Differences between actual behavior and planned behavior are analyzed quantitatively in variance analysis. By investigating areas in which unexpected failures have occurred, this analysis serves to maintain control over a business. Variance analysis indicates a $ difference between what you PLANNED and what was ACTUAL.
The variance analysis is particularly useful when you analyze changes in a variance level from month to month on a trend line so that you can track any changes in the variance level more quickly. Compared to expectations, variance analysis also investigates these differences, and with this, you have a complete interpretation of these variances.
Common Variances and variance analysis
Variances are commonly derived from the following variance analysis factors:
Purchase price variance
This variance is calculated by the actual price you paid for materials used to complete the production process. Then it would help if you subtracted the standard or budgeted cost and then multiply the actual number of units purchased.
This ratio is more relevant when the business needs to decide the order quantity for the material to be purchased. It helps business managers to assess if purchases are expected to remain within the prescribed limit of the budget.
Further, the price is estimated when planning for the year. So, the standard price set in the budget may not reflect the actual price on account of inflation and other economic crunches.
So, It’s often discussed if price variance is controllable by the business managers. The manager can control not all aspects of the material supply, and however, supplier selection, the process of quotation, and price negotiation are dependent on the managers to a greater extent.
The following formula is used in the calculation of the purchase price variance.
Price variance = (Actual price – standard price) x Actual quantity purchased.
If the actual price is more than planned in the budget, the variance is adverse. On the other hand, if the actual price is less than the budget, the variance is favorable. Further, variance needs to be analyzed if that is controllable or uncontrollable by the business managers.
Labor rate variance
This variance is calculated based on the actual rate paid to the labor directly involved in the production process. Then you need to minus its budgeted or standard rate. In the end, you need to multiply the number of actual hours worked by the labor.
The following formula is used to calculate the labor rate variance.
Labor rate variance = (Actual rate – standard rate) x Actual hours worked by labor.
It’s important to note that this variance is only about the labor rate and is more about the human resource and payroll department of the business.
Variable overhead spending variance
This variance is calculated by subtracting the budgeted or standard variable overhead cost per unit from the actual cost. Then you need to multiply the remainder value with the total quantity of units for the output.
Following is the formula to calculate the variable overhead spending ratio
Variable overhead spending ratio = (Actual rate-standard rate) x Actual hours worked
This ratio helps to understand standard overheads and how much the business has incurred on overheads to perform the level of activity. Further, the overheads rate can be presented in terms of labor hours and machine hours as well.
Fixed overhead spending variance
This variance is for the total amount. And these are the fixed overhead costs that exceed your standard cost in a particular reporting period.
It’s one of the simplest ratios to understand and computed by a given formula.
Fixed overhead spending variance = (Actual fixed overheads- Budgeted fixed overhead)
If actual overheads are more than budgeted, the variance is adverse and favorable otherwise.
Selling price variance
This variance is calculated based on the actual selling price, then subtracted from your product’s budgeted or standard selling price. In the end, multiply it by the number of production units sold in the market.
This ratio helps to understand if the business has successfully sold products at a pre-set price or not. The following formula is used to calculate the selling price variance.
Selling price variance = (Actual selling price – Standard selling price) x units sold
Material yield variance
This variance helps if the business has efficiently used material in the production process. If there is a higher production loss, there seems to be an adverse material yield ratio. On the other hand, the expected variance is favorable if the business processes have been efficient.
The following formula is used to calculate the material yield variance,
(Actual usage – Budgeted usage) x standard cost per unit
So, such variance is calculated by subtracting the overall budgeted or standard quantity of materials from actual usage. Then you need to multiply with the standard rate; this results in the usage variance.
Labor efficiency variance
This variance is based on the math that what should have been the labor cost and what it has been in the actual. This variance arises due to the efficiency or speed of the work performed by the business. For instance, if the labor has maintained a speed of the work, the variance is expected to be favorable and adverse otherwise.
Following is the formula to calculate the labor efficiency variance.
Labor efficiency variance = (Actual hours – standard hours) x standard rate.
So, this variance is calculated by subtracting the standard or budgeted time of labor consumed from actual time and multiplying the value with the standard labor rate per hour.
Variable overhead efficiency variance
This variance is about the timing of the manufacturing/production process. If the production process is lengthy, it’s expected to consume more overheads and resources. On the other hand, if the process is relatively short, it’s expected to consume fewer resources or overheads with time.
The following formula is used to calculate the variable overhead efficiency ratio.
VOER = (Actual labor hours-Budgeted labor hours) x budgeted overhead per hour
Using this ratio, the efficiency of labor and machine hours can be assessed. Further, it’s quite logical to assume that lengthy periods of both machine and labor consume higher resources and vice versa. Likewise, controlling production hours can lead to improvement in the overall production and business profitability.
It is not compulsory to calculate all the variances at the same time. Many organizations follow different techniques and use a mix of these variances to arrive at a sound decision. So, the main objective of the variance analysis is to control the cost and enhance business profitability.
Conclusion for variance analysis
Variance analysis is an important managerial concept, and it’s been used by companies around the globe to control their cost and direct their efforts to enhance profitability. There are two main types of variances: rate and usage/efficiency.
Rate variance is when the business needs to control the purchasing price of the product that may be done by doing proper product research, analyzing new markets, negotiating prices with the suppliers, etc. On the other hand, efficiency variance is about the speed of the time completion. So, if the business can complete the work on a timely basis, it will lead to higher efficiency and higher business profitability.
Also read, the importance of financial analysis