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:
A favourable variance might mean that:
By contrast, an adverse variance might arise because:
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:
“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.