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Flexible Budgets

Variance Analysis

Variance Analysis Defined

Variance analysis tells an organization how accurate its managers' predictions were.

Variance analysis examines the difference between a company's predicted performance and its actual performance. The company's predicted performance is called a standard. A standard refers to a company's budgeted figure, such as cost or quantity, that is based on specific circumstances and that is used for planning and long-term goals.

Companies use variance analysis to determine the accuracy of management's predictions. For example, managers at a shoe company predicted that it would cost $8,000 to make a batch of 2,000 limited-edition sneakers. The actual cost turned out to be $9,500. Variance analysis helps these managers understand why the project did not meet the standard. Did raw materials turn out to be more expensive than expected? Did a machine break down? Did managers have to devote more time to training than the company had anticipated? When managers have this type of specific, targeted information about shortfalls, they can figure out ways to improve the process and meet standards in the future.

Variances happen in revenues and spending, too. Revenue variance is the difference between what a company expects to sell within the budget period and what it actually sells. Spending variance is the difference between how much a company expects to spend in a budget period and how much it actually spends.

Variance analysis leads to management by exception, which is when managers concentrate their efforts on the company's areas of concern that are not operating as expected and spend less time on areas that the company more accurately predicted. Variance analysis gives managers a tool to determine whether decisions were properly carried out, whether the company was able to stay within earlier viable budgets, whether resources are being used to their full potential, and whether resources should be reallocated to maximize efficiency. This may save the company vast resources, including time, investments, and raw materials.

Variance Analysis Process

Variance analysis shows the difference between a company's projected performance and its actual performance. Companies can learn from this variance and make adjustments, so as to increase profitability.
If management is able to learn from its variance analyses, then its future predictions should become more accurate, which is likely to create a more efficient and profitable company. Because of the substantial benefits of variance analysis, it is the most popular budgeting tool among companies. It can even be used in the public sector to better use government resources and improve decision-making.

Not only does variance analysis help managers pinpoint areas that need improvement, but companies also use this analysis to evaluate manager performance and determine whether to adjust the company's overall strategy. For instance, substantial negative variances in a product's return rate suggest that the product is not performing as expected. In response, managers will investigate whether the product is flawed. While completing this investigation, management may alter the company's sales mix to prevent selling more of the less profitable products. Sales mix is the proportion of different products or services, which usually vary in profitability, that make up a company's total sales. Another possible explanation for variance is that there has been a shift in demand; perhaps people's tastes have changed or a more attractive option is available from a rival. In this case, the company would alter the sales mix to reflect consumer trends and market competition.

Variance Analysis Example

Variance analysis looks at the difference between actual costs and predicted (or budgeted) costs.

Variance analysis measures the difference between actual costs and predicted (or standard or budgeted) ones. Managers look at a variety of expenses as they prepare a variance analysis.

Among the expenses are fixed costs and variable costs. A variable cost is a company's expense that increases or decreases with the level of production. Variable costs include direct materials, manufacturing labor, and manufacturing overhead. Direct materials are raw goods that can be traced directly to or easily identified with a specific product; in other words, they are items that are put together to create a finished product. When something affects a company's volume of goods for sale, such as the number of units manufactured, it is considered something that drives cost up or down, or a cost driver. A cost driver is a factor that causes a company to incur expenses because it affects volume or activity levels. For example, for a company that makes bed linens, the number of bed linens manufactured is a cost driver for each of the variable costs.

Heavenly Sleep Systems, which makes bed linens, sells all its units in a given period to a distributor and has no holdover inventory in finished products, work in process, or direct materials. The company has variable costs per unit of $20 in direct materials, $5 labor cost, and $4 in manufacturing overhead costs, for a total of $29 variable cost per unit.

For its next period, the company plans its static budget at 4,000 units. The static budget is based on the forecasted production level that starts at the beginning of the budget period and remains unchanged. The company budgeted $80,000 in fixed costs and planned to sell the units at $50 each, for a projected revenue of $200,000 ($50per unit×4,000units\$50\;\text{per unit}\times4{,}000\;\text{units}). The company actually sold 3,500 units during the budget period, with revenues of $156,000. This demonstrates a static-budget variance because the actual selling price per unit was $44.57 $156,000Revenue/3,500Units Sold\$156{,}000\;\text{Revenue}\text{/}3{,}500\;\text{Units Sold} instead of the projected $50 per unit.

Example Static Budget

Static Budget Actual Results Static-Budget Variance
Units Sold 4,000 3,500 500 Unfavorable
Revenues $200,000 $156,000 $44,000 Unfavorable
Variable Costs
Direct Materials $80,000 $81,000 $1,000 Unfavorable
Direct Manufacturing Labor $20,000 $13,000 $7,000 Favorable
Manufacturing Overhead $16,000 $11,000 $5,000 Favorable
Total Variable Costs $116,000 $105,000 $11,000 Favorable
Contribution Margin $84,000 $51,000 $33,000 Unfavorable
Fixed Costs $80,000 $80,000 $0 Neutral
Operating Income $4,000 $29,000 $33,000 Unfavorable
Total static budget variance=$33,000Unfavorable\text {Total static budget variance}=\$33{,}000\;\text {Unfavorable}

The static-budget variance is calculated by subtracting the actual results from the static budget figures. This method demonstrates whether any variances were favorable or unfavorable to the company's profitability.

Static-budget variance is the difference between the projected static budget and the actual result, which applies to variances in projected units, revenue, and costs. Generally, a variance is favorable when it increases operating income and unfavorable when it decreases operating income. In this example, the variance was unfavorable because the budgeted price per unit was higher than the actual price per unit, which lowered the company's projected revenues.

Favorable Variance versus Unfavorable Variance

Favorable variances result in a lower actual cost, which makes a company more profitable. Unfavorable variances result in a higher actual cost, which cuts into a company's profitability.

Cost Drivers

Cost drivers can be adjusted based on the variance analysis.
Because variances can be favorable or unfavorable, companies may want to revise their cost drivers based on those variances. Consider the example of the company that makes bed linens. The company learned that its actual direct materials cost for the production of the 3,500 units it sold was $81,000, or $23.14 per unit. This resulted in an unfavorable variance because the company had budgeted a direct materials cost of $20 per unit. The unfavorable variance caused a decrease in the company's operating income. If the company wants to continue selling the product despite the variance, it will need to adjust its cost drivers to become more profitable.

Decrease in Operating Income

Units Produced Budgeted per Unit Cost Actual per Unit Cost Unfavorable Variance
3,500 $20 $23.14 $10,990

When direct materials cost for production are more than the cost budgeted, it results in an overall decrease in operating income.

In this scenario, the cost drivers for the bed linens' direct materials include cotton and polyester. The company discovers that a recent spike in the cost of cotton has increased its direct material cost, which was at least one of the factors that played a role in its unfavorable variance. It is possible that other cost drivers also contributed to the unfavorable variance, however. For this reason, the company should not end its investigation once it finds one cause, as it may not be the only cause.

The company's product development team examines the relationship between polyester and cotton in the units to determine whether using less cotton and more polyester would decrease the company's direct material costs. Using less cotton and more polyester will not affect other costs of the company, as the materials use similar storage space and the company already has equipment and staff that can work with both materials.

After a series of studies, the company determines that it can produce its units with less cotton and more polyester. This scenario shows how a company can adjust a cost driver in response to an unfavorable variance.