Variance analysis is a key financial tool used by managers to compare budgeted expectations with actual outcomes, aiding decision making and performance control.
What is Variance Analysis?
Variance analysis is the process of identifying and analysing the difference between budgeted (planned) financial figures and actual performance results. It allows businesses to examine where they have over-performed or under-performed and helps managers understand the reasons behind those differences.
At its core, variance analysis answers the question: Did we do better or worse than expected, and why?
A budget is a financial plan that sets out a business's expected revenues, costs, and profits over a period (often a year or a quarter).
Actual performance is the recorded financial data from operations during the same period.
The variance is calculated as:
Variance = Actual figure – Budgeted figure
If this difference is positive or negative, it tells managers whether their performance was better or worse than expected. However, it is not just the number that matters—understanding the reason for the difference is key.
Types of Variance
There are two main categories of variances that are analysed in business finance: favourable and adverse. Each can occur in different financial areas, including sales revenue, material costs, labour costs, overheads, and profits.
Favourable Variance
A favourable variance occurs when performance is better than the budget. This might mean:
Actual revenue is higher than the budgeted revenue, or
Actual costs are lower than the budgeted costs
In both cases, the business has outperformed its expectations, which is generally seen as a positive outcome.
Examples of favourable variance:
The marketing budget forecasted sales revenue of £50,000 for June, but actual revenue came in at £55,000.
Variance = £55,000 – £50,000 = £5,000 (Favourable)The business planned to spend £6,000 on raw materials in April but only spent £5,500.
Variance = £5,500 – £6,000 = -£500 (Favourable)
(Note: A negative variance in costs can still be favourable if it indicates reduced spending.)
Favourable variances may arise due to:
Better sales performance (e.g. increased demand or successful marketing)
Cost savings through negotiation or efficiency
Lower than expected prices for inputs (e.g. cheaper materials or energy)
Reduced waste or improved productivity
Adverse Variance
An adverse variance is when performance is worse than the budget. This occurs when:
Actual revenue is lower than the budgeted revenue, or
Actual costs are higher than the budgeted costs
Adverse variances indicate underperformance and may signal potential issues that need investigation and correction.
Examples of adverse variance:
Expected sales revenue for Q2 was £120,000, but actual sales were only £110,000.
Variance = £110,000 – £120,000 = -£10,000 (Adverse)The budget for factory wages was £30,000, but the actual wage bill was £33,000.
Variance = £33,000 – £30,000 = £3,000 (Adverse)
Adverse variances may result from:
Weak sales due to poor demand, competition, or ineffective promotions
Increases in supplier prices
Inefficiencies or wastage in production
Overtime payments or unexpected repair costs
Calculating Variance
The basic formula for calculating any variance is:
Variance = Actual result – Budgeted result
After calculating the numerical difference, the result must be labelled as favourable (F) or adverse (A) based on the nature of the outcome.
For revenues:
If actual > budget → favourable
If actual < budget → adverse
For costs:
If actual > budget → adverse
If actual < budget → favourable
Always specify which type of variance it is when answering exam questions.
Worked Numerical Examples
These examples show how to apply variance analysis in practical business scenarios.
Example 1: Sales Revenue Variance
Budgeted revenue = £80,000
Actual revenue = £85,000
Variance = £85,000 – £80,000 = £5,000 favourable
This indicates that the business earned £5,000 more than expected.
Example 2: Raw Material Cost Variance
Budgeted material cost = £20,000
Actual material cost = £22,500
Variance = £22,500 – £20,000 = £2,500 adverse
The company spent more than budgeted, which could indicate waste or supplier price increases.
Example 3: Labour Cost Variance
Budgeted labour cost = £12,000
Actual labour cost = £11,000
Variance = £11,000 – £12,000 = £1,000 favourable
The business saved on labour, which might be due to increased efficiency or fewer hours worked.
Example 4: Multiple Variance Analysis
A company has the following figures for July:
Sales Revenue: Budget = £100,000, Actual = £98,000
Variance = -£2,000 → Adverse
Production Costs: Budget = £40,000, Actual = £38,000
Variance = -£2,000 → Favourable
Marketing Costs: Budget = £10,000, Actual = £12,500
Variance = +£2,500 → Adverse
Total variances show that while costs were saved in production, overspending in marketing and a drop in sales revenue led to a mixed performance.
Importance and Application of Variance Analysis
Identifying Problem Areas
Variance analysis allows businesses to spot areas where performance deviates from expectations. It flags underperforming departments, overspending, or declining revenue streams so management can act quickly.
For example:
A sudden adverse variance in labour costs may reveal inefficient overtime practices.
A large drop in revenue could point to a failed marketing campaign or declining market share.
Performance Monitoring and Evaluation
Managers use variance analysis to assess how well teams or departments have met their financial targets. Positive variances might result in performance bonuses, while negative variances could trigger performance reviews or changes in leadership.
Financial Planning and Forecasting
Patterns in variances over time help in future planning. If variances regularly occur in certain areas (e.g. energy costs), the business can revise future budgets to reflect more accurate expectations.
This contributes to more realistic and informed financial forecasting.
Better Decision Making
Variance analysis supports strategic decisions such as:
Whether to increase or reduce spending
Where to invest more resources
Whether price adjustments are needed
Whether operations should be scaled up or down
It helps reduce guesswork by basing decisions on actual performance evidence.
Budget Control and Cost Management
By regularly comparing budgeted costs with actual outcomes, businesses can:
Tighten control over spending
Investigate areas of overspending
Reduce waste and inefficiencies
Ensure financial discipline across departments
This level of control is particularly important for businesses operating with tight cash flow or low margins.
Limitations of Variance Analysis
Despite its benefits, variance analysis is not without drawbacks. Understanding its limitations helps provide balanced evaluations in exams and business use.
Delayed Information
Variance analysis is often performed at the end of a reporting period. By the time adverse variances are identified, the opportunity to correct the problem may have passed.
Quality of Data
If budgeted figures are based on poor forecasting or unrealistic expectations, variances may not be meaningful. Inaccurate budgets will lead to misleading variances.
Not Always Clearly Favourable or Adverse
Some variances are not straightforward. For example:
Favourable labour cost variance might be due to under-staffing, which could affect output quality.
Adverse marketing cost variance might lead to long-term sales growth and therefore be worthwhile.
Thus, interpretation must consider the wider business context.
Overemphasis on Quantitative Factors
Variance analysis focuses on financial data and may overlook qualitative factors such as customer satisfaction, employee morale, or brand reputation. Managers should use it alongside other performance indicators.
Practical Uses in Business Scenarios
Real-world companies use variance analysis in many ways:
Retailers may analyse sales variance across different stores to decide where to allocate advertising budgets.
Manufacturers monitor cost variances in materials to assess supply chain efficiency.
Service firms might evaluate staff cost variances to manage payroll and shift scheduling more effectively.
Exam Tips for Students
Learn to identify and calculate different types of variances using the correct formula.
Always label each variance as favourable or adverse.
Show full working and clearly state figures in exam answers.
In evaluation questions, avoid generic statements. Explain the impact of the variance and consider context.
Be prepared to discuss both the usefulness and limitations of variance analysis.
Use practical examples to support your points in longer answers (e.g. “A restaurant business may face adverse food cost variances due to inflation.”)
FAQ
Variance analysis can serve as a motivational tool by setting clear financial targets for departments or teams. When performance is monitored against budgets, employees may feel incentivised to achieve or exceed targets to generate favourable variances. This can be linked to performance-related pay, bonuses, or recognition schemes. However, it’s essential that targets are realistic—overly ambitious budgets may demotivate staff, while consistent favourable variances might suggest budgets are too lenient and not stretching performance effectively.
Static budgets remain fixed regardless of actual output levels, while flexible budgets adjust based on activity or production changes. Variance analysis using a static budget may produce misleading results if output levels vary significantly from expectations. In contrast, flexible budgeting allows for more accurate variance comparisons by recalculating budgeted figures to match actual activity. This means variances are more reflective of performance, especially in industries with fluctuating production volumes or seasonal demand shifts.
Not all variances require immediate managerial response. Businesses often set thresholds—known as control limits—beyond which a variance is considered significant. This might be a specific percentage or monetary amount. Significance is also determined by the impact on profitability, trends across time, and the strategic importance of the affected area. For example, a small variance in stationery costs might be ignored, while a similar-sized variance in raw materials for production may demand investigation and intervention.
A business might accept adverse variances if they result from strategic decisions that support long-term growth. For example, overspending on marketing to build brand awareness or launching a new product may create adverse cost variances in the short term but deliver future gains. Similarly, higher labour costs may arise from investing in training or recruitment. These deliberate choices are sometimes budgeted conservatively to manage stakeholder expectations while allowing flexibility in financial planning.
Yes, non-financial factors play a crucial role in understanding variances. For instance, a favourable variance in staff wages might indicate cost savings, but it could also suggest understaffing, leading to lower employee morale or reduced customer service quality. Likewise, adverse variances in production costs may reflect investment in higher-quality materials. Managers must consider qualitative outcomes such as employee wellbeing, customer satisfaction, and strategic positioning when interpreting variances to avoid short-termism in decision making.
Practice Questions
Analyse the possible causes of an adverse variance in labour costs for a manufacturing business. (6 marks)
An adverse labour cost variance may occur if employees worked overtime, increasing total wages beyond the budget. It could also result from hiring higher-skilled, more expensive workers or a rise in wage rates due to union negotiations. Additionally, inefficiencies such as low worker productivity or machinery breakdowns can lead to longer working hours and higher costs. Poor management or scheduling issues might also cause unnecessary labour costs. These factors increase actual expenditure above budgeted levels, resulting in an adverse variance that the business must investigate and address to restore financial control and protect profit margins.
Evaluate the usefulness of variance analysis to a business planning to expand into a new market. (10 marks)
Variance analysis can help a business monitor its performance against forecasts during expansion. It highlights areas where costs exceed budget or revenue falls short, allowing corrective action. This is especially important when entering a new market where uncertainty is high. Favourable variances can indicate effective strategy implementation, while adverse variances expose weaknesses in planning. However, reliance on past data may be less useful in unfamiliar markets, and budget assumptions may be flawed. Moreover, variance analysis focuses on financial figures and may miss qualitative factors. Still, when used with contextual judgement, it remains a valuable planning and control tool.
