In accounting, variance refers to the difference between the standard and actual variables. For example, you can calculate the selling price variance to find the difference between the actual and standard selling prices.
Variance analysis is a way of looking at the costs and finding out the causes of any variation in them. This analysis helps you determine which costs are high and which ones are low.
There are 2 types of variances: favourable and adverse. As the name suggests, a favourable variance is a variance that is beneficial to the firm. If the actual costs are less than the standard costs, the variance is favourable as the company was able to lower its costs and therefore increase its profits.
The other type of variance is an adverse variance. This type of variance is disadvantageous to the firm. For example, if the actual labour rate efficiency is lower than the standard labour rate efficiency, the variance between the two is adverse as the company was spending more than the standard amount on salaries.
Purpose of Variance Analysis
After calculating variance, managers must investigate why the variance occurred to know what they did right or wrong. For example, suppose the company has a favourable direct materials variance because it purchased raw materials from a particular supplier. In that case, it will know that it is best to buy from the company again.
When performing variance analysis, you must remember that you should compare like with like. For example, if the company doesn’t have figures for the actual production level, it cannot substitute the budgeted level of output for the actual level when performing variance analysis. This is why the flexed budget is important. Budgeted figures must be flexed to reflect the actual figures (or what the actual figures would have been).
We will be talking about different types of variances. They can be classified as follows:
- Direct material cost variances
- Direct material price variance
- Direct material usage variance
- Direct labour cost variances
- Direct labour rate variance
- Direct labour efficiency variance
- Sales variances
- Sales volume variance
- Sales price variance
- Fixed overhead variances
- Expenditure variance
- Volume variance
- Capacity variance
- Efficiency variance
Various businesses utilise variance analysis in various ways. The first step is to establish benchmarks against which actual results can be measured. Numerous businesses generate variance reports, and the management responsible for the variances must provide an explanation for any outliers. Some companies only require explanations of unfavourable variances, while the majority require explanations of both favourable and unfavourable variances.
Insisting that managers determine the causes of unfavourable variances compels them to identify potential problem areas or consider whether the variance was an isolated incident. By requiring managers to explain favourable variances, they can determine whether the variance is sustainable. Knowing what caused the favourable variance allows management to plan for it in the future, depending on whether or not it was a one-time occurrence or if it will be a recurring occurrence.