Definition:
In budgeting (or management accounting in general), a variance is the difference between a budgeted, planned or standard amount and the actual amount incurred/sold. Variances can be computed for both costs and revenues. It is the Process aimed at computing variance between actual and budgeted or targeted levels of performance, and identification of their causes.
Explanation:
Variance analysis is usually associated with explaining the difference (or variance) between actual costs and the standard costs allowed for the good output. For example, the difference in materials costs can be divided into a materials price variance and a materials usage variance. The difference between the actual direct labor costs and the standard direct labor costs can be divided into a rate variance and an efficiency variance. The difference in manufacturing overhead can be divided into spending, efficiency, and volume variances. Mix and yield variances can also be calculated. Variance analysis helps management to understand the present costs and then to control future costs.
Variance analysis is also used to explain the difference between the actual sales dollars and the budgeted sales dollars. Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance. A difference in the relative proportion of sales can account for some of the difference in a company’s profits.
Types of variances
Variances can be divided according to their effect or nature of the underlying amounts.
1) When effect of variance is concerned, there are two types of variances:
· Favorable variance When actual results are better than expected results given variance is described as favorable variance. In common use favorable variance is denoted by the letter F - usually in parentheses (F).
· Unfavorable variance When actual results are worse than expected results given variance is described as adverse variance, or unfavorable variance. In common use adverse variance is denoted by the letter A or the letter U - usually in parentheses (A).
2) The second typology (according to the nature of the underlying amount) is determined by the needs of users of the variance information and may include e.g.
· Direct Material Variance
i. Direct Material cost Variance
ii. Direct Material price Variance
iii. Direct Material usage Variance
iv. Direct Material yield Variance
v. Direct Material Mix Variance
· Direct Labor Variance,
i. Direct Labor cost Variance
ii. Direct Labor rate Variance
iii. Direct Labor efficiency Variance
iv. Direct Labor mix Variance
· Variable overhead Variance,
i. Variable overhead cost Variance,
ii. Variable overhead efficiency Variance,
iii. Variable overhead spending Variance,
· Fixed Overhead Variance,
i. Fixed Overhead cost Variance
ii. Fixed Overhead efficiency Variance
iii. Fixed Overhead spending Variance
· Sales Variance
i. Sales price Variance
ii. Sales value Variance
iii. Sales volume Variance
iv. Sales mix Variance
Advantages of Variance Analysis
In short, variance analysis helps the management in
1. Decision-making.
2. is used in cost-control,
3. gives early warning for corrective action and
4. Is useful in accountability.
5. Helps management to understand the present costs and then to control future costs.
Significance of variances
The decision as to whether or not a variance is so significant that it should be investigated should take a number of factors into account.
- The type of standard being used
- Interdependence between variances
- Controllability
- Materiality
Limitation
There are several problems with variance analysis that keep many companies from using it. They are:
- Time delay. The accounting staff compiles the variances at the end of the month before issuing the results to the management team. In a fast-paced environment, management needs the information much faster than once a month.
- Variance source information. Many of the reasons for variances are not located in the accounting records, so the accounting staff has to sort through such information as bills of material, labor routings, and overtime records to determine the causes of problems.
- Standard setting. Variance analysis is essentially a comparison of actual results to an arbitrary standard that may have been derived from political bargaining.
Many companies prefer to use horizontal analysis, rather than variance analysis, to investigate and interpret their financial results.
Conclusion
Variance means difference while analysis means breakdown. In Cost or Management Accounting, variance would relate to difference between Standard and Actual Costs. Analysis would break this difference into various parts like quantity, price and capacity. Any wide variation would be thoroughly investigated and persons responsible (purchase manager, human resource manager, factory manager or marketing manager) would be asked to explain. If it proved avoidable or controllable, someone would be penalized or reprimanded else measures would be taken to avoid in future as far as possible.