Standard costs (SC) indicate what costs should be for a unit of production. The difference between actual cost (AC) and SC is called a variance.
Accountants can analyze variances to determine why they exist. This analysis can also provide a basis for corrective action. If AC is greater than SC, the variance is unfavorable; if AC is less than SC, the variance is favorable. In other words:
- AC > SC = Unfavorable
- AC < SC = Favorable
Variance analysis helps to identify cost differences between actual performance and desired performance. Hence, it helps to pinpoint efficient and inefficient operating areas.
It also helps when assigning responsibility to individuals and assists in motivating employees and other staff to achieve the organization’s performance targets.
Variance Analysis Technique
The technique of variance analysis enables the investigator to isolate the causes of differences between actual costs and standard costs. For proper control, both favorable and unfavorable variance should be analyzed.
Variance analysis is also used to identify the causes of variances and the individuals responsible for instances of variance. Hence, the system of variance analysis helps management to find answers to the following two questions:
- Is the variance due to loose or tight standards?
- Have the standards been set scientifically?
Variance analysis helps management to rely on the principle of management by exception.
Management is usually not concerned with analyzing every performance report. Instead, the company may decide that performance within ± 3 percent of the budget or standards is acceptable when examining performance reports.
In such cases, the management will only examine more cost areas where differences exceed these limitations. This is a prime example of how variance analysis is used to achieve efficiency.
Types of Variance
Variances can be divided into three main types:
Do you want to test your knowledge about Variance Analysis? Take the quiz we have prepared for you here.
Variance Analysis FAQs
Variance analysis is a technique of investigation using which the possible causes for cost differences between estimated and actual costs can be identified. The goal of variance analysis is to explain why there are deviations from standards (or budgets).
Variance analysis enables managers to identify efficient operation areas by comparing Standard Costs with actual costs. This technique also helps managers provide feedback to employees for improvement efforts. It also provides a method for assigning responsibility when dealing with variances.
Material Variance, Labor Variance, and Overhead or Indirect cost variance are three main types of variances.
A material variance occurs when Standard Costs for quantities purchased or manufactured are compared to actual costs incurred. Any difference between the standard price and the actual cost is a material variance.
A labor variance occurs when Standard Costs for wages paid to employees are compared with actual costs incurred. Any difference between the standard price and the actual cost is considered as labor variance.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.