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Budgeting - Variance Analysis

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Budget variances and management by exception

A key word to understand when you are looking at budgets is “variance”

A variance arises when there is a difference between actual and budget figures

Variances can be either:

  • Positive/favourable (better than expected) or
  • Adverse/unfavourable ( worse than expected)

A favourable variance might mean that:

  • Costs were lower than expected in the budget, or
  • Revenue/profits were higher than expected

By contrast, an adverse variance might arise because:

  • Costs were higher than expected
  • Revenue/profits were lower than expected

Should variances be a matter of concern to management? After all, a budget is just an estimate of what is going to happen rather than reality. The answer is – it depends.

The significance of a variance will depend on factors such as:

  • Whether it is positive or negative – adverse variances (negative) should be of more concern
  • Was it foreseen?
  • Was it foreseeable?
  • How big was the variance - absolute size (in money terms) and relative size (in percentage terms)?
  • The cause
  • Whether it is a temporary problem or the result of a long term trend

Management by exception” is the name given to the process of focusing on activities that require attention and ignoring those that appear to be running smoothly

Budget control and analysis of variances facilitates management by exception since it highlights areas of business performance which are not in line with expectations.

Items of income or spending that show no or small variances require no action. Instead concentrate on items showing a large adverse variance.

Are all adverse variances bad news?

Here is a point that students often find hard to understand – or believe!

An adverse variance might result from something that is good that has happened in the business.

For example, a budget statement might show higher production costs than budget (adverse variance).  However, these may have occurred because sales are significantly higher than budget (favourable budget).

Remember, it is the cause and significance of a variance that matters – not whether it is favourable or adverse.

Variances illustrated

Consider the following budget statement:

Item

Budget

Actual

Variance

Favourable

£'000

£'000

£'000

or Adverse

SALES REVENUE

Standard product

75

90

15

F

Premium product

30

25

-5

A

Total sales revenue

105

115

10

F

COSTS

Wages

35

38

3

A

Rent

15

17

2

A

Marketing

20

14

-6

F

Other overheads

27

35

8

A

Total costs

97

104

7

A

Profit

8

11

3

F

What do the numbers in the budget statement tell us?

Looking at the sales revenue section, you can see that actual sales of standard product were £15k higher than budget – this is a positive (favourable) variance.

Turning to the costs section, actual wages were £3k higher than budget – i.e. an adverse (negative) variance. 

Overall, the profit variance was positive (favourable) – i.e. better than budget




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Starting a Business

Sources of Finance for a Startup
Franchising
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Market Research for a Startup
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Finance

Revenues
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Costs, Revenues and Profits
Business Costs
Using Budgets
Using Breakeven in Decision-Making
Investment Appraisal Basics
Financial Strategies
Measuring and Improving Profit
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Working Capital
Balance Sheet
Income Statement
Financial Efficiency Ratios
Profitability Ratios and ROCE
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Gearing

Marketing

Competition
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Place (Distribution)
Promotion
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Price Elasticity of Demand

Business Organisation

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Legal Structure Basics
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People

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Using Technology in Operations
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Economic Environment

Economic Sectors
Government Spending & Taxation
Inflation
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Interest Rates & Monetary Policy

Business Strategy

Leadership styles
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Change Management





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