Variance Analysis

Variance analysis is a tool that can make or break a company’s financial performance. It’s not just for big corporations but for anyone handling a business’s money – from small businesses to big firms. It helps you compare what you expected to happen versus what actually happened. So, let’s break it down without the jargon. It’s all about understanding how well things are going financially and why they might be going off track.

What’s Variance Analysis?

At its core, variance analysis is comparing actual financial results to the budgeted or expected numbers. Simple, right? You plan out how much money you think you’ll make and how much you think you’ll spend. Then, you check if you hit those targets. If you don’t, why not? This “why not” part is where the magic happens.

When a company makes a plan for the future (like sales, expenses, or profits), they have to stick to it. If they don’t, there’s usually a reason. Variance analysis helps them figure out if they need to change course or just fine-tune things.

Why Is Variance Analysis Important?

Most businesses want to make money and stay on budget. But sticking to those budgets isn’t always easy. That’s where variance analysis comes in. Here’s why it’s crucial:

1. Tracking Performance: By looking at how much you planned to earn or spend versus what actually happened, you can see if you’re on the right path. It’s similar to a financial performance review.
2. Spotting Problems Early: If expenses are higher than expected, variance analysis will highlight this early. This way, you don’t find out too late that your budget’s totally off.
3. Making Decisions: It helps you decide what to fix and how to fix it. Maybe you need to cut costs, sell more, or change your pricing strategy. Variance analysis tells you exactly what needs attention.
4. Cost Control: Keeping costs low is key to staying profitable. If a certain cost is higher than expected, variance analysis points it out, allowing you to adjust.
5. Risk Reduction: The earlier you catch a financial problem, the better you can deal with it. Variance analysis helps you spot risks before they get out of hand.

Types of Variance

Variance analysis isn’t just a one-size-fits-all deal. There are two main types: cost variances and revenue variances. Let’s look at each one:

1. Cost Variance

This type looks at whether the actual cost of things is higher or lower than what you planned. There are a few subcategories here:

• Material Cost Variance: If you’re making a product, the cost of materials can change. If you budgeted Rs.10 per unit of material but spent Rs.12, that’s a variance. Why did it happen? Did prices increase, or did you use more material than expected?
• Labor Cost Variance: The same goes for labor costs. If you thought it would cost Rs.50 to make something but it cost Rs.60, that’s a variance. This can happen if you paid workers more or they took longer than expected.
• Overhead Cost Variance: Overhead costs (like rent, utilities, etc.) also matter. If your actual overhead is more than what you planned for, it’s important to figure out why.

2. Revenue Variance

Revenue variance looks at how much money you actually earned compared to what you expected. Two main factors drive this:

• Sales Volume Variance: If you planned to sell 100 units but sold 150, that’s a favorable variance. On the flip side, if you only sold 50, it’s an unfavorable variance.
• Sales Price Variance: Sometimes, the price per item can differ from your expectations. Maybe you planned to sell a product for Rs.20, but sold it for Rs.18 instead. That’s a variance.

How to Do Variance Analysis

You don’t need a degree in finance to get this. Here’s how you can run a basic variance analysis:

1. Create a Budget: You start by setting a target – how much you expect to make and spend. Depending on your company, this might be done regularly or annually.
2. Track Actual Results: After the month or quarter is over, gather all the real numbers. How much did you actually earn? How much did you really spend?
3. Calculate the Variances: Subtract the actual numbers from your budgeted ones. In case the result is positive, it is a beneficial variance, and on the other hand, if it’s negative, it becomes unfavorable for the business.
4. Dig into the Causes: Now that you’ve spotted a variance, ask why. Did something unexpected happen, like a price hike or a drop-in sale?
5. Take Action: Based on your findings, you might need to change your approach. Maybe it’s time to cut back on spending or ramp up marketing to boost sales.

Common Pitfalls in Variance Analysis

While variance analysis is useful, it’s not foolproof. Here are some things to watch out for:

• Focusing Too Much on Small Variances: Not all variances are a big deal. Sometimes, the difference is so small that it won’t affect the overall performance. Focus on the bigger issues.
• Not Getting to the Root Cause: Finding the variance is just half the battle. You need to figure out why it happened. Maybe a supplier raised prices, or sales didn’t go as expected due to bad weather.
• Ignoring External Factors: Sometimes variances happen because of factors beyond your control, like a recession or a new competitor. Keep these in mind when analyzing your numbers.

Questions to understand your ability

Q1.) Why do businesses do variance analysis?

A) To figure out profits
B) To check if actual results match the budget
C) To create a new budget
D) To get ready for tax season

Q2.) Which of these isn’t a cost variance?

A) Material Cost Variance
B) Sales Price Variance
C) Labor Cost Variance
D) Overhead Variance

Q3.) If you planned to sell 100 units but only sold 50, what’s that?

A) A win
B) A failure
C) A break-even point
D) Price issue

Q4.) After spotting a variance, what’s the next move?

A) Ignore it and move on
B) Ask why it happened and fix it
C) Change everything right away
D) Wait till the end of the year

Q5.) What’s the problem with obsessing over tiny variances?

A) It leads to unnecessary changes
B) It helps with perfect decisions
C) It’ll make you rich
D) It stops big problems from being noticed

Conclusion

Variance analysis is like a map for your business’s finances. It tells you where you are compared to where you wanted to be, and it shows you how to get back on track if needed. Whether you’re just starting out or working in a large corporation, variance analysis helps you stay on top of your financial game. You’ll understand what’s working, what’s not, and most importantly, why things are happening the way they are. So, don’t just glance at the numbers – dive in, ask questions, and make better decisions.