What Is Variance?

What Is Variance?

Variance is a measure of the difference between actual and expected results. In personal budgeting and management accounting, it's used to determine whether an individual or organization has exceeded or fallen short of its budgeted income and expenses.

• Alternate definition: In statistics, variance represents the spread of a set of numbers and is calculated as the average squared deviation from the mean.

How Variance Works

At the end of the budgeting or accounting period, an individual or business may calculate the variance between their actual and expected income and expenses to determine whether they went over or fell under budget. By assessing variance, a person or business can take the corrective steps needed to bring actual and budgeted amounts into alignment during the next accounting period and thereby more efficiently allocate dollars (as well as staff and other resources at a business) and negotiate better financial arrangements.

For example, let's say that Bob is a college student who pays for college expenses with a combination of wages from a job and a student loan. He budgets for $2,100 in income and $2,000 in expenses for the month, which would leave him with a budget surplus of $100. During the month, he brings in $2,100 in income but incurs $2,075 in expenses thanks to an unplanned parking ticket, resulting in an actual budget surplus of only $25. At the end of the month, he calculates that the variance between his expected and actual income is $0 ($2,100 less $2,100). But the variance between his expected and actual expenses is $75 ($2,000 less $2,075).

Finally, he calculates the variance between his expected and actual budget surplus, which is $75 ($100 less $25). In other words, he has gone $75 over budget for the month. If he wants to keep the same expected budgetary figures next month but wants them to align with his actual results, he needs to cut unplanned expenses or increase his income.

Types of Variance

Variance may be measured at multiple levels, including:

• Income variance: This is the difference between actual and expected income. If the actual figure is higher than you expected, the variance is said to be favorable. If it's less than the expected figure, you have an unfavorable variance in income. In a budget, you may choose to further break down income into categories (salary and freelance income, for example) and assess the variance at the income category level.
• Expense or cost variance: This represents the difference between actual and budgeted expenditures. If you spend less than you budgeted for, the difference is said to be a favorable variance; if you spent more than you budgeted for, you have an unfavorable variance. You may also calculate variance for a specific expense category (for example, the variance between your expected and actual food and transportation costs. Businesses often track the variance in different types of costs, such as direct material or labor costs and overhead.
• Surplus/deficit or profit/loss variance: An individual may also choose to calculate the variance between the actual and expected surplus, or in the case of an income shortfall, the variance between the actual or expected deficit. Similarly, a business may choose to measure the variance between actual and expected profit or loss.

How to Correct for Variance

Your goal is not to avoid variance completely—that's almost impossible, as you likely have both fixed and variable expenses. Instead, your goal should be to minimize variance. How you go about minimizing variance depends on the specific cause of variance in your budget, so you'll first need to assess that cause.

If, for example, your expenses put you over budget because you tend to spend more on food when you dine out with friends, look for ways to curb spending in the eating-out category ("go dutch" or throw potlucks at home, for example) or compensate for added expenses in that category by decreasing expenses in another category like clothing. If your income rather than spending is the problem, look for a job that pays more, get a second job, or create a passive income stream (such as a money-making blog).

Similarly, if you run a business and face unfavorable expense variance, it may be because the price of raw materials or labor has increased. A possible solution is to work with a different supplier to secure cheaper raw materials, use less raw materials, or reduce overhead or other expenses. If you can't reduce your expenses, you may be able to compensate for the higher expenses by increasing the sales volume or sales price. If you're not bringing in enough revenue, you may need to lower your product price or change the product mix by innovating.