In the world of accounting, there are several practices that you can use to judge your organization's financial performance and health. One of the most important is variance analysis, which helps you understand whether your company is meeting its goals.
What is variance analysis?
Simply, variance analysis assesses the gap between estimated behavior and actual results. Any two comparison points can be used, though in accounting the most frequent is actual financial results and projected budget or forecast.
By performing variance analysis, you'll discover how much difference there is between the two and determine a comprehensive explanation for the difference.
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Why is variance analysis important?
The information gained from the analysis can help you to understand how your business is performing and whether operational changes are required. Not only will it help inform future business decisions, but it can also be helpful if you are looking to adopt a flexible budget process.
By enabling you to detect accounting errors and omissions, variance analysis can also alert you to unusual activity that may indicate fraud. Auditors will often request a variance analysis to quickly identify areas that may need closer examination.
The benefits of regularly conducting variance analysis include:
- Identifying performance trends – Understanding where you are excelling and where you are struggling is key to optimizing your performance.
- Improving budgeting accuracy – By identifying discrepancies between expected and actual results, your organization can improve its budgeting process to ensure that future budgets are more accurate.
- Greater cost control – Variance analysis can help you to identify areas where your company may be overspending or underspending. This data can then be used to adjust and ensure better financial performance.
How do I conduct variance analysis?
At its most basic, you can conduct a variance analysis by comparing your actuals — the real payments or revenue that are paid out or collected by a company — with another financial record such as the previous year or budget.
A variance analysis can be conducted on a monthly, quarterly, or annual basis, depending on the reporting periods of your organization. You can also conduct a variance analysis to identify favorable or adverse variances. While the more obvious application is to see why your organization underperformed against the expected budget, it can be equally as important to determine the causes of a favorable variance. For instance, if you overperformed your budget, you need to verify that it was not due to improper budgeting or miscalculations.
As an example of looking at adverse variances, let's assume that your company's year-over-year (YOY) growth is positive 100K or 10%; however, actuals are negative 50K. This means that YOY you are growing, but you are not meeting your goals laid out before the year started.
Once you've recognized this, you must determine why. Did you estimate too high? Did you lose salespeople? Did an expected deal not close? If the budget differences are significant, then you'll want to forecast the remainder of the year.
For example, if you expected a customer to close with a $1M deal, but that customer went bankrupt, and that $1M is about 10% of your budgeted revenue growth, you'd want to forecast the remainder of the year without the $1M. That would then tell you if you should reduce expenses to maintain a certain level of profitability.
On occasion, variances may be seasonal or random. Regular variance analysis is important for your organization to calculate the impact of these events to perform more effective future analyses.
Your organization may also want to set a threshold, or a standard, for how significant a variance should be before it requires further investigation. As an example, your team might determine that any variance below 5% does not require additional action.
What are the limitations of variance analysis?
While a useful tool, there are certain limitations and drawbacks to variance analysis. First and foremost is the fact that it's strictly a reactive tool. As such, it only identifies a problem after it has already occurred. This means that companies may suffer losses before detecting the issue. Because of this, it should not be an organization's sole source of grading performance.
Once a variance analysis has been conducted, the interpretation of the data is also subjective. When looking to identify why a variance exists, the answer may be strongly subjective based on the person or persons conducting the study. In addition, variance analysis relies on standards. In the above example, your company may have set a standard of 5% variance before action is required. However, this standard can also be subjective and could lead to substantial issues being overlooked.
Finally, depending too strongly on variance analysis can cause companies to take a short-term approach to their finances. While every organization wants to avoid adverse variances, there are occasions when that may be unavoidable, such as when your business is pursuing a long-term growth plan. By avoiding them, you could limit your company's potential.
These limitations highlight the importance of measuring multiple key performance indicators (KPIs) and using a variety of analytical methods when studying your data.
To get the most out of your organization's data, it helps to adopt an automation solution, such as Quadient AP, that provides full transparency and customizable reporting. By integrating with the rest of your tech stack, it provides a single source of truth to access all your financial information.
Find out how Quadient AP can elevate your data analysis by booking a demo today!
Featured Resource: How to track, benchmark, and improve your Accounts Payable KPIs
