NOTE ON VARIANCE ANALYSIS

Variance analysis is an analytical process for evaluating and explaining business performance by comparing it to an accepted benchmark. It is an important component of a business Management Control Cycle as it provides information about what is happening in the business (both good and bad) upon which management can take action.

Consider the following simple example:

A trip to Grandmas house in Washington D.C.

Grandma offered to pay for your trip but shes tough! Explain to Grandma why it cost you $4.00 more than you had planned to drive to Washington from Boston:

Miles Gallons Gallons

Driven X per Mile = Used X $/Gallon = Total Cost

PLAN 500 1/20 25 $2.00 $50.00

ACTUAL 540 1/18 30 $1.80 $54.00

VARIANCE $ (4.00) Unfavorable

In this example, the process is the development of a plan and measurement of actual results against that plan. The plan becomes the benchmark. In order to explain the unfavorable $4.00 extra cost, you must evaluate each of the variables impacting that cost versus the benchmark.

The variables that need to be examined fall into 3 categories:

VOLUME: Typically units in a manufacturing environment but, more broadly, whatever measure of output that is meaningful for the analysis. For instance, miles would be the volume variable in Grandmas; hours (or # billable professionals x average hours per period) would be the volume variable in a professional firm (consulting, law etc.).

RATE: There are many types of rate variables that can be used to explain variances. In Grandmas, there is a gasoline utilization rate gallons per mile and a gasoline cost rate - $ per gallon. Other rates may include market share, sales price, labor rate per hour, material used per unit, etc.

This leads to three basic rules of variance analysis:

1. Always change variables in the sequence of VOLUME, MIX, RATE

1. Change only ONE variable at a time; once changed it stays at the new number

1. When multiple rates exist, change the $ rate last so you are pricing out actual quantity

The following chart may help visualize the above rules:

VOLUME MIX RATE 1 RATE 2

START Plan Plan Plan Plan

Step 1 Volume Actual Plan Plan Plan

Step 2 Mix Actual Actual Plan Plan

Step 3 Rate 1 Actual Actual Actual Plan

Step 3 Rate 2= END Actual Actual Actual Actual

The example below follows the framework in the above chart. It changes the variable to actual and re-computes the total cost. It then calculates the change in total cost from the prior line giving the variance caused by that variable. Applying this methodology to your trip to Grandmas in Washington:

VOLUME RATE 1 RATE 2 TOTAL VARIANCE

START 500 x 1/20 x $2.00 = $50.00

Step 1 540 x 1/20 x $2.00 = $54.00 $(4.00) Unfav. Volume

Step 2 540 x 1/18 x $2.00 = $60.00 $(6.00) Unfav. Gals/Mile

END 540 1/18 $1.80 = $54.00 $ 6.00 Fav. $/Gallon

TOTAL VARIANCE $(4.00) Unfav.

Now use the results of the variance analysis to tell Grandma what happened and WHAT ACTIONS you would take next time to avoid the cost overrun:

What Happened Corrective Action Plan

1.

2.

3.

BRACKETS ARE BAD

Favorable variances- spending less than plan, bringing in more revenue/profit than plan - are POSITIVE values.

Unfavorable variances- spending more than plan, bringing in less revenue/profit than plan - are NEGATIVE values. They are best displayed inside brackets ( XXX.XX)

In order to make the variance calculations come out with the correct +/- signs, you need to use the following conventions:

Revenue/profit related items use Actual - Budget

Expense related items use Budget - Actual

Please make sure you label your variances with a U for Unfavorable and an F for Favorable