What is variance?

Definition and Examples of Variance

What is Variance?

Variance is the difference between actual income and expenses versus the budget. It is used in personal budgeting and management accounting to determine whether an individual or organization has exceeded or fallen short of the budgeted income and expenses.

Alternative Definition: In statistics, variance represents the spread of a set of numbers and is calculated as the average of the squared deviations from the mean.

How Does Variance Work?

At the end of a budgeting or accounting period, an individual or company can calculate the variance between actual and expected income and expenses to determine whether they have exceeded or fallen short of the budget. By assessing the variance, a person or company can take corrective actions necessary to align actual amounts with the budget during the next accounting period and thus allocate dollars (along with employees and other resources in the company) more efficiently and negotiate better financial arrangements.

For example, let’s assume Bob is a college student who pays for university expenses with a mix of wages from a job and a student loan. Bob plans a budget of $2,100 as income and $2,000 for expenses for the month, which will leave him with a budget surplus of $100. During the month, Bob earns $2,100 and incurs expenses of $2,075 due to an unplanned parking ticket, resulting in an actual budget surplus of only $25. At the end of the month, Bob calculates that the variance between his expected and actual income is $0 ($2,100 minus $2,100). However, the variance between expected and actual expenses is $75 ($2,000 minus $2,075).

Finally, he calculates the variance between the expected and actual budget surplus, which is $75 ($100 minus $25). In other words, Bob overspent the budget by $75 during the month. If he wishes to maintain the same projected budget figures for the next month but wants to align them with actual outcomes, he will need to reduce unplanned expenses or increase his income.

Note: Businesses typically calculate variance as part of variance analysis, which divides variance by type (for example, cost variance or profit variance).

Types of Variance

Variance can be measured at multiple levels, including:

• Income Variance: This is the difference between actual and expected income. If the actual figure is higher than anticipated, the variance is favorable. If it is lower than the expected figure, you have an unfavorable income variance. You can also calculate variance for a specific category of income (e.g., variance between expected and actual expenses for food and transportation).
• Expense or Cost Variance: This represents the difference between actual expenses and the budget. If you spend less than you planned, the difference is a favorable variance; if you have spent more than you planned, you have an unfavorable variance. You can also calculate variance for a specific category of expenses (e.g., variance between expected and actual expenses for food and transportation). Companies often track variance in different types of costs, such as direct material costs or direct labor and overhead costs.
• Surplus/Deficit or Profit/Loss Variance: An individual may also choose to calculate the variance between actual and expected surplus, or in the case of a shortfall in income, the variance between actual or expected deficit. Similarly, a company may opt to measure the variance between actual and expected profits.

How to Correct Variance

Your goal is not to avoid variance altogether – this is nearly impossible as you likely have fixed and variable expenses. Instead, your goal should be to minimize variance. How to reduce variance depends on the specific reason for the variance in your budget, so you will first need to assess this cause.

If
Your expenses might exceed your budget because you spend more on food when dining out with friends. Look for ways to limit spending in the dining category (for example, split the bill or organize group meals at home) or offset the additional expenses in that category by reducing spending in another category like clothing. If your income rather than spending is the issue, look for a higher-paying job, get a side job, or create a passive income source (like a money-generating blog).

Note: Sometimes, variance is artificially created (for example, your accounting software might spread the annual insurance premium cost over 12 months). As a result, you may notice favorable variance in some months and unfavorable variance in others, but generally, you do not need to take any specific corrective action for this type of variance.

Similarly, if you run a business and face unfavorable expense variance, it could be due to rising costs of raw materials or labor. A possible solution might be to work with a different supplier for cheaper raw materials, use less raw material, or cut overhead or other expenses. If you cannot reduce your expenses, you may be able to offset higher expenses by increasing sales volume or the sales price. If you’re not generating enough revenue, you may need to lower the product price or change the product mix through innovation.

Conclusion

Variance is a term used in personal budgeting and business to refer to the difference between actual and expected results, and it can tell you how much you are over or under budget. It can be measured at multiple levels, including income, expenses, and budget surplus or deficit. You can correct variance by examining its cause in your budget and then reducing expenses or increasing income as necessary.

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Sources:

• UMN Libraries. “14.3 The Financial Planning Process.” Accessed Nov. 1, 2020.
• BYU Idaho. “What Causes Variance?” Accessed Nov. 1, 2020.

Source: https://www.thebalancemoney.com/what-is-variance-453768