Variance analysis, sensitivity analysis, and contribution margin in financial management

Finance: Variance Analysis

Describe how variance analysis can be applied to flexible and static budgets

A variance is the difference between an actual amount and a budgeted amount. Budget variances are used by management in their control and planning decisions, particularly in the case of management by exception, which entails identifying areas that are not performing according to plan, and dedicating more attention to the same. Variance analysis has to do with the calculation of variances, and identification of the possible causes of the same. It essentially involves comparing and monitoring actual vs. planned costs, with the aim of identifying trends, threats, and opportunities - and adjusting strategies, goals and objectives if need be (Steffan, 2008). Towards this end, variance analysis helps managers evaluate business performance by assessing the level of effectiveness -- the degree to which targets have been met; and the level of efficiency -- the input cost being incurred in production vis-a-vis the revenues being realized from output.

Its main components are sales volume variances and price and efficiency variances.

Sales volume variance = flexible budget amount (actual sales volume) -- static budget amount

Price variance = (actual input price -- budgeted input price) x actual quantity of output

Efficiency variance = (actual input usage -- budgeted input usage) x budgeted input price

The Concepts of Contribution Margin and Break-Even Analysis

Contribution margin basically measures the contribution of a single unit of output to the production process (Jackson, Sawyers & Jenkins, 2008). It is calculated as the difference between revenues and variable expenses (revenues -- variable expenses). For a single unit of output, contribution margin is given by the revenue per unit of output minus the variable per-unit expenses (Jackson, Sawyers & Jenkins, 2008). A per-unit contribution margin of $20, for instance, can be interpreted to mean that after the per-unit variable expenses have been covered, each unit of output contributes $20 towards the company's fixed costs, and once the fixed expenses have been covered, the profit increases by $20 with every unit of output produced.

The break-even point is that level of production at which the company just breaks even, covering its variable and fixed expenses without making any profits or losses.

Break-even sales level = fixed expense + contribution per unit of output

Graphical Representation of the Break-Even Level of Production

Break-even point Income

Cost Variable costs

Loss Profit Fixed costs

Output