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birthday cake | accountingweb | Variance analysis
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Celebrate the difference between hope and reality

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Just as becoming another year older makes us stop and take stock of our lives, variance analysis can be used to reflect on how business performance has met expectations.

17th May 2023
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This month I turn 54 (cough). Where has all the time gone? Like most people I tend to take stock of life at birthdays, assessing to what extent I have met my goals, what stuff is left to do and generally reassessing my targets. For example, a few years ago I never would have thought I’d be on TV embarrassing myself with cookies on The Great British Bake Off.

We all perform a reality check at important anniversaries. Reflection is important. It keeps us on track and nudges us into action and injects motivation to finish that novel we all have within us and perhaps do more to make a positive difference to other people’s lives.

Taking this reflection to a more academic level, management accounting has the concept of variance analysis. As periods close and, in my case, a new financial year begins, we conduct an assessment on performance with expectation. Did it all go as planned?

Analysing the differences

Variance analysis is a technique used in management accounting to compare actual results with planned or expected results. It involves analysing the differences, or variances, between the planned or budgeted amounts and the actual amounts incurred. By examining these variances, managers can gain insight into the reasons for deviations from expected results and take corrective action if necessary.

Variance analysis is typically performed on key performance indicators (KPI) such as revenue, expenses, and profitability. It can be used to identify trends, highlight areas of concern, and improve decision-making. Common types of variances include:

  • Price variances The difference between the actual price paid for a product or service and the budgeted price
  • Quantity variances The difference between the actual quantity used or produced and the budgeted quantity
  • Mix variances The difference between the actual product mix sold and the budgeted product mix
  • Yield variances The difference between the actual yield of a manufacturing process and the budgeted yield.

By analysing these variances, managers can identify areas of the business that are performing well and those that require improvement. They can also use the information to revise budgets, adjust prices or quantities, or take other actions to improve performance. Variance analysis is a powerful tool for financial analysis and management decision-making in any organisation.

Understanding budget variances

Business performance can fall under three broad categories – and no prizes for guessing what they are.

  1. Performance exceeded expectations, favourable
  2. Performance met expectations, neutral
  3. Performance fell below expectation, adverse

Departmental performance must be congruent with the overall business objectives. It would be of concern if a cost centre was coming under budget but the quality of work was also below standards. This has long-term ramifications to the integrity of the business and the costs that will be incurred later to get the job done properly.

In my sector, the social housing industry, where scrutiny is perhaps greater and penalties are a real threat when service standards fall below legal requirements it is vital performance variances are monitored to industry regulations. These key performance indicators may not always be financial.

External factors that lead to financial variances

Anyone can work out the differences between two columns of numbers. That is simple maths. The role of the management accountant is to then look beyond the obvious and interpret the variances. This cannot be done in isolation. The seasoned management accountant will have relationships built up with area managers. Together they can provide answers and many times variances happen because of external factors that were difficult to forecast when budgets were set.

variance table
Makbul Patel

It can be seen that variances happen for many reasons that are outside the control of the managers. Management accountants must also bring these into consideration when explaining variances.

The limitations of variance analysis

Though variance analysis is a key component in management accounting and holding managers accountable for departmental performance it does come with many drawbacks.

  • Non-standardised variances

During the early days of a new business or project it is very difficult to pin down what to forecast or even set a concrete budget. Using arbitrary budgets and forecasts would result in variances that are difficult to interpret as no historical benchmark exists. A short life cycle isn’t realistic and significant time would be needed to add some context to the variances.

  • Variances of service organisations

Variance analyses are best suited to departments or organisations with a measurable output. Service sector organisations are mostly made up of overheads. Sure, variance analysis can be applied to the departmental cost but how can this be a measure of performance away from overheads? Variance analysis is a tool to provide a constructive assessment to improve performance.

  • Lack of control

One of the biggest complaints I get from my managers is about to what extent are they responsible for the adverse (or favourable) variances on costs that are beyond their control. One such example is linked to the technical department in our firm that fits wIndows and doors. Outputs have remained consistent to budget but unit costs are far higher. On dissection of the costing analysis it is immediately obvious to see raw material costs have shot up, which has led to unit costs being far greater than the budget, which was set over a year ago. The manager looks at me and shrugs his shoulders – what can they do?

  • Historic performance

Variance analysis is usually conducted as part of the periodic or annual budgeting exercise. The usefulness of variance analysis as a control mechanism declines as the duration of reporting period increases. This is because the delay in the provision of such information reduces its relevance for the decision-making needs of management. Use of continuous performance review, using real-time data can be implemented but that regime would be costly.

  • Behavioural issues

Conducting variance analysis on a budget that was set months and months ago would not necessarily be the method that could lead to increased performance. The budget may have become irrelevant in the face of business and economic changes. Many times managers have carried on with the “business as usual” mentality. What they did previously is what they will do now and what they will do in the near future. In large organisations slack in budgets may not be addressed as the culture of long-winded bureaucracy is a barrier to improving outputs and performance.

Simple yet powerful

Variance analysis on performance is one of the basic tools a management accountant uses in assessing outcomes. It is simple yet powerful. Used in the correct way it provides so much insight into KPIs and should not be underestimated. Its value is held only if it can lead to understanding and improvement.

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By tom123
18th May 2023 14:04

I do like a variance, in some circumstances - but you can end up with death by a thousand cuts. To a certain extent life is what it is - and of course variance are often only as good as the original budget was to start with.

Having said that, I have generally only published variances in terms of monetary difference on a finance report line - rather than trying to split out price and quantity components.

Less is more is my current thinking..

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