What Is Variance Analysis? How To Calculate and Analyze Variances With Ease

Table of Contents

• What Is Variance Analysis?
• Variance Analysis: Key Vocabulary
• Why Is Variance Analysis Needed?
• Benefits of Conducting Variance Analysis
• Different Types of Variance Analysis
• Key Steps in Conducting Variance Analysis
• How to Calculate Variance Analysis: Examples and Formula
• Challenges of Variance Analysis in Accounting
• 4 Best Practices For Effective Variance Analysis
• Streamline and Enhance the Variance Analysis Process With OneStream

What Is Variance Analysis?

Variance analysis is the process of examining how and why actual figures for costs, sales, or other business metrics differ from initial projections.

There are several different applications for variance analysis, meaning companies that use it tend to focus on the metrics that are the most relevant for their business.

For instance, a manufacturing company might choose to run variance analysis on purchase costs, since this is directly relevant to its bottom line. On the other hand, a website development company doesn’t have much in the way of raw material costs to worry about. In that case, running variance analysis on labor costs or sales figures would be more appropriate.

Variance Analysis: Key Vocabulary

Before we go any further, let’s define a few key terms that will be useful in understanding how variance analysis works.

Why Is Variance Analysis Needed?

Analysis of variance is a key component of the broader field of financial planning and analysis (FP&A). It’s a good way of spotting trends in business-critical metrics so that companies can determine what they’re doing right, and where they could stand to improve their performance.

Making forecasts is one thing, but it’s crucial to measure how those forecasts match up to reality. When there’s a big discrepancy, it’s important to ask why. Did company performance exceed or significantly undershoot projections? Or were the forecasts themselves too ambitious or pessimistic?

Drilling down into the details of why a discrepancy occurs allows a company to adjust its strategy to improve future performance. But this is only one of several benefits of analyzing variance.

Benefits of Conducting Variance Analysis

Carrying out a variance analysis regularly provides many advantages to businesses. Here are a few of the main ones.

1. Allows Problems to Be Identified

First and foremost, a variance analysis can be the first, vital step in identifying a problem that needs to be addressed. Let’s say a company that makes furniture conducts variance analysis on purchasing costs.

Suppose the analysis finds that the cost of buying raw materials is 20% more than forecast for a particular time period. On further examination, it turns out that suppliers have hiked the price for a particular type of hinge used in a core product.

Over time, continuing to use this hinge could threaten profitability. Management can then make a decision to resolve the problem, possibly by downgrading to a cheaper hinge, raising prices for finished goods, or some mixture of the two.

2. Useful For Assessing Managerial Performance

In some circumstances, variance analysis can be useful for determining how well individual managers are performing. In the case of the furniture company, the analyst might well research whether managers could have done anything to pre-empt the situation, for example, by attempting to negotiate bulk discounts on the hinges.

This is one reason why going into granular detail is such a vital element of carrying out variance analysis. The top-line numbers will show you the patterns, but digging deeper to examine why those patterns are emerging. Sometimes, it can even point to areas where staff could benefit from further training.

3. Enables Tighter Control of Operations

Imagine if the furniture company hadn’t done any variance analysis. What then? It’s quite possible the hinge cost issue could have flown under the radar for a prolonged period of time.

The fact that the variance analysis alerted management to the problem meant they could step in and do something about it. In other words, it put control in their hands, allowing them to resolve the issue as quickly as possible.

4. Helps Improve Business Strategy

Finally, there’s the big-picture aspect. Taking a systematic approach to understanding the reasons reality diverges from forecast figures allows you to make well-informed decisions.

Perhaps the management team at the furniture company would prefer not to compromise on quality by using lower-grade hinges. And maybe they don’t want to risk hiking prices either.

That kind of dilemma calls for a strategic rethink. For example, management might decide it would be more cost-effective to change the design of some key products. In this way, variance analysis can set off a completely new strategic direction — and all thanks to the price of a humble hinge.

Different Types of Variance Analysis

We’ve already mentioned that there’s a variety of different types of variance analysis, depending on the context. It’s time to take a closer look at a few of the most commonly used ones.

Sales Variance

Sales variance is all about checking how close a company’s actual sales were to their sales projections. If the two figures are similar, that’s all to the good. But if there’s a big disparity, looking a little deeper to find out why is essential.

Remember that this doesn’t necessarily just mean when sales figures disappoint. When sales figures are much healthier than expected, it’s equally as important to understand why – because you can learn how to make sure it’s not a one-off fluke.

Cost Variance

Similarly, cost variance looks at the difference between expected costs and actual costs. In any business, tracking costs is imperative to ensure the financial stability of the company. If costs run too far out of control, it can create cash flow problems.

Checking in on cost variance regularly can alert management to emerging issues related to costs. This allows them to address them before they turn into more serious problems.

Profit Variance

Profit variance is important to monitor because it’s a metric that all company stakeholders will be interested in. On top of this, it can play a crucial role in financial forecasting.

Maintaining healthy profit margins is a core objective of any company’s management. If the profit variance figure is negative, it’s crucial for senior decision makers to know about it so they can tweak their strategy.

Material Variance

Is the company using its resources efficiently? The material variance figure can help to answer this question. It represents the difference between the quantity of materials the company expects to get through as part of the production process and the amount it actually uses.

Finding a significant material variance merits a closer look at the production process. The company may be able to find ways of making it more efficient. Alternatively, it might be better to replace the materials with a different product.

Labor Variance

Labor costs represent a large proportion of any business’s cost base. Tracking labor variance is crucial to make sure you pick up early signals of those costs beginning to rise too much.

Overhead Variance

Similarly, keeping control of overheads is essential as they also contribute substantially to fixed costs. Monitoring overhead variance over time alerts managers to any potential problems that could eat into profit margins.

Key Steps in Conducting Variance Analysis

That’s the theory. But how do you put it into practice? Here are the steps you need to take to implement variance analysis and get the most out of it.

1. Collecting Actual and Budgeted Data

First, you need to get the two sets of data together so you can compare them. The budgeted data should already be available, as it will have been generated in advance as part of operational planning. Then, it’s just a matter of gathering the actual data and putting it side by side.

2. Calculating Variances

Determine the variances you want to monitor. In simple terms, this involves subtracting the actual figures from the estimates, although some types of variance analysis need a couple of extra steps before you reach the final figure.

3. Analyzing the Causes of Variances

When you discover a large variance, it’s important to explore what’s caused it. Sometimes the answer will be obvious, but often you’ll need to do a bit of digging. Make sure you understand the root causes before moving to the final step.

4. Reporting and Interpreting Results

Compile a report and make sure to include as much detail as is useful. Include both the raw data and a detailed account of your research into any variance figure that stands out. The aim is to create a document that forms a robust basis for adapting your strategy.

How to Calculate Variance Analysis: Examples and Formula

The best way to understand the variance analysis formula in action is to look at how it applies to different cost centers. Below, we examine two common versions (Labor and Overhead) to illustrate the process.

1. Labor Variance

This is composed of two elements: the rate variance and the efficiency variance.

Formulas:

• Total Labor Variance = Rate Variance + Efficiency Variance
• Rate Variance = (Actual Hours x Actual Rate) − (Actual Hours x Estimated Rate)
• Efficiency Variance = (Actual Hours x Estimated Rate) − (Estimated Hours x Estimated Rate)

Calculation:

Let’s say a company that offers plumbing services wants to work out its overall labor variance. The actual hours worked in one month were 3,000 at a rate of $20 per hour. Its estimated hours worked were forecast to be 2,500 at a rate of $15 per hour.

• Rate Variance = (3,000 x $20) − (3,000 x $15) = $60,000 − $45,000 = $15,000
• Efficiency Variance = (3,000 x $15) − (2,500 x $15) = $45,000 − $37,500 = $7,500
• Overall Variance = $15,000 + $7,500 = $22,500

The labor variance is substantial here, suggesting management may want to explore possibilities for cutting labor costs.

2. Overhead Variance

Getting to grips with the fixed overhead variance can be a little confusing at first. Overhead variance measures the difference between actual fixed costs and "absorbed" costs — overhead assigned to units based on production volume or labor hours. Because the absorption rate per unit fluctuates with actual output, this calculation provides a clear picture of operational efficiency compared to fixed budget allocations.

Let’s break this down to see how it works.

Formulas:

• Budgeted Fixed Overhead Cost = Estimated Production Level x Estimated Rate
• Budget Variance = Actual Fixed Overhead − Budgeted Fixed Overhead
• Fixed overhead cost applied to inventory = Standard Hours x Estimated Rate
• Volume Variance = Budgeted Fixed Overhead − Fixed Overhead Applied to Inventory
• Overall Variance = Budget Variance + Volume Variance

Calculation:

Let’s assume the level of activity is 10,000 at an estimated rate of $20 per hour. The fixed overhead cost is $220,000, and the standard hours amount to 8,000. This means:

• Budgeted Fixed Overhead Cost: 10,000 x $20 = $200,000
• Budget variance = $220,000 − $200,000 = $20,000
• Fixed Overhead Cost Applied to Inventory = 8,000 x $20 = $160,000
• Volume variance = $200,000 − $160,000 = $40,000
• Overall variance = $20,000 + $40,000 = $60,000

This is quite a large overhead variance, so management may consider exploring ways to allocate resources more efficiently.

Challenges of Variance Analysis in Accounting

Carrying out variance analysis in finance and accounting contexts can be useful, but does present challenges. Here are some of the most common ones:

Overcoming these hurdles requires shifting from manual spreadsheets to a unified data environment. By automating the data pull and providing real-time 'drill-down' capabilities, OneStream transforms variance analysis from a slow, reactive task into a proactive strategic asset.

4 Best Practices For Effective Variance Analysis

Getting financial variance analysis right means following a few key principles. Let’s explore those now.

1. Communication and Transparency

Top of the list is that it’s crucial to encourage a culture of openness around variance figures. Make sure all your team members know to report their findings in good time. That doesn’t just mean when newly generated figures suggest there’s an issue that needs resolving, but all the time to ensure consistency.

2. Establish Clear Performance Metrics

Set down clear objectives and KPIs that are relevant to the variances you’re monitoring. For instance, if you’re analyzing purchase cost variance, it would be a good idea to track metrics like procurement cycle time and cost per invoice.

3. Resist Political Standard-Setting

The nature of variance analysis means that all variance figures are compared to a standard to determine whether they’re significant or not and worthy of deeper exploration. That means there can be political incentives to increase or reduce the standard in an arbitrary way. It’s crucial to avoid doing this because it undermines the effectiveness of the process.

4. Monitor Regularly

As with any analytics-related process, you’ll reap the largest benefits when you deploy variance analysis consistently over time and monitor the results regularly. That’s because you’ll be able to spot patterns emerging and respond to them quickly.

Streamline and Enhance the Variance Analysis Process with OneStream

Deploy effective variance analysis and generate actionable insights with OneStream’s AI-powered financial planning solution. As it’s a unified data platform, it simplifies the task of collecting the data you need and helps your teams make even more accurate forecasts.

If you’d like to see how OneStream can take your business to the next level, you can sign up for a live demo or explore our extensive library of on-demand webinars. These sessions provide a deep dive into the platform's capabilities, from AI-powered planning to global financial consolidation. Check out our resources library to find the session that best fits your schedule.

Alternatively, reach out to one of our experts today to request a demo. They’ll be very happy to help.