Variance Analysis Fundamentals

Quick Answer: Variance analysis compares actual results to budgeted amounts, helping managers identify performance gaps. Static budget variances use the original budget regardless of activity, while flexible budget variances adjust for actual volume, providing more meaningful comparisons.

Variance analysis is a cornerstone of management accounting and performance evaluation. It provides the framework for understanding why actual results differ from planned results and forms the basis for corrective action.

Understanding Budget Variances

Static Budget vs. Flexible Budget

The key insight is that comparing actual results to a static budget mixes two effects:

1. Volume Effect: Producing/selling more or less than planned
2. Efficiency/Price Effect: Spending more or less per unit than planned

The Variance Hierarchy

Total Static Budget Variance
├── Sales Volume Variance (Volume Effect)
│   └── Compares flexible budget to static budget
└── Flexible Budget Variance (Efficiency/Price Effect)
    └── Compares actual to flexible budget

Static Budget Variance

Formula: $\text{Static Budget Variance} = \text{Actual Results} - \text{Static Budget}$

Example:

• Static budget: 10,000 units at $50 revenue = $500,000
• Actual results: 11,000 units at $48 revenue = $528,000
• Static Budget Variance = $528,000 - $500,000 = $28,000 F

This variance is favorable because actual revenue exceeded budgeted revenue. However, this doesn't tell the full story—did we do well because we sold more units or because of better pricing?

Flexible Budget Variance

Formula: $\text{Flexible Budget Variance} = \text{Actual Results} - \text{Flexible Budget}$

The flexible budget adjusts the static budget for the actual activity level:

Flexible Budget Calculation: $\text{Flexible Budget} = \text{Budgeted Price} \times \text{Actual Quantity}$

Continuing the Example:

• Flexible budget: 11,000 units × $50 = $550,000
• Actual results: 11,000 units × $48 = $528,000
• Flexible Budget Variance = $528,000 - $550,000 = $(22,000) U

This unfavorable variance reveals that although we sold more units, we actually underperformed on price—charging $2 less per unit than standard.

Sales Volume Variance

Formula: $\text{Sales Volume Variance} = \text{Flexible Budget} - \text{Static Budget}$

Or equivalently: $\text{Sales Volume Variance} = (\text{Actual Qty} - \text{Budgeted Qty}) \times \text{Budgeted Contribution Margin}$

Continuing the Example:

• Sales Volume Variance = $550,000 - $500,000 = $50,000 F
• Or: (11,000 - 10,000) × $50 = $50,000 F

This favorable variance shows the benefit of selling 1,000 extra units.

Reconciling the Variances

This breakdown reveals the complete picture: we benefited from higher volume ($50,000 F) but lost ground on pricing ($22,000 U).

Multi-Level Variance Analysis

For deeper insights, variances can be further decomposed:

Revenue Variances

Sales Mix Variance (Multi-Product Companies)

When companies sell multiple products, the sales mix variance captures the impact of selling a different proportion of products than planned:

$\text{Sales Mix Variance} = \sum[(\text{Actual Mix \%} - \text{Budgeted Mix \%}) \times \text{Actual Total Qty} \times \text{Budgeted CM per unit}]$

Example:

Sales Mix Variance:

• Product A: (55% - 60%) × 10,000 × $30 = $(15,000) U
• Product B: (45% - 40%) × 10,000 × $20 = $10,000 F
• Total Mix Variance: $(5,000) U

The unfavorable variance indicates the company sold proportionally fewer of the higher-margin Product A.

Interpreting Variances

Common Causes of Variances

Management Actions

1. Investigate Significant Variances: Focus on material amounts
2. Distinguish Controllable vs. Uncontrollable: Market conditions vs. internal efficiency
3. Link to Responsibility Centers: Hold appropriate managers accountable
4. Take Corrective Action: Adjust pricing, operations, or budgets as needed
5. Update Forecasts: Revise future projections based on insights