The definition of a variance

A variance refers to the gap between what was planned in a budget and the actual results recorded at the end of the budgeting period.

The importance of calculating and analysing variances

Calculating and analysing variances is essential for monitoring business performance and guiding future actions.

Key reasons for variance analysis

• Measuring performance differences - Identifies variations from planned outcomes in each department over a specific period.
• Improving future budgets - Helps create more accurate and realistic budgets.
• Supporting decision-making - Provides data that enables managers to make informed choices.
• Appraising business units - Allows for objective evaluation of cost centres and profit centres, ensuring accountability.

Types of variances and their causes

Variances are classified based on their impact on profit.

Main types of variances

• Favourable variance - Occurs when the difference boosts profit beyond the budgeted amount.
• Unfavourable (or adverse) variance - Happens when the difference reduces profit below the budgeted level.

Possible causes of unfavourable variances

• Revenue shortfalls - Fewer units sold than planned or reduced selling prices due to increased competition.
• Elevated raw material expenses - Higher output levels requiring more materials or increased unit costs from suppliers.
• Increased labour costs - Raised wage rates or extended production times leading to overtime.
• Higher overheads - Unexpected rises in fixed or variable overhead expenses beyond the budget.

Possible causes of favourable variances

• Revenue surpluses - Improved economic conditions leading to higher sales or reduced competition allowing better pricing.
• Reduced raw material expenses - Lower output levels using fewer materials or decreased unit costs from better deals.
• Decreased labour costs - Lower wage rates or quicker task completion improving efficiency.
• Lower overheads - Overheads coming in below budget due to cost-saving measures or reduced activity.

Variances can be verified by ensuring the net total of all individual variances matches the overall profit variance, confirming calculation accuracy.

Responding to variances

Managers must act promptly on both unfavourable and favourable variances to maintain control and optimise performance.

Strategies for addressing unfavourable variances

• Cost reduction tactics - Source cheaper materials or enhance labour productivity to cut expenses.

Strategies for analysing favourable variances

• Budget review - Examine if the variance results from overly high cost budgets.
• Contextual evaluation - Note that a favourable direct cost variance might stem from lower output, which is not necessarily positive.

Monthly variance analysis helps spot issues early, such as sales drops, allowing corrective actions like targeted strategies to regain market share.

Benefits of regular variance analysis

Conducting variance analysis on a regular basis offers several advantages.

Key benefits of variance analysis

• Early problem detection - Identifies potential issues quickly, allowing timely remedial steps to prevent escalation.
• Management by exception - Focuses managerial attention on significant problem areas, improving efficiency.