One of the most useful principles in financial analysis is that identifying a difference is only the beginning.

Nicholas T. Rafael Jr. examines variance analysis as a process for understanding not just what changed, but why it changed.

Variance analysis compares actual financial performance against another benchmark, such as a budget, forecast, or previous period.

The difference between those numbers is called a variance.

What Is Variance Analysis?

Suppose an organization budgeted $5 million of quarterly revenue but generated $4.6 million.

That produces a $400,000 unfavorable revenue variance.

The calculation is simple.

The explanation may not be.

Finance professionals then need to investigate the factors responsible for the difference.

Possible causes might include:

• Lower sales volume
• Lower pricing
• Customer losses
• Seasonality
• Product mix
• Timing
• Market conditions

That investigation is what makes variance analysis valuable.

Favorable vs. Unfavorable Variances

A favorable variance generally means financial results exceeded expectations.

Examples might include:

• Revenue above budget
• Expenses below budget
• Higher margins
• Better collections

An unfavorable variance generally means results were weaker than expected.

However, these labels should always be interpreted in context.

Lower expenses may appear favorable but could be caused by delayed hiring or an important project that was never completed.

Higher revenue might appear favorable but could come from aggressive discounting that reduces profitability.

The underlying business explanation always matters.

Revenue Variance

Revenue can change for many reasons.

Finance teams may examine:

Volume

Did the organization sell more or fewer units?

Price

Did average pricing change?

Mix

Did customers buy different products or services?

Timing

Did revenue shift between periods?

Customer behavior

Did the company gain or lose significant customers?

Breaking revenue performance into drivers helps management understand what really happened.

Expense Variance

Expense variances can also reveal important operational changes.

Potential causes include:

• Payroll
• Overtime
• Vendor pricing
• Rent
• Insurance
• Marketing
• Technology
• Professional services
• Repairs
• Travel

An expense variance may be temporary or it may indicate a permanent change in the cost structure.

Finance should attempt to distinguish between the two.

Budget vs. Actual

Budget-to-actual analysis compares actual results with the approved financial plan.

This helps management determine whether the organization is meeting expectations.

Not every variance requires detailed investigation.

Many organizations establish thresholds so finance teams can concentrate on differences that are financially significant.

Forecast vs. Actual

Forecast-to-actual analysis evaluates how accurately the organization predicted results.

Repeated forecasting misses can indicate problems involving:

• Assumptions
• Data
• Forecasting methods
• Communication
• Business volatility
• Bias

Studying forecast variance is therefore useful for improving future planning.

Prior-Period Analysis

Finance teams may also compare results with earlier periods.

Examples include:

Month over month.

Quarter over quarter.

Year over year.

These comparisons can help identify seasonality and longer-term operating trends.

A Better Variance Analysis Process

Nicholas Rafael’s approach to explaining financial performance can be summarized through four questions:

What changed?

Why did it change?

Will the change continue?

Does management need to respond?

The fourth question is particularly important.

Financial analysis should ultimately contribute to a decision.

Avoid Variance Overload

Finance teams sometimes provide extremely detailed variance explanations.

More detail does not necessarily produce better analysis.

Executives typically need to understand the most material drivers affecting performance.

Focus should remain on significance.

Frequently Asked Questions

What is variance analysis?

Variance analysis compares actual financial performance against a budget, forecast, prior period, or other benchmark.

What is an unfavorable variance?

An unfavorable variance generally occurs when performance is worse than the comparison benchmark.

What is a favorable variance?

A favorable variance generally occurs when results outperform expectations.

Why is variance analysis important?

It helps management understand the factors driving financial performance.