No matter how well-informed and detailed our budgets are, it's a rare case that actual revenue and expenditure match the plan.
The difference is known as variance. Measuring, interpreting, and analyzing variance is critical to managing costs, maintaining operational profit, and improving budget accuracy.
In this article, we’ll explain what variance analysis is, the different kinds, and how to perform your own variance analysis to improve financial and operational health.
What is variance analysis?
Variance analysis is the process of comparing actual performance against budgeted figures.
It helps us identify discrepancies—which may be favorable or unfavorable—allowing business leaders to dig into the reasons behind them.
Importance of variance analysis in financial management
In financial management, variance is critical for monitoring performance, controlling costs, and improving our ability to make good decisions.
By identifying deviations from budgets, variance analysis helps us uncover inefficiencies and areas that require corrective actions.
It also supports forecasting accuracy, fosters accountability, improves resource allocation, and ensures financial discipline.
Types of variance analysis
There are a few different kinds of variance analysis business leaders employ to improve operational and financial efficiency.
Cost variance analysis
Cost variance analysis evaluates differences between actual and budgeted expenses.
Revenue variance analysis
Revenue variance analysis helps us examine the gap between expected and actual revenue to understand whether changes in revenue relate to pricing, volume, or external factors like market conditions.
Material variance analysis
Material variance analysis looks at discrepancies in material costs. We can break this down into two components:
- Price variance: Differences due to paying more or less for materials than budgeted.
- Usage variance: Differences in the quantity of materials used versus the budget.
Labor variance analysis
This form of variance analysis focuses on deviations in labor costs.
This includes rate variance (caused by paying workers at different rates than planned) and efficiency variance (caused by actual hours worked differing from expectations).
Overhead variance analysis
Overhead variance analysis evaluates differences between budgeted and actual overhead costs.
This is often broken down into:
- Variable overhead variance: Differences in costs tied to production levels.
- Fixed overhead variance: Differences in fixed expenses.
Examples of variance analysis
What does variance analysis look like in practice? Here are three examples.
Calculating and interpreting material price variance
The formula for calculating material price variance is:
If, then, we have the following figures:
- Standard price: $5 per unit
- Actual price: $6 per unit
- Actual quantity purchase: 1,000 units
Then our calculation looks like this:
(6-5) x 1,000 = $1,000
In this case, we spent $1,000 more than expected on materials due to a price increase
Analyzing labor efficiency variance
To calculate labor efficiency variance, we use this formula:
So, if we have these figures:
- Standard hours: 500
- Actual hours worked: 550
- Standard rate: $20
We calculate as such:
(550-50) x $20 = $1,000
Here, we spent an actual $1,000 on labor due to the increase in hours worked.
Understanding overhead spending variance
The formula for calculating overhead spending variance is:
This one is nice and easy to calculate. If we budgeted $10,000 for overhead but actually spent $12,000, then we’ve gone over budget by $2,000.
Benefits of variance analysis
Why invest time in variance analysis to begin with?
Here are a few of the most important benefits of analyzing variance:
- Performance monitoring: Identifying areas where actual performance deviates from expectations.
- Identifying cost-saving opportunities: Analyzing the cause of cost overages to detect operational issues and excessive spending.
- Improving resource allocation: Determining where additional budget needs to be allocated to support growth or deal with operational pressures.
- Enhanced decision-making: Gather insights to inform strategic decisions such as pricing adjustments.
- Improved forecasting: Understand the causes behind variances to make more accurate future projections.
- Accountability: Assigning responsibility for a variance to specific departments to promote better performance.
- Risk management: Identifying variances early to signal potential risks and facilitating decisions to mitigate these risks.
How to conduct variance analysis
Getting ready to conduct your first variance analysis?
Here’s a quick guide on how.
1. Define objectives
Your first step is to define what you want to achieve with the variance analysis. For example, are you analyzing costs, revenue, or production efficiency?
2. Set standards or budgets
Then, make sure you have clear benchmarks for comparison, such as budgeted figures, standardized costs, or operational targets.
3. Collect actual data
Next, pull together your actual performance, such as the number of hours worked or the actual costs incurred.
4. Calculate variances
Now, you can select the appropriate formulas from those we discussed above, and calculate your variance.
5. Categorize variances
This one’s quick and easy.
You simply categorize variances as favorable or unfavorable, depending on whether actual performance is better or worse than the budget or established standard.
6. Analyze causes
Here, you dig into the root causes of each variance.
They might include:
- Price fluctuations (e.g., raw materials or labor rates).
- Inefficient resource use (e.g., higher-than-expected material waste or labor hours).
- Changes in market conditions or unexpected events.
7. Prioritize significant variances
It's generally a smart practice to focus on the variances with the largest financial or operational. Categorize and sort these by significance and impact now.
8. Take corrective action
Here’s where you put an action plan together, establishing what you’ll do to address unfavorable variances.
For instance, you might choose to:
- Renegotiate supplier contracts
- Invest in further employee training
- Optimizing inefficient processes
9. Monitor and report
Put a process in place for reviewing the impact of your action plans on both variance and actual results and report any findings to management for strategic decision-making.
Tools and techniques for variance analysis
Beyond the step-by-step process we outlined above, here are a few important tools and techniques to consider implementing as part of your variance analysis practice:
- Flexibility budgeting: Budgets that adjust for changes in activity levels or sales volume.
- Standard costing: Setting predetermined costs for materials, labor, and overhead.
- Variance reports: Breaking down the variances into different categories.
- Break-even analysis: A technique used to understand the level of sales required to cover fixed and variable costs.
- Trend analysis: Analyzing historical data to identify patterns and trends.
- Variance analysis software: Using specified software to automate the calculation and reporting of variances.
- Root cause analysis: Digging deeper into variance data to identify underlying causes, including methods like the "Five Whys" or Fishbone Diagrams .
Common challenges and solutions in variance analysis
Understanding some of the challenges many finance leaders face when analyzing variance is important for improving the effectiveness of your own processes.
Here are the most common challenges and how to solve them.
- Inaccurate or inconsistent data: Improve data quality by implementing regular data audits, using automated data entry systems to reduce errors, and training staff to input data consistently.
- Over-simplification: Instead of focusing on surface-level variances, use root cause analysis techniques to explore variances beyond just the numbers.
- Misleading conclusions: Make sure to incorporate external factors such as market conditions, seasonality, and one-off events, into your variance analysis. Be cautious about drawing conclusions solely based on variances.
- Difficulty in identifying the right standards. Benchmark against industry standards, or establish realistic historical performance data. Review standards periodically to ensure they remain relevant and achievable.
- Complexity in analyzing multiple variances. Break down variances into smaller components (e.g. price and quantity variance), and analyze these components individually.
Best practices for successful variance analysis
Before we sign off and let you get to performing your own variance analysis, here are five quick best practices to take forward with you:
- Set realistic benchmarks and targets
- Use the same methodology when analyzing variance to improve your ability to compare
- Monitor and track variances regularly (e.g., quarterly()
- Leverage modern tech and financial automation to speed up analysis
- Encourage collaboration between finance and operational teams to improve your ability to put variance mitigation strategies into action
Get on top of variance with BILL
Variance analysis is an important activity for finance and business leaders to engage in, allowing them to improve budget accuracy and identify areas to improve operational efficiency.
With a quality financial operations platform like BILL, you can improve variance analysis by:
- Using automation to automatically identify discrepancies
- Putting cost control measures into play
- Automating financial reporting
- Creating custom dashboards to measure key metrics like revenue variance
- Forecasting cash flow in real time
