Variance Analysis is a technique used in financial management to measure and evaluate the differences between budgeted and actual figures. It is used to identify variances between the budgeted and actual amounts for each line item of a company’s financial statements, allowing managers to understand why those differences exist. Variance Analysis is an important tool for financial managers to identify potential issues and opportunities that can help an organization improve the performance and profitability of its operations.
Defining Variance Analysis
Variance Analysis is a quantitative examination of the differences between expected and actual results. It is used in financial management as an important tool to measure the performance of an organization against its budgeted or expected amounts. By breaking down the budgeted and actuals into line items on financial statements (e.g. income statement, balance sheet, and cash flow items), variances between the two sets of data can be identified and analyzed to gain insight into the underlying causes and identify potential issues or areas for improvement.
Objective of Variance Analysis
The objective of Variance Analysis is to provide a procedure to identify, quantify, and explain the differences between the budgeted and actual figures, and to use this information to identify potential risks and opportunities to improve the organization’s financial performance. The variances that are identified must then be acted on to address the issues and capitalize on the opportunities.
Calculation of Variances
Variances are calculated by subtracting the actual figures from the budgeted figures for each line item on the financial statements. This results in two variances, one for each of the two sets of figures. The variance can then be expressed as either a percentage or an absolute amount of money. This comparison is typically expressed as a variance percentage, which is calculated by dividing the actual figure by the budgeted figure and then expressing the difference as a percentage.
Analyzing Variances
Once the variances have been calculated, they must be analyzed to identify the underlying causes. To do this, financial managers must look into the factors that may have caused the variances. The analysis is typically broken down into three categories: quantity, price, and efficiency. Quantity refers to the number of items produced or sold, price refers to the prices charged for the items, and efficiency refers to the cost incurred to produce or acquire the items.
By analyzing the variances in these three areas, financial managers can gain insight into the root cause of the variances and identify potential issues and opportunities that can be addressed to improve the organization’s performance.
Considerations for Variance Analysis
When conducting Variance Analysis, it is important for financial managers to take into account the following considerations:
• Time period: Variances must be evaluated over a specified period of time in order to make meaningful comparisons.
• Cause of variance: The cause of the variance must be identified in order to take corrective action and address the underlying issue.
• Size of variance: The magnitude of a variance should be taken into consideration when making decisions.
• Industry standard: Comparing the variances to industry standards can help to assess the performance of the organization relative to others.
Example Application of Variance Analysis
An example of Variance Analysis in practice is when a company’s actual sales figures for the past quarter are compared to its budgeted figures. In this example, a financial manager can analyze the variances between the two sets of figures and identify the underlying causes. For example, the variance may have been caused by a difference in quantity, price, or efficiency. If the variance is due to quantity, then the manager can look into the reasons for the difference in number of units sold or produced. If the variance is due to price, then the manager can look into the pricing strategy and whether it was effective. If the variance is due to efficiency, then the manager can look into the production methods and processes and determine if there are ways to improve them.
By applying Variance Analysis, financial managers can gain insight into what is causing a discrepancy between the budgeted and actual figures and take steps to address it, thereby helping to improve the financial performance of the organization.
Conclusion
Variance Analysis is a key tool used in financial management to compare budgeted and actual results and identify areas of potential improvement. It is used to identify and quantify the variances and then analyze the underlying causes in order to identify potential risks and opportunities. By applying Variance Analysis, financial managers can gain insight into the performance of an organization and take corrective action to address the discrepancies and capitalize on the opportunities.
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