What is variance analysis?

Budgets are financial syntheses representing managers’ expectations about their future activity. To build them, managers rely on forecasts, estimates, and decisions they make. Now, what actually happens is rarely exactly what was expected. Sometimes, differences between actual and budgeted performance are barely noticeable. Sometimes however, actual Operating Income can be significantly different from what was budgeted and managers need to understand why. Variance analysis is designed to help them identify which departures from budget explain most of the observed difference in Operating Income.

Variance analysis consists in systematically comparing actual with planned results for the period. It relies on the systematic assessment of the impact on Operating Income of differences between actual and budgeted performances.

A variance signals that some of the assumptions upon which the budget was built were not realized. What caused the variance (which assumptions) direct managers’ attention towards potential issues and its magnitude triggers an investigation to determine whether a corrective action is necessary. At the end of this chapter, you should be able to:

  • Explain the purposes of variance analysis;
  • Explain the principles of underlying variance analysis;
  • Compute first, second, and third level variances;
  • Explain the meaning of different kinds of variances;
  • Properly report and interpret variances.