"Variance analysis" might sound like a technical term reserved for the elite in finance departments, but it's an essential concept that managers should embrace. It’s a meticulous investigation of performance differences between budgeted and actual values. 

This critical process enables businesses to pinpoint where and why discrepancies occur, empowering them to optimize operations, control costs, and make informed decisions. As markets and prices fluctuate, the ability to analyze financial performance is indispensable.

In this comprehensive article, we explore the concept of variance analysis, its types, and real-world examples so you understand how they help businesses. 

A variance analysis is a business process that considers the difference between current and future situations. It measures multiple variables and combines them to create a clear picture of the business and know if there are favorable and unfavorable variances.

The variables could be anything. For example:

• Direct labor costs
• Labor hours
• Product actual costs
• Standard costs
• Materials
• Staff

A company could analyze its financial statements or check the quantity of materials during a specific period to prevent underperformance. You can prepare a variance analysis as frequently as you want. The more you do it, the more opportunities you find for improvement.

However, a regular business would perform it monthly, quarterly, or annually.

There are five main formulas you should use when preparing a variance analysis. Each one is applied to different variances:

• Material Cost Variance Formula = Standard Cost - Actual Cost = (SQ x SP) - (AQ x AP)
• Labor Variance Formula = Standard Wages - Actual Wages = (SH x SP) - (AH x AP)
• Variable Overhead Variance Formula = Standard Variable Overhead - Actual Variable Overhead = (SR - AR) x AO.
• Fixed Overhead Variance Formula = (AO x SR) - Actual Fixed Overhead.
• Sales Variance Formula = (BQ x BP) - (AQ x AP)

Glossary Terms:

• SQ = Standard Quantity for actual output.
• SP = Standard Price.
• AQ = Actual Quantity.
• AP = Actual Price.
• SH = Standard Hours.
• AH = Actual Hours.
• SR = Standard Rate.
• AR = Actual Rate.
• AO = Actual Output.
• BQ = Budgeted Quantity.
• BP = Budgeted Price.

A variance analysis allows you to determine if your business exceeds expectations (favorable variance) or falls short of resources and performance (unfavorable variance). 

But that’s not the only thing this process does. You can also:

• Reveal processes that require adjustment.

• Discover initiatives when a favorable variance occurs.

• Find activities that prevent unfavorable budget variances and other unfortunate situations.

• Create a roadmap according to the business variance objectives.

• Assess if goals will be achieved after a period.

• Develop corrective actions for favorable or unfavorable variances.

A detailed variance analysis will provide an overall view of internal and external factors that could make your business perform differently than usual.

You must consider seven variance analysis types when auditing your business.

Let’s break them down: 

Material Variance

The variance tries to identify the business units using more materials than they need.

You can then determine if your supplier is providing enough resources or if you need to search for another. But it requires specific formulas to give the actual costs and quantities needed.

• Quantity variance = (Actual quantity x Standard price) - (Standard quantity x Standard price)

• Price variance = (Actual quantity x Standard price) - (Actual quantity x Actual price)

• Overall variance = Quantity variance + Price variance

After getting the formula results, a variance will occur.

Labor Efficiency Variance

The labor variance provides information about using staff and team members as labor resources and getting better results for your business. The gathered data will show how your operations develop and the chances to save money.

The formulas to use are:

• Rate variance = (Actual hours x Actual rate) − (Actual hours x Standard rate)

• Efficiency variance = (Actual hours x Standard rate) − (Standard hours x Standard rate)

• Overall labor variance = Rate variance + Efficiency variance

Employ them to calculate variances and inefficiencies, along with higher labor prices. For example, you can measure if the standard labor rate or the direct labor hours are aligned with what an employee produces on a working day.

Fixed Overhead Variance

Overhead costs are all those indirect and ongoing expenses your business needs to run. They are based on a budget and follow a strict policy.

Overhead variances identify the inconsistencies in your actual overhead costs and determine the volume produced with that money.

The formulas are:

• Budget variance = Actual fixed overhead cost - Budgeted fixed overhead cost
• Fixed overhead cost applied to inventory = Standard hours x Standard rate
• Volume variance = Budgeted fixed overhead cost - Fixed overhead cost applied to inventory
• Overall variance = Budget variance + Volume variance 

Companies can then adjust their budgeted costs and use a fixed overhead expense budget variance to allocate money properly instead of wasting it in areas that don’t need it. Hence, a favorable budget variance.

Budget Variance

A budget variance analysis measures the money allocated and analyzes for variances throughout a period.

But why is a budget variance analysis important?

Comparing budgeted values reveals how the business performs and develops all operations. And since a company’s budget guides its objectives, you should audit it constantly to know there is no leakage.

The formula you’ll use will be expressed in dollars or percentages. It’s up to you to determine which one suits you best.

• Percentage variance formula = (Actual sales ÷ Budgeted sales) –1
• Dollar variance formula = Actual sales dollar value - Budgeted sales value

It doesn’t matter whether you get positive or negative budget variances. The idea is to obtain data about the business’s processes and see if your expectations are met.

Cost Variance

The cost variance considers an accounting approach. It helps you investigate cost variances and irregularities that could happen and aren’t adequately addressed.

Cost variances occur when there’s a difference between the budgeted cost allocated and the money spent. This could cause a favorable or unfavorable cost variance, depending on whether the predicted costs align with the spending.

The formula you’ll use to calculate this variance is:

Cost variance = Projected cost – actual cost

You should consider production costs, materials, staff labor, and other additional costs to your measures to make them as accurate as possible. This is how you determine if the event is a one-time situation or if it has occurred in other moments.

Volume Variance

The production volume variance provides merchandise information and determines the cost of production of each product sold compared to the budgeted cost. 

This process helps businesses to understand if they can develop enough products with a budget and get a profit. This variance uniqueness considers the cost per item, not the entire production overhead cost.

The formula is:

Production volume variance = (actual units produced - budgeted production units) x budgeted overhead rate per unit

And since a company has multiple fixed costs, the more it produces, the more benefits it can produce.

Let's see three variance examples based on the types we’ve mentioned above.

Manufacturer Desk Company

Suppose a company manufactures desks. The standard cost of wood needed for one desk is $200 (100 units of wood at $2 per unit). Build-It plans to produce 500 desks, approximately.

The standard monthly materials cost is 500 desks x $200/desk = $100,000.

That month, the company used 52,000 wood units, costing $2.10 per unit, to manufacture 500 desks. So, the actual monthly materials cost is 52,000 units x $2.10/unit = $109,200.

We can break down the direct material variance analysis into Material Price Variance (MPV) and Material Quantity Variance (MQV).

MPV = (Actual Price - Standard Price) x Actual Quantity

MPV = ($2.10 - $2.00) x 52,000

MPV = $0.10 x 52,000

MPV = $5,200 

Unfavorable since the actual price is greater than the standard price.

MQV = (Actual Quantity - Standard Quantity) x Standard Price

MQV = (52,000 units - 50,000 units) x $2.00

MQV = 2,000 units x $2.00

MQV = $4,000 

Unfavorable since the actual quantity is greater than the standard quantity.

So, the total direct material variance would be the sum of the MPV and MQV, which in this case is $5,200 (MPV) + $4,000 (MQV) = $9,200 Unfavorable.

This unfavorable variance indicates that the business spent $9,200 more on materials than expected in the standards for the actual number of desks produced. 

Management would investigate this to identify reasons for the increased costs. It could be due to price inflation, inefficiencies in the production process, waste, theft, or other factors.

Online Retailer

Imagine a small online retailer, "Books Galore," which specializes in selling books. The retailer estimated selling $50,000 worth of books in June 2023.

However, when Books Galore reviewed its performance at the end of that month, the actual sales were $55,000.

We can now calculate the budget variance in both dollar terms and percentage terms:

Dollar Variance:

Actual Sales - Budgeted Sales = $55,000 - $50,000 = $5,000

Percentage Variance:

[(Actual Sales ÷ Budgeted Sales) – 1] x 100 = [($55,000 ÷ $50,000) - 1] x 100 = 10%

So, Books Galore has a favorable dollar variance of $5,000 and a favorable percentage variance of 10%. 

This means the retailer sold $5,000 more books than expected, a performance that was 10% better than the budgeted sales.

Let’s see the process of preparing a cost variance analysis for your business.

Identify The Variance

Determine what’s the main cost variance. Subtract the planned budget from the money you actually spent. The difference will be the variance, which could be related to materials, labor, budget, volume, etc.

Compare Expenses to Find Differences

Compare your expenses and fixed costs with the actual costs to get the differences in your business. This process contrasts standard costs for each item.

You will have to determine the total cost variance for each item using the formula:

Total cost variance = (standard price A x standard price B) - (actual price A x actual price B)

Calculate the Variance

Decide which variance you’ll calculate based on the types mentioned above.

Ask yourself if you want to identify budget, volume, costs, fixed overhead, etc.

Recheck Variance Results

After getting the first result, recheck the elements in your variances to confirm that you consider all factors involved. That includes actual prices, items, and budgeted prices. You may need to rework your formulas if you don’t consider other price and quantity variances.

Prepare Reports

Compile reports after verifying your numbers. Include potential causes for variances and recommendations to avoid them. Describe how they could have appeared in your operations and between the initial budget and the final invoice.

You could use a template or another intuitive format to help stakeholders and managers understand. Flowcharts and graphics work great.

Develop a Plan to Correct The Variance

Finally, you should develop a straightforward plan to prevent favorable and unfavorable variances. 

Speak with stakeholders and department managers – if any – to create improvement strategies and plan a budget that aligns with your real costs. With this, you can effectively identify where to cut expenses and prevent deficits.

It also helps you plan and avoid the same variances again.

To prepare an intuitive variance analysis, we recommend the Microsoft Office suite. This productivity software allows you to create business documents with graphics, charts, and flow using Excel.

You can automate formulas and build dynamic fields that adjust to your needs.

Businesses need a serial code that activates the software after getting it from the official website. RoyalCDKeys offers you an original and cheap Microsoft Office 2021 CD key so you activate all the software features.

Note: Use the code in the Account tab after installing the program.

Variance Analysis Templates

Here are the best variance analysis templates you can use on your business to conduct variance analysis.

Template #1

Percentage Variance Analysis Template - Download Link

Template #2

Simple Variance Analysis Template - Download Link

Variance analysis is more than complex calculations and financial jargon. It's a strategic tool that facilitates businesses in making more accurate predictions, spotting trends, identifying inefficiencies, and enhancing their financial health. 

Understanding its types and how they impact your operations is crucial for financial professionals and business owners. 

Variance analysis’ strength lies in its ability to clear past events and compare current situations to find nuances. However, like any financial tool, variance analysis is as good as the data it's built on. Therefore, you should use accurate financial records and implement robust budgeting processes.