1. An overview of variance analysis as a process
Every business owner must have a budget which lays out the company's future course of activities. A budget helps to showcase from where the sales would come and how the funds would be spent to achieve those sales, with the key objective of generating a profit. While budgeting is a great planning tool, it is also a useful management tool for keeping the business on track for meeting its objectives. For accomplishing this goal, budgeting and variance analysis provides key insights to help the management in taking prompt and feasible decisions.
Preparing a budget at the commencement of the year is a critical exercise for a business and is known as budgeting. It helps in gathering the input from various departments and brings every stakeholder on the same page. It also works as an excellent medium of communication conveying to everyone where the organization wishes to go and how it plans to get there.
3. Variance Analysis
After the year gets going and the actual results start coming, the management starts comparing the actuals with the budgets. At this time variances from the budget are identified, and the management has to dig deep to find out the reasons for such variances. This analysis is used for maintaining a control over the business. For instance, if the budget for sales is INR 1,00,000 and the actual sales are INR 80,000, variance analysis produces a difference of INR 20,000. This analysis is effective when the management reviews the variance on a trend line. Sudden changes in a month to month (MoM) variance are clearly visible. This analysis also requires investigation of these variances which helps the management to interpret as to why such variance or differences occurred.
4. How companies apply variance analysis?
Most of the companies are concerned with business planning and meeting their financial commitments. Ultimately all want growth. Accordingly, they analyze the variances between:
a. Previous-year actual results and current year’s budget, which helps them in planning and this is also a part of the budgeting process.
b. Existing budget (current financial year) and current-year actuals, which helps them in meeting their commitments. This activity is performed at regular intervals throughout the year like at close of every quarter and at year-end.
c. Previous-year actual and current-year actual for analyzing growth. This is done at year-end.
5. Application of Variance Analysis
a. Comparing Budget with Actual: Variance analysis helps in managing the annual budgets by monitoring the budgeted figures and comparing it with the actual revenue/cost. In case of companies which are project or program driven, the financial data are evaluated at key intervals such as month close, quarter end, ect. For example, the month end reports can just provide quantitative data with respect to revenue and expenses or inventory levels. However, variance analysis would help to understand the reasons behind the variances between planned and actual revenue/cost which could lead to adjustments in the business strategies and end objectives.
b. Identifying Relationships: Relationship between a pair of variables/elements/items could also be identified with the help of variance analysis. Correlations (both positive and negative) are critical in business planning. For instance, variance analysis could reveal that when the sale for Product A rises there’s a correlated rise in the sales for Product B. Thereby, revealing a positive correlation between 2 products.
c. Forecasting: Forecasting uses patterns of the past data for developing a theory about the future business performance. Variances are placed into the context which helps analysts in identifying factors. For example, seasonal change holidays could be a major cause of positive/negative variances.
6. Most commonly used variances
a. Purchase price variance: Purchase Price Variance results when actual price which is paid for materials is different from the budgeted cost for such materials. It is usually used as a lagging indicator for quantifying the efficiency of the procurement function. (How efficiently can you procure/purchase required material)
b. Labor rate variance: This variance shows the variance between the actual price which is paid for direct labor that is used in the process of production and its standard labor cost (the cost that is acceptable and usually a standard price). Unfavorable variances mean that cost of labor exceeds the budgeted value, while favorable variances mean that labor cost was less than planned. Such information could be used for the planning and budgeting for future periods, and also works as a feedback for employees responsible for direct labor component of the business.
c. Material yield variance: This variance is the difference between actual quantity of material used and the standard quantity expected to be used in course of production, multiplied by the standard cost of such materials.
d. Volume Variance: Volume variance measures the difference between actual quantities sold or consumed and budgeted quantity expected to be consumed or sold, multiplied by the standard price per unit. The volume variance is a general measure of whether the business is generating the volume of products that it had planned.
7. Benefits of using variance analysis
Using variance analysis in the decision-making process renders the following positive impacts:
a. Competitive advantage: Variance analysis helps an organization to be proactive in achieving their business targets, helps in identifying and mitigating any potential risks which eventually builds trust among the team members to deliver what is planned.
b. Identifying the changes required in the business strategy: In some of the cases, comparing budget with actual results may point out the requirement for re-evaluating the target customer base or product line of the company. Several assumptions go into developing a budget. In case those assumptions are blowing up the budget, it could be because the budget-related projections are wrong for a variety of reasons. It could also be due to changes in the economy or delays in getting the products/services sent to end customers.
c. Identifying any managerial concerns : At times, variance analysis could also provide insight as to how well an organization is being managed. For instance in the case of purchasing, the inability to negotiate volume discounts or securing the competitive bids could indicate managerial problems within the purchasing department. Moreover, weak sales could also be an indication that the salespersons are not trained properly or they lack motivation. By addressing such issues, the variances could disappear as the organization gets on track.
d. Managing risk: With the help of variance analysis, the finance heads gather insights which they require to understand the reasons for controllable and uncontrollable variances. Once they’re aware of such variance, they’re in a position to implement policies to mitigate such risks arising from such variances.
e. Creating shareholder value: When an organization brings in proper internal controls, a cross-functional environment, efficient internal audit process, and the culture of meeting commitments, it increases the chances that the variances would be favorable which means that the business commitments would be met or even exceed the expectations.
8. Problems associated with variance analysis
a. Timing delay: The accounting staff gather variances at end of every month before providing results to the management. In most of the cases, management requires the feedback much faster, and so it tends to rely on warning flags or measurements which are generated on spot.
b. Source of variance: Most of the reasons for the variances aren’t available in accounting records, so accounting personnel needs to go through the information like labor routings, bills of material, and overtime records for determining the reasons for such variances. Such add-on activity is cost-effective only when the management could actively fix the problems based on the information provided.
c. Detailed analysis: If budgeting isn’t performed considering the detailed analysis of every factor, the budgeting process might be loosely done that would deviate from actual numbers. Analyzing variances might not make sense in such scenario.