Using Variance Analysis to Inform Business Decisions

Understanding Variance Analysis

Variance analysis is a financial tool that helps businesses to understand the difference between actual performance and budgeted performance.
It entails the process of systematically identifying the causes of the difference (variance) between actual costs and budgeted costs.
It’s a significant part of a company’s management controls system that allows to monitor expenses and income.

Components of Variance Analysis

Variance analysis is composed generally of two types - cost variance and revenue variance.
Cost variance is the difference between actual expenditure and the standard or budgeted cost.
Revenue variance is the difference between actual income and the standard or budgeted income.

Calculating Variance

Variance is calculated as: Actual results - Budgeted results
A favourable variance is when the actual results are better than the budgeted results (higher revenues, lower costs).
An unfavourable variance is when the actual results are worse than the budgeted results (lower revenues, higher costs).

Significance of Variance Analysis

Variance analysis aids in performance measurement by indicating how well or poorly a business has done against its plan.
It provides a basis for performance improvement by highlighting areas where outcomes did not meet expectations, stimulating analysis on possible reasons.
It can help identify trends, giving indications for future financial planning and forecasting.

Types of Variances

Sales variance: Occurs when actual sales differ from the predicted sales, further divided into sales volume variance and sales price variance.
Direct cost variance: Caused by a difference in actual and budgeted costs of direct labour or materials, further divided into direct labour variance and direct material variance.
Indirect cost variance: Caused by a difference in actual and budgeted indirect costs, such as rent, utilities, insurance, etc.

Limitations of Variance Analysis

Variance analysis makes the presumption of perfect linear relationship between costs, overheads, and production volume, which might not hold true under all circumstances.
It may lead to short term focus due to its reliance on meeting short term budget goals, which can sometimes result in overlooking strategic objectives.
A big challenge in variance analysis is determining the root cause of a variance - it may not always be straightforward due to numerous intertwined business factors.

Variance Analysis is a critical tool for sound business decisions, as it provides detailed insights into the performance of a business, highlighting where changes may be necessary.