Study Notes: Business Finance & Accounting

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:

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