What Is Variance Analysis? How To Calculate and Analyze Variances With Ease

Variance analysis is a practical technique that can be useful for helping businesses identify operational issues and improve performance. It’s also pretty versatile. Companies use it to analyze all kinds of metrics in order to fine-tune their business strategy.

In this article, we’ll look at what variance analysis is and how it works. We’ll also explore the benefits it brings to businesses and work through a couple of examples to illustrate how to calculate it.

Table of Contents

• What Is Variance Analysis?
• Why Is Variance Analysis Needed?
• Benefits of Conducting Variance Analysis
• Key Terms For Variance Analysis
• Different Types of Variance Analysis
  1. Sales Variance
  2. Cost Variance
  3. Profit Variance
  4. Material Variance
  5. Labor Variance
  6. Overhead Variance
• Key Steps in Conducting Variance Analysis
  1. Collecting Actual and Budgeted Data
  2. Calculating Variances
  3. Analyzing the Causes of Variances
  4. Reporting and Interpreting Results
• How to Calculate Variance Analysis: Examples and Formula
  1. Labor variance
  2. Overhead variance
• Challenges of Variance Analysis in Accounting
• 4 Best Practices For Effective Variance Analysis
  1. Communication and Transparency
  2. Establish Clear Performance Metrics
  3. Resist political standard-setting
  4. Monitor regularly
• Streamline and Enhance the Variance Analysis Process
• FAQs About Variance Analysis

What Is Variance Analysis?

Let’s begin with a simple variance analysis definition. In essence, variance analysis is the process of examining how and why actual figures for costs, sales, or other business metrics differ from initial projections.

There are a number of different applications for variance analysis, meaning companies that use it tend to focus on the metrics that are the most relevant for their business.

For instance, a manufacturing company might choose to run variance analysis on purchase costs, since this is directly relevant to its bottom line. On the other hand, a website development company doesn’t have much in the way of raw material costs to worry about. In that case, running variance analysis on labor costs or sales figures would be more appropriate.

Why Is Variance Analysis Needed?

Analysis of variance is a key component of the broader field of financial planning and analysis (FP&A). It’s a good way of spotting trends in business-critical metrics so that companies can determine what they’re doing right, and where they could stand to improve their performance.

Making forecasts is one thing, but it’s crucial to measure how those forecasts match up to reality. When there’s a big discrepancy, it’s important to ask why. Did company performance exceed or significantly undershoot projections? Or were the forecasts themselves too ambitious or pessimistic?

Drilling down into the details of why a discrepancy occurs allows a company to adjust its strategy to improve future performance. But this is only one of several benefits of analyzing variance.

Benefits of Conducting Variance Analysis

Carrying out a variance analysis regularly provides a number of advantages to businesses. Here are a few of the main ones.

1. Allows problems to be identified

First and foremost, a variance analysis can be the first, vital step in identifying a problem that needs to be addressed. Let’s say a company that makes furniture conducts variance analysis on purchasing costs.

Suppose the analysis finds that the cost of buying raw materials is 20% more than forecast for a particular time period. On further examination, it turns out that suppliers have hiked the price for a particular type of hinge used in a core product.

Over time, continuing to use this hinge could threaten profitability. Management can then make a decision to resolve the problem, possibly by downgrading to a cheaper hinge, raising prices for finished goods, or some mixture of the two.

2. Useful for assessing managerial performance

In some circumstances, variance analysis can be useful for determining how well individual managers are performing. In the case of the furniture company, the analyst might well research whether managers could have done anything to pre-empt the situation, for example by attempting to negotiate bulk discounts on the hinges.

This is one reason why going into granular detail is such a vital element of carrying out variance analysis. The top-line numbers will show you the patterns, but digging deeper to examine why those patterns are emerging. Sometimes, it can even point to areas where staff could benefit from further training.

3. Enables tighter control of operations

Imagine if the furniture company hadn’t done any variance analysis. What then? It’s quite possible the hinge cost issue could have flown under the radar for a prolonged period of time.

The fact that the variance analysis alerted management to the problem meant they could step in and do something about it. In other words, it put control in their hands, allowing them to resolve the issue as quickly as possible.

4. Helps improve business strategy

Finally, there’s the big-picture aspect. Taking a systematic approach to understanding the reasons reality diverges from forecast figures allows you to take well-informed decisions.

Perhaps the management team at the furniture company would prefer not to compromise on quality by using lesser-grade hinges. And maybe they don’t want to risk hiking prices either.

That kind of dilemma calls for a strategic rethink. For example, management might decide it would be more cost-effective to change the design of some key products. In this way, variance analysis can set off a completely new strategic direction – and all thanks to the price of a humble hinge.

Key Terms For Variance Analysis

Before we go any further, let’s define a few key terms that will be useful in understanding how variance analysis works.

• Purchase costs: the amount of money a company spends buying raw materials
• Overhead costs: the amount of money a company spends on operating expenses such as rent
• Budget: the amount of money a company allocates to each category of spending
• Variable price/rate variance: changes in the cost of a good/service
• Variable quantity and efficiency variance: the difference between how much input (in terms of e.g. raw materials or labor costs) a company estimates will produce a given output, compared to the actual input used to achieve that outcome
• Fixed budget variance: difference between the overhead costs allocated in the budget for a given period and the actual costs

Different Types of Variance Analysis

We’ve already mentioned that there’s a variety of different types of variance analysis, depending on the context. It’s time to take a closer look at a few of the most commonly used ones.

1. Sales Variance

Sales variance is all about checking how close a company’s actual sales were to their sales projections. If the two figures are similar, that’s all to the good. But if there’s a big disparity, looking a little deeper to find out why is essential.

Remember that this doesn’t necessarily just mean when sales figures disappoint. When sales figures are much healthier than expected, it’s equally as important to understand why – because you can learn how to make sure it’s not a one-off fluke.

2. Cost Variance

Similarly, cost variance looks at the difference between expected costs and actual costs. In any business, tracking costs is imperative to ensure the financial stability of the company. If costs run too far out of control, it can create cash flow problems.

Checking in on cost variance on a regular basis can alert management to emerging issues related to costs. This allows them to address them before they turn into more serious problems.

3. Profit Variance

Profit variance is important to monitor because it’s a metric that all company stakeholders will be interested in. On top of which, it can play a crucial role in financial forecasting.

Maintaining healthy profit margins is a core objective of any company’s management. If the profit variance figure is in the negative, it’s crucial for senior decision makers to know about it so they can tweak their strategy.

4. Material Variance

Is the company using its resources efficiently? The material variance figure can help to answer this question. It represents the difference between the quantity of materials the company expects to get through as part of the production process and the amount it actually uses.

Finding a significant material variance merits a closer look at the production process. The company may be able to find ways of making it more efficient. Alternatively, it might be better to replace the materials with a different product.

5. Labor Variance

Labor costs represent a large proportion of any business’s cost base. Tracking labor variance is crucial to make sure you pick up early signals of those costs beginning to rise too much.

6. Overhead Variance

Similarly, keeping control of overheads is essential as they also contribute substantially to fixed costs. Monitoring overhead variance over time alerts managers to any potential problems that could eat into profit margins.

Key Steps in Conducting Variance Analysis

That’s the theory. But how do you put it into practice? Here are the steps you need to take to implement variance analysis and get the most out of it.

1. Collecting Actual and Budgeted Data

First, you need to get the two sets of data together so you can compare them. The budgeted data should already be available as it will have been generated in advance as part of operational planning. Then, it’s just a matter of gathering the actual data and putting it side by side.

2. Calculating Variances

Determine the variances you want to monitor. In simple terms, this involves subtracting the actual figures from the estimates, although some types of variance analysis need a couple of extra steps before you reach the final figure.

3. Analyzing the Causes of Variances

When you discover a large variance, it’s important to explore what’s caused it. Sometimes the answer will be obvious, but often you’ll need to do a bit of digging. Make sure you understand the root causes before moving to the final step.

4. Reporting and Interpreting Results

Compile a report and make sure to include as much detail as is useful. Include both the raw data and a detailed account of your research into any variance figure that stands out. The aim is to create a document that forms a robust basis for adapting your strategy.

How to Calculate Variance Analysis: Examples and Formula

The best way of understanding how this all works is to look at a specific variance analysis example. We’ll look at two different versions to illustrate the process.

1. Labor Variance

This is composed of two elements: the rate variance and the efficiency variance. The formula to apply is:

Overall labor variance = rate variance + efficiency variance

To calculate the individual components, use these formulas:

Rate variance = (actual hours worked x actual rate) − (actual hours worked x estimated rate)

Efficiency variance = (actual hours worked x estimated rate) − (estimated hours x estimated rate)

Let’s say a company that offers plumbing services wants to work out its overall labor variance. The actual hours worked in one month were 3,000 at a rate of $20 per hour. Its estimated hours worked were forecast to be 2,500 at a rate of $15 per hour.

Rate variance = (3,000 x $20) − (3,000 x $15) = $60,000 − $45,000 = $15,000

Efficiency variance = (3,000 x $15) − (2,500 x $15) = $45,000 − $37,500 = $7,500

Overall variance = $15,000 + $7,500 = $22,500

The labor variance is substantial here, suggesting management may want to explore possibilities for cutting labor costs.

2. Overhead Variance

Getting to grips with the fixed overhead variance can be a little confusing at first. Bear in mind that what we’re doing here is essentially assigning a unit average value for overhead costs.

The unit in question could be a unit of production, or you can work it out on a per labor hour basis. This concept is sometimes referred to as “absorption” – in other words, each individual unit is considered to “absorb” some of the overall costs.

Basically, this measure represents the difference between the amount absorbed into the cost of the actual units produced and the actual cost of fixed overheads. The reason this is a little more complicated than some other types of variance analysis is that the amount being absorbed per unit will depend on how many units are actually produced.

Let’s break this down to see how it works. Here are the formulas we’ll need for this one:

Budgeted fixed overhead cost = estimated production level x estimated rate

Budget variance = actual fixed overhead cost − budgeted fixed overhead cost

Fixed overhead cost applied to inventory = standard hours x estimated rate

Volume variance = Budgeted fixed overhead cost − fixed overhead cost applied to inventory

Overall variance = Budget variance + Volume variance

Let’s assume the level of activity is 10,000 at an estimated rate of $20 per hour. The fixed overhead cost is $220,000, and the standard hours amount to 8,000. This means:

Budgeted fixed overhead cost = 10,000 x $20 = $200,000

This gives a budget variance of:

Budget variance = $220,000 − $200,000 = $20,000

Next comes the fixed overhead cost applied to inventory:

Fixed overhead cost applied to inventory = 8,000 x $20 = $160,000

This gives us a volume variance of:

Volume variance = $200,000 − $160,000 = $40,000

Which results in an overall variance of:

Overall variance = $20,000 + $40,000 = $60,000

This is quite a large overhead variance, so management may consider exploring ways to allocate resources more efficiently.

Challenges of Variance Analysis in Accounting

Carrying out variance analysis in finance and accounting contexts can be useful but does present challenges. Here are some of the most common ones:

• Missing data: if the data collection process isn’t as efficient as it could be, the data you do have may be inaccurate or insufficient to make the required calculations.
• Lack of resources: for variance analysis to work, you need to dedicate time and resources into collecting and analyzing the data, but this can be difficult, particularly for smaller teams.
• Shallow analysis: sometimes, it’s not obvious what’s causing a large variance. If the process doesn’t result in any useful insights, following it won’t help the business.
• Dates quickly: variance analysis is a reactive technique that goes out of date fast. In some circumstances, the insights it leads to may already have been found elsewhere.

4 Best Practices For Effective Variance Analysis

Getting financial variance analysis right means following a few key principles. Let’s explore those now.

1. Communication and Transparency

Top of the list is that it’s crucial to encourage a culture of openness around variance figures. Make sure all your team members know to report their findings in good time. That doesn’t just mean when newly generated figures suggest there’s an issue that needs resolving, but all the time to ensure consistency.

2. Establish Clear Performance Metrics

Set down clear objectives and KPIs that are relevant to the variances you’re monitoring. For instance, if you’re analyzing purchase cost variance, it would be a good idea to track metrics like procurement cycle time and cost per invoice.

3. Resist Political Standard-Setting

The nature of variance analysis means that all variance figures are compared to a standard to determine whether they’re significant or not and worthy of deeper exploration. That means there can be political incentives to increase or reduce the standard in an arbitrary way. It’s crucial to avoid doing this because it undermines the effectiveness of the process.

4. Monitor Regularly

As with any analytics-related process, you’ll reap the largest benefits when you deploy variance analysis consistently over time and monitor the results regularly. That’s because you’ll be able to spot patterns emerging and respond to them quickly.

Streamline and Enhance the Variance Analysis Process

Deploy effective variance analysis and generate actionable insights with OneStream’s AI-powered financial planning solution. As it’s a unified data platform, it simplifies the task of collecting the data you need and helps your teams make even more accurate forecasts.

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