# All about variance analysis

Last updated: 10.11.2016

This series describes in detail variance analyses - what it is about, when is the varince significant and how to breakdown and analyse the variances on various types of costs.

## Variance analysis

The purpose of variance analysis is to ascertain the quantitative deviation between budgeted, forecasted or otherwise estimated figures and accounting actuals and analyze this deviation into bigger detail. It is a valuable control mechanism.

Factors to consider when deciding whether it is worth to investigate the variance:

• materiality – small variances are usually either not analyzed or analyzed only to lower extent. Materiality levels can be defined:
• in absolute figures – e.g. variances over € 100 are investigated
• in % - e.g. variances over x% from budgeted figure are investigated
• are not defined and analysts evaluate their significance subjectively
• controllability –uncontrollable variances shall be given lower care than to controllable
• whether the variance is favorable or unfavorable – investigation is more about unfavorable variances
• trend – if the monthly (or other period) variances keep showing a trend, it is certainly worth further analyses
• standards used in budget preparation – if for example ideal standard is used, the variances are expected to be unfavorable
• the cost of variance investigation should not exceed the benefits resulting from the possible remedial action (28)
• interrelationship of variances – one variance can be related with another and it therefore depends on their cumulative effect. For example:
• using poor-quality material can cause:
• favorable direct material price variance
• unfavorable direct material quantity variance (more wastage)
• unfavorable direct labor quantity variance (worse handling)
• more qualified staff can result in:
• unfavorable direct labor rate variance (higher wages)
• favorable direct material quantity variance (less wastage)
• favorable direct labor quantity variance (less hours necessary to produce the same output)

In general, direct costs, revenues and margin variances can be split into:

• price variance

Calculation:  (actual unit price – budgeted unit price) x actual quantity

Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed price (unit margin).

• quantity (or volume or usage) variance

Calculation:  (actual quantity – budgeted quantity) x budgeted unit price

Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed quantity sold/produced.

More detailed variance calculations can be found here:

Direct material cost variance

Direct labor cost variance

Variable production overheads variance

Fixed production overheads variance

## Direct material cost variance

Direct material cost variance can be split into:

• Direct material price variance

Calculation:  actual total material costs - (actual quantity of total material used x budgeted price per unit of material used)

Interpretation:  calculates the portion of variance driven by the changed prices of raw materials

Possible reasons for variances:  price increases/discounts, changes in material quality (27; p.232-8), poor budgeting

• Direct material quantity (usage) variance

Calculation:  (actual quantity of total material used -   budgeted quantity of total material used) x budgeted price per unit of material used

Interpretation:  calculates the portion of variance driven by the changed quantity of raw materials consumed

Possible reasons for variances:  changes in material quality, care devoted to quality control, thefts, errors in allocating material to products (27; p.232-8), change in wastage level due to changes in staff qualification and skills, poor budgeting

## Example:

Budget: 5 units of raw material purchased at €8/piece; produced output is 1 000 units

Actual: 6 units of raw material purchased at €7/piece; produced output is 1 100 units

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Total variance = (6 * 7* 1 100) – (5 * 8 * 1 000) = 46 200 – 40 000 = 6 200 (unfavorable)

Direct material price variance = (6 * 7 * 1 100) – (1 100 * 6 * 8) = 46 200 – 52 800 = - 6 600 (favorable)

Direct material quantity (usage) variance = (1 100 * 6 – 1 000 * 5) * 8 = 12 800 (unfavorable)

Check: Price variance + Quantity variance = - 6 600 + 12 800 = 6 200

## Direct labor cost variance

Direct labor cost variance can be split into:

• Direct labor rate variance

Calculation:  actual total direct labor costs - (total actual labor hours worked  x  budgeted labor hour rate)

Interpretation: calculates the portion of labor costs variance driven by the changed labor rate per hour

Possible reasons for variances:  changes in staff qualification and skills, general increase of wages in economy, premiums paid to finish a job quickly, poor budgeting

• Direct labor quantity (efficiency) variance

Calculation:  (total actual hours worked – total budgeted hours worked) x budgeted labor hour rate

Interpretation:  calculates the portion of labor costs change driven by the changed number of labor hours worked

Possible reasons for variances:  the effect of learning curve, errors in allocating labor hours to products (27; p.232-8), changes in staff qualification and skills, changes in material quality, idle time, poor budgeting

## Variable production overheads variance

Variable production overheads variance is calculated similarly as direct labor cost variance. Only variable production overhead per labor hour must be calculated instead of labor rate.

## Example

Budget: 10 labor hours per €10/hour are necessary to produce a unit; produced output is 1 000 units

Actual: 8 labor hours per €12/hour are necessary to produce a unit; produced output is 1 100 units

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Total variance = (1 100 * 8 * 12) – (1 000 *10 * 10) = 105 600 – 100 000 = 5 600 (unfavorable)

Direct labor rate variance = (1 100 * 8 * 12) – (1 100 * 8 * 10) = 105 600 – 88 000 = 17 600 (unfavorable)

Direct material quantity (efficiency) variance = (1 100 * 8 – 1 000 *10) * 10 = - 12 000 (favorable)

Check: Rate variance + Quantity variance = 17 600 – 12 000= 5 600

## In absorption costing, the total variance in fixed production overheads is equal to the amount of unabsorbed overheads, i.e.

total actual overheads – overheads absorbed to products = total actual overheads – (budgeted overheads per unit of production quantity * actual production quantity)

It can be split into:

• Fixed production overheads expenditure variance

Calculation:  total actual overheads - total budgeted overheads

Interpretation:  calculates the portion of fixed production overheads variance driven by the changed amount of overheads

• Fixed production overheads quantity (volume) variance

Calculation:  (budgeted production quantity - actual production quantity) * total budgeted overheads per budgeted number of units

Interpretation:  calculates the portion of fixed production overheads variance driven by the changed production volume. If the actual production quantity is higher than budgeted, this variance will be favorable and vice versa.

Fixed production overheads quantity variance can be further split into:

• Fixed production overheads efficiency variance

Calculation:  (actual labor hours for the actual production quantity - budgeted labor hours that would be needed for the actual production quantity) * budgeted labor hour rate

Interpretation:  calculates the portion of fixed production overheads volume variance driven by the changes in labor efficiency. If total actual labor hours are lower than budgeted labor hours necessary to produce actual quantity, the variance is favorable, because the staff worked more efficiently and vice versa.

• Fixed production overheads capacity variance

Calculation:  (budgeted total labor hours - actual total labor hours) * budgeted labor hour rate

Interpretation:  calculates the portion of fixed production overheads volume variance driven by the changes of the number of hours worked. If total actual labor hours are higher than budgeted, the variance is favorable, because the staff worked extra hours (e.g. overtimes) and vice versa (e.g. breakdowns).

## Example

Budget: 10 labor hours per €10/hour are necessary to produce a unit; produced output is 1 000 units

Actual: 8 labor hours per €12/hour are necessary to produce a unit; produced output is 1 100 units and total fixed production overheads 120 000

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Total fixed production overheads variance = unabsorbed overheads = 120 000 – (10 * 10 * 1 100) = 120 000 - 110 000 = 10 000 (under-absorbed overheads) split into:

Fixed production overheads expenditure variance = 120 000 – (10 * 10 * 1 000) = 120 000 – 100 000 = 20 000 (unfavorable)

Fixed production overheads quantity (volume) variance = (1 000 – 1 100) * (10 * 10) = - 10 000 (favorable) split into:

• Fixed production overheads volume efficiency variance = (8 * 1 100 – 10 * 1 100) * 10 =     (8 800 – 11 000) * 10 = - 22 000 (favorable as less labor hours are necessary in actuals to achieve the actual production volume)
• Fixed production overheads volume capacity variance = (10 * 1 000 – 8 * 1 100) * 10 = (10 000 – 8 800) * 10 = 12 000 (unfavorable as total actual labor hours are lower than budgeted)

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