Using Variance Analysis to Track Business Performance
Variance analysis can be used to observe how well a business is performing and also how close actual costs and revenues are to expected costs and revenues. However there are some caveats to its usefulness.
Definition of Variance Analysis
In accounting, a variance is defined as the difference between the expected amount and the actual amount of costs or revenues. Variance analysis uses this standard or expected amount versus the actual amount to judge performance. The analysis includes an explanation of the difference between actual and expected figures as well as an evaluation as to why the variance may have occurred. The purpose of this detailed information is to assist managers in determining what may have gone right or wrong and to help in future decision-making.
A variance can be put into the favorable category when the results are better than expected. This means that revenues were more than the expected amount or costs were below the budgeted amount. In accounting practice, a favorable variance is shown by noting a letter F in parenthesis on the reports. A favorable variance might earn a bonus for a manger, or perhaps a move up the corporate ladder.
In contrast, the variance can be judged as unfavorable if the results are worse than expected. If the revenues were below expectations or the costs were higher than standard, the variance would be termed unfavorable or adverse. This would be denoted on the reports with the letter A or U, usually in parenthesis. Consistently creating an unfavorable variance might result in a manger being reprimanded or losing their job. However, the analysis is typically used to help mangers prevent a negative situation from recurring by providing information about what went wrong.
Variance analysis is commonly used in several aspects of business accounting. One of the most common is in the purchase of manufacturing materials. The variance is the price paid for the materials less the expected cost and then multiplied by the actual number of units used in the process. Another commonly seen usage is the selling price variance or the actual sales price minus expected, times the number of units. The analysis is also used with overhead and labor spending and efficiency.
Not all companies utilize variance analysis in their managerial process. There are several reasons for this, one of which is that it can be quite complex for the accountants to process all of the information necessary to discover why there may have been a problem or benefit that caused the variance. In addition, the variance is not calculated until the end of the accounting period, when the information gleaned from the analysis may be too late to assist managers with their decision-making. Finally, the standard figures used to calculate the variance may not be as accurate as the actual figures, thus the analysis may have little usefulness.
Other Types of Analysis
The companies that choose not to use variance may perform horizontal or vertical analysis instead. Horizontal analysis is practiced by comparing results over time rather than comparing actual results to be expected as with variance. For example, revenues can be compared between the first and second quarter of the fiscal year to see how they have changed. Vertical analysis is practiced by assigning percentages to items on the profit and loss statements and balance sheet depending on how much they contribute to the bottom line. These percentages can be compared over time as well.
Businesses sometimes will experience a positive variance offset by a negative variance. For example sales may improve due to an increase in staffing, resulting in a favorable sales variance combined with an unfavorable labor cost variance. Thus in the end, the total variance would balance out.