Variance (Accounting)

In accounting and budgeting, a variance is the difference between an actual result and a planned, budgeted or standard amount. Variances are calculated for costs, revenues, sales volumes and profits. A favorable variance is one that improves profit compared with the plan, such as lower costs or higher sales, while an unfavorable variance reduces profit.

Variance analysis is a core tool of management accounting, especially in standard costing systems, where each unit has a predetermined cost for materials, labor and overhead. It supports management by exception: managers spend their time on the results that differ most from plan. The accounting sense should not be confused with variance in statistics, which measures how widely data are spread around their mean and is the square of the standard deviation.

A family plans to spend $600 on groceries in a month and actually spends $650. The $50 difference is a variance, and because it means less money left over, it is unfavorable. If they had spent $560 instead, the $40 saving would be a favorable variance.

Knowing the size of the gap is only the start. The useful question is why it happened. Perhaps prices rose at the supermarket, or perhaps the family hosted guests and simply bought more food. Businesses ask the same two questions, about price and about quantity, so that they can fix the right problem or adjust the plan.

• Budget variance. A budget variance compares actual results with a static budget prepared for the expected level of activity.
• Flexible budget variance. Compares actual results with a flexible budget restated for the actual level of activity, separating efficiency from volume effects.
• Sales variances. Split differences in revenue into a price effect and a volume or mix effect.
• Materials variances. The direct materials price variance and the direct materials usage variance separate paying a different price from using a different quantity.
• Labor variances. The direct labor rate variance and the direct labor efficiency variance do the same for wages and hours.
• Overhead variances. Spending and efficiency variances cover variable overhead, and the fixed manufacturing overhead volume variance reflects producing more or fewer units than planned.

The two direct materials variances are calculated as:

• $AP$ is the actual price paid per unit of material.
• $SP$ is the standard price per unit of material.
• $AQ$ is the actual quantity of material used.
• $SQ$ is the standard quantity allowed for the actual output.

A positive result is unfavorable and a negative result is favorable. A manufacturer's standard is 2 pounds of material per unit at $4.00 a pound. It makes 1,000 units, so the standard quantity allowed is 2,000 pounds and the standard cost is $8,000. It actually uses 2,150 pounds bought at $3.80 a pound, a cost of $8,170.

The price variance is ($3.80 minus $4.00) times 2,150, or $430 favorable. The quantity variance is (2,150 minus 2,000) times $4.00, or $600 unfavorable. Together they explain the total variance of $170 unfavorable, the difference between $8,170 and $8,000.

Few businesses investigate every variance. Many set thresholds, such as a percentage of the budgeted amount or a fixed dollar figure, and look into anything larger or anything that recurs. Variances are often linked: in the example above, cheaper material may have been of lower quality, causing more waste. Responsibility matters too, since the purchasing manager usually answers for price variances and the production manager for usage. A favorable variance is not automatically good news. Skipping maintenance or training can produce one in the short term at the cost of larger problems later.

In a standard costing system, variances are recorded in separate variance accounts during the year. At year-end, small net variances are usually closed to cost of goods sold. Large ones are spread across inventory and cost of goods sold, because US GAAP requires inventory to be reported at amounts that approximate actual cost. Public companies also explain significant differences from prior-year results in the management's discussion and analysis section of their annual and quarterly reports.

• Institute of Management Accountants