Variance analysis
What a variance is
- A variance is the difference between a budgeted figure and the actual figure.
- Variance analysis is the process of calculating those differences, working out why they happened, and deciding what to do about them.
- It is the controlling function of management in practice.
Favourable and adverse
- A variance is named by its effect on profit, not by whether the number went up or down. This is the part students get wrong.
| Variance | Revenue | Costs |
|---|---|---|
| Favourable (F) | Actual revenue above budget | Actual cost below budget |
| Unfavourable / adverse (U) | Actual revenue below budget | Actual cost above budget |
- So a cost that comes in lower than budget is favourable, and revenue that comes in lower than budget is unfavourable. Higher is not automatically better.
What causes an unfavourable variance
Cost variances
- Supplier price increases — materials, fuel, freight
- Wage increases, overtime worked to catch up, or extra staff hired
- Waste, rework and defects consuming more material than planned
- Equipment breakdowns requiring urgent repairs and expedited parts
- A project running longer than planned, so time-based costs continue
Revenue variances
- Sales volume below forecast — a new competitor, weaker demand, a lost contract
- Discounting to shift stock, so each unit earns less than budgeted
- Production or delivery problems meaning orders could not be filled
What management does about it
- Investigate the cause first. A variance is a symptom. Acting before knowing the cause usually cuts the wrong thing.
- Judge whether it is controllable. A global increase in fuel prices is not within the business's control; excessive overtime is.
- Then act:
- Renegotiate with suppliers, or find an alternative supplier
- Change the specification or reduce waste in the process
- Adjust prices, if the market will bear it
- Reduce discretionary spending elsewhere to protect the overall result
- Revise the budget if the assumption behind it is now permanently wrong
- Investigate favourable variances too. A large favourable cost variance can mean a saving — or it can mean maintenance was skipped, quality was cut, or the budget was too generous.
Worked ExampleReading a monthly variance report
A large New Zealand food producer (invented) budgets for a month as follows. Actual results are shown alongside.
| Item | Budget | Actual |
|---|---|---|
| Sales revenue | $820,000 | $795,000 |
| Raw materials | $310,000 | $338,000 |
| Wages | $180,000 | $176,000 |
| Freight | $46,000 | $59,000 |
Calculate each variance, label it favourable or unfavourable, and explain what management should investigate first.
Step 1 — Calculate each variance
Sales revenue: $795,000 − $820,000 = −$25,000 Revenue is below budget, so this is unfavourable.
Raw materials: $338,000 − $310,000 = +$28,000 Costs are above budget, so this is unfavourable.
Wages: $176,000 − $180,000 = −$4,000 Costs are below budget, so this is favourable.
Freight: $59,000 − $46,000 = +$13,000 Costs are above budget, so this is unfavourable.
Step 2 — Find the net effect on profit
Unfavourable total: 25,000 + 28,000 + 13,000 = $66,000 Favourable total: $4,000
Net: $62,000 worse than budget for the month.
Step 3 — Decide what to investigate first
Rank by size and by whether the business can control it.
- Raw materials ($28,000 U) is the largest and is at least partly controllable — it could be a supplier price rise, or it could be waste and rework, and those need completely different responses. Investigate first.
- Sales revenue ($25,000 U) is next. Was volume down, or was price discounted? If volume held and price fell, the business has a competitor problem, not a demand problem.
- Freight ($13,000 U) is smaller and may be an external fuel or carrier increase, which is largely uncontrollable — but it might also be small, frequent deliveries that could be consolidated.
Step 4 — Notice what the favourable variance might be hiding
Wages came in $4,000 under budget while raw material usage rose. That combination is worth checking: if the plant ran short-staffed, less experienced or rushed work could be causing the extra material waste — in which case the "saving" on wages cost the business seven times as much in materials.
Net unfavourable variance of $62,000; investigate raw materials first, and check whether the favourable wage variance caused part of it.