Variance Analysis: The Intuition First
Imagine you're a student who planned to spend ₹500 on textbooks this month. At the end of the month, you actually spent ₹650. The difference — ₹150 extra — is a variance. Variance analysis is simply the process of breaking down why that difference happened.
In business and finance, every plan has a standard (the expected number) and an actual (what really happened). Variance analysis compares the two and explains the gap. It's the financial equivalent of "what went right, what went wrong, and why."
The Core Idea
Variance = Actual Result − Standard (or Budgeted) Result
A positive variance isn't always good, and a negative one isn't always bad — it depends on what you're measuring.
- Revenue variance: Actual revenue − Budgeted revenue. If actual > budget, that's favourable (you earned more).
- Cost variance: Actual cost − Budgeted cost. If actual > budget, that's adverse (you spent more than planned).
So the sign flips meaning depending on whether it's income or expense.
The Precise Statement
Variance analysis is a quantitative technique that decomposes the total difference between actual and standard performance into its root causes. For costs, the two primary drivers are:
- Price variance — Did we pay more or less per unit than planned?
- Quantity (or usage) variance — Did we use more or fewer units than planned?
Total Cost Variance=Actual Cost−Standard Cost
Total Cost Variance=Price Variance+Quantity Variance
Where:
- Price Variance = (Actual Price − Standard Price) × Actual Quantity
- Quantity Variance = (Actual Quantity − Standard Quantity) × Standard Price
A Concrete Example
Suppose a factory plans to produce 1,000 units of a product. The standard says each unit should use 2 kg of raw material at ₹10 per kg. So standard cost per unit = ₹20.
Actual results: Produced 1,000 units, used 2,200 kg of material at ₹9 per kg. Actual cost = ₹19,800.
Step 1: Total variance
- Standard cost for 1,000 units = 1,000 × ₹20 = ₹20,000
- Actual cost = ₹19,800
- Total variance = ₹19,800 − ₹20,000 = −₹200 (favourable, because we spent less)
Step 2: Break it down
Always use the actual quantity for price variance and the standard price for quantity variance. This avoids double-counting.
- Price variance = (₹9 − ₹10) × 2,200 kg = −₹2,200 (favourable — paid less per kg)
- Quantity variance = (2,200 kg − 2,000 kg) × ₹10 = +₹2,000 (adverse — used more material) …