Building on our explanatory articles of finance terms, we will guide through an explanation of the term variance as well as its many helpful applications in finance.
Variance, in finance, is a term used to explain that an analysis of 2 or more sets of financial data has been done and changes have been noted. This could be a comparison of data from one month versus another month or one quarter of a year versus the same quarter in any previous year.
The comparison does not have to be of the actuals (actual financial results). In fact, it is frequently actuals versus budget or budget versus a forecast.
Variances are very helpful management tools as they identify problems that can be proactively solved. From month-to-month comparisons to building a trendline over a few months of side-by-side data (horizontal analysis), it is a powerful financial tool.
How can you use the variance tool?
Firstly, to use variance, you should collate your data into a spreadsheet of your choice with, for example, one month’s data in column A, the next month’s data in column B and column C will contain the resulting variance (the difference) between column A and B.
You might want to compare your SMME’s budget data to how you actually performed. If your turnover budget for April was £6000, but your actual was £4000, then you have a budget-to-actual variance. The variance is £2000.
Here are more examples of variances and the terminology used:
Positive budget variance
When your revenue actuals result in a figure that is higher than your budgeted expectations, this is called a positive budget variance or a favourable budget variance. The positive result could also be due to expenses being lower than your budget amount.
The strategic action to take would be to analyse this variance in direct relation to the line items involved. For example, find out if a higher sales price drove up the results, greater volumes, or a better mix of profitable products being sold.
If expenses came in below budget, then the strategic action would be to ascertain whether this was a once-off event, whether your budget was flawed with poorly researched assumptions, or whether your team had had a brilliant long-term cost-cutting idea.
Negative budget variances
Unfortunately, there are negative variances that occur. Last year was a year filled with negative variances. When your sales perform less than the projected budget or those pesky expenses exceeded the allotted budget, you have a negative budget variance.
The same strategic analysis would be taken here as with a positive variance. The key is to ascertain whether the event was controllable or uncontrollable.
Analysis varies from company to company, e.g. a manufacturer might analyse variances of the purchase prices of raw materials or material yield efficiencies, but a service-based company could look at labour efficiencies such as calls achieved per week.
Before drawing conclusions on the variances against budget, it is important to be sure that the differences are not performance but rather inferior budget assumptions or company politics. The latter is a common bad behaviour of corporate branches to keep the head office happy. Monthly budget figures are uploaded with amounts that will please head office projects but are not realistic. This leads to ineffectual variance reporting and hollow resolutions.
Presenting the good (or bad news) to the stakeholders
As with most business presentations, in particular finance presentations, use objective, accurate, and unemotional language. Avoid unfounded hypotheses and personal opinions unless you happen to be a specialist, deeply experienced economist, or finance strategist, with an opinion steeped in factual insights.
Don’t drown the facts in overly detailed explanations. Clearly and succinctly identify the exact issue and the related solution and use a consistent format for your presentation.
To start, it would be helpful to state the variance as the ‘headline’, follow that with the reason ascertained to be the cause of it, state the effect on the company’s performance and the solution proposed for it. Here is an example:
“April sales show a negative variance of £2,000 versus the budget of £6,000. This is attributed mainly due to the loss of a key client, viz. ACME, at the end of March, thereby cutting their monthly £1,800 sales from the books. The loss of ACME was ascertained to be due to ongoing late deliveries over the past 2 quarters. A logistics review is underway, to be concluded within the next 2 weeks.”
Variances commonly used in finance reporting
If you are new to variance reporting and are not sure which would be the most helpful data variances, have a look at the below commonly used variances.
Purchase price variance
This is definitely an important one to track as it also gives you an insightful trendline over the months and years. Compare the actual price paid for raw materials or components used for production, minus the standard price, multiplied by the quantity purchase.
The standard price is a collective opinion from a select group of employees, e.g. your engineers. It is derived from assumptions regarding quality levels, purchase volumes, and speed/cost of delivery. This means that the standard price is always subject to needing an update or an assessment of assumptions. Big highs or lows in variances indicate a need to reassess the standard price.
Labour rate variance
For this variance, you will use your actual price paid for the labour used directly in the production process (not the office staff, cleaning staff, etc.). Deduct the projected labour cost from this amount and multiply the answer by the volume of units used. A negative variance means productivity needs to be looked at, or your hiring manager is possibly not negotiating hard enough.
Selling price variance
This is where you minus the standard selling price from the actual selling price and multiply that answer by the number of units sold.
Material yield variance
This variance shows the difference between the volume of material actually used and the amount projected to be used. The result of this is multiplied by the standard cost. The formula is:
(Actual volume used – projected unit usage) x each units standard cost = Material yield variance
There are a number of causes that could be responsible for a material yield variance, such as:
Scrap – Each machine setup, an adjustment of tolerance levels, or a change in the thoroughness quality inspections can alter the amount of scrap.
Quality of material – A change in material quality can alter the volume of failed final products.
Spoilage – Changes in inventory handling procedures or the storage type or location can increase spoilage.
Logistics quality – Damage may occur in transit, making materials unusable.
There are many more, but you don’t have to analyse all the variances. A services company might only track labour efficiency variances, and a manufacturer might closely track purchase price variances. Track the variances that make the biggest impact on your business and focus remedial efforts there.