A variance is the difference between actual results and expected performance. The expected performance is also called budgeted performance, which is a point of reference for making comparisons.
Variances bring together the planning and control functions of management and facilitate management by exception. Management by exception is a practice whereby managers focus more closely on areas that are not operating as expected and less closely on areas that are. Consider the scrap and rework costs at a Maytag appliances plant. If actual costs are much higher than originally budgeted, variances prompt managers to find out why and correct the problem to reduce future scrap and rework. If a positive variance occurs, such as lower-than-planned costs, managers try to understand the reasons for the decrease (better operator training or changes in manufacturing methods, for example) so these practices can be continued and implemented by other divisions.
Variances are also used for evaluating performance and to motivate managers. For example, production-line managers at Maytag may have incentives linked to achieving a budgeted amount of operating costs.
Sometimes variances suggest that the company should consider a change in strategy. For example, large negative variances caused by excessive defect rates for a new product may cause managers to investigate and modify the product design or withdraw the product from the market. Variances also help managers make more informed predictions about the future and thereby improve the quality of the five-step decision-making process.
The benefits of variance analysis are not restricted to companies. Public officials have realized that the ability to make timely tactical changes based on variance information can result in making fewer draconian adjustments later. For example, the city of Scottsdale, Arizona, monitors its tax and fee performance against expenditures monthly. Why? One of the city’s goals is to keep its water usage rates stable. By monitoring the extent to which the city’s water revenues are matching its current expenses, Scottsdale can avoid sudden spikes in the rate it charges residents for water as well as finance water-related infrastructure projects.*
How important is variance analysis as a decision-making tool? Very! A survey by the United Kingdom’s Chartered Institute of Management Accountants found that it was easily the most popular costing tool used by organizations of all sizes.