What Is a Budget Variance?
Let me explain budget variance directly to you: it's a periodic measure that governments, corporations, or individuals use to quantify the difference between what was budgeted and what actually happened in a specific accounting category. If you see a favorable budget variance, that means positive variances or gains; an unfavorable one points to negative variance, like losses or shortfalls. These variances happen because no one can predict future costs and revenue with perfect accuracy.
You should know that budget variances can come from controlled or uncontrollable factors. For example, a poorly planned budget or labor costs are things you can control, while uncontrollable factors are often external, like a natural disaster hitting your operations.
Key Takeaways
- A budget variance describes cases where actual costs are higher or lower than standard or projected costs.
- An unfavorable budget variance indicates a shortfall, possibly from missed revenues or higher-than-expected costs.
- Variances can arise from internal or external reasons, including human error, poor expectations, and shifting business or economic conditions.
Understanding Budget Variances
There are three main causes of budget variance that I want you to consider: errors, changing business conditions, and unmet expectations. Errors happen during budget creation, maybe from faulty math, wrong assumptions, or bad data. Changing business conditions could involve economic shifts, higher raw material costs, or a new competitor affecting prices—political or regulatory changes fit here too.
Unmet expectations occur when management overperforms or underperforms. Remember, expectations are based on estimates that rely on inputs and assumptions, so variances are more common than managers prefer.
Significance of a Budget Variance
You need to label a variance as 'favorable' or 'unfavorable' appropriately. A favorable one means revenue is higher than budgeted or expenses lower, leading to greater income. An unfavorable variance happens when revenue is short or expenses higher, potentially lowering net income below expectations.
If variances are material, investigate them to find the cause, and then management must address it. What's material depends on the company and variance size, but persistent ones signal a need to review the budgeting process.
Budget Variance in a Flexible Budget Versus a Static Budget
Consider this: a flexible budget lets you make changes when assumptions shift, while a static budget stays fixed even if things change. The flexible approach adapts better to circumstances, resulting in fewer variances, positive or negative.
For example, if production drops, variable costs drop too, and a flexible budget reflects that for evaluation. A static budget keeps the original production level, making the variance less useful. That's why most companies use flexible budgets.
Example of Unfavorable Variance
Here's a straightforward example: suppose a company's sales were budgeted at $250,000 for the first quarter, but actual sales were only $200,000 due to falling demand. That's an unfavorable variance of $50,000, or 20%. The company would analyze the sales mix variance per product to pinpoint issues.
On the expense side, if projected expenses were $200,000 but actual came to $250,000, that's an unfavorable variance of $50,000, or 25%.
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