The meaning of variances and their types

Variances represent the differences between what a business actually achieves and what it planned in its budget. These differences show whether performance is better or worse than anticipated.

Favourable variances

A favourable variance occurs when actual figures lead to higher profits than budgeted. This happens when actual revenue is greater than budgeted revenue, or when actual costs are lower than budgeted costs.

Adverse variances

An adverse variance arises when actual figures result in lower profits than expected. This takes place when actual revenue is less than budgeted revenue, or when actual costs exceed budgeted costs.

How to calculate variances

Variances are calculated by subtracting the budgeted figure from the actual figure. Variances can be computed for individual items, monthly, or as running totals across budget categories.

Variances can also accumulate. If one favourable variance on sales combines with another on costs, the total effect is a cumulative favourable variance.

Formula for calculating a variance

$\text{Variance}=\text{actual figure}-\text{budgeted figure}$

Where:

• Actual figure = The real amount spent or earned (£)
• Budgeted figure = The planned amount in the budget (£)

Worked example - Calculating a variance

A business budgeted £6,500 for raw materials but actually spent £9,200. Calculate the variance and state whether it is favourable or adverse.

Step 1: Identify the values

• Actual figure = £9,200
• Budgeted figure = £6,500

Step 2: Apply the variance formula

$\text{Variance}=\pounds \mathrm{9,200}-\pounds \mathrm{6,500}=\pounds \mathrm{2,700}$

Step 3: Interpretation

This is an adverse variance of £2,700 because actual spending exceeded the budget, reducing profits.

Worked example - Calculating a cumulative variance

A business budgeted sales revenue of £12,000 but achieved £15,500. It also budgeted £4,200 for utilities but spent only £3,100. Calculate the cumulative variance.

Step 1: Identify the values

• Actual sales revenue = £15,500
• Budgeted sales revenue = £12,000
• Actual utilities cost = £3,100
• Budgeted utilities cost = £4,200

Step 2: Calculate individual variances

Sales variance = £15,500 - £12,000 = £3,500 favourable
Utilities variance = £3,100 - £4,200 = -£1,100 favourable (since costs are lower)

Step 3: Calculate cumulative variance

Cumulative variance = £3,500 + £1,100 = £4,600 favourable

Step 4: Interpretation

The combined effect is a £4,600 favourable variance, increasing profits beyond expectations.

The importance and causes of variances

Variances highlight how a business's performance deviates from its plans. Identifying them early allows businesses to investigate reasons and make adjustments. Even favourable variances should be examined, as they might suggest budgets were not ambitious enough or reveal successful practices to replicate across the organisation. Spotting adverse variances quickly is essential to prevent ongoing issues.

External causes of variances

These are factors outside the business's control that can lead to either favourable or adverse variances:

• Shifts in competitor actions or consumer tastes, which might reduce demand for products.
• Economic fluctuations, such as rising labour costs due to inflation.
• Increases in raw material prices from supply disruptions, like poor harvests.

Internal causes of variances

These stem from within the business and can create favourable or adverse outcomes:

• Enhancements in operational efficiency, leading to cost savings.
• Overly optimistic estimates of savings from process improvements.
• Underestimating expenses related to business restructuring.
• Alterations in pricing approaches that affect sales income.
• Issues with internal communication.

The variance analysis process and its effects on employee motivation

Variance analysis involves examining differences between actual and budgeted figures to understand their causes and implement fixes. This process helps businesses decide on corrective steps to improve future performance.

Steps in the variance analysis process

• Spot the variances by comparing actual and budgeted data.
• Explain the reasons behind them, considering internal and external factors.
• Take action to address issues, such as adjusting strategies to realign with goals.

How variances affect employee motivation

Variances can influence staff morale and productivity in different ways:

• Small variances:
  • Minor adverse ones might prompt employees to fix issues independently.
  • Small favourable ones can encourage ongoing strong performance.
• Large variances:
  • Major favourable ones may lead staff to reduce effort.
  • Significant adverse ones can demotivate workers.

Business responses to favourable and adverse variances

Businesses must respond to variances thoughtfully to maintain alignment between operations and financial plans. Options include modifying activities to match the budget or revising the budget itself, though frequent changes should be avoided to ensure stability and motivation.

Responses to adverse variances

These actions aim to correct issues and restore profitability:

• Revise the marketing mix to boost appeal.
• Adjust prices if the market is sensitive to changes.
• Update products to better meet customer needs.
• Seek new markets for expansion.
• Alter promotional efforts to increase visibility.
• Enhance production processes for efficiency.
• Boost staff motivation to raise output.
• Renegotiate deals with suppliers for better rates.
• Perform further market research to understand trends.

Responses to favourable variances

These steps help capitalise on successes and set higher standards:

• Raise targets if original budgets were too conservative.
• Apply effective methods to other parts of the business.
• Expand capacity or hire more staff to handle increased demand.