Introduction

The​‍​‌‍​‍‌​‍​‌‍​‍‌ fiercely competitive business environment of today demands that organisations must design and execute control systems in order to achieve their objectives. Organisations use budgets, standards, and forecasts to support their business operations; however, there are often occurrences of actual performance deviating from the planned one. These differences in performance are referred to as variances. It is a matter of priority for organisations to figure out the reasons for variances, as well as how to react to them, if they want to succeed. Analysing variances reveals the causes of variances and the way managers should handle the variances.

Analyzing variances is not only about numbers that are calculated by an accountant; it offers organisations a tool for management and control to pinpoint waste, control costs, enhance performance, and take operational decisions. The correct application of variances enables managers to see problems at the earliest stage and to take action before the issue becomes bigger or more expensive.

This article will briefly explain variance analysis by firstly discussing variance analysis definition, secondly, major factors contributing to variances in projection of budgets and actual results, and most importantly, how managers can use variance analysis to prepare a response plan for variances. The material will be simplified, using everyday words and examples, to make sure that the content is accessible to everyone who is interested in finance and management, irrespective of their background or experience in ​‍​‌‍​‍‌​‍​‌‍​‍‌finance.

Understanding Variance Analysis

Variance​‍​‌‍​‍‌​‍​‌‍​‍‌ analysis is basically a tool for increasing effectiveness, it doesn't only serve the purpose of finding faults in the business processes, and it is meant to help the management keep track of the business operation which is a prerequisite for the business's capability to provide the chosen products or services continuously.

Objectives

The main objectives of variance analysis are:

1) To detect inefficiencies

2) To manage costs

3) To evaluate the performance of employees and departments

4) To advance the planning and budgeting of the participants

5) To supply the necessary information for making qualified decisions

The outcome of variance analysis may thus be greater rigor especially when linking the results to the managers or departments accountable for them.

Types of Variances

Keeping in mind the causes for various variances, it is first and foremost important to be aware of the types of variances that exist in organizations.

Variances in Cost

Cost variances are those situations where actual costs differ from standard or projected costs. These variances will be present in any cost that a business is associated with, such as material costs, labor costs, overhead costs, and operating expenses.

Sales Revenue Variances

Sales revenue variances represent the difference between the actual sales revenue of a company and the budgeted revenue being higher or lower. These variances can be induced by price changes, volume changes, or product mix changes.

Profit Variances

Profit variances are a result of changes in costs, revenues, or a combination of both which cause fluctuations in a company's profits. Profit variances reflect a company’s overall financial performance.

Operational Variances

Operational variances represent the efficiency and productivity of the business operations as well as how the resources are used to produce the product. Some examples are the number of machine hours, labor hours, and the material used to make the ​‍​‌‍​‍‌​‍​‌‍​‍‌product.

Major​‍​‌‍​‍‌​‍​‌‍​‍‌ Causes of Variance Analysis

Variances are differences due to either internal or external factors, and they are not the result of random chance. It is very important to understand the causes of your variances so that you can decide what kind of measures to take.

Inaccurate Standards Or Budgets

Variance is most frequently caused by insufficient or inadequate planning. Unrealistic, outdated, or inaccurate standards and budgets based on incorrect assumptions will result in variances for you.

For instance, if a company sets its material cost standards without considering that materials prices have risen, then actual costs will be higher than standard ones. Moreover, a sales budget created in an overly optimistic manner without any market research will lead to the actual sales volume being lower than the one projected.

For this reason, inaccurate standards will give an inaccurate measurement of variance analysis as the source of the variances is planning, not performance.

 

Changes In Market Conditions

Market conditions are subject to rapid changes. Some of these can be demand, competition, inflation, interest rates, and customer preferences, all of which can affect the sales, costs, and profit levels of a company.

For instance, if competition increases, a company may have to lower its prices, thus resulting in an unfavorable sales price variance. Inflation can cause a company's raw material and labor costs to increase, causing cost variances to be unfavorable.

Most of the changes resulting from market conditions may happen beyond the management's control, and hence, these market conditions will have an impact on the company's ​‍​‌‍​‍‌​‍​‌‍​‍‌performance.

The​‍​‌‍​‍‌​‍​‌‍​‍‌ Labor Efficiency Variance

Labor Efficiency Variance refers to the difference between the actual and the budgeted time for producing a certain amount of output.

Some of the factors that cause labor efficiency variance are lack of training through not giving proper training to new employees; low employee motivational factors, e.g. not providing employees with incentives for performing jobs; breakdown of equipment due to machine failure; poor supervision; inefficient workflows; and absenteeism. On the contrary, more training and motivation will certainly bring about favorable labor efficiency variances.

Labor Efficiency Variance is an indicator of the company's human resources effectiveness.

Overhead Variance

Overhead Variance is a situation in which the actual overhead cost is either more or less than the budgeted one.

Although, Overhead Variance can be either Fixed Overhead or Variable Overhead.

The existence of Fixed Overhead Variance can be explained by many reasons, such as Underutilization of Capacity, Unexpected Maintenance Costs, Additional Rental and Insurance Costs due to Increases, etc. On the other hand, Variable Overhead Variance can be caused by such factors as inefficient use of utilities, indirect materials, and indirect labor.

Companies usually feel that Overhead Variance is complex and will require a thorough investigation.

Sales Volume Variance

Sales Volume Variance refers to the situation when the actual number of units sold is either higher or lower than the number of units in the budget.

This variance may result from several reasons, such as inaccurate demand forecasting, changes in customer preferences, the impact of an economic slowdown, supply chain disruptions, and ineffective marketing strategies.

Positive sales volume variance most likely signals either a strong product demand or good sales efforts, whereas negative sales volume variance is usually an indication of the need for changes in marketing or pricing ​‍​‌‍​‍‌​‍​‌‍​‍‌strategies.

Sales Price Variance

The variance at sales pricing refers to the difference between the actual and the budgeted sales prices.

Sales price can be affected by factors such as discounts, promotions, competition, changing customer base, and product quality decline. The drop in price is usually accompanied by a decrease in margin; however, the increase in volume resulting from the price decrease can compensate for the lower margins, and thus should be considered together with the margin analysis.

Product Mix Variance

The product mix variance is the difference between the planned and the actual proportion of each product's contribution to total sales.

Some products are more profitable than others; thus, if a company sells more low-priced products than expected, it will have a lower total profit margin even if its total revenue from sales remains the same.

Product mix variances also reveal the importance of a strategic sales plan for an organisation.

Operational Inefficiencies

Operations such as machine breakdowns, neglected maintenance, poorly-designed layouts, obsolete technology, and improperly designed processes can cause a variety of variances.

Inefficient operations cause higher costs and lower output, as well as lower quality, and therefore result in an unfavourable cost or efficiency ​‍​‌‍​‍‌​‍​‌‍​‍‌variance.

How to Take Action Based on Variance Analysis

Discovering a variance is just one element of the whole procedure. You are required to take suitable steps depending on what you found.

Instead of focusing on each and every variance that you find through your analysis, you should focus on the largest ones only; still, be reasonable with the way you react to each of them; make a plan that describes how you will respond to the various differences you find.

1. Identify Key Differences

It is not necessary for a variances in any case to take action. Sometimes insignificant variances may happen due to changes in the economy that occur routinely.

 

The management ought to focus on those variances which are able to have a significant impact on the cost, revenue or profit of the company. It is necessary to set tolerance limits in order that management can decide which variances need more investigation.

2. Analyze the Root Cause

It is very important for the management, before they decide to take the action of correction, to identify the root cause of the variance. If only the symptoms of a variance are dealt with by management, it is highly probable that the same issues will come up again in the future.

As an illustration, if the management figures out that the material cost variance is too high, it might be due to; paying more for raw materials than before, the materials being poorly handled thus causing the waste to be greater than it, and/or bad vendor management practices. Each of the reasons for deviation cited above requires a different way of solving it.

3. Assign Responsibility

The management must be in a position to recognize the responsibility centre(s) for each variance in its variance analysis. By better identifying each centre it provides management with the opportunity to more precisely measure performance, accountability, and overall performance. Nevertheless, it is very important that management create a culture where people support each other in order to enhance the overall performance of each ​‍​‌‍​‍‌​‍​‌‍​‍‌department.

4. Take Corrective Actions

The​‍​‌‍​‍‌​‍​‌‍​‍‌ variations in performance will have corrective actions that depend on the type of variance.

In case of a cost variance, corrective action can include such activities as renegotiating contracts of the existing suppliers, changing the manner of inventory management, cutting waste, upgrading production machinery, and/ or changing the labour schedule.

If there is a variance in sales, the corrective action will include changing the pricing strategies, starting a new campaign, improving product quality, getting new distributorships, and/or increasing the marketing efforts.

5. Revise Standards and Budgets

When variance results from unrealistic or outdated benchmarks or standards, you may feel it necessary to change both the budget and benchmarks.

Benchmarks/standards have to be a reflection of market conditions, technology, and business that are current. Regular review of benchmarks/standards leads to the accuracy of the next variance analysis.

6. Improve Processes and Systems

Through variance analysis, operational inefficiencies can be discovered, and there may be a corrective action for process improvement.

Examples of process improvement may be the automation of a process, changing a manufacturing method, implementing the lean process methodology, enhancing a quality control process, and/or upgrading the IT systems used for support.

Besides that, most of the process improvements, which are aimed at cost reduction, offer operational efficiencies in the long run that will be a source of benefits to the company beyond the immediate cost ​‍​‌‍​‍‌​‍​‌‍​‍‌savings.

7.​‍​‌‍​‍‌​‍​‌‍​‍‌ Put Money into Training and Employee Motivation

Employee training and engagement should be regarded as necessary expenditures when variances in efficiency or productivity are the result of a skills gap or lack of motivation.

On their own, motivated employees who are adequately trained, make an environment that leads to higher efficiency levels, improved-quality, and favourable variances.

8. Improve Communication

Variance analysis outcomes need to be communicated not only to managers but also to employees at all levels within the organization.

By being open about the results of the analysis, employees get a better understanding of what is expected from them and how they have performed. This form of communication also energises employees to co-operate in problem-solving activities should any issues be identified.

9. Consider Long-term Trends

As a rule, one-time variations may be small, but a repeated occurrence may signal that there is a more serious issue.

By evaluating trends, management is able to locate issues that are always there and see the effectiveness of the corrective measures that have been taken in the past.

10. Use Variance Analysis for Strategic Planning

It is not necessary to only use variance analysis for operational control; it can help in such areas as pricing, product mix optimization, capacity expansion, and cost leadership.

The overall advantage of the analysis is considerably increased when variance analysis is combined with strategic ​‍​‌‍​‍‌​‍​‌‍​‍‌planning.

Limitations of Variance Analysis

Variance analysis, while beneficial, has a few limitations. The analysis is based upon prior historical events and may not take into consideration potential future risks. The process could also take a considerable amount of time and could be quite complicated to complete depending on the size of the organisation. A major drawback of variance analysis is that an organisation may put too much emphasis on the deviation of variances from expectations and as such stifle their ability to innovate and take risks.

 

It is important to note that using variance analysis alone is not enough to measure an organisation’s performance. The results of variance analysis must be assessed in conjunction with other management control systems to provide the best overall assessment of performance.

Conclusion

Variance analysis provides valuable insight into how performance is deviating from the original goals that were set in place. A number of issues may cause these variances such as inaccurate budgeting, changing market conditions, changing costs, inefficiencies in operations and/or employee behaviour.

Ultimately the value of variance analysis is not just in identifying variance but in being able to act on the variance in a timely and effective way. By reviewing impactful variances, digging down to determine where the problems originated from and holding people accountable for their contributions to the variance, organisations will be able to increase their efficiency, control their costs and improve overall performance.

Variance​‍​‌‍​‍‌​‍​‌‍​‍‌ analysis is of greatest value to organisations when they decide to take timely and effective measures after the identification of variances instead of merely identifying variances without any action.

Timely and effective measures can be taken by organisations when they concentrate on the major variances, find out the root causes of them, take responsibility for them, and carry out the corrective actions. In this way, enterprises can become more efficient in their operations, have better control over their costs and overall business performance.

In a situation where variance analysis is used properly, supported with good communication, training, and strategic alignment, it ceases to be merely an accounting function; it can be a powerful agent of continuous improvement and business ​‍​‌‍​‍‌​‍​‌‍​‍‌success.