For companies to make maximum profits, they must carefully consider the costs involved in the operation of the business. Variance analysis comes in handy to help management make important decisions and improve the overall performance of a company. Not all variances are useful in making decisions, though. Some of the most important ones include variable overheads, quantity, and price of materials and labor.
Before you delve further into the technical details, you need to understand the basics, such as variance analysis definition. Knowing the definition will set the foundation for you to understand variance analysis, its importance, problems, and limitations. So, what is a variance analysis?
Definition of Variance Analysis
Variance analysis is the breakdown of the differences between actual and planned numbers. When all variances are added, the value obtained paints a picture of the overall performance of a company. Actual costs are compared to standard costs for each item to determine if a company has performed either poorly or exceptionally well within a financial period.
Take the example of variance analysis in a cement manufacturing company. The company needs raw materials, and the set standard cost for the raw materials is $20,000. If the actual cost of acquiring the raw materials is lower than the standard cost, the variance is favorable as it saves costs. A favorable variance only applies if the volume of the materials set for the standard cost is equal to the volume set for the actual cost. A higher quantity in the actual variance than the standard variance is unfavorable because more materials are required than envisioned.
The Most Common Types of Variances
The following are the various variance analysis examples:
1. Cost Variances
Cost variance is obtained from the difference between actual and the budgeted expenditure of a company. Cost variances cover a wide scope of expenses, including administrative costs and the cost of goods sold. This variance helps the management of a business to stick within a budget when running the business. Cost variance has two elements that make up its formula; price and volume.
The price variance is the value obtained from calculating the difference between a particular unit’s actual and speculated price multiplied by a standard number of units. Volume variance is obtained from subtracting the actual and expected unit volume and multiplying the resulting figure by a standard price per unit. The sum of price and volume Variance reveals the total cost variance for a certain expenditure.
2. Material Variances
Material variances are calculated and included in a variance analysis report by calculating the difference between the standard and the actual costs of raw materials used in a company’s production process. Material variances are sub-divided into the material price and material usage variance, which calculate variances in price and quantity of raw materials used.
3. Labor Variances
Labor variances calculate the differences between the standard labor cost and the actual costs incurred in labor activities. Labor variances are divided into labor rate variance and labor efficiency variance.
4. Variable Variances
The difference between the actual variable output and the standard variable output in a company is a variable variance. The variance is further classified into variable overhead efficiency variance and variable overhead expenditure variance.
5. Fixed Variances
This variance arises from the difference between the standard fixed overhead, that’s used for for actual output and the actual fixed overhead. Fixed variances are also broken down into fixed overhead expenditure and fixed overhead volume variances.
6. Sales Variances
Sales variances are the difference obtained from subtracting the actual sales from the budgeted sales of units in a company. Sales variances are classified into sales volume variance and sales price variance.
7. Profit Variances
They are the difference between the budgeted profit level and the actual profits gained from selling goods or services in a company. Four types of profit variances retrieved from a company’s income statement include:
- Net profit variance
- Gross profit variance
- Operatingprofit variance
- Contribution margin variance
Need and Importance of Variance Analysis
Variance analysis is very important in improving the overall performance of any business. Analyzing the actual versus the expected costs incurred in the company processes helps management make informed decisions about the correct tasks, processes, and projects to implement. Accuracy and consistency are key when performing variance analysis, as the right data is required to obtain the correct figures used for variance analysis. Companies and businesses need variance analysis in accounting to help them align their long-term and short-term goals to achieve success.
Limitations of Variance Analysis
The following are the limitations experienced in variance analysis:
I. Non-standardized Production
Standard costing is only ideal for companies involved in mass production, as they are easier to maintain historical benchmark standard for manufactured products. Businesses that produce smaller batches of goods find it difficult to develop standards each time they manufacture goods.
II. Assigning Responsibilities
It is very difficult to point out the causes and assign responsibilities to specific individuals or departments within an organization. The difficulty arises from the management failing to understand the operational environment of a company, creating room for variances in production and operation.
III. Behavioral Issues
Poor variance analysis and standard costing system may indirectly encourage management to focus on short-term goals, forgetting long-term objectives and results. Failure to involve employees in budget settings is also deemed unfair and may encourage employees to introduce budget deficits.
IV. Service Organizations
Service industries like hotels are limited in conducting variance analysis because they mostly deal with overheads rather than production expenses. Newer approaches in standard costing can be used in such scenarios, for instance, using activity-based costing. However, the new approach may be costly and time-consuming.
V. Reporting Delay
The usefulness of variance analysis depreciates the more the duration of a reporting period increases. Reporting delay is experienced when variance analysis is conducted, which is normally during an annual budgeting timeframe. Management is prompted to make important decisions without a variance analysis report, reducing its relevance.
Problems with Variance Analysis
- Variance analysis is prone to time delays, as they are calculated at the end of each month. Meanwhile, companies continue their operations oblivious to the warning signs that a timely variance analysis would have availed.
- Getting the correct information from different departments in a company may prove useless, especially if not available in the regular financial reports. Company politics may distort the information intended for variance analysis.
Companies need an in-depth analysis of variance to determine if they are making profits. Variance analysis also guides management in making important decisions, as the information helps them identify factors affecting the company’s performance. Management should choose the appropriate variance analysis suited for their industry that will help paint a clear picture of the overall state of the business.