the actual and expected sales mix, measured by its impact on profit.

How Variance Analysis Is Used in Management by Exception

Variances enable management by exception, whereby leaders focus their attention on significant financial results — favorable or unfavorable. This involves highlighting variances that exceed a predetermined materiality threshold, ensuring leadership focuses only on the most critical issues.

The review process is conducted with three goals in mind:

  1. Determine the root cause of the variance.
  2. Assess the extent to which it is controllable.
  3. Assign responsibility to a specific division, team or individual who is then tasked with developing and implementing a solution.

Material favorable variances are not immune from analysis. They should be analyzed to determine if they:

  1. Result from beneficial practices that should be adopted.
  2. Lead to quality issues (e.g., using low-quality, cheap materials).
  3. Cause related unfavorable variances (e.g., hiring less experienced workers to save on labor costs, which might reduce future sales).

Unfavorable variances should, of course, be eliminated whenever possible. When evaluating variances, focus on their informational value rather than assuming they are purely positive or negative, as they are often a mixture of both.

Read More About Budgeting and Variance Analysis

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