How to Perform Variance Analysis on Financial Statements

Variance analysis is an important management accounting technique to measure a product’s cost and profitability. Managers use variance analysis to make decisions about the labor and materials costs incurred to create a product or deliver a service. The technique also helps managers with sales and production forecasting.

To perform variance analysis accurately, you need to identify and record all business costs. Stampli is a complete Accounts Payable Automation (AP Automation) software that brings together accounts payable communications, documentation, corporate credit cards, and ACH or check payments all in one place, allowing AP to have full control and visibility over corporate spending. Use Stampli to compute total costs and to perform variance analysis.

Managers must understand each type of variance, and how favorable variances and unfavorable variances are calculated.

As an example for this discussion, assume that Outfield Sporting Goods produces baseball gloves for high school, college, and professional players. Jenny is the owner of Outfield, a business that operates in a highly competitive industry. She is performing variance analysis to determine if costs can be reduced.

Defining a Variance

A variance is defined as the difference between standard (budgeted) cost and actual costs. Deviations from budgeted costs may reveal areas where management can reduce spending. Performing variance analysis requires several steps.

Creating a budget

Outdoor creates a budget, based on projected sales, production, and other assumptions. Management will create standard, or budgeted amounts for material, labor, and overhead costs. Outdoor uses accounting software to the budget, rather than excel spreadsheets that may generate errors.

The budget to produce a single baseball glove includes these costs:

Direct materials

Leather, plastic, and other raw materials are used to produce a glove. The cost per glove is based on the amount of material used, and the price paid for materials. The business assumes that 4 square feet of leather is used per glove, and that the leather cost (or standard price) is $5 per square foot.

Direct labor

Outfield incurs labor costs to run machinery, and to package completed gloves for shipment to customers. The labor hours required per glove, and the labor rate determine the direct labor costs. The budgeted labor cost is $25 per hour, and each glove requires two hours of labor.

Overhead costs

These are costs that cannot be directly traced to production. For example, Outdoor incurs utility costs on the factory, and pays insurance premiums to insure the factory building and equipment. Overhead costs are assigned to the products that Outdoor produces, including baseball gloves.

The company allocates $3 in overhead costs to each glove produced. This template lists the budgeted costs:

At the end of each month, the owner compares the budget assumptions to actual results.

Reviewing actual costs

A quantity variance is the difference between the actual amount of a resource, and the expected (planned) usage. Material, labor, and overhead costs all use resources, and quantity variances can impact each of these costs. 

Here are the March actual costs incurred to manufacture one baseball glove:

Direct materials

Material cost variances are due to differences in material usage, or a difference in the price paid for material (price per unit, per square foot, etc.).

The actual quantity used was 4.2 square feet of leather per glove, compared to the 4 square feet budgeted. The production manager didn’t account for some parts of the glove that require two layers of material. When a business purchases more or less than the standard quantity (planned quantity), it generates an efficiency variance. 

The actual price paid was $5.30 per square foot, which is higher than the $5 per glove budgeted amount. High-quality leather supplies are low, and Outdoor paid more for leather than planned. A price variance (or material price variance) means that the business paid more or less than planned for materials or labor. 

Direct labor

The actual amount paid for labor was lower than budgeted, because of an economic slowdown. Outdoor paid $21.50 per hour, not the $25 per hour budgeted, and this means that the company has a rate variance. The actual numbers for labor hours matched the two hours budgeted per glove. If the budgeted hours differed from actual hours worked, Outdoor would have a labor efficiency variance.

Volume variance occurs when a company produces more or less than planned. If the budgeted number of units differs from actual production, both material cost and labor cost are impacted. For this example, assume that the number of gloves actually produced matches the budget.

Overhead costs

Outdoor installed new factory windows and insulation last fall, and utility costs were lower than budgeted. The company also paid lower factory insurance premiums, because the firm has not filed an insurance claim in over 10 years. 

The company allocated $2.75 in actual overhead costs to each glove produced. Since the company budgeted $3 in overhead costs per glove, Outdoor has an overhead variance.

Here are the actual costs per glove:

Computing Favorable and Unfavorable Variances

Managers can think of the budget as a benchmark that the company wants to achieve, and it’s not surprising that there are fluctuations between budgeted and actual results. When you perform analysis of variances, you may find both favorable and unfavorable variances. 

This chart summarizes budgeted costs, actual costs, and the types of variances:

Favorable variances

If actual costs are lower than budgeted, a company has a favorable variance. There are two components to a variance: the amount or usage of a resource, and the rate or price paid for a resource: 

Outdoor paid less per hour for direct labor than budgeted ($21.50 vs. $25), which generates a favorable variance. The overhead variance is favorable, because the actual overhead rate is less than budgeted ($2.75 vs. $3.00). 

Unfavorable variances have the opposite effect.

Unfavorable variances

If actual costs are higher than budgeted, or if the rate or price paid is higher than budgeted, the variance is unfavorable. The direct material variance is unfavorable, because Outdoor used more material than planned (4.2 square feet vs. 4 square feet), and paid more per square foot than planned ($5.30 vs. $5 per square foot).

The total variance for baseball gloves includes direct material, direct labor, and overhead. Overhead can be further divided between variable overhead and fixed overhead.

Impact of variances

Variances impact each of the financial statements, including the balance sheet and income statement. If higher costs lead to increased spending, the business may develop a cash flow shortage. When costs are higher, profits decline, and net income is lower.

Keep in mind that a budget variance may change from one reporting period to the next. A material shortage may end, and labor costs vary with economic conditions. For these reasons, you should perform variance analysis each month, and assess the results.

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