Variance Analysis in Management Accounting: Experts Guide

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Although forecasting is based on mathematical algorithms and historical data, it’s not always entirely accurate because of the fluidity of business and their surrounding environments. As such, variance analysis in management accounting helps companies to understand how their forecasts differ from actual situations.

In this article, we’ll look at how a variance analysis formula can be of aid, and how automation solutions can play a pivotal role in forecasting correctly from the start.

Coming Up

What is Variance Analysis?

What is the Importance of Variance Analysis?

What are the Problems of Variance Analysis?

How is Variance Analysis Used?

What are the Types of Variances?

What is the Role of Standards in Variance Analysis?

How to Define a Variance? Budget vs Costs

What are Favourable vs Unfavourable Variances?

The Bottom Line

What is Variance Analysis?

Variance analysis is as it sounds - the analysis of the variance between forecasting and actual numbers. With the sum of all variances, you can see how the business either over or under-performed for each given reporting period.

Not only does variance analysis help you to deduce how far your forecasts are from reality, but they also allow you to compare your numbers to industry benchmarks. Ultimately, variance analysis is a part of management accounting that allows business leaders and stakeholders to review their products’ and services’ cost and profitability.

What is the Importance of Variance Analysis?

Variance analysis in management accounting is of great value to anyone who performs it. Here’s what you stand to gain from performing variance analysis:

1. Internal Control

Variance analysis is a great way to oversee how your business functions. It places a spotlight on deviations from what’s considered standard. As such, you’re able to understand what is affecting your business’ financial performance.

2. Planning

For variance analysis to work, it all has to start with budgets and forecasts in advance. This is what you get to compare the actual numbers to for any project. So, if you’re consistently performing variance analysis, you will be consistently planning, budgeting, and setting benchmarks, which all work to improve your business’ functions.

3. Accountability

Since variance analysis helps to categorise each line item by department, it adds a level of responsibility to each division. For example, if the cost of materials is rising which causes a material price variance, then the procurement department is the responsible party to deal with adjustments.

What are the Problems of Variance Analysis?

Variance analysis in cost accounting is incredibly useful for any size business to perform. But alongside its benefits, there are also some challenges that arise. These include:

  • Variance Source Information: At the heart of every forecast and analysis sits data. If data isn’t located in accounting records, then it becomes time-consuming to source the initial data and perform variance analysis or to correct any problems.
  • Delayed Timing: Typically, the accounting team is responsible for performing variance analysis at the end of the month and then sharing it with the management team. However, management teams need access to this type of valuable information more often than once a month.
  • Standard Setting: There must be standards set to identify benchmarks and budgets from the start, which can’t be affected by political bargaining or anything else. The result of variance analysis depends on the validity of the standards set from the start.

Finance automation solutions can help overcome these challenges. Automation solutions are able to connect to all of your data sources and centralise the necessary information at your fingertips for use. Additionally, since the tool can execute analysis with the click of a button, you gain analytics as quickly as you want them, and even in real time, rather than having to wait until the end of each month.

How is Variance Analysis Used?

Variance analysis in management accounting serves various purposes. At the top of the list, it helps managers to outline, understand, and rectify any major shifts in what’s expected from a budget versus the actual amount being spent. It can be used for any department, including sales.

Here’s a list of some of the types of variances in accounting that can offer useful insights:

  • Labor efficiency variance
  • Material yield variance
  • Purchase price variance
  • Selling price variance
  • Labor rate variance
  • Variable overhead efficiency variance

These types of variance analysis help to see the price and quantity of labour, materials, and overhead costs to maximise revenue and minimise costs. Management is in the loop so that decisions can be made based on the numbers, with a goal to improve the company’s overall performance.

If you perform variance analysis manually, you’ll have to prioritise which type to focus on because there’s only so much time in a day. However, if you leverage finance automation software, you can perform any analysis you want at any point in time depending on what’s most important to the business at that time.

Additionally, along with automating variance analysis, financial automation solutions can streamline processes like: revenue management, rebate management, APRA reporting, account reconciliation, and more.

What are the Types of Variances?

When you’re ready to implement variance analysis in cost accounting, it’s useful to know the different methods that you can use and types of variances to prioritise. Here’s a good place to begin:

1. The Column Method

Also called the cost vs. budget approach, this form of variance analysis includes placing the budgeted values in one column and the actual results in a column next to the budget. Then, you can calculate the variances (or gap) between the two columns in the third column.

2. Materials Variance

Materials variance shows the difference between the actual cost of raw materials versus the standard (or expected) cost of the same materials. The variance analysis formula for materials variance is: Vm = (Actual quantity purchased * actual unit cost) - (actual quantity purchased * standard unit cost).

3. Labour Variance

Labour variance is much like materials variance except instead of assessing materials, you’re focused on the cost of labour. The reason for labour variances may be because of the difficulty of production, the amount of time production ends up taking, and the actual cost of labour itself.

4. Fixed Overhead Variance

At the end of the period, the cost accounting reporting package includes your fixed overhead variance. This displays the difference between the amount of fixed overhead that was used to produce products versus the amount that was budgeted. Fixed overhead costs include: rent, salaries, equipment depreciation, insurance, etc.

What is the Role of Standards in Variance Analysis?

Variance analysis in cost accounting relies on setting standards. A standard is considered the “norm” or a benchmark to base your expectations off of. Standards are set by industry and set for items like labour, materials, and overhead costs needed to produce goods and offer services.

Without standards, you’d have nothing to set your actual experience against in order to judge if you’re performing better or worse off than expectations. Standards also help you to define reasonable goals for your business when it comes to labour, materials, and production.

How to Define a Variance? Budget vs Costs

Defining a variance depends on two main factors: setting a budget and tracking your actual costs. Identifying and recording all business costs is a must-do within the process of variance analysis.

As such, if you’re managing many transactions and different line items, it can become overwhelming to keep track of everything. This is where a finance automation solution can be a gamechanger from the start.

Finance automation solutions store all your transaction data so you can easily refer back to it and perform automated calculations with actual numbers at the end of a project or accounting period.

Remember to keep track of labour, materials, and overhead costs. Once you have your actual numbers (when the project or production comes to an end), you can deduce how you performed against the benchmarks that were set in advance.

What are Favourable vs Unfavourable Variances?

Culminating variance analysis in management accounting leaves you with two potential outcomes.

You may find yourself with:

  • Favourable variances: This happens when the actual costs turn out to be lower than what was budgeted.
  • Unfavourable variances: On the other side of the coin, this is when you end up having to spend more than what you had set out to in the budget.

Undoubtedly, any company would hope for favourable variances, but that doesn’t mean that you’d want to purposefully underestimate your budgets. The entire point is to set your budgets as accurately as possible based on industry standards. This way, you can gauge how your business is performing against what’s expected.

Variances will ultimately impact your financial statements, including your income statement and balance sheet. Higher costs result in increased spending, which can cause a cash flow shortage.

Since businesses are fluid, as are costs, budget variances are likely to shift from one reporting period to another. That’s why it’s a best practice to perform variance analysis on a monthly basis. With the aid of automation solutions, this practice is seamless rather than time-consuming and overwhelming.

The Bottom Line

Variance analysis in management accounting helps businesses to reach their goals while remaining realistic about costs and budgets. Although materials, labour, and overhead costs are likely to shift, keeping an eye on variance analysis is one of the best ways to stay on top of how your business allocates its finances and performs.

With finance automation software, variance analysis doesn’t become just another to-do, it becomes an “It’s already done” as the automation solution streamlines your analysis and provides you with instant insights.

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