Variance analysis is a key part of assessing how a business is performing against its budget. Financial expert Adrian Goodman explains.
IF YOU HAVE read my previous articles, you will be aware of my stance on financial control, performanceevaluation and, specifically, management accounts. In summary, monthly management accounts are vital for any business keen to achieve profitable growth.
However, management accounts are only really the first part of your analysis. Once you have carried out your performance evaluation, you need to understand what went well, what went not so well and the reasons why. This is where variance analysis comes in.
Put simply, variance analysis is the process of comparing your actual results to your budgeted results and understanding the reasons why you exceeded or fell short. This means you need to have a budget in place. I extolled the benefits of a well-crafted budget in last month’s article and this is where putting the work in to create it will start to pay off.
If you have compiled your sales budget based on selling x number of products at £x price, then you can simply multiply one by the other to arrive at your budgeted sales revenue for the period. When the period is over and the results are in, you can review the actual volume of products sold and the average selling price, then compare this to the expectations set in your budget.
This leads to an overall sales variance, which is either adverse (worse than budgeted) or favourable (better than budgeted). The overall sales variance consists of two composite variances:
- Sales volume variance: The volume actually sold compared to the volume we expected to sell.
- Sales price variance: The price actually charged to customers compared to the price we expected to charge.
These variances, when added together, will match the overall sales variance as these are the only two reasons your sales revenue can deviate from budgeted levels. They will also be adverse or favourable variances, although it is possible that one could be adverse and the other favourable.
For example if you sold more products than expected, your volume variance will be favourable but if you charged a much lower price in order to achieve higher sales volumes, your price variance would be adverse. The hope would be that the volume variance would be favourable enough to cancel out the adverse price variance and leave you with a favourable variance overall. But it can also go the other way.
Cost variances work in the same way. For example, if you expected to buy a certain amount of material at a certain price but you actually needed more material than expected, or your supplier charged a different price, this will lead to a material cost variance. As before, this is broken down into:
- Material usage variance: Material actually used compared to the amount we expected to use.
- Material price variance: The price actually paid to the supplier, compared to the price we expected to
This type of analysis applies to any line of your budget which was calculated as volume x price (or similar metrics, such as hours required x hourly rate)
So if you have management accounts and a budget in place, you are halfway there. Unless you are following up with variance analysis, you are missing a trick.
Adrian Goodman is managing director of PPX Consulting and author of Achieving Profitable Growth, a guide to establishing financial control in business.
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