Variances in accounting tell you how much a business result varied from another value, such as a budgeted, target or expected amount. For example, if you budgeted $500 for postage and spent $600, the variance is $100, and it might be explained by an unanticipated increase in postage rates. When you read that a company's sales were lower than expected, it means the company had a negative variance in actual sales compared to expected sales. This is different from a variance in statistics, which tells you the difference between an individual value and the average of all values.
You can take advantage of different types of variance analysis to get information your business needs to monitor operational performance and make adjustments to future budgets. You can also calculate variances in dollar and percentage amounts.
Calculating Dollar Variance
In accounting, you calculate a variance by subtracting the expected value from the actual value to determine the difference in dollars. A positive number indicates an excess, and a negative number indicates a deficit. Negative numbers are usually denoted in parentheses. Both excesses and deficits can be good or bad, depending on what the variance pertains to.
As a variance analysis example, consider that revenue was budgeted to be $1 million and actual revenue was $900,000. This means the variance is ($100,000), which negatively impacts profitability. If expenses were budgeted to be $800,000 and actual expenses were $700,000, the variance is also ($100,000), but it has a positive impact on profitability — despite the variance being a negative number.
Calculating Percentage Variance
A $1 million variance might be small or large, depending on what it's being compared to. That's why you should calculate variance as a dollar amount and a percentage, which indicates the relative size of the variance.
To calculate a percentage variance, divide the dollar variance by the target value, not the actual value, and multiply by 100. For this variance analysis example, the percentage variance for the previous revenue example is ($100,000) divided by $1 million times 100, or (10)%. The percentage variance for expenses is ($100,000) divided by $800,000 times 100, or (12.5)%.
Calculating Variance of a Percentage
You should not calculate a percentage difference for a number that's already expressed as a percentage.
For example, the gross profit for $1 million in revenue and $800,000 in expense is $200,000. The gross margin is $200,000 divided by $1 million times 100, or 20%. The gross profit for $900,000 in revenue and $700,000 in expense is also $200,000, so the variance in gross profit is $0. The gross margin is $200,000 divided by $900,000 times 100, or 22.2%. The margin variance is 22.2% minus 20%, or 2.2%, expressed only as a difference in the two percentages.
Importance of Variance Analysis
When examined in isolation, variances can be misleading. In the example above, the profitability variances indicate solid financial performance, as profit was equal to budgeted profit and the profit margin was higher than budgeted. However, the detail reveals that sales were behind budget and that the increased profitability was a result of managing or reducing expenses. Depending on the circumstances, this might indicate that the business is declining and that cost-saving measures such as layoffs were necessary to maintain the budgeted profit margin.
Naming Conventions for Variances
Many variances have specific names to indicate the values being compared. For example, if the total labor cost was budgeted to be $5 million and the actual cost was $5.2 million, the labor cost variance is $200,000. Since labor cost is the number of hours worked times the rate paid per hour, you can calculate a variance for each component to further explore the reason for the variance.
The difference in the rate paid is called the rate variance, and the difference in the hours worked is called the efficiency variance. Likewise, the materials usage variance is one component of the variance in the cost of materials. The other component is the materials price variance.
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