The process of comparing the actual performance of a business with the budgeted numbers is known as Variance Analysis. The comparison will be made both during the period covered by the budget and at the end of it.
In case of any differences between the original targets and the actual figures, variances will be identified and the reasons for those discrepancies will be investigated.
What is a variance?
A variance is the difference between the budgeted figures in the budget and the actual figures achieved by the business. Variances help business managers to monitor and control budgets as well as to review the annual budget against original targets.
Budgetary control measures require managers to also investigate the cause or causes of any variance.
Also, budgetary control corrective measures will be taken to ensure that actual outcomes equal, or are very close to, the budgeted figures.
How to calculate a variance?
A variance is calculated as a difference between the actual results and the budgeted numbers:
Variance = Actual Results – Budgeted Results
Let’s take a look at the following example of the budgeted Profit and Loss Account (P&L Account) of a hamburger restaurant.
| Budgeted | Actual | Variance | |||||||
|---|---|---|---|---|---|---|---|---|---|
| Sales Revenue | $10,000 | $8,000 | $2,000 | (Adverse) | |||||
| – | |||||||||
| Cost of Goods Sold (COGS) | $5,000 | $4,000 | $1,000 | (Favorable) | |||||
| Expenses (Overheads | $1,000 | $2,000 | $1,000 | (Adverse) | |||||
| = | |||||||||
| Profit | $4,000 | $2,000 | $2,000 | (Adverse) |
The Variance for Sales Revenue of $2,000 is Adverse as the actual sales revenue is lower than the budgeted sales revenue which is not favorable.
Secondly, the Variance for Cost of Goods Sold (COGS) of $1,000 is Favorable as the actual Cost of Goods Sold (COGS) is lower than the budgeted Cost of Goods Sold (COGS) which is favorable.
Next, the Variance for Expenses (Overheads) of $1,000 is Adverse as the actual Expenses (Overheads) are higher than the budgeted Expenses (Overheads) which is not favorable.
Finally, the Variance for Net Profit of $2,000 is Adverse as the actual Net Profit is lower than the budgeted Net Profit which is not favorable.
Two types of variances: Favorable Variance and Adverse Variance
1. Favorable Variance
A Favourable Variance exists when the discrepancies between the actual results and the budgeted numbers are financially beneficial to the firm. Higher sales revenue, higher profit and lower costs are considered financially beneficial.
Favourable Variance exists when the difference between the budgeted and actual figure leads to a higher-than-expected sales revenue and profit (overselling), and lower-than-expected costs (underspending).
| Budgeted | Actual | Variance | |||||||
|---|---|---|---|---|---|---|---|---|---|
| Sales Revenue | $10,000 | $12,000 | $2,000 | (Favorable) | |||||
| Cost of Goods Sold (COGS) | $5,000 | $4,000 | $1,000 | (Favorable) | |||||
| Expenses (Overheads | $2,000 | $1,000 | $1,000 | (Favorable) |
Possible causes of Favourable Variances include:
- Sales Revenue to be above the budgeted amount due to increased quantity sold, more revenue streams and price alteration having positive effect on sales.
- The cost of production Cost of Goods Sold (COGS) to be below the budgeted amount due to decrease in direct materials costs and decrease in direct labor costs.
- The Expenses (Overheads) to be below the budgeted amount due to lower rent, lower management costs, lower marketing costs and lower administrative costs.
2. Adverse Variance
An Adverse Variance exists when the discrepancies between the actual results and the budgeted numbers are not financially beneficial to the firm. Lower sales revenue, lower profit and higher costs are considered not financially beneficial.
Adverse Variance exists when the difference between the budgeted and actual figure leads to a lower-than-expected sales revenue and profit (underselling), and higher-than-expected costs (overspending).
| Budgeted | Actual | Variance | |||||||
|---|---|---|---|---|---|---|---|---|---|
| Sales Revenue | $12,000 | $10,000 | $2,000 | (Adverse) | |||||
| Cost of Goods Sold (COGS) | $4,000 | $5,000 | $1,000 | (Adverse) | |||||
| Expenses (Overheads | $1,000 | $2,000 | $1,000 | (Adverse) |
Possible causes of Adverse Variances include:
- Sales Revenue to be below the budgeted amount due to decreased quantity sold, less revenue streams and price alteration having negative effect on sales.
- The cost of production Cost of Goods Sold (COGS) to be above the budgeted amount due to increase in direct materials costs and increase in direct labor costs.
- The Expenses (Overheads) to be above the budgeted amount due to higher rent, higher management costs, higher marketing costs and higher administrative costs.
How should managers respond to Variance Analysis results?
Managers need to respond to both Favorable Variances and Adverse Variances. Once all variances have been calculated, then managers need to investigate their causes to implement corrective measures.
It is a common practice to place greater emphasis on investigating the areas with Adverse Variances.
1. Responding to Adverse Variances. Firstly, increase Sales Revenue by selling more products, create more revenue streams and alter the prices in a way to have positive effect on sales. Secondly, decrease the cost of production Cost of Goods Sold (COGS) by lowering direct materials costs and lowering direct labor costs. Thirdly, decrease the Expenses (Overheads) by lowering rent, management costs, marketing costs and administrative costs. Any Adverse Variance caused by an increase in output leading to higher raw materials costs and direct labor costs is of much less concern.
2. Responding to Favorable Variances. Favorable Variances happen either because something positive happened, or they may reflect a poor and inaccurate budgeting process where sales budgets were set to be too low and costs budgets were set to be too high. A Favourable Variance caused by a decrease in Cost of Goods Sold (COGS) due to lower output sold than budgeted is of much concern.
Should a variance be expressed in monetary terms or as a percentage?
Variances can be expressed either in monetary terms or as percentages. While Variances do not have to be expressed as percentages, some businesses prefer to use percentage figures to show differences between budgeted figures and actual values.
Benefits of conducting Variance Analysis
Analyzing variances in the budgets is an essential part of budgeting. Here are the following benefits gained from conducting regular Variance Analysis:
- Measures deviations. Variances show differences from the budgeted performance of each department and division. Deviations from the planned numbers can be measured both each month and at the end of each year.
- Helps to identify causes of deviations. Variances assist in analyzing the causes of deviations from the original budget. They help budget holders with understanding the reasons for the deviations from planned levels. For example, Variance Analysis will help to determine whether lower profit was due to lower sales revenue or higher costs. After causes of deviations are clearly understood by managers, it will be easier to make future budgets more accurate.
- Allows for solving budgetary problems. By allowing managers to concentrate on the major problem area, the likely causes of the issue can be investigated quickly. Identifying potential problems as early as possible can help with taking actions to make corrections.
- Assesses performance against the budget. Variance Analysis can help with evaluating the performance of each individual department or division. Each budget-holding section of the firm can be appraised in a quantitatively objective way.
In summary, while Variance Analysis helps with budgetary controls and assessing performance, it is not a planning tool. It is because variances can only be calculated at the end of the budgeting period, not at the beginning of the process when planning is usually made.
