Budgets: Variances (Copy)

5.5.2 Variances

1. The Meaning Of Adverse Variances And Favourable Variances

Variance Definition

• A variance is the difference between the budgeted (planned) financial figure and the actual result.
• Variances are used in variance analysis, a management accounting tool to monitor performance.

Favourable Variance

• Occurs when actual performance is better than budgeted performance.
• Examples:
  • Actual sales revenue higher than forecast.
  • Actual costs lower than expected.
• Implication: Improves profitability and shows efficiency or strong demand.
• Example: A retailer budgeted $50,000 in sales but achieved $60,000 → $10,000 favourable variance.

Adverse Variance

• Occurs when actual performance is worse than budgeted performance.
• Examples:
  • Actual costs higher than expected.
  • Actual sales revenue lower than forecast.
• Implication: Reduces profitability and indicates inefficiency or weak demand.
• Example: A manufacturer budgeted $30,000 in raw material costs but spent $35,000 → $5,000 adverse variance.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change AS Level Business Full Scale Course

2. The Calculation And Interpretation Of Variances

Formula For Variance

Variance = Actual Figure – Budgeted Figure

• Positive Variance: If actual > budgeted for revenue OR actual < budgeted for costs → favourable.
• Negative Variance: If actual < budgeted for revenue OR actual > budgeted for costs → adverse.

Example 1: Sales Variance

• Budgeted sales revenue = $80,000.
• Actual sales revenue = $90,000.
• Variance = 90,000 – 80,000 = +$10,000.
• Interpretation: Favourable, because higher sales increased profit potential.

Example 2: Cost Variance

• Budgeted labour cost = $25,000.
• Actual labour cost = $30,000.
• Variance = 30,000 – 25,000 = +$5,000.
• Interpretation: Adverse, as labour cost exceeded budget.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change AS Level Business Full Scale Course

Example 3: Combined Variances In A Business

• Interpretation:
  • Sales revenue is lower than expected (adverse).
  • Raw materials and marketing saved money (favourable).
  • Labour overspent (adverse).
  • Overall: Mixed performance requiring managerial attention.

3. Strategic Use Of Variance Analysis

• Performance Monitoring: Identifies areas where departments are overspending or underperforming.
• Cost Control: Encourages managers to control variable and fixed costs.
• Resource Allocation: Directs investment into high-performing areas.
• Decision-Making: Helps assess whether variances are temporary or structural problems.
• Employee Accountability: Assigns responsibility to managers for areas under their control.
• Example: Airlines analysing fuel cost variances to decide whether to hedge fuel prices in future contracts.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change AS Level Business Full Scale Course

4. Limitations Of Variance Analysis

• Focuses heavily on financial numbers and may ignore qualitative issues like employee morale or customer satisfaction.
• Time lag between results and variance analysis reduces responsiveness.
• External factors (inflation, exchange rates, supply disruptions) may distort variances outside management control.
• Overemphasis on strict budget compliance can discourage innovation.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change AS Level Business Full Scale Course