What Are Variances In Accounting

Decoding Variances in Accounting: A Comprehensive Guide

Understanding variances in accounting is crucial for any business, regardless of size. Variances represent the difference between planned or budgeted figures and the actual results. This article provides a comprehensive explanation of variances, their types, calculation methods, and how they can be used to improve business performance. We'll cover various aspects, from simple sales variances to more complex manufacturing variances, ensuring a thorough understanding for both beginners and those seeking to deepen their knowledge.

Introduction to Variances

In accounting, a variance is the difference between a budgeted, planned, or standard cost and the actual amount incurred. Analyzing these variances allows businesses to identify areas of strength and weakness in their operations. By understanding why variances occur, businesses can make informed decisions to improve efficiency, profitability, and overall financial health. The process of investigating and interpreting variances is known as variance analysis. This analysis is a key component of management accounting and provides vital insights for strategic planning and decision-making.

Types of Variances

Variances can be categorized in many ways, depending on the context. However, some common types include:

1. Sales Variances: These variances focus on the difference between actual and budgeted sales revenue. They can be broken down further:

Sales Price Variance: The difference between the actual selling price and the budgeted selling price, multiplied by the actual quantity sold. A positive variance indicates prices exceeded expectations, while a negative variance signifies prices fell short.
Sales Volume Variance: The difference between the actual quantity sold and the budgeted quantity sold, multiplied by the budgeted selling price. This variance isolates the impact of changes in sales volume on revenue.

2. Material Variances: In manufacturing, material variances are critical for cost control. They include:

Material Price Variance: This variance measures the difference between the actual price paid for materials and the standard or budgeted price, multiplied by the actual quantity used. It highlights inefficiencies in purchasing or unexpected price fluctuations.
Material Usage Variance: This variance shows the difference between the actual quantity of materials used and the standard quantity allowed for actual production, multiplied by the standard price of materials. It identifies issues with material wastage, inefficient production processes, or poor quality materials.

3. Labor Variances: These variances analyze the costs associated with labor:

Labor Rate Variance: The difference between the actual labor rate and the standard labor rate, multiplied by the actual labor hours worked. This points to issues like paying above-standard wages or employing higher-skilled labor than planned.
Labor Efficiency Variance: The difference between the actual labor hours worked and the standard labor hours allowed for actual production, multiplied by the standard labor rate. This variance reveals inefficiencies in labor productivity, possibly due to training deficiencies, equipment malfunction, or poor work scheduling.

4. Overhead Variances: Overhead costs, which are indirect costs not directly tied to production, also have variances:

Variable Overhead Spending Variance: This variance compares the actual variable overhead costs to the budgeted variable overhead costs. It highlights discrepancies in variable overhead spending.
Variable Overhead Efficiency Variance: This variance compares the actual hours of machine time or labor used with the standard hours allowed for production, multiplied by the standard variable overhead rate. It measures the efficiency of variable overhead usage.
Fixed Overhead Spending Variance: The difference between the actual fixed overhead costs and the budgeted fixed overhead costs. This variance shows deviations from the planned fixed overhead budget.
Fixed Overhead Volume Variance: This variance arises from the difference between the actual production level and the budgeted production level, multiplied by the budgeted fixed overhead rate per unit. It illustrates the impact of production volume on fixed overhead absorption.

Calculating Variances: A Step-by-Step Approach

The calculation of variances typically involves comparing actual results to budgeted or standard figures. Here’s a general approach:

Identify the Standard or Budgeted Value: Determine the expected cost or revenue based on planning and budgeting.
Determine the Actual Value: Gather the actual cost or revenue figures from accounting records.
Calculate the Variance: Subtract the budgeted value from the actual value. A positive variance is favorable (better than expected), while a negative variance is unfavorable (worse than expected).
Analyze the Variance: Investigate the causes of the variance. This often requires further investigation into operational data and potentially interviewing staff involved.

Example: Material Price Variance

Let's assume a company budgeted to buy 1000 units of raw material at $10 per unit. However, they actually purchased 1100 units at $12 per unit.

Budgeted Cost: 1000 units * $10/unit = $10,000
Actual Cost: 1100 units * $12/unit = $13,200
Material Price Variance: $13,200 - $10,000 = $3,200 (Unfavorable)

This unfavorable variance of $3,200 indicates that the company paid more for the material than anticipated.

Understanding Favorable and Unfavorable Variances

It's crucial to understand that the terms "favorable" and "unfavorable" are relative to the specific variance. A favorable sales price variance (higher actual price than budgeted) is generally good, but a favorable material usage variance (less material used than expected) might indicate a potential quality issue if less material resulted in fewer finished goods. Always consider the context and investigate the root causes behind the variance before drawing conclusions.

The Importance of Variance Analysis in Decision-Making

Variance analysis is not merely about identifying differences; it’s about using those differences to improve business performance. By thoroughly analyzing variances, managers can:

Improve Budgeting Accuracy: Identify flaws in the budgeting process and refine future budgets for greater accuracy.
Enhance Operational Efficiency: Pinpoint inefficiencies in production, purchasing, or sales processes.
Improve Cost Control: Implement measures to reduce costs and improve profitability.
Enhance Product Quality: Identify issues that lead to material waste or labor inefficiencies, potentially affecting product quality.
Improve Strategic Decision-Making: Use variance information to inform decisions on pricing, production levels, and resource allocation.

Advanced Variance Analysis Techniques

While basic variance calculations are straightforward, more sophisticated techniques can provide deeper insights. These include:

Investigating Interrelationships: Often, variances are interconnected. For example, a favorable labor efficiency variance might be offset by an unfavorable material usage variance if workers rushed through the process to save time, leading to greater material waste. Identifying these relationships requires careful investigation.
Using Statistical Methods: Statistical analysis can help identify trends and patterns in variances over time, which can aid in forecasting and proactive management.
Benchmarking: Comparing variances against industry benchmarks or competitors' performance can provide a broader perspective and highlight areas for improvement.

Frequently Asked Questions (FAQ)

Q1: What are some common causes of sales price variances?

Changes in market demand
Competitive pricing pressures
Changes in customer preferences
Marketing and promotion effectiveness
Pricing strategies

Q2: How can I improve material usage variance?

Implement stricter quality control measures for incoming materials.
Improve employee training on efficient material handling techniques.
Upgrade equipment to reduce waste.
Invest in better inventory management systems.

Q3: Why is labor efficiency variance important?

Labor efficiency variance is critical because it directly impacts production costs and profitability. A large unfavorable variance could indicate issues with employee training, equipment problems, or poor work scheduling, all leading to higher labor costs per unit.

Q4: How can I reduce overhead variances?

Review and optimize fixed overhead costs regularly.
Implement better control mechanisms over variable overhead expenses.
Monitor energy consumption and other utility costs.
Regularly assess the efficiency of overhead processes.

Q5: What software can assist with variance analysis?

Many accounting software packages, enterprise resource planning (ERP) systems, and specialized business intelligence tools have built-in capabilities for variance analysis and reporting.

Conclusion: The Power of Understanding Variances

Variance analysis is a powerful tool for businesses of all sizes. By understanding the types of variances, mastering calculation methods, and thoroughly investigating the underlying causes, businesses can significantly enhance their operational efficiency, improve cost control, and make more informed strategic decisions. Remember that the goal isn't just to identify variances but to use them as a pathway to continuous improvement and increased profitability. The insights gained from variance analysis can lead to more robust budgeting, more efficient processes, and a stronger financial future. Investing time and resources in understanding and implementing variance analysis is a worthwhile investment in the long-term success of any organization.