What is Variance Analysis in Budgeting?
Variance analysis is budgeting is the study of deviation of the actual outcome against the forecasted behavior in finance. This is essentially concerned with how the difference between actual and planned behavior indicate and how business performance is being impacted.
Business can often improve their result if they will first plan their standards for their performance but sometimes, their actual result doesn’t match their expected standard results. When the actual result comes in, Management can focus on variances from the standards to find area needing improvement.
For Example, let’s assume that Taj Hotel pays housekeeping crew $5 per hour. Did the Housekeeping crew take longer to clean the room then that management planned? This result in a direct Labour Variance efficiency.
Explanation of Variance analysis in Budgeting
Suppose a company set a target to make a profit of an amount of $100 million by selling good worth $200 million and the total production cost is $100 million.
But at the end of the year, the company observed that the profit is $50 million instead of $100 million which is not a good fit for an organization so the company has to think about the reason for not achieving the target set by the company. There are certain factors that affect the profit of the company by analyzing the facts they came to know that the production cost changes from $100 million to $120 million. Production cost changes due to the following factors
- Change in Material cost.
- Change in Labour Cost
- Change in Overhead Cost
So the difference from the Actual output to the Standard output is called as variance
Types of Variance
- Controllable variance can be controlled by taking necessary action
- Uncontrollable Variance (UV) is the beyond the control of Departmental head.
- If UV is standard in nature and persistent, the standard may require revision
- It is very important to know the cause of variance analysis so that one can approach for corrective measure
Top 4 Types of Variance analysis in Budgeting
Given below are the Top 4 types of Variance Analysis
#1 – Material Variance Analysis
- If you pay too much then the purchasing cost increases
- If you use too many materials then the production cost increase
Both purchasing and production cost are dependent on each other so we have to look into not only the purchasing cost but also the Production Cost to know the total variance as well.
Example of Material Variance Analysis
Given below is the example of material variance
A: (Standard Quantity: 800 Kg)* (Standard Price: Rs.6/-) – (Actual Quantity: 750kg)*(Actual Price: Rs.7/-)
B: (Standard Quantity: 400 Kg)* (Standard Price: Rs.4/-)– (Actual Quantity: 750kg)*(Actual Price: Rs.5/-)
The Impact of the variance of Cost of Material is due to Price and Quantity
Impact of Price on Material Variance Analysis
The Variation of Price for Type A is (Rs.7/- minus Rs.6/-) for 750 Kg
- Impact of Price on Material A : ( Rs.1/-)*(750Kg) = Rs.750 (A)
The Variation of Price for Type B is (Rs.5/- minus Rs.4/-) for 750 Kg
- Impact of Price on Material B : ( Rs.1/-)*(500Kg) = Rs.500(A)
Total impact of Price = Rs.750 (A) + Rs.500 (A)= Rs.1250 (A)
- *F stands for Favourable
- *A stands for Adverse.
Impact of Quantity on Material Variance analysis
Variation of Quantity Used in Type A material is (800 Kg- 750Kg)*6
- Price due to change in Quantity or Type A is: 300(F)
Variation of Quantity Used in Type B material is (400 Kg- 500Kg)*4
- Price due to change in Quantity or Type A is: 400(A)
Impact of Quantity on Cost Variance is 300(F)-400(A) = 100(A)
Quantity further can be analyzed into two category i.e Yield and Mix, Yield occurs due to use of inferior material or excess material whereas Mix is due to using of a combination of two material in a different proportion during a production process.
#2 – Labour Variance Analysis
Labour Variance occurs when the actual cost of labor differ from the projected labor Cost
- If you paid too much that will be personal
- If you use too many hours which is called efficiency of the Labour that will affects the production
Example of Labour Variance Analysis
Standard (4 pieces production for 1 Hour)
- Skilled: 2workers@20/
- Semiskilled: 4 workers@ 12/-
- Unskilled: 4 Workers@ 8/-
- Skilled: 2workers@20/
- Semiskilled: 3 workers@ 14/-
- Unskilled: 5 Workers@ 10/-
- 200 Hours Work
- 12 Hours Idle time
- 810 Pieces Production
- Actual Time for Skilled Worker: 200*2(No .of Employee) = 400 Hours
- Actual Time Work for Skilled Worker: (200 Hrs- 12(Idle Time)*2(No of Employee) = 376 Hours
Standard Time for Skilled Worker
- To produce 4 Pieces (Standard time) a skilled worker needed 2 Hours so to produce 810 pieces standard time required
- 4/2 *(810)= 405 Hours
Direct Labour Cost Variance Analysis
- (Standard time* Standard Rate)- (Actual Time*Actual Rate)
Direct Labour Rate Variance Analysis
- (Standard Rate- Actual Rate)*Actual Time
Direct Labour Efficiency Variance Analysis
- Standard Rate*(Standard Time – Actual Time)
Reasons for Labour Variance
- Time-Related Issues.
- Change in design and quality standard.
- Low Motivation.
- Poor working conditions.
- Improper scheduling/placement of labour.
- Inadequate Training.
- Rate Related Issues.
- Increments / high labor wages.
- Labour shortage leading to higher rates.
- Union agreement.
#3 – Variable Overheads (OH) Variance Analysis
Variable overheads include costs such as
- Patents that have to be paid on units produced
- Power Cost per unit produced
The total overhead variance is the difference between
- The actual Variable Overhead incurred for the actual output of the business
- The standard variable overhead we should have incurred for the actual output
- Variable OH Variance=(SH*SR)-(AH*AR)
Example of Variable Overheads Variance Analysis
Reasons for Overheads Variance Analysis
- Under or over absorption of fixed overheads.
- Fall in demand/ improper planning.
- Breakdowns /Power Failure.
- Labour issues.
- Lack of planning.
- Lack of cost control
#4 – Sales Variances Analysis
- Sales Value Variance = Budgeted Sales – Actual Sales
Further Sales Variance is due to either change in sales price or Change in Sales Volume
- Sales Price Variance = Actual Quantity (Actual Price – Budgeted Price)
- Sales Volume Variance = Budgeted Price (Actual Quantity – Budgeted Quantity)
Reasons for Sales Variance
- Change in Price.
- Change in Market Size.
- Change in Market Share
- Change in Customer Behaviour
Thus Variance analysis helps to minimize the Risk by comparing the actual performance to Standards.
This has been a guide to what is Variance analysis. Here we look at the calculation and examples of top 4 types of variance analysis including material variance, sales variance, labor variance, and variable overheads. You may also take a look at the following articles:-