What is Variance Analysis? Definition, Explanation, 4 Types of Variances

Definition:

Variance analysis is an important aspect of cost and management accounting systems. It is the process of comparing the budgeted/standard costs or revenue to the actual costs incurred or revenue earned.

Variance analysis is more on cost or management accounting rather than financial accounting.

It is generally served management for their performance management especially in the areas of costs management both labor and material as well as sales performance.

It is also used as a tool to improve the company performance overs these areas.

This comparison is then analyzed whether the differences were favorable or unfavorable to the business.

The following is an explanation of how the variance is used in the company.

Explanation:

At the end of each accounting period, a master budget or final plan is prepared that is followed by the company throughout the year. The master budget is a compilation of several other lower-level budgets.

Initially, a sales budget is prepared by estimating the selling price you intend to sell your goods in the future and the future market demand by customers for the commodity.

After the sales budget has been prepared a production budget is prepped as per the number of units that are expected to be sold.

This production budget measures the number of units that shall be produced in order to meet the given market demand.

The next step is to estimate the cost of producing the required number of units. All the direct and indirect costs are estimated by adjusting the inflation factor.

Since these costs are being forecasted and inflation tends to increase or decrease each year, we must take into account the inflation rate.

The total variable costs or direct costs are calculated by multiplying the number of direct materials or labor hours that will be required with the estimated, inflation-adjusted price of the direct materials or direct labor.

The total direct cost or prime cost can easily be calculated this way since these are directly attributable to the output and increases as the output increases at a fixed rate.

Similarly, the indirect costs include depreciation of fixed assets, utility expenses, supervisor’s salaries, bad debts, etc. These costs are estimated as well after adjusting the inflation factor and any other changes.

These costs are to be paid whether there has been any production or not and hence they don’t vary with the number of units produced.

When these budgeted costs and revenues are actually incurred, the prices may vary a little bit or maybe by a large margin sometimes.

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For example, the supplier that had been providing raw material at the time of budgeting has gone bankrupt and raw materials have been purchased from a new supplier now.

The quality or price of these new raw materials may vary which might impact the profitability of the business either negatively or positively.

A negative impact would mean an unfavorable variance i.e. the actual cost incurred is higher than the budgeted cost.

A favorable variance is when the actual cost incurred is less than the budgeted cost and has a positive impact on the profitability of the business.

4 types of variances:

The four major variances are as follows:

1) Direct material variance:

The direct material variance or we can call the direct material total variance can be subdivided into two:

The first one is the direct material price variance,

and,

The second one is the direct material usage variance.

However, the direct material total variance is the difference between what the output actually costs the company and what it should have cost (as per the company’s budget), in terms of material.

For example, the company spends USD1,200 for 1,000 units of Product A while the budget for these 1,000 units is only USD1,000. Direct material variance is USD200.

The direct material price variance. This is the difference between the standard cost and the actual cost for the actual quantity of material used or purchased.

In other words, it is the difference between what the material did cost and what it should have cost.

For example, material Aa use for production A cost the company USD0.01 per unit while the budget price for this material Aa is only USD0.005 per unit. So the material price variance is (0.01-0.005)*total number of units of material Aa to be used for production.

The direct material usage variance. This is the difference between the standard quantity of materials that should have been used for the number of units actually produced, and the actual quantity of materials used, valued at the standard cost per unit of material.

In other words, it is the difference between how much material should have been used and how much material was used, valued at standard cost.

For example, the actual usage of material Aa for 1,000 units of products A are 1,500 units while the budget of material Aa for 1,000 units of products A are only 1300 Units. Therefore, the material usage variance is 200 Units @ the standard price of material Aa.

2) Direct labor variances:

The labor variance is the comparison between the actual salaries paid to direct labor and the standard salaries that were decided to be paid to the direct labor as per the budget.

For example, the total budgeted direct labor variance for 1000 units of products B is USD1,500. However, the actual direct labor that incurred was only USD1,400. The total direct labor cost is USD100.

This direct labor cost variance is caused by two main factors. Or we can call two sub variances i.e. the labor rate variance (LRV) and the labor efficiency variance (LEV).

The labor rate variance (LRV) is the difference between the actual labor rate of production and the budget labor rate of production at the total production units.

For example, the labor rate per budget for product B is USD15 per hour and the actual labor rate paid was USD20 per hour. The total number of hours for 1,000 units of Product B was 1500 Hours. Therefore, the labor rate variance is 1,500*5.

The labor efficiency variance (LEV) is different between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour.

For example, the budgeted hours for 1,000 units of product B are 1,500 hours but the actual hours that used for these 1,000 units are 1,400 hours. If the standard rate is USD15, then the efficiency variance is 100*15

3) Overhead variance:

Overhead variance is the difference between the budget overhead at the standard rate or the applied overhead and the actual overhead incurred during the period.

In other words, It is the difference between the absorbed overheads and the actual overheads that have been incurred. The overhead variance is considering both fixed overhead or variable overhead.

For example, Company A incurred the actual overhead costs of USD100,000 to produce 500 units of product B.

The company has a budget overhead rate of USD50 per hour and direct labor hour is the cost drive to calculate the overhead expenses.

The company needs 3 hours to produce a unit of product B.

Based on this example, we can calculate applied overhead and it is equal to

50*3*500 = USD75,000

The actual overhead is USD100,000

Therefore, overhead variance = 100,000 – 75,000 = USD25,000

Since the actual overhead is higher than, then the variance is USD25,000 adverse. It means the company incurred more overhead than what it has budgeted.

If we want to know what contributes to the total variance the most, we can break it down by calculating the fixed overhead total variance and variable overhead total variance.

The overhead variance can be divided or breakdown into subcategories, two the fixed overhead total variance and the variable overhead total variance.

Now, let see fixed overhead total variances:

The fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead absorbed.

For example, a company plans to produce 2,000 units of product A in December 2020. The budget hours to produce a unit of A is 4 hours, and the budgeted fixed overhead is USD40,000. The standard fixed overhead cost per unit of product A will, therefore, be as follows:

4 hours * 5$ = 20$ per unit

The company incurred actual fixed overhead USD45,000 for 2,300 units.

Therefore,

The fixed overhead total variance is

Overhead incurred = 45,000

Overhead absorbed = 2,300*20 = (46,000)

Fixed overhead total variance = (1,000)

Now, let see the variable overhead variance

The variable overhead variance is basically referred to as the variance between the total variable costs at the standard rate for the actual output and the actual variable overhead at the actual output.

For example, the company incurred variable costs at the standard rate for the actual output is USD35,000 and the actual variable overhead at the actual output is USD30,000. Therefore, the variable overhead variance is 5,000 favorable.

4) Sales variance:

A sales variance is the difference between the actual sales and budgeted sales. It is caused by either a change in price or a change in volume.

It is actually the sum of the two sub-variances i.e. the sales price variance and the sales volume variance.

The selling price variance is a measure of the effect on the expected profit of a different selling price to standard selling price.

It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was.

The sales volume profit variance is the difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit.

In other words, it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted (planned).

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