What is Variance Analysis in Management Accounting?

In the following sections, we’ll explore the definitions of different types of variance analysis, the methods used for this, and real-world examples of this. So, if you’re ready to gain a deeper understanding of how businesses navigate the complex ocean of finance and stay on course, let’s dive into the world of variance analysis in management accounting.

Table of content

• Variance Analysis Definition
• Types of Variance Analysis
• Material Variance
• Labour Variance
• Overhead Variance
• Sales Variance
• Profit Variance
• Variance Analysis Examples
• Variance Analysis Importance and Variance Analysis Limitation

Variance Analysis Definition

Variance analysis in management accounting is a technique used to evaluate and understand the differences between planned or budgeted figures and actual performance within an organization. It helps managers and financial analysts assess how well a company meets its financial and operational goals, as well as identify areas where corrective actions may be needed. Here’s a breakdown of key concepts related to variance analysis:

1. Budget or Standard: A predefined target or goal set for performance
2. Actual Performance: Real results achieved during a specific period
3. Variance: The difference between the actual and budgeted performance
4. Favorable Variance: When actual performance is better than budget, it’s good news.
5. Unfavorable Variance: When actual performance falls short of the budget, it’s a problem.
6. Causes of Variances: Reasons why actual and budgeted numbers differ
7. Responsibility Analysis: Identifying who’s responsible for the variances
8. Management Action: Taking steps to fix unfavorable variances and maintain favorable ones

Types of Variance Analysis

Costing is an essential aspect of business management. It helps in determining the cost of production, selling, and profit. One of the critical components of costing is variance analysis. This analysis helps identify the differences between actual and standard costs. Let’s delve into the various types of variances:

Material Variance

This refers to the difference between the standard labor cost and the actual labor cost.

Material Cost Variance Analysis Formula:

Standard Cost – Actual Cost
Alternatively, (Standard Quantity x Standard Price) – (Actual Quantity x Actual Price)

It can be categorized into the following:

Material Cost Variance: The difference between the actual and standard cost of materials used

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

Material Usage Variance: The difference between the amount of material used and the expected amount

MUV = (Standard Quantity – Actual Quantity) x Standard Price

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Labour Variance

This is about the difference between the normal labor cost and the real labor cost.
Labor Variance Analysis Formula:

Standard Wages – Actual Wages
Alternatively, (Standard Hours x Standard Rate) – (Actual Hours x Actual Rate)

It can be categorized into the following:

Labour Rate Variance: The difference between the actual and standard labor costs

LRV = (Standard Rate – Actual Rate) x Actual Hours

Labour Efficiency Variance: The difference between the actual hours worked compared to the standard hours

LEV = (Actual Hours – Standard Hours) x Standard Rate

Overhead Variance

This is the difference between the standard overhead costs and the actual overhead costs.

Standard Variable Overhead – Actual Variable Overhead
Alternatively, (Standard Rate – Actual Rate) x Actual Output

It includes:

Variable Overhead Variance: The difference between actual and standard variable overheads

VOV = (Actual Output – Standard Output) x Standard Rate

Fixed Overhead Expenditure Variance: The difference between actual and standard fixed overheads

FOVV = (Actual Output x Standard Rate per unit) – Standard Fixed Overhead

Sales Variance

This variance is the difference between the actual sales and the standard sales.
Sales Variance Formula:

(Budgeted Quantity x Budgeted Price) – (Actual Quantity x Actual Price)

It can be further divided into the following:

Sales Price Variance: The difference between the actual selling price and the standard selling price

SPV = (Budgeted Price – Actual Price) x Actual Quantity

Sales Volume Variance: The difference due to the actual quantity sold compared to the standard quantity

SVV = (Budgeted Quantity – Actual Quantity) x Budgeted Price

Profit Variance

This is the difference between the actual profit and the standard profit. It can be categorized into:

1. Profit Volume Variance: The difference is due to the actual sales volume compared to the standard sales volume.
2. Profit Margin Variance: The difference between the actual and standard profit margins

Variance analysis is a crucial tool for businesses. It helps in identifying areas of inefficiency and provides insights into cost management. By understanding these variances, businesses can make informed decisions and optimize their operations.

Variance Analysis Examples

In our previous section, we talked about different types of variance analysis that businesses use to understand their financial performance. Now, let’s apply what we’ve learned to real-life situations and specific examples. Variance analysis is a versatile tool that can be used to address different challenges in business. These examples show how variance analysis helps in different industries and financial situations.

Example #1: XYZ Manufacturing Company

XYZ Manufacturing Company produces electronic gadgets. They budgeted the following for a specific month:

• Material cost for 1,000 gadgets: $12,000
• Labor cost for 1,000 gadgets: $8,000
• Overhead expenses: $5,000
• Expected sales price per gadget: $25
• Expected sales volume: 1,200 gadgets
• Target profit: $10,000

Now, let’s look at their actual performance for the month:

• Material cost for 1,000 gadgets: $13,000
• Labor cost for 1,000 gadgets: $9,500
• Actual overhead expenses: $4,800
• Actual sales price per gadget: $24
• Actual sales volume: 1,000 gadgets
• Actual profit: $8,500

Now, we can calculate the variances:

1. Material Variance:

Material Variance = Actual Material Cost – Budgeted Material Cost

Material Variance = 13,000 – 12,000 = 1,000 (unfavorable)

The material variance is unfavorable because they spent $1,000 more on materials than budgeted.

2. Labour Variance:

Labor Variance = Actual Labor Cost – Budgeted Labor Cost

Labor Variance = 9,500 – 8,000 = 1,500 (unfavorable)

The labor variance is unfavorable because they spent $1,500 more on labor than budgeted.

3. Overhead Variance:

Overhead Variance = Budgeted Overhead – Actual Overhead

Overhead Variance = 5,000 – 4,800 = 200 (favorable)

The overhead variance is favorable because they spent $200 less on overhead expenses than budgeted.

4. Sales Variance:

Sales Variance = (Actual Sales Volume * Actual Selling Price) – (Budgeted Sales Volume * Budgeted Selling Price)

Sales Variance = (1,000 * $24) – (1,200 * $25) = -1,200 (unfavorable)

The sales variance is unfavorable because they generated $1,200 less in revenue than budgeted due to lower sales volume and selling price.

5. Profit Variance:

Profit Variance = Actual Profit – Target Profit

Profit Variance = 8,500 – 10,000 = -1,500 (unfavorable)

The profit variance is unfavorable because they fell short of their target profit by $1,500.

In this example, the company experienced unfavorable variances in material, labor, sales, and profit but a favorable variance in profit variance. This variance analysis helps the company identify areas where they need to improve (e.g., controlling material and labor costs, increasing sales volume, or price) to achieve their desired profit target.

Example #2: ABC Furniture Manufacturing Company

Imagine a furniture manufacturing company expected to produce 100 wooden tables in a month. They budgeted $50 per table for the wood, but due to market fluctuations, the actual cost came out to be $55 per table.

The material cost variance is ($55 – $50) x 100 tables = $500 (unfavorable).

Suppose the company used 110 units of wood to produce the 100 tables. The standard usage rate was 100 units.
The material usage variance is (110 – 100) x $50 = $500 (unfavorable).

In the same furniture company, they expected to pay their laborers $15 per hour, but they had to pay $16 per hour due to increased demand for skilled labor. If they budgeted for 500 hours and worked 510 hours, the labor rate variance is ($16 – $15) x 510 hours = $510 (favorable).

The standard time to make a table was 5 hours, but due to the increased experience of the workers, they completed it in 4.5 hours per table. If they produced 100 tables, the labor efficiency variance is (5 – 4.5) x 100 tables = $50 (favorable).

Assume the company expected variable overhead costs of $10 per table, but it ended up being $11 per table. If they produced 100 tables, the variable overhead variance is ($11 – $10) x 100 tables = $100 (unfavorable).

The company budgeted $5,000 for fixed overhead costs for the month, but they spent $4,800. 

The fixed overhead expenditure variance is ($5,000 – $4,800) = $200 (favorable).

The company sold its tables for $200 each, but the budgeted price was $220. If they sold 150 tables, the sales price variance is ($200 – $220) x 150 tables = $3,000 (unfavorable).

The company expected to sell 200 tables, but they only sold 150. If the standard profit per table was $30, the sales volume variance is (150 – 200) x $30 = $1,500 (unfavorable).

Combining the above variances, the company expected to make a profit.

Profit = $3,000 (Sales Price Variance) – $1,500 (Sales Volume Variance) + $500 (Material Cost Variance) – $500 (Material Usage Variance) + $510 (Labour Rate Variance) + $50 (Labour Efficiency Variance) – $100 (Variable Overhead Variance) + $200 (Fixed Overhead Expenditure Variance) = $2,860

The actual profit earned was $2,800. 

Therefore, the profit margin variance is ($2,800 – $2,860) = $60 (unfavorable).

These examples illustrate how variance analysis is used to assess the differences between expected and actual outcomes in various aspects of a business, helping management make informed decisions and take corrective actions when necessary.

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Variance Analysis Importance and Variance Analysis Limitations

In the last section, we learned how variance analysis helps businesses. It helps them find trends, budget better, monitor finances, control costs, and make good choices. Next, we’ll explore the wider scope of variance analysis and its importance and limitations in financial management. Variance analysis, while undeniably beneficial, is not without its challenges and constraints. In this discussion, we will explore the two sides of this analytical approach. We will talk about its importance and what businesses need to think about when using it for financial decisions.

Variance Analysis Importance

• Identify Performance Trends: Variance analysis allows businesses to track and identify performance trends by comparing actual results to expected outcomes over time. This enables them to recognize areas of both strength and weakness, facilitating data-driven decisions and performance improvements.
• Improve Budgeting Accuracy: By pinpointing discrepancies between actual and expected results, variance analysis aids in refining budgeting processes. Businesses can learn from these discrepancies and enhance the accuracy of their future financial forecasts, leading to better financial planning.
• Monitor Business Performance: Variance analysis serves as a valuable tool for ongoing monitoring of financial performance. Through the examination of variances between actual and expected figures, businesses can promptly detect areas of concern or opportunities for growth, allowing them to take the necessary actions.
• Control Costs: Cost control is a critical aspect of financial management. Variance analysis helps businesses identify areas of over- or under-expenditure. Armed with this knowledge, they can implement cost-cutting measures and optimize their spending for improved financial performance.
• Make Informed Decisions: Variance analysis provides businesses with essential information for making informed decisions. By analyzing discrepancies between actual and expected results, businesses can uncover issues that require attention or opportunities that warrant pursuit. This empowers them to make informed changes and enhancements to their financial strategies.

Variance Analysis Limitation

• Use of Standards: Variance analysis relies on the establishment of standards for each cost or income, which can be a time-consuming and error-prone process. Frequent revisions are also needed to account for changes, posing a challenge to their implementation.
• Lengthy Process: The process of setting standard costs and performing variance analysis on actual performance can be quite time-consuming, making it less suitable for companies with limited resources or those seeking quick insights.
• Costly Process: Calculating, investigating, and reporting variances involves significant effort and may require professional employees, leading to increased costs that may outweigh the benefits.
• Subjective Interpretation: The investigation of variances and the establishment of variance thresholds can result in subjective interpretations, potentially causing significant variances to be overlooked or improperly assessed.
• Reactive Approach: Variance analysis is inherently reactive, identifying problems only after they have occurred. It does not offer a proactive solution to prevent issues, potentially leading to losses before deficiencies are detected.
• Manipulation of Data: When strictly enforced, variance analysis standards can incentivize departmental managers to manipulate data to show favorable variances, particularly if bonuses are tied to these variances.
• Limited Applicability to Service Businesses: Variance analysis is most effective in production-based companies, making it less suitable for service-oriented businesses where the structure and nature of operations differ significantly.
• Short-Term Focus: The periodic nature of variance analysis may encourage a short-term focus on immediate goals and objectives, potentially hindering long-term strategic planning and growth.
• Limited Scope: In complex organizations with interdepartmental dependencies, variance analysis may provide limited meaningful results, and it could even create internal conflicts between managers when addressing adverse deficiencies.

Conclusion

In conclusion, variance analysis helps businesses stay on track financially. By dissecting material, labor, overhead, sales, and profit variances, organizations gain invaluable insights into their financial health. Managers use this tool to find strengths and weaknesses, make adjustments, and promote transparency.

However, like any tool, it has its limitations. However, when used with other insights, variance analysis can guide companies through budgeting and financial management. It is like a trusted map, leading them to success in today’s dynamic business world. Transform your career with our intensive data analytics course!