Variance Analysis

It assesses how far apart each number in a collection is from the mean (average) and, consequently, from each other

Variance is a measurement of the range of values within a collection of data. It assesses how far apart each number in the collection is from the mean (average) and, consequently, from each other. 

Variance Analysis

This symbol is frequently used to represent variation: σ2. Both analysts and traders use it to assess market volatility and risk.

The standard deviation (SD), which aids in determining the consistency of an investment's returns over time, is the square root of variation (thus, it is signified with σ).

Investors use it to assess an investment's risk level and potential profitability. It is also used to get the ideal asset allocation in a portfolio.

On the other hand, discrepancies between planned and actual numbers are the focus of variance analysis. A picture of the overall over- or under-performance for a certain reporting period may be obtained by adding all variations together. 

Companies evaluate their favorability for each item by contrasting real costs with average costs in the sector.

We refer to the main role of "variance analysis" as the difference between standards and actual performance figures. The price and quantity of the materials, labor cost, and variable overhead are computed and reported to management. 

Differentiations are not all significant, however.

Only those that are uncommon or especially important need management's attention. Businesses may frequently utilize the information obtained from examining these differences to either better their overall performance or to pinpoint an issue that needs to be corrected.

The Most Common Types of Variance Used in Analysis

The most typical generated variances for variance analysis are listed below. It is, however, not required to keep track of every variation mentioned. One or two variations may be enough to evaluate in many companies. 

Equality

For instance, a company that provides services (like a consulting firm) may only be interested in the labor-efficiency variation, while a manufacturer operating in a market with intense competition might be more interested in the buy-price variance. 

In other words, focus most of your variance analysis efforts on the variations that, if addressed, would have the most impact on your business.

  • Overhead Costs: Deduct the standard variable overhead cost per unit from the actual cost incurred, then multiply the remaining amount by the total number of production units.
  • Variation in Fixed Overhead Costs: The total amount of fixed overhead expenditures for the reporting period surpasses their overall standard cost.
  • Buy/Purchase Price: The actual cost of materials used in the manufacturing process, less the standard cost, multiplied by the quantity utilized.
  • Labor Rates: The actual cost of the direct labor utilized in the production process, less the standard cost, divided by the quantity used.
  • Labor Efficiency: Deduct the standard amount of labor from the actual amount, then multiply the remaining amount by the standard labor rate per hour.
  • Variable Fluctuation in Overhead Efficiency: Calculate the difference between the budgeted units of activity on which the variable overhead is paid and the actual units of activity, multiplied by the standard variable overhead cost per unit.
  • Selling Price: The actual selling price, less the standard selling price, multiplied by the number of units sold.
  • Material Yield: Subtract the total standard quantity of materials from the level of usage that actually occurred, then multiply the remaining amount by the price per unit.

Technicality

The "standard" term mentioned above is a baseline in cost accounting used to gauge performance. Standards are often set for the price and amount of materials, labor, and overhead required to manufacture items or render services.

Quantity standards specify how many hours of effort or kilograms of materials should be utilized to produce one unit of a good. Cost standards, on the other hand, specify what the true cost of the work hour or material should be. 

Standards are essentially projections of the costs or quantities that a corporation will experience.

Challenges

Variance analysis has several issues that prevent many businesses from implementing it:

Confusion

1. Time Delay: The management team receives the data from accounting staff after the end of the month, after compiling the variances. 

Management frequently relies on additional metrics or warning flags that are produced immediately. This is especially important in a fast-paced workplace since input is needed much more often than once per month, especially in production.

2. Setting of the Standard: Variance analysis basically compares the actual outcomes to an artificial norm that could have been arrived at through political haggling. Therefore, the resultant variance might not provide any insightful data.

3. Source of Information: The accounting staff must go through data like bills of material, labor routings, and overtime records to identify the root causes of issues because many of the causes of variations are not found in the accounting records. 

Only when management can actively rectify issues based on this knowledge is the additional work cost-effective.

Instead of using variance analysis, many businesses choose to look into and evaluate their financial data using horizontal analysis. This method shows the outcomes of many periods side by side, making it simple to see trends.

Example

The overhead for the tables produced by ABC Company is calculated based on the number of direct labor hours.

Question

Given: 

Standard costs:

  • 5000 hours of activity (denominator) 
  • Five pieces per table, priced at $0.10 each (Direct Material)
  • 1.5 hours of work for each table at a wage of $10 per hour (Direct Labor) 
  • 1.5 hours per item at $5 per hour (Variable Manufacturing Overhead) 
  • 1.5 hours per device at an hourly rate of $8 (Fixed Manufacturing Overhead)

Actual costs:

  • ABC Company produced 2,500 tables.
  • The fixed overhead expense budget was $20,000
  • 25,000 pieces purchased at $0.25 per piece (Direct Material)
  • 4,000 hours were worked for a total of $35,000 (Direct Labor)
  • The actual variable cost was $15,000 (Variable Manufacturing Overhead)
  • The actual fixed cost was $17,500 (Fixed Manufacturing Overhead)

Try to apply the given data to the variance analysis calculations below to understand better the calculation process and what will be "favorable."

1. Material Variance

Companies may use the material variance to pinpoint areas where they may be consuming more materials than necessary. 

Market

For instance, if a business has to place a second order for supplies due to quality issues, the extra expenditures may generate a discrepancy in their analysis. 

This data may be used by the business to decide whether to stick with the current material supplier or look for a different one. 

The following material formulae may need to be used in this analytical procedure to determine both individual and total variances:

Quantity variance = (actual quantity x standard price) - (standard quantity x standard price) 

Price variance = (actual quantity x standard price) - (actual quantity x actual price) 

Variance = quantity variance + price variance

2. Labor Variance

Companies may use the labor variance to determine how effectively they employ labor and how effective their pricing is. 

For instance, if a business analyzes variation and discovers inefficiencies or greater labor costs, it may decide to make improvements for the following fiscal year. 

The firm might be able to save money and further simplify processes using this information. To determine both individual and total deviations, this analytical procedure may call for the use of several material formulas:

Rate = (Actual hours x actual rate) - (actual hours x standard rate)

Efficiency = (Actual hours x standard rate) - (standard hours x standard rate) = efficiency variance

Variance = Rate variance + Efficiency variance

Teamwork

3. Fixed Overhead

Companies may be able to find discrepancies between the number of used overhead costs and the number of planned overhead costs by comparing the fixed overhead variance to the number of used overhead costs.

They may calculate this based on production volumes.

For instance, if a business wishes to review its spending plans, it may utilize fixed overhead variance to determine if it would be feasible to cut its present budget.

By using this information, the firm may be able to save costs or reallocate funds to other parts of the operation.

In order to determine both individual and total variations, this analytical method may necessitate the application of many material formulations, including:

Budgeted fixed overhead cost = denominator level of activity x standard rate

Budgeted variance = actual fixed overhead cost - budgeted fixed overhead cost 

Fixed overhead cost applied to inventory = standard hours x standard rate

Volume variance = budgeted fixed overhead cost - fixed overhead cost applied to inventory

Overall = budget variance + volume variance

Key Takeaways

  • The range of values within a set of data is measured by variance. The distance between each number in the collection and the mean (average) and, consequently, the distance between each other is measured.
  • The discrepancy between expected performance levels and actual performance levels is what we refer to as the major purpose of "variance analysis." The materials' cost and quantity, labor costs, and variable overhead are calculated and reported to management.
  • The most common types of variances used in the analysis are:
    • Variation in fixed overhead costs
    • Overhead Costs
    • Buy/purchase price
    • Selling price
    • Material Yield
    • Labor rates
    • Labor efficiency
    • Variable fluctuations in overhead efficiency
  • Many firms opt to examine and assess their financial data utilizing horizontal analysis rather than variance analysis. This approach makes it straightforward to see trends by displaying the results of several periods side by side.
  • The difference between the actual cost of the materials used in production and the standard cost of the materials specified for the items produced causes material variances.
  • Labor variations refer to the difference between the workers' real pay and the going rate for the given output. When labor expenses exceed projected amounts, the variation is not in your favor.
  • The total of the expenditures for indirect materials, labor, and expenses is known as the overhead expense. The difference between the planned standard overhead expenses and the actual overheads incurred may result in overhead variations.
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Researched and authored by Chadi Kattoua l LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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