## Creating a Variance Analysis Model – Part 1

Today we will take a more detailed look at Variance Analysis. In this article, we will deal with the theory, and in next week’s article, we will build an Excel model to look more practically at the subject.

# Variance Analysis

Variance analysis looks at the differences between planned and actual numbers. This method is used a lot in management accounting as a way to maintain control over the business. When we perform variance analysis, we compare the actual amount incurred/sold to either budgeted amount, planned amount, or standard amount.

## Types of Variances

Variances can be two types based on their effect:

• (F) Favorable Variance – when actual results are better than expected results;
• (A) Adverse Variance – when actual results are worse than expected results.

A specific level of variance analysis allows the management to understand why discrepancies and fluctuations occur in the business and how to control them better. When calculating variances, we should always take the planned or budgeted amount and subtract the actual value. This way, we ensure that a positive number means a favorable variance, and a negative number – adverse variance.

The most common variances used in financial analysis are:

• Variable cost variances
• Direct Material variances
• Direct Labour cost variances
• Budget Variance
• Volume Variance
• Sales Variances
• Price Variance
• Volume Variance

## Variable Cost Variances

### Direct Material Variances

The Total Direct Material Variance shows the difference between the standard and actual cost of materials for production activities. It consists of two variances:

#### Purchase Price Variance

The Purchase Price Variance, also known as Material Price Variance, calculates the difference between the actual price to buy an item and its expected standard price, multiplied by the actual number of units purchased. A positive variance means actual costs have increased, and vice versa.

Purchase Price Variance = (Actual Price – Standard Price) x Actual Quantity

#### Material Yield Variance

The Material Yield Variance, also known as Material Usage Variance, illustrates the difference between standard quantity expected to be used and the actual quantity of materials used, multiplied by the expected standard cost of materials. Unfavorable variance means that usage was higher than expected.

Material Yield Variance = (Actual Usage – Standard Usage) x Standard Cost Per Unit

### Direct Labour Cost Variances

The Total Direct Labour Variance looks at the effect of the combination of labor rates and worked hours. The total variance can be broken down to the Direct Labour Price Variance and the Direct Labour Quantity Variance.

#### Direct Labour Price Variance

The Direct Labour Price Variance, also known as the Direct Labour Rate Variance, is calculated by taking the difference between the Standard Rate and the Actual Rate for labor cost, multiplied by the Actual Hours worked. It shows the effect on the labor costs by the change in the hourly labor rate, between the expected and the actual.

Direct Labour Price Variance = (Standard Rate – Actual Rate) x Actual Hours

Most common drivers for the variance can be:

• pay premiums like bonuses or overtime;
• incorrect pay rates laid down in the standard;
• staffing issues – e.g., per standard we might plan one task for a lower pay rate employee;
• production changes – increase in manual labor to decrease the quantity of used material or overhead absorption.

#### Direct Labour Quantity Variance

We calculate the Direct Labour Quantity Variance, also known as the Direct Labour Efficiency Variance, by taking the difference between the expected Standard Hours and Actual Hours worked, multiplied by the Standard Rate expected for hired labor.

Direct Labour Quantity Variance = (Standard Hours – Actual Hours) x Standard Rate

Some drivers for this variance can be:

• employees may not be provided with the proper instructions to do their job;
• employees did not receive the planned training;
• we did not configure workstations adequately;
• the mix of employees and competences is different than expected.

We calculate the Total Variable Production Overhead Variance in two parts.

We calculate the Variable Overhead Spending Variance by subtracting the Actual Hours valued at the Standard Rate for the absorption of variable production costs from the Actual Costs incurred. Actual Rate is not used here, as we do not ‘purchase’ the variable overhead costs per direct labor hours.

Variable Overhead Spending Variance = Actual Costs – (Actual Hours x Standard Rate)

Some causes for this variance can be account misclassification, changed prices by suppliers, and outsourcing of various tasks.

We calculate the Variable Overhead Efficiency Variance by subtracting the Standard Hours value at the Standard Rate from the Actual Hours valued at the Standard Rate. The variance calculation assumes that variable overhead costs are genuinely driven by direct labor hours. It shows us the effect on costs from the change between the expected Standard Hours to the Actual Hours.

Variable Overhead Efficiency Variance = (Actual Hours x Standard Rate) – (Standard Hours x Standard Rate)

The calculation of the variance can be simplified as follows:

Variable Overhead Efficiency Variance = (Actual Hours – Standard Hours) x Standard Rate

There are two Fixed Production Overhead Variances. First, we have the Budget Variance, also known as the Fixed Overhead Expenditure Variance. Second, we have the Fixed Overhead Volume Variance. Based on the costing model, we can calculate both variances in the case of Absorption Costing. When applying Marginal Costing fixed production overheads are not absorbed in the cost of output, budgeted overheads and flexed overheads (fixed overheads absorbed) are the same. Therefore only the Budget Variance is calculated.

### Budget Variance

The Budget Variance, also known as Fixed Overhead Expenditure Variance or Fixed Overhead Spending Variance, is calculated to illustrate the deviation from the budget in the fixed production costs. We derive it the same way under the Absorption and Marginal costing system.

Drivers of this variance can be the seasonality in fixed costs or when manufacturing reaches a new step cost trigger point, where we will incur a whole further expense.

### Volume Variance

The Fixed Overheads Volume Variance is the difference between budgeted and actual absorbed fixed production costs.

A seasonal business can cause it if the allocation base is the number of sold units. If the allocation base is labor hours, the cause can be optimizations of manual labor. Moreover, if the allocation base is machine hours, the variance can be caused by outsourcing some aspects of the production process.

We can further analyze the variance into two sub-variances.

The Fixed Overhead Capacity Variance calculates the variation in absorbed fixed production overheads attributable to changes in the manufacturing hours, as compared to the budget.

Fixed Overhead Capacity Variance = (Budgeted Production Hours – Actual Production Hours) x Fixed Overheads Absorption Rate

The Fixed Overhead Efficiency Variance shows the variation attributable to the change in the manufacturing efficiency, i.e., manufacturing hours being more or less than what we expected.

Fixed Overhead Efficiency Variance = (Standard Production Hours – Actual Production Hours) x Fixed Overheads Absorption Rate

## Sales Variances

The primary sales variance that can be calculated as Budgeted Sales less Actual Sales is the Sales Value Variance.

To further analyze it, we can break it down into two sub-variances.

### Sales Price Variance

Sales Price Variance = (Actual price – Standard price) * Actual sold quantity

This variance shows us a comparison between the actual sales realized and the actual sales at standard prices.

### Sales Volume Variance

The Sales Volume variance shows the deviation from budgeted sales to actual sales at actual prices. We calculate it as follows:

Sales Volume Variance = (Actual quantity sold – Budgeted quantity sold) * Budgeted price per unit

Calculated that way, the sales volume variance is unfavorable, or averse, when fewer items were sold than initially budgeted.

Some of the reasons for the volume variance can include:

• competitors may release a similar newer product which is more attractive to the audience;
• the company may release other products that compete with the product in question, cannibalizing its sales;
• the company may change the selling price, which can influence the volume of sales.

We can further break down the Sales Volume variance into the Sales Mix variance and the Sales Quantity variance.

#### Sales Mix Variance

We use the sales mix variance to evaluate how much of the sales volume variance was due to a difference between actual and budgeted sales mix.

Sales mix variance = (Actual sales quantity – Actual sales volume at budgeted mix) * Standard price

It can also be calculated as Standard Sales – Revised Standard Sales.

The mix variance is favorable if the actual volume is higher than the actual volume at the budgeted (standard) mix, and vice versa.

#### Sales Quantity Variance

The quantity variance shows the effect of the unit volume that varies from the budget. It shows how much of the volume variance is due to the difference between the actual quantity sold at the budgeted mix and the planned quantity. We calculate it as follows:

Sales quantity variance = (Actual sales quantity at budgeted mix – Budgeted sales quantity) * Standard price

We can represent this as Revised Standard Sales – Budgeted Sales.

A favorable variance means that the actual volume at the budgeted sales mix is higher than the budgeted volume. If the actual volume at the budgeted mix is lower than the budgeted sales volume, the formula gives an adverse variance.

# Limitations of Variance Analysis

We have to note that there are some problems with variance analysis that keep companies from overusing it. This type of analysis is mostly based on financial results that are sometimes released much later. In a fast-paced environment, management might need such information much faster and more regular than the usual once a month calculation after closing the financial accounts.

Variance calculations require more data than what is available in the accounting records, so the accounting staff usually has to go through other information such as bills of material, and overtime records to evaluate the causes of variances. The extra labor cost is only reasonable when management can correct problems based on the calculated deviations.

Also, loosely done or political budgeting is bound to deviate a lot from the actual results. Comparing to such unrealistic expectations may provide misleading signals and not be useful at all.

# Conclusion

We do not need to analyze all variances. When we make our selection, we need to take into consideration the company’s profile, the nature of the industry, and the life cycle of the business. Also, it is essential to remember that not all unfavorable variances are bad, and vice versa. The management of a company faces a challenge to take variance information, evaluate the underlying reasons and causes, and take necessary corrective measures to optimize the business processes. However, one must be mindful, that variance analysis is essentially a comparison between standard (budgeted) values and actual results, and if the budget was unrealistic, then the resulting signals from the variance analysis might turn out to be very misleading.

Thank you for reading! Please tune in next week, when we will take a more practical look at variances by applying all this knowledge in building a variance analysis model in Excel. ## FCCA, FMVA

Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.

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