How Variance Analysis Can Improve Financial Results

Creating a detailed budget is critically important for the success of your business. A well-managed company will budget for sales, production costs and all other expenses.

No manager can make informed decisions unless they know the total costs they incur to run the business. If you don’t know your total costs, you can’t price your product to reach a specific profit margin. Before you start a new fiscal year, sit down and create a budget.

Introducing variances

Many owners create a company budget, but don’t use it to make changes in the business. To make use of your budget, compare your actual results to your budget. Any differences you find between budgeted and actual results are called variances.

Essentially, a variance means that things didn’t work out as your planned. The question is why not? If you can find out why you have a particular variance, you can make changes to improve your business results.

Types of variances

Assume that you own Greengrass Sporting Goods. You manufacture sporting goods equipment, including baseball gloves. Management created a budget for baseball glove production. The managers then review the actual results for the month and comparing them to the budget.

This manufacturing business will have three broad categories of variances:

• Material variances: Greengrass buys leather, plastic and other material to make baseball gloves.

• Labor variances: The company pays people to run machinery to assemble the baseball gloves. Workers also package and ship gloves to customers.

• Overhead: Greengrass also incurs costs that cannot be directly traced to baseball glove production. The lease payment on the factory, utility costs and insurance expenses are considered overhead costs. These costs are allocated to the product, based on an overhead rate.

If any of these cost areas generate a variance, that variance needs to be analyzed.

 Material variances

When Greengrass creates a budget, they create standards for many of their costs. One standard cost is the amount of leather material used for each baseball glove. Let’s assume that the each glove requires 2 square feet of leather. To keep it simple, assume that 2 square feet is consider one unit of material.

At the end of the month, Greengrass compares their actual results to the standards in the budget. You can think of your budget as “what you planned” and your actual results as the “check you wrote”.

Here are the budgeted and actual results for the month of January:

Budgeted material costs                                                Actual material costs

Standard quantity 9,000 units                                        Actual quantity 10,000 units

Standard price        $4/ unit                                              Actual price         $4.20/ unit

Standard cost         $36,000                                            Actual cost          $42,000

Actual costs are higher than budgeted ($42,000 vs. $36,000). You have a variance of $6,000. Because costs are higher than you planned, the variance is unfavorable. A favorable variance exists when actual costs are lower than planned.

There are two possible reasons why you have an unfavorable variance. One reason is that you used for material than you planned. You may also have a variance because you paid more than you planned.

To understand the reasons for a material variance, think about using a recipe for baking a cake. The recipe represents your standard costs. You’re supposed to use a specific amount of flour, for example. If you use more flour than the recipe calls for, you’ll have an unfavorable variance.

Components of a material variance

Your $6,000 unfavorable variance can be broken down into a price variance and an efficiency variance. Here are the formulas for each variance:

Price variance

($4.20 actual price – $4 standard price) X (10,000 actual quantity) = $2,000 unfavorable variance

Because the actual price we paid was greater than planned ($4.20 – $4), we have an unfavorable price variance. We paid more than budgeted

Efficiency variance

(10,000 actual quantity – 9,000 standard quantity) X ($4 standard price) = $4,000 unfavorable variance

We used more leather (measured by units) than we planned.

$2,000 price variance + $4,000 efficiency variance = $6,000 unfavorable material variance.

Labor variances

Greengrass also pays workers to produce the baseball gloves. Employees load leather and other raw materials into machinery. They move the work in process from one machine to another, and then package the gloves for shipment to customers.

The company creates a budget (standard costs) for hours incurred for the month and the hourly rate paid to workers.

Here are the budgeted and actual results for the month of January:

Budgeted labor costs                                                       Actual labor costs

Standard quantity 200 hours                                          Actual quantity  180 hours

Standard price        $25/ hour                                          Actual price         $23/ hour

Standard cost         $5,000                                               Actual cost          $4,140

In this case, actual costs are lower than budgeted. This is a favorable variance of ($5,000 – $4,140), or $860.

Just as with the material variance, we can separate the labor variance into two components:

Rate variance

($23 actual price – $25 standard price) X (180 hrs actual quantity) = ($360) favorable variance

You’ll note that the labor variance is referred to as a rate variance. That’s because the labor costs relate to a pay rate.

Because the actual hourly rate we paid was less than planned ($23 – $25), we have a favorable price variance. We paid less than budgeted. Because the variance relates to a cost, a negative number indicates a cost savings.

Efficiency variance

(180 hrs actual quantity – 200 hrs standard quantity) X ($25 standard price) = ($500) favorable variance

The negative $500 indicates a cost saving here, too. Because we used fewer labor hours than planned, the variance is favorable.

$360 rate variance + $500 efficiency variance = $860 favorable labor variance.

Overhead variances

Overhead costs, by definition, cannot be directly traced to your product or service. While material and labor cost can be traced, overhead cost must be applied. Overhead is applied based on a rate that you include in your budget.

Overhead costs can be both fixed and variable. The lease payment for your factory and your equipment insurance premiums are fixed costs. Repair and maintenance costs, on the other hand, can vary with your level of production.

Allocation rates

Let’s assume you need to allocate repair and maintenance costs for your machinery. You need to come up with an allocation rate for this variable overhead cost. Ideally, you want to find an activity that drives this overhead cost. In other words, what activity in your production process causes the variable overhead spending to increase?

On common activity level is labor hours. You notice that the more labor hours you require, the more repair and maintenance costs you incur. That makes sense, since more production means more wear and tear on your machines. As you use the machines more, they tend to break down.

Variable overhead applied

You decide to use labor hours to apply overhead to production. In your budgeting process, you estimate a standard variable overhead rate of $10 per labor hour. That rate is based on a review of your historical costs. Your budget uses the same budgeted labor hours that you calculated earlier.

Here are the budgeted and actual results for the month of January:

Budgeted overhead costs                                              Actual overhead costs

Standard quantity 200 hours                                          Actual quantity  180 hours

Standard price        $10/ hour                                          Actual price         $12/ hour

Standard cost         $2,000                                               Actual cost          $2,160

We can separate the variable overhead variance into two components. You’ll notice that the variance that relates to differences in price is the spending variance. In accounting, we often have multiple terms that mean the same thing. For variances, “price”, “rate” and “spending” variances all refer to the price you pay- as opposed to the amount that you use.

Spending variance

($12 actual price – $10 standard price) X (180 hrs actual quantity) = $360 unfavorable variance

Because the actual hourly rate we paid was more than planned ($12 – $10), we have an unfavorable variance. We paid more than budgeted.

Efficiency variance

(180 hrs actual quantity – 200 hrs standard quantity) X ($10 standard price) = ($200) favorable variance

The negative $200 indicates a cost saving here. Because we used fewer labor hours than planned, the variance is favorable.

$360 unfavorable variance + ($200) favorable variance = $180 unfavorable variable overhead variance.

You’ll note that we added an unfavorable to a favorable variance. It’s possible that the two components that make up your total variance can look this way.

Changes to improve your business

Well, that seemed like a great deal of work- why did we go through it? You can use these variances to make changes and improve your business results. Here are some examples:

• Unfavorable material variance: If your actual costs were more than budgeted, consider getting a bid on materials from another vendor. You might be able to lower your costs.

• Labor variance- unfavorable: If your production process required more hours than planned, your employees may need better training so that they can work more efficiently.

• Unfavorable overhead variance: You may find that your variable overhead cost for machine maintenance is more than budgeted. If that’s the case, see if you can negotiate a lower cost with your maintenance company.

While your first pass at variance analysis may seem overwhelming, your accounting software can generate these reports for you. Part of your management process should be a review of all variances. Use variance analysis to make changes and improve your business.