A Variance is the difference between the actual cost and standard cost. If the effect of the variance is to increase the profit, the variance is said to be favorable. In the reverse case, it is adverse or unfavorable.

Variances are of two categories, those relating to quantities which are the result of efficiency or inefficiency in the use of material, labour etc., and those relating to price or rates. The first mentioned category of variance is calculated as follows:

Standard rates x Difference between actual and standard quantities.

The second type of variance is calculated as follows:

Actual quantities x Difference between actual and standard prices.

The variances may be classified into two categories:

1. Cost Variances
2. Sales Variances

1. Materials Variances

Labour variances: These are similar to material variances.

Overhead variances

Overhead variances arise due to the difference between actual overheads and absorbed overheads. Thus if we have to calculate an overhead variance, we have to know the amount of the actual overheads and that of absorbed overheads.

The actual overheads can be known only at the end of the accounting period, when the expense accounts are finalised. The absorbed overheads are the overhead charged to each unit of production on the basis of a pre-determined overhead rate. This predetermined overhead rate is also known as standard overhead recovery rate, standard overhead absorption rate or standard overhead burden rate. To calculate the standard overhead recovery rate, we have to first make as estimate of the likely overhead expenses for each department for the next year. The estimate of budget of the overheads to be divided into fixed and variable elements. An estimate of the level of normal capacity utilisation is then made either in terms of production or machine hours or direct labour hours. The estimated capacity level to calculate the pre-determined overhead absorption rate as shown below divides the estimated overheads:

Standard Fixed Overhead Rate = Budgeted Fixed Overheads/Normal Volume

Standard Variance Overhead Rate = Budgeted Variable Overheads/Normal Volume

The Sales variances can be computed in the two following ways:

1. Sales turnover or value method
2. Profit of sales margin method

Sales turnover or sales value method: In the sales turnover or sales value method, the variances are computed on the basis of sales value. This method will give the sales manager an idea of the effect of various factors affecting sales such as prices, quantity and sales mix on the overall sales value.

The sales value variances are more or less similar to material cost variances or labour cost variances.

1. Firstly, the total sales value variance is to be calculated. Obviously, this is the difference between the actual sales and budgeted sales. The variance can be bifurcated into sales price variance and sales volume variance.

2. Sales price variance can be calculated as below:

Actual quantity X (Actual price - Budgeted price) or Actual sales minus actual quantity at budgeted price.

3. Sales volume variance can be calculated by the following formula:

Budgeted price X (Actual quantity - Budgeted quantity) or Actual quantity at budgeted price minus budgeted sales.

As in the case of materials, the sales volume variance can be bifurcated into sales mix variance and sales quantity variance. The former shows the difference in sales value due to the fact that the actual sales mix is different from what was expected as the budgeted mix. The latter shows the effect of total quantity being larger or smaller than what was budgeted.

For calculating the sales mix variance, we have to calculate the average budgeted price per unit of budgeted mix and the budgeted price per unit of actual mix.

The sales mix variance can then be calculated as below:

Actual quantity x (Budgeted price per unit of budgeted mix minus Budgeted price per unit of actual mix)

The sales quantity variance can be calculated as below:

Budgeted price per unit of budgeted mix x (Budget total qty. - Actual total qty.)

Profit or sales margin method - The purpose of measuring the variances under this method is to identify the effect of changes in sale quantities or selling prices on the profits of the company. The quantity and mix variances should be analyzed in conjunction with each other because the sales management is responsible for both these variances. Where a company is engaged in the manufacture and sale of multiple products, the variances between budgeted sales and actual sales' may arise due to the following reasons:

(a) Changes in unit price and cost.
(b) Changes in the physical volume of each product sold. This is quantity variance.
(c) Changes in the physical volume of the more profitable or; less profitable products. This is mix variance.

There are five distinct variables that can cause actual performance to differ from budgeted performance. They are:

(a) Direct substitution of products.
(b) Actual quantity of the constituents of sales is different from the budgeted quantity.
(c) Actual total quantity being different from budgeted total quantity.
(d) Difference between actual and budgeted unit cost.
(e) Difference between actual and budgeted unit sale price.

The sales management should consider particularly the interaction of more than one variable in making decisions. For example, decrease in selling price coupled with a favorable product quantity variance may help to assess the price elasticity of demand. The formulae for the calculation of sales margin variances are as under:

(a) Total sales margin variance (TSMV): It is the difference between the standard margin and the actual margin.

(b) Sales margin price variance (SMPV): This variance arises because of the difference between the standard price of the quantity actually sold and the actual price thereof.

SMPV = Actual quantity X (Std. margin per unit - Actual margin per unit).

(c) Sales margin volume variance (SMVV): This variance arises because of the difference between the budgeted and actual quantities of each product both evaluated at standard margin.

SMVV = Std. margin per unit X (Budgeted units - Actual units sold)

This can be further sub-divided into the following two variances:

(d) Sales margin quantity variance (SMQV): This variance arises because of the difference between the budgeted quantity and the actual quantity and is ascertained by multiplying this difference by standard margin per unit of standard mix.

(e) Sales margin mix variance (SMMV): This variance arises because of the change in the quantities of actual sales mix from budgeted sales mix and can be computed as below: .

SMMV = Total actual quantity sold X (Standard margin per unit of standard mix Standard margin per unit of actual mix)

As we all know that profit making is the prime objective of a business enterprise, which depends basically on two factors i.e. Costs and Sales. In order to achieve better performance, it is necessary that a business lay down target in respect of both of them. Variance analysis is intimately connected with budgetary control that helps the management in:

1. Planning future activities
2. Comparing actual performance with the budgeted performance
3. Identifying the variances as to their causes
4. Ensuring that remedial measures are taken at appropriate time.

After the variances have been computed and analyzed, the next logical step for the management is to trace the responsibility for the variances to particular individuals or departments. The Management/Cost Accountant may be required to prepare necessary report for this purpose. The report submitted to the management should clearly indicate where action is required. On the basis of this report, the management will try to identify the specific individuals for adverse controllable variances, which being within their control could have avoided. It was earlier mentioned that certain factors, such as changes in market conditions, demand and supply position, etc. are beyond the control of managers. Hence, action to pinpoint responsibility for such uncontrollable variances is not called for.

In case of controllable variances, the responsibility could be traced as shown below to the different departments for different variances:

It may be noted that variance analysis, in itself, would not help in achieving the desired objective of minimizing costs, unless managerial action is prompt and is in the right direction. The direction, of course, shall be indicated by the analysis of variances, but it is the executive side which would be responsible for taking immediate action, exercising proper control, having a close watch over operations, etc., so that economies may be effected inefficiencies minimized and performance improved. A continuous and rigorous effort in the direction of cost control would help the management to achieve the goal of standard costing.