Understanding Variances in Accounting
A variance is defined as the difference between budgeted and actual amounts in an account balance. Keep in mind, however, that the CPA exam uses the terms budgeted and planned to mean the same thing. Business managers analyze variances to make decisions about company costs and sales. You can think of a variance as a red flag to a manager. A variance is a warning that something in your business isn't going as planned.
The variance process starts with planning. All businesses should have a budgeting or planning meeting to forecast sales, production, and costs for the next year. Part of the budgeting process involves setting standard amounts. A standard is management's forecast of a cost, production amount or sales level.
Say, for example, that you make denim blue jeans. In planning, you determine that your material cost for denim will be $5 per yard. So $5 per yard is your standard cost. In addition to the cost of denim, your firm plans a standard level of denim usage per pair of jeans. Your firm decides that each pair of jeans will require 3 yards of denim. You now have a standard cost and a standard usage amount.
Suppose that after the first quarter, you decide to compare your actual results to the standard amounts you set in planning. Your actual cost per yard for denim is only $4.50 per yard. You have a favorable variance of $5 standard cost – $4.50 actual cost = $.50 variance. The variance is favorable because you spent less than you planned. Your actual cost is less than budgeted. If you generate more revenue than planned, you also have a favorable variance.
The first quarter results also indicate that you actually used 4 yards of denim for each pair of pants, compared with your budgeted amount of 3 yards. In this case, you have an unfavorable variance of 4 yards actual usage – 3 yards budgeted usage = 1 yard variance. The variance is unfavorable because you used more than planned. If you generate less revenue than planned, you also have an unfavorable variance.
As you review variances, consider analyzing the largest variances first. Take a look the variances that are the largest as a percentage of your budgeted amount. For the denim standard cost, the variance is $0.50 ÷ $5 = 10%. You can also define the largest variances as total dollar amount rather than as a percentage. In either case, these are the variances you should investigate first. Hopefully, your analysis will allow you to make changes that will improve your profitability.