What is variance analysis? (Definition and examples)
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Variance analysis can help companies manage projects, productions or operational expenses by monitoring and comparing planned and actual costs. Creating an effective analysis helps businesses maintain and improve operations. Calculating this analysis is also a useful skill for businesses once they understand the formulaic steps. In this article, we define variance analysis, list key terms related to it, explore its different types and share examples that you can review to better understand this budgeting concept.
What is variance analysis?
Variance analysis (VA) is a common budgeting and accounting process that studies the difference between actual behaviour and forecasted or planned behaviour. The primary goal of this analysis is to allow you to understand how this difference impacts the performance of a business. As an accounting management tool, this analysis has many benefits and serves to identify budgeting problems, revenue and expense issues, potential adjustments to the business, managerial issues and any potential criminal issues and risks.
Key terms in VA
Gaining a better understanding of VA can improve your management accounting skills. Here are some key terms you can review when learning about this type of analysis:
Overhead costs: Overhead costs, often referred to as operating expenses, are expenses that help businesses maintain their daily operations. Some examples include insurance, utilities, rent or the cost of accounting.
Budgets: A budget is a financial plan that a company makes to estimate how much money it's likely to spend on a project, such as manufacturing and launching a new product. Most businesses regularly reevaluate their existing budgets to make sure they're accurate to the company's current situation.
Variable price and rate variance: Variable price and rate variance are changes in the cost of a product or service. These can be often unpredictable, as there are many factors that might impact them, including world events or market crashes.
Variable quantity and efficiency variance: Variable quantity and efficiency variance are fiscal differences between a business's actual input of materials and labour and the amount of overall allowed material and labour input.
Fixed budget variance: Fixed budget variance is the difference between how much fixed overhead a company included in its budget and how much it actually spent. Typically, this refers to a specific period, such as one quarter or calendar year, but it's also possible to use this term when referring to a specific project.
Fixed volume variance: Fixed volume variance refers to fiscal differences between the amount of fixed overhead costs a company applies during a variance period and the fixed amount of recorded overhead costs in a company's budget.
Related: 9 essential business analyst skills
Types of VA with formulas
Depending on a company's industry, budgeting processes and goals, there are different analyses that you can apply to gain insight into its condition and operational situation. Some common types of VA to consider include:
A cost variance studies the difference between what a company expected to spend and what its actual expenditure was. It's a highly versatile analysis that businesses from any industry can use. It allows them to gain insight into all kinds of expenses, including admin expenses or the cost of raw materials.
The cost variance formula takes into consideration two elements. Firstly, there's the volume variance. It represents the difference between the actual and planned unit volume of what you want to measure, which you then multiply by the standard price per unit. Then, there's the price variance. It's the difference between the actual and expected price of what you want to measure, which you then multiply by the number of units. Here are the formulas that illustrate that:
Volume variance = (budgeted number of units - actual number of units) x price per unit
Price variance = (standard price per unit - actual price) x quantity purchased
Using the material variance formula is a great idea when you want to determine if the company's been using more materials than it had planned or more than its production process requires. Typically, companies tend to order more materials to cover any losses or quality concerns. Calculating material variance allows them to make sure they work with reliable suppliers. Here are the formulas you can use to calculate that:
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
The cost of labour is how much a company pays in wages and other employee benefits. Labour variance is the difference between how much a company planned to pay their staff and how it ended up paying. The basic formula for labour variance is the following:
Labour variance = (standard hours x standard rate) - (actual hours x actual rate)
After calculating the labour variance, you can then split this into two other sub-sections to gain a better understanding of how a company finances human talent. You can do this with the following formulas:
Labour rate variance = (standard rate - actual rate) x actual hours
Labour efficiency variance = (actual hours - standard hours) x standard rate
Fixed overhead variance
The fixed overhead variance allows you to determine the difference between the fixed overhead costs that the company expected and how much it actually paid for fixed overhead. For instance, it's good to use fixed overhead variance when you'd like to revisit a company's budget plans and determine if there's a better way to allocate money. Calculating fixed overhead variance requires using the following formulas:
Budgeted fixed overhead cost = denominator level of activity x standard rate
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
Challenges in VA
VA is a highly effective method of seeing how accurate a company's financial expectations are when you compare them to the actual money that the company spends. Just like any analytical instrument, it has some limitations and knowing how to overcome them can help you improve how you use this type of analysis. These limitations include:
Time-consuming: The analysis can be a lengthy process. Employers can eliminate this challenge by offering variance training and giving their accounting teams access to modern software tools.
Costly: When analysing a company's costs takes a lot of time, it often becomes costly for the employer. Companies can reduce these costs by requesting that highly experienced professionals take care of analysing these differences.
Subjective: Once a company calculates its variables, it prepares a conclusion, which may result in subjective interpretation. To avoid this, it's helpful to use an external analyst who can assess the variables objectively only using quantitative data.
Examples of VA
Reviewing examples is one of the most effective methods to learn new concepts. Here are examples of using VA in real-life business scenarios:
Material variance example
World of Fabric, a clothing manufacturer, wants to calculate its overall material variance. It has an actual quantity of 54,000 pieces of fabric at a standard price of £2.45 per fabric and a standard quantity of 50,000 pieces of fabric at an actual price of £2.30 per fabric. Using this information, you can apply the quantity variance formula like this:
(54,000 x £2.45) - (50,000 x £2.45) = £132,300 - £122,500 = £9,800
The next step is to calculate the price variance:
(54,000 x £2.45) - (50,000 x £2.30) = £132,300 - £115,000 = £17,300
To calculate the overall material variance, you add the quantity variance and the price variance:
£9,800 + £17,300 = £27,100
Labour variance example
The same company, World of Fabric, wants to calculate its overhead labour variance. The organisation's actual hours are 6,500 at an actual rate of £14 per hour and 5,900 standard hours at a standard rate of £11 per hour. Using these numbers you can help the company calculate their labour variance this way:
(6,500 x £14) - (6,500 x £11) = £91,000 - £71,500 = £19,500
The next step involves calculating the efficiency variance. You can do this using the following formula:
(6,500 x £11) - (5,900 x £11) = £71,500 - £64,900 = £6,600
Lastly, you add the two results to get the overall labour variance:
£19,500 + £6,600 = £26,100
Please note that none of the companies, institutions or organisations mentioned in this article are affiliated with Indeed.
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