What is Variance Analysis: Types, Examples and Formula

Introduction

In any business, having a grasp of projected cashflows, and available cash is crucial for daily financial operations. Enterprises utilize variance to measure the disparity between expected and actual cash flow.

Variance analysis involves assessing the reasons for the variances and understanding their impact on financial performance. In this ever-changing global economy, variance is an important metric for enterprises to track more than ever as it helps understand how accurate your cash forecasts are and whether you need to adjust your financial plans or take corrective actions to survive in the ever-changing volatile business environment. 

By the end of this blog, you will be able to understand variance analysis, its importance, and how to calculate it so you can leverage the cash properly and make strategic and informed business decisions.

What is Variance Analysis?

Variance analysis measures the difference between the forecasted cash position and the actual cash position. A positive variance occurs when actual cash flow surpasses the forecasted amount, while a negative variance indicates the opposite. Variance analysis helps you understand where you went over or under budget and why. 

This analysis provides insights into budget deviations and their underlying causes. It holds significance by enabling financial performance monitoring, trend identification, and informed decision-making for future planning. Through variance analysis, you can stay aligned with financial objectives and progressively enhance your profitability.

Types of Variance Analysis

Different types of variances can occur in the cash forecasting process due to reasons such as changes in market scenarios, customer behavior, and timing issues, among other factors. These variances can impact both sales revenue and expenses. By understanding the core impacts of these variances, companies can make necessary adjustments to their budgets, mitigate risks, and improve their overall financial performance.

Broadly, variances can be classified into two major categories:

1. Materials, Labor, and Variable Overhead Variances
2. Fixed Overhead Variances

Materials, labor, and variable overhead variances

These include price/rate variances and efficiency and quantity variances. Price/rate variances show the differences between industry-standard costs and actual pricing for materials, while efficiency variances and quantity variances refer to the differences between actual input values and the expected input values specified. This analysis plays a crucial role in managing procurement costs, making informed decisions, optimizing cost structures, and maintaining positive cash flow.

Fixed overhead variances 

Fixed overhead variances include volume variances and budget variances. Volume variances measure the difference between the actual revenue and budgeted revenue that is derived solely from changes in sales volume. Meanwhile, budget variances indicate the differences between actual and budgeted amounts. These variances help businesses understand the influence of sales volume fluctuations on financial performance, provide insights into the effectiveness of financial planning, and identify areas of overperformance or underperformance. 

Budget variances 

Budget variances can be divided into two subgroups: expense variances and revenue variances. Expense variance measures actual costs compared to the budgeted costs while revenue variances measure actual revenue with the budgeted revenue. Positive revenue variances represent revenue that exceeds the expected revenue, while negative revenue variances represent lower expected revenue.

Budget variance analysis are important to understand the reasons behind the deviations from the budgeted amounts. It enables the identification of avenues for enhancing business processes, boosting revenue, and cutting costs. By examining revenue variances, you can uncover possibilities for long-term efficiency improvements and increased business value.

Let’s take a look at an example of variance in budgeting 

Let’s say that your enterprise sells gadgets, and you’ve projected that you’ll sell $1 million worth of gadgets in the next quarter. However, at the end of the quarter, you find that you’ve only sold $800,000 worth of gadgets. That’s a variance of $200,000, or 20% of your original plan. By analyzing this variance, you can figure out what went wrong and take steps to improve your sales performance in the next quarter. Here, variance analysis becomes the vital tool that enables you to quickly identify such changes and adjust your strategies accordingly to manage your financial performance and optimize cash forecasting.

Role of Variance Analysis 

In periods of market instability, your business could face unforeseen fluctuations in revenue, costs, or other financial indicators. In such cases, one of the most crucial tools in your financial management system is variance analysis.

Variance analysis allows you to track the financial performance of your organization and implement proactive measures to decrease risks and enhance financial health. It enables businesses to compare their expected cash flow with their actual cash flow and to identify the root reasons for any discrepancies. Businesses can acquire an important understanding of their cash flow performance and decide on appropriate actions in response to fluctuating market conditions.

For instance, If a company realizes its cash inflows are lower, it can cut costs or alter its pricing strategy to stay profitable. Likewise, if its real cash outflows exceed because of unforeseen costs, it can modify its financial plan or explore other funding choices.

Variance Analysis Formula 

The key components of variance are relatively straightforward; actuals vs. expected. Let’s look into the key variance analysis formula that focuses on specific financial metrics. These formulas unveil gaps between expected and actual results, providing insights into specific aspects of performance. 

Cost variance formula

Cost variance measures the difference between actual costs and budgeted costs. The cost variance formula is:

This formula helps identify cost control issues, inefficiencies, and opportunities for improvement.

Efficiency variance formula

Efficiency variance measures the difference between actual input values (e.g., labor hours, machine hours) and budgeted or standard input values. The efficiency variance formula is:

This formula helps organizations identify variations in productivity and pinpoint areas for improvement.

Volume variance formula

Volume variance, also known as sales volume variance, measures the impact of changes in sales volume on revenue compared to the budgeted volume. The variance volume formula is: 

This formula helps organizations to understand the contribution of sales volume to revenue performance.

Budget variance formula

Budget variance measures the actual revenue with the budgeted revenue. The budget variance formula is:

This formula aids in evaluating pricing strategies, market demand, and sales effectiveness.

Examples of Variance Analysis 

For instance, let’s consider, a company that plans to create a new mobile app with a projected cost of $50,000. The expected timeline for completion is 4 months, with a budgeted labor cost of $10,000 per month. The target is to release the application with 10 key features. Here are the examples that demonstrate different types of variances under this scenario:

Cost variance:

During the development process, the company implements cost-saving measures and efficient resource allocation, resulting in lower actual costs. The actual cost of the project at completion is $45,000. The cost variance can be calculated as follows:

Here, the negative cost variance of -$5,000 indicates that the company has achieved cost savings of $5,000 compared to the budgeted cost for the project.

Efficiency variance:

The project is efficiently managed, and the team completes the development in 3.5 months instead of the budgeted 4 months. Assuming a budgeted labor cost of $10,000 per month, the efficiency variance can be calculated as follows:

The negative efficiency variance of -$5,000 indicates that the project was completed ahead of schedule, resulting in labor cost savings of $5,000.

Volume variance:

The final version of the mobile application is released with 12 key features instead of the budgeted 10 features. Assuming a budgeted revenue of $2,000 per feature, the volume variance can be calculated as follows:

The positive volume variance of $4,000 indicates that the company delivered additional features, resulting in increased revenue of $4,000 compared to the budgeted amount.

Budget variance:

The company spent $8,000 on marketing and promotional activities for the mobile application launch, while the budgeted amount was $10,000. The budget variance can be calculated as follows:

The negative budget variance of -$2,000 indicates that the company spent $2,000 less than the budgeted amount for marketing and promotional activities.

In these scenarios, the company achieved cost savings, enhanced efficiency, delivered additional features, and spent less than the budgeted amount on marketing expenses. These variances provide insights into cost management, efficiency, revenue generation, and budget adherence within the given software development project scenario.

Benefits of Conducting Variance Analysis

Let’s take a look at the top 4 benefits enterprises can reap by conducting variance analysis for cash forecasting:

Identify discrepancies

Variance analysis helps identify discrepancies between the actual cash inflows and outflows and the forecasted amounts. By comparing the forecasted cash flow with the actual cash flow, it is easier to identify any discrepancies, enabling the stakeholders to take corrective measures. 

Refine cash forecasting techniques

Conducting variance analysis allows for a review of past forecasts to identify any errors or biases that may have impacted accuracy. This information can be used to refine forecasting techniques, improve future forecasts make adjustments to existing forecast templates, or build new ones.

Improve financial decision-making

Understanding the reasons for variances can provide valuable insights that can help improve financial decision-making, which is critical in a volatile market. For example, if a variance is caused by unexpected expenses, management may decide to reduce expenses or explore cost-saving measures.

Better cash management

By analyzing variances, companies can identify areas where cash management can be improved. This can include better management of accounts receivable or accounts payable, more effective inventory management, or renegotiating payment terms with the suppliers.

Role of AI in Variance Analysis for Cash Forecasting

Amid turbulent market conditions, as companies prepare for 2024 and beyond, enterprises’ finance chiefs professionals are recommending various enhancements to improve decision-making. The most commonly mentioned improvements are the adoption of digital technologies, AI, and automation, and the enhancement of forecasting, scenario planning, and consistency in measuring key performance indicators, as per the Deloitte CFO Signals Survey.

This goes to show the significance of the adoption of advanced technologies, such as AI, for companies preparing for uncertain markets. The challenge with traditional variance analysis is that it is difficult for treasurers to create low-variance cash flow forecasts for enterprises as they utilize manual methods and spreadsheets while dealing with large volumes of data. Moreover, relying on manual variance reduction approaches leads to high variance and can be time-consuming, labor-intensive, and expensive, thus, delaying the decision-making process.

Here’s how AI addresses this challenge and enables it to take variance analysis to the next level: 

• AI-based cash forecasting software helps in variance analysis by taking additional steps to improve the accuracy of the cash forecast by 90-95%. 
• It enables organizations to continuously improve the forecast by understanding the key drivers of variance. 
• It compares cash forecasts to actual results to check for variances, aligning the forecast with other aspects such as monthly, quarterly, and yearly forecasts, thus, ensuring that the forecast is accurate across various scenarios.
• AI also analyzes the accuracy of cash forecasts through a line item analysis across multiple horizons and makes tweaks to the algorithm through an AI-assisted review process. 
• Finally, AI fine-tunes the forecast model and enhances the data as needed to achieve the desired level of forecast accuracy. 

Benefits of Leveraging AI in Variance Analysis

Here are some of the key benefits you can achieve by conducting variance analysis with AI in cash forecasting:

Automated reporting

AI can streamline the process of reporting discrepancies in cash flow by delivering consistent reports that emphasize developments and regularities. Automating the process of reporting allows organizations to save time and resources that would otherwise have been spent on manual reporting. This also guarantees consistent and accurate reporting, removing the chance of human mistakes. By receiving frequent updates on discrepancies in cash flow as they occur, you can effectively monitor your business’s cash flow and pinpoint opportunities for enhancement to optimize your financial results.

Faster, data-driven decision-making

AI can assist in making quicker, better-informed decisions about managing cash flow by providing in-depth insights on cash forecasts in real time. This can assist companies in promptly addressing fluctuations in cash flow and implementing necessary measures. This is especially crucial in periods of market volatility when cash flow trends can quickly fluctuate and unforeseen circumstances may arise.

Real-time cash analysis & better liquidity management 

With AI at its core, cash flow forecasting software can learn from industry-wide seasonal fluctuations to improve forecasting accuracy. AI-powered cash forecasting software that enables variance analysis can also create snapshots of different forecasts and variances to compare them for detailed, category-level analysis. Offering such comprehensive visibility, helps you respond quickly to changes in cash flow, take corrective action as needed, and manage your enterprise’s liquidity better. 

Improved cash forecasting accuracy with real-time cash analysis

AI streamlines your examination of cash flow by delving deeply into and analyzing a large volume of data from various sources, such as past cash flow information, market trends, and economic indicators, in real time. Therefore, it allows for an immediate understanding of discrepancies in cash flow. This can offer a more in-depth assessment of cash flow discrepancies, enabling the recognition of trends and patterns that may not be visible through manual review.

How HighRadius Can Help Automate Variance Analysis in Cash Forecasting? 

In a rapidly evolving business landscape, market uncertainties and disruptions can have a significant impact on an enterprise’s financial stability. That’s why having a robust cash forecasting system with AI at its core is essential for businesses to conduct automated variance analysis. HighRadius’ cash forecasting software enables more advanced and sophisticated variance analysis that helps you achieve up to 95% global cash flow forecast accuracy. 

By leveraging its AI capabilities in data analysis, pattern recognition, real-time integration, and predictive modeling, it empowers finance teams to gain deeper insights, improve accuracy, and make more informed decisions to manage cash flow effectively. Furthermore, our solution helps continuously improve the forecast by understanding the key drivers of variance. The AI algorithm learns from historical data and feedback, continuously improving their accuracy and effectiveness over time. This iterative learning process enhances the quality of variance analysis results. 

Our AI-based cash forecasting solution supports drilling down into variances across various cash flow categories, geographies, and entity-level variances performing a root cause analysis, and helps achieve up to 98% automated cash flow category tagging. 

FAQs

1) What is the difference between standard costing and variance analysis?

Standard costing is setting an estimated (standard) cost on metrics such as input values, materials, cost of labor, and overhead based on industrial trends and historical data. Variance analysis focuses on analyzing and interpreting differences (variances) between actual costs and standard costs.

2) What are the three main sources of variance in an analysis?

In variance analysis, the three main sources of variance are material variances (differences in material usage or cost), labor variances (variations in labor productivity or wage rates), and overhead variances (deviations in overhead costs).

3) What is P&L variance analysis?

P&L (profit & loss) variance analysis is the process of comparing actual financial results to expected results in order to identify differences or variances. This type of variance analysis is typically performed on a company’s income statement, which shows its revenues, expenses, and net profit or loss over a specific period of time. 

4) Why is the analysis of variance important?

The analysis of variance is important to keep track of as it tells about the financial health of your business. With proper variance analysis, you can measure the financial performance of your business, keep track of over and under-performing financial metrics, and identify areas for improvement.