Variance Analysis

Volume Effect = (Actual Volume - Budget Volume) x Budget Price x Budget Mix
Price Effect  = (Actual Price - Budget Price) x Budget Volume x Actual Mix
Mix Effect    = Budget Price x Budget Volume x (Actual Mix - Budget Mix)

Example — Revenue variance:

• Budget: 10,000 units at $50 = $500,000
• Actual: 11,000 units at $48 = $528,000
• Total variance: +$28,000 favorable
  • Volume effect: +1,000 units x $50 = +$50,000 (favorable — sold more units)
  • Price effect: -$2 x 11,000 units = -$22,000 (unfavorable — lower ASP)
  • Net: +$28,000

Rate / Mix Decomposition

Used when analyzing blended rates across segments with different unit economics.

Formula:

Rate Effect = Sum of (Actual Volume_i x (Actual Rate_i - Budget Rate_i))
Mix Effect  = Sum of (Budget Rate_i x (Actual Volume_i - Expected Volume_i at Budget Mix))

Example — Gross margin variance:

• Product A: 60% margin, Product B: 40% margin
• Budget mix: 50% A, 50% B → Blended margin 50%
• Actual mix: 40% A, 60% B → Blended margin 48%
• Mix effect explains 2pp of margin compression

Headcount / Compensation Decomposition

Used for analyzing payroll and people-cost variances.

Total Comp Variance = Actual Compensation - Budget Compensation

Decompose into:
1. Headcount variance    = (Actual HC - Budget HC) x Budget Avg Comp
2. Rate variance         = (Actual Avg Comp - Budget Avg Comp) x Budget HC
3. Mix variance          = Difference due to level/department mix shift
4. Timing variance       = Hiring earlier/later than planned (partial-period effect)
5. Attrition impact      = Savings from unplanned departures (partially offset by backfill costs)

Spend Category Decomposition

Used for operating expense analysis when price/volume is not applicable.

Total OpEx Variance = Actual OpEx - Budget OpEx

Decompose by:
1. Headcount-driven costs    (salaries, benefits, payroll taxes, recruiting)
2. Volume-driven costs       (hosting, transaction fees, commissions, shipping)
3. Discretionary spend       (travel, events, professional services, marketing programs)
4. Contractual/fixed costs   (rent, insurance, software licenses, subscriptions)
5. One-time / non-recurring  (severance, legal settlements, write-offs, project costs)
6. Timing / phasing          (spend shifted between periods vs plan)

Materiality Thresholds and Investigation Triggers

Setting Thresholds

Materiality thresholds determine which variances require investigation and narrative explanation. Set thresholds based on:

1. Financial statement materiality: Typically 1-5% of a key benchmark (revenue, total assets, net income)
2. Line item size: Larger line items warrant lower percentage thresholds
3. Volatility: More volatile line items may need higher thresholds to avoid noise
4. Management attention: What level of variance would change a decision?

Recommended Threshold Framework

Set dollar thresholds based on your organization's size. Common practice: 0.5%-1% of revenue for income statement items.

Investigation Priority

When multiple variances exceed thresholds, prioritize investigation by:

1. Largest absolute dollar variance — biggest P&L impact
2. Largest percentage variance — may indicate process issue or error
3. Unexpected direction — variance opposite to trend or expectation
4. New variance — item that was on track and is now off
5. Cumulative/trending variance — growing each period

Narrative Generation for Variance Explanations

Structure for Each Variance Narrative

[Line Item]: [Favorable/Unfavorable] variance of $[amount] ([percentage]%)
vs [comparison basis] for [period]

Driver: [Primary driver description]
[2-3 sentences explaining the business reason for the variance, with specific
quantification of contributing factors]

Outlook: [One-time / Expected to continue / Improving / Deteriorating]
Action: [None required / Monitor / Investigate further / Update forecast]

Narrative Quality Checklist

Good variance narratives should be:

• Specific: Names the actual driver, not just "higher than expected"
• Quantified: Includes dollar and percentage impact of each driver
• Causal: Explains WHY it happened, not just WHAT happened
• Forward-looking: States whether the variance is expected to continue
• Actionable: Identifies any required follow-up or decision
• Concise: 2-4 sentences, not a paragraph of filler

Common Narrative Anti-Patterns to Avoid

• "Revenue was higher than budget due to higher revenue" (circular — no actual explanation)
• "Expenses were elevated this period" (vague — which expenses? why?)
• "Timing" without specifying what was early/late and when it will normalize
• "One-time" without explaining what the item was
• "Various small items" for a material variance (must decompose further)
• Focusing only on the largest driver and ignoring offsetting items

Waterfall Chart Methodology

Concept

A waterfall (or bridge) chart shows how you get from one value to another through a series of positive and negative contributors. Used to visualize variance decomposition.

Data Structure

Starting value:  [Base/Budget/Prior period amount]
Drivers:         [List of contributing factors with signed amounts]
Ending value:    [Actual/Current period amount]

Verification:    Starting value + Sum of all drivers = Ending value

Text-Based Waterfall Format

When a charting tool is not available, present as a text waterfall:

WATERFALL: Revenue — Q4 Actual vs Q4 Budget

Q4 Budget Revenue                                    $10,000K
  |
  |--[+] Volume growth (new customers)               +$800K
  |--[+] Expansion revenue (existing customers)      +$400K
  |--[-] Price reductions / discounting               -$200K
  |--[-] Churn / contraction                          -$350K
  |--[+] FX tailwind                                  +$50K
  |--[-] Timing (deals slipped to Q1)                 -$150K
  |
Q4 Actual Revenue                                    $10,550K

Net Variance: +$550K (+5.5% favorable)

Bridge Reconciliation Table

Complement the waterfall with a reconciliation table:

Note: Percentages can exceed 100% for individual drivers when there are offsetting items.

Waterfall Best Practices

1. Order drivers from largest positive to largest negative (or in logical business sequence)
2. Keep to 5-8 drivers maximum — aggregate smaller items into "Other"
3. Verify the waterfall reconciles (start + drivers = end)
4. Color-code: green for favorable, red for unfavorable (in visual charts)
5. Label each bar with both the amount and a brief description
6. Include a "Total Variance" summary bar

Budget vs Actual vs Forecast Comparisons

Three-Way Comparison Framework

When to Use Each Comparison

• Actual vs Budget: Annual performance measurement, compensation decisions, board reporting. Budget is set at the beginning of the year and typically not changed.
• Actual vs Forecast: Operational management, identifying emerging issues. Forecast is updated periodically (monthly or quarterly) to reflect current expectations.
• Forecast vs Budget: Understanding how expectations have changed since planning. Useful for identifying planning accuracy issues.
• Actual vs Prior Period: Trend analysis, sequential performance. Useful when budget is not meaningful (new business lines, post-acquisition).
• Actual vs Prior Year: Year-over-year growth analysis, seasonality-adjusted comparison.

Forecast Accuracy Analysis

Track how accurate forecasts are over time to improve planning:

Forecast Accuracy = 1 - |Actual - Forecast| / |Actual|

MAPE (Mean Absolute Percentage Error) = Average of |Actual - Forecast| / |Actual| across periods

Variance Trending

Track how variances evolve over the year to identify systematic bias:

• Consistently favorable: Budget may be too conservative (sandbagging)
• Consistently unfavorable: Budget may be too aggressive or execution issues
• Growing unfavorable: Deteriorating performance or unrealistic targets
• Shrinking variance: Forecast accuracy improving through the year (normal pattern)
• Volatile: Unpredictable business or poor forecasting methodology