Understanding Variance Accounting- A step-to-step guide
In business and finance, firms will always attempt to operate within their budget. In many instances, things will never be as planned.
Business tends to spend more or less than budgeted; the firm sells more or fewer units than as projected by them.
The difference of the actual and budgeted value is called variance. In order to understand why there are the respective variances, businesses will study them by using variance accounting.
In this post, we break it all down: what variance accounting is, why it matters, and how it works-all in simple terms.
You will walk away with a concrete understanding of how variance accounting works when businesses want to get a handle on their finances.
What is Variance Accounting ?
Variance accounting is the process of comparison of planned or budgeted financial outcomes with the actual outcome and which lets business understand how well they are sticking to their financial plans.
In brief, it answers such a question as follows: "Why is there a difference between what we expected and what we got?
Consider the case of an organization that has planned to sell 1,000 units of a product within a month.. Nevertheless, it sold only 800 units.
Again, a firm might plan to incur ₹10,000 for the month's expense but at the end of the month has incurred ₹12,000.
Such differences are called variances, and variance accounting finds out all the causes why these differences occurred.
It then becomes easier for companies to make the right decisions in the future and modify their budget or prices to suit reality.
Types of Variances :
Two common categories of variances that businesses adhere to are cost variances and sales variances. These place most of the tracked variances into two broad categories.
1. Cost Variances
This is known as a cost variance, where the actual cost of something is not the same as budgeted or expected cost.
Such variances can arise for many reasons: costs of materials, labor, or overheads are higher than budgeted for, or the following might be the result of the organisation: quite unforeseen or unavoidable overheads.
There are several types of cost variances :
Material Variance :
This arises when the price or quantity of material in use in the production process differed from the standard. For instance, if the firm budgeted for ₹ 50 per unit of material and later incurred a total of ₹ 70 on it then that would be negative material variance.
Labor Variance:
It arises when labor cost is deviated from budgeted, though in any direction. Assume that the company had budgeted to pay ₹ 500 per hour, but has to pay ₹ 600. Then labor variance would be negative.
Overhead Variance:
It arises when overhead is either greater or lower than budgeted. Overhead consist of indirect costs such as utilities or rent.
2. Sales Variances
A sales variance refers to the actual quantity of a difference between a company's revenue and budgeted revenue earned.
Sales variances may result from selling either more or less products than those projected, or from selling the products at a price other than that estimated.
Some examples of some common sales variances include:
Volume Variance:
If the number of units sold is different than what was expected, then we have volume variance.
Let's understand this by one example.
Suppose a company sold 500 units less than the number it had expected. In this case, the selling of 450 units will be against its expected selling quantity with negative volume variance.
Price Variance :
The difference between realised selling price and budgeted price will be the case. It will be negative if, in anticipation, the selling price was budgeted at ₹500 but could realise only ₹450.
Mix Variance:
At times, a company sells various products and each has a different profit margin. If the company sells more of the low-margin products and fewer of the higher-margin ones, then they could possibly have mix variance.
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Why Variance Accounting Matters ?
Variance accounting has great significance for several reasons:
1. Aids in Decision Making
Understanding where and why variations occur allows businesses to make intelligent decisions.
A company could realize that labor costs tend to be consistent highs; this information could lead them to adjust such costs through efficiency improvements or negotiating better rates with suppliers.
2. Keeps Budgets Realistic
Over time, one can use the data from variances to make better budgets. If material costs are consistently over budget, then it's likely time to raise the material budget.
This means future financial plans will be based on realistic expectation rather than outdated assumptions.
3. Identifies Potential Issues Early
Variance accounting can identify problems early, when they are still manageable.
For example, if a business finds that its sales are not going as well as one might have hoped, it can continue to investigate why.
Its prices may be too high, or perhaps its products aren't quite as sought after as once thought. In these ways, early detection of problems allows adjustment before it is too late.
How Variance Accounting Works ?
Now that we know what is variance accounting and why is it necessary, let's look at how variance accounting plays out in practice.
Here are the main steps of variance accounting:
1. Set a Budget or Standard
The first step of variance accounting is the budget or standard. This is a kind of financial plan or expectation.
For instance, a firm may budget ₹100,000 for its next month's production costs or expect to sell 1,000 units of a particular product.
2. Record Actual Results
Then, after the budget or standard, the company continues with the normal running of business.
At this step, it will have actual results from the financials, for example, how much it spends to bring them forth or how many units of the product sold.
3. Calculation of Variance
Once you have actual results in hand, calculate variance by comparing the actual results to budgeted results.
There's a simple formula that will be explained for variance as:
Variance = Actual Result - Budgeted Result
For example, suppose the budget had planned to spend ₹100,000 on the cost of production and incurred ₹110,000. Then, there would be a variance of -₹10,000.
Suppose it had budgeted to sell 1,000 units but was able to sell only 900; then, a variance of -100 units happened.
4. Examining the Variance
After computing the variance, the firm would further like to know why it happened. That is where analysis takes place.
The firm will evaluate the factors like cost of materials, labor rates, and market conditions as to who caused the actual variance to happen.
5. Follow-Up Action
Action from the company can finally be taken upon variance analysis. It can alter the budget for the next period, alter the strategy in operations, or seek ways to make the services even more efficient.
The goal is to have the least number of unfavorable variances and reasonable expectations financially.
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Positive Variance vs. Negative Variance
The two kinds of variances are positive or negative variance.
This is known as positive variance, indicating the actual output on the cost side is better than the budgeted or estimated one.
For instance, if a company had planned to spend ₹20,000 on materials and ultimately spent only ₹18,000, then it would be its positive variance of ₹2,000, which indicates it is performing better than estimated-by either saving cost or earning more revenue.
On the contrary, if Negative variance happens, that means that the real result was even worse than predicted.
In this case, the company planned for ₹50,000 in sales but only received ₹45,000. That left a shortfall of ₹5,000 and had the result coming in worse than budgeted, it could either mean higher expenses than budgeted or revenues less than budgeted.
Good news is that positive variance and bad news or something requiring investigation or improvement is a negative variance.
Variance Accounting Example
ABC Furniture plans to sell 500 chairs in the month for ₹100 per chair. It also plans to use ₹30 per chair for material and ₹20 per chair for labor. This is their budget.
- Sales Budget: ₹50,000 (500 chairs × ₹100)
- Budget for Material Costs: 500 chairs × ₹30 = ₹15,000.
- Budget for Labour Costs: 500 chairs x ₹20 = ₹10,000
At the end of the month, ABC Furniture made ₹32 in material purchases and ₹18 in labour sales, totalling 450 chairs at ₹95 each. With actuals, here is how it all worked out:
- Actual Sales: 450 chairs x ₹95 = ₹42,750
- Actual Material Costs: 450 chairs x ₹32 = ₹14,400
- Actual Labour Cost: 450 Chairs x ₹18 = ₹ 8,100
Now to calculate the variances:
- Sales Variance: ₹42,750 - ₹50,000 = -₹7,250 (negative)
- Material Variability: ₹14,400 - ₹15,000 = ₹ 600 (Positive)
- Labour Variance: ₹8,100 - ₹10,000 = ₹ 1,900 (positive)
The sales variance was negative because of the sale of fewer chairs at the lower price than budgeted.
On the other hand, material and labor variances were positive since it spent lesser on these cost elements as compared to the quantity budgeted to be spent.
Conclusion
This is the reason why variance accounting is so helpful in knowing the financial situation of the business in relation to budget.
Monitoring and analyzing variances keeps companies ahead on identifying problems early, adjusts their strategies, and makes smarter financial decision.
All this is aimed at keeping them on track to success in the long run.
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