Variance Analysis - definition & overview

Variance Analysis is a critical tool in financial management that allows small businesses to understand the difference between planned and actual performance. This method of financial analysis is a cornerstone in the field of management accounting, providing the means to assess and control business operations.

Understanding Variance Analysis is essential for small business owners, as it can provide valuable insights into the financial health of the business, identify areas of concern, and help in strategic decision-making. In the context of Australian small businesses, where the market is highly competitive and dynamic, variance analysis can be a game-changer.

Concept of Variance Analysis

Variance Analysis is essentially a quantitative investigation of the difference between actual and planned behaviour. This technique is used in budgeting or financial planning and control to assess the performance of a business. The variance can be computed for both costs and revenues.

The concept of Variance Analysis is rooted in the principle of management by exception, which suggests that management's focus should be on areas not operating as expected rather than those performing according to plan. By identifying these variances, businesses can take corrective actions to ensure they are on the right track.

Types of Variances

There are several types of variances that businesses can analyse. These include sales variance, cost variance, volume variance, and mix variance. Each of these variances provides different insights into the business's performance and can help identify specific areas of concern.

Sales variance, for instance, analyses the difference between actual and budgeted sales. Cost variance, on the other hand, looks at the difference between actual and budgeted costs. Volume variance analyses the difference in actual and budgeted quantity of goods sold or produced, while mix variance analyses the difference in the actual and budgeted mix of products sold.

Importance of Variance Analysis

Variance Analysis is a vital tool for small businesses as it helps identify performance gaps, enabling the management to take corrective action. It provides a systematic approach to identify where the business is over-performing or under-performing against its plans or budgets.

Moreover, Variance Analysis can also be used to forecast future performance based on past trends. This predictive aspect of variance analysis is particularly useful for small businesses, as it can help them prepare for future challenges and opportunities.

Process of Variance Analysis

The process of Variance Analysis involves several steps, starting from setting a standard or budget. This is followed by measuring actual performance, calculating the variance, investigating the reasons for variance, and finally taking corrective actions.

Each step in the process is crucial and requires careful attention. For instance, setting unrealistic standards can lead to unnecessary variances, while not properly investigating the reasons for variances can lead to incorrect conclusions and actions.

Setting Standards

The first step in Variance Analysis is setting standards or budgets. These standards act as a benchmark against which actual performance is compared. It's important for these standards to be realistic and achievable, as setting too high or too low standards can lead to misleading variances.

Standards can be set for various aspects of the business, including sales, costs, production volumes, and so on. They should be based on careful analysis and consideration of various factors such as market conditions, past performance, and future projections.

Measuring Actual Performance

Once the standards are set, the next step is to measure actual performance. This involves collecting data on various aspects of the business such as actual sales, costs, production volumes, etc. The accuracy of this data is crucial, as inaccurate data can lead to incorrect variances and misleading conclusions.

Measuring actual performance can be challenging, especially for small businesses that may not have sophisticated data collection systems. However, even simple methods of data collection can be effective if they are done consistently and accurately.

Calculating the Variance

The next step in the process is to calculate the variance. This involves subtracting the standard or budgeted figure from the actual figure. The result can be a positive variance, indicating that actual performance is better than the standard, or a negative variance, indicating that actual performance is worse than the standard.

It's important to note that a positive variance is not always good, and a negative variance is not always bad. For instance, a positive variance in costs means that actual costs are higher than budgeted costs, which is not a good thing. Similarly, a negative variance in sales means that actual sales are lower than budgeted sales, which is also not a good thing.

Analysing the Variance

Once the variance is calculated, the next step is to analyse it. This involves investigating the reasons for the variance. The aim is to understand why the actual performance was different from the standard and what can be done to improve it.

Analysing the variance can be a complex process, as it involves understanding the various factors that can affect business performance. However, it is a crucial step in the process, as it provides the insights needed to take corrective action.

Taking Corrective Action

The final step in the process is to take corrective action. This involves making changes to the business operations to bring performance in line with the standards. The nature of the corrective action will depend on the reasons for the variance.

For instance, if the variance is due to higher than expected costs, the corrective action may involve finding ways to reduce costs. If the variance is due to lower than expected sales, the corrective action may involve improving marketing efforts or adjusting the product mix.

Challenges in Variance Analysis

While Variance Analysis is a powerful tool, it is not without its challenges. One of the main challenges is setting realistic standards. If the standards are too high or too low, it can lead to misleading variances and incorrect conclusions.

Another challenge is the accuracy of data. If the data on actual performance is not accurate, it can lead to incorrect variances. Moreover, analysing the variance can be complex, as it involves understanding the various factors that can affect business performance.

Overcoming the Challenges

Despite these challenges, there are ways to make Variance Analysis more effective. One way is to ensure that standards are set based on careful analysis and consideration of various factors. This can help ensure that the standards are realistic and achievable.

Another way is to ensure that data on actual performance is collected accurately and consistently. This can help ensure that the variances are based on accurate data. Moreover, investing in training and development can help improve the skills and knowledge needed to analyse the variances effectively.

Conclusion

In conclusion, Variance Analysis is a powerful tool that can help small businesses understand their performance and make strategic decisions. While it has its challenges, with careful planning and execution, it can provide valuable insights and help businesses improve their performance.

So, embrace the power of Variance Analysis, and let it guide your business towards success. Remember, every variance is a learning opportunity, a chance to improve, and a step towards success.