What is variance analysis?

In accounting, a variance is the difference between an expected or planned amount and an actual amount. For example, a variance can occur for items contained in a department's expense report. Variance analysis attempts to identify and explain the reasons for the difference between a budgeted amount and an actual amount.

Variance analysis is usually associated with a manufacturer's product costs. In this setting, variance analysis attempts to identify the causes of the differences between a manufacturer's 1) standard costs of the inputs that should have occurred for the actual products it manufactured, and 2) the actual costs of the inputs used for the actual products manufactured. To illustrate, let's assume that a company manufactured 10,000 units of product (output). The company's standards indicate that it should have used $40,000 of materials (an input), but it actually used $48,000 of materials. This unfavorable variance needs to be analyzed. A common variance analysis will divide the $8,000 into a price variance and a quantity variance. The price variance identifies whether the company paid too much for each unit of input. (Perhaps it paid more per pound of the input than it had planned.) The quantity variance identifies whether the company used too much of the input. (Perhaps it used too many pounds of the raw materials for the number of products it manufactured.)

Variance analysis for manufacturing overhead costs is more complicated than the variance analysis for materials. However, the variance analysis of manufacturing overhead costs is very important as manufacturing overhead costs have become a very large percentage of a product's costs.