Financial Analysis: How to Calculate Variances

by Craig Anthony

4 min read

Variance analysis is a financial analysis technique that looks into why your actual results are different than your budget. By knowing why you missed your spending targets, you can make better plans for the future. Some variances look at whether you were efficient with how you make your products. Other variances look at the prices you are paying. By using variance equations, you can see where you are overspending. You can also see where you are doing better than your budget and try to copy that success other places in your business.

Material Variances

You can use two different variances equations to see how well you are using your materials. First, the efficiency variance measures the difference between the amount of materials you expected to use and what you actually used. Pretend that you make clothes and bought 5 metres to make a dress. If you only needed to use 4 metres, you have a favourable efficiency variance because you didn’t use all the material you expected. You can use this information to try and copy your efficiency in other places within your business. Another way to check your raw materials spending is by using the material price variance. You use this equation to see if the prices you paid were what you originally expected. When you bought the fabric to make the dress above, imagine you paid $20 per metre. If you originally planned to spend $18 per metre, you paid $2 more per metre and have an unfavourable variance.. This information can help you understand the trend of prices and can set your expectations for spending in the future.

Labour Variances

Your company may be more labour-intensive, so it is also helpful for you to know your performance relating to your compensation. First, you can use the labour efficiency variance to see if you’re spending time the way you planned. Continuing the example above, say it takes you 6 hours to sew a dress. If you had budgeted 7 hours of your time, you are being inefficient with your time. Your unfavourable variance would be equal to one hour of your pay. A second labour variance is very similar to the materials price variance mentioned earlier. Your labour price variance tracks how much you spend for labour and how this is different from your original plans. If you have an employee that makes the dress for you by paying $20 per hour, you would have a favourable variance if you originally planned to pay that employee $22 per hour.

Sales Variances

You can also see how your business is doing by calculating variances for your sales. First, you can use the sales volume variance to understand whether you reached your expected sales levels. At the beginning of the year, you planned to sell 100 dresses over the next 12 months. At the end of the year, you ended up selling 95. Your sales volume variance is price of the five dresses you didn’t sell. Because you didn’t quite sell as many dresses as you would have hoped, this variance is unfavourable. Another variance equation useful to track your sales numbers is the sales price variance. You can determine this variance by looking at what you sold your products for. At the beginning of the year, you planned to sell each dress for $250. During the year, you ended up selling each dress for an average price of $300. Even though you might have sold less dresses than you planned, you were still able to sell your goods for more than you wanted. This example would mean you have a favourable sales price variance. Last, your sales mix is the breakdown of what you sold. If you planned to sell 100 dresses and 100 shirts, your sales mix is 50% dresses and 50% shirts. At the end the period, you should count the total of each inventory item sold. If your total sales were actually 60% dresses and 40% shirts, you were favourable in selling dresses but unfavourable in selling shirts. You can use this information to develop a stronger marketing plan to push certain goods.

Understanding Variance Relationships

The variances above have relationships that are useful to know for your small business. Take a situation where you spent $26,000 on raw materials. At the beginning of the year, you planned to spend $25,000 so you spent $1,000 more than you planned. A critical part of variance analysis is understanding why you were off. Were you paying higher prices than expected? Were you using more materials than you had planned? Was there a combination of both? If you do variance analysis, you will get the valuable answers to these questions.

Benefits of Variance Analysis

By incorporating variance analysis into your business, you will get a better understanding of what goes on in your company. You will learn more about the prices you pay, efficiency of your business, time it takes to perform processes, and what inventory you are selling. You will make smarter decisions about what products to make, what vendors to use, and what customers to target. By looking at your variances, you will use the short-term information you have to make smarter long-term plans. Understanding why differences exist is the goal of variance analysis, and incorporating it into practice can help improve your company’s operations.

References & Resources

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