The meaning and types of variances

Variance refers to the gap between what a business actually achieves and what was planned in its budget. This difference shows whether performance is ahead of or behind expectations.

Types of variances

• Favourable variance - This occurs when results are better than budgeted, which is positive for the business. It is also known as a positive variance.
• Adverse variance - This happens when results are worse than budgeted, which is negative for the business. It is also known as a negative variance.

Examples:

• Favourable variance: actual revenue or profit exceeds the budgeted amount, or costs come in lower than expected.
• Adverse variance: fewer products are sold than predicted or spending on materials exceeds the budget.

Note that describing a variance as positive or negative refers to its impact on the business (good or bad), not whether the calculated number is mathematically positive or negative.

How to calculate variances

Variances can be worked out for individual budgets on a monthly basis, as a cumulative total over time, or for groups of budgets either monthly or as a running total. When multiple variances are combined, this creates a cumulative variance.

Formula for calculating 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 (£)

A positive result from this calculation indicates a favourable variance for revenue (higher than expected) but an adverse variance for costs (higher than expected). A negative result shows the opposite.

Worked example - Calculating variance

A business budgets £35,000 for marketing costs but actually spends £42,000. Calculate the variance and determine if it is favourable or adverse.

Step 1: Identify the values

• Actual figure = £42,000
• Budgeted figure = £35,000

Step 2: Apply the variance formula

$\text{Variance}=\pounds \mathrm{42,000}-\pounds \mathrm{35,000}=\pounds \mathrm{7,000}$

Step 3: Interpret the result

This is an adverse variance of £7,000, as the business has overspent compared to the budget.

Worked example - Calculating cumulative variance

A company budgets £60,000 in sales revenue but achieves £69,000. It also budgets £20,000 for transport costs but spends only £17,000. Calculate the cumulative variance.

Step 1: Identify the values

• Sales revenue: Actual = £69,000, Budgeted = £60,000
• Transport costs: Actual = £17,000, Budgeted = £20,000

Step 2: Calculate individual variances

Sales variance = £69,000 - £60,000 = £9,000 (favourable)
Transport variance = £17,000 - £20,000 = -£3,000 (favourable, as costs are lower)

Step 3: Calculate cumulative variance

Cumulative variance = £9,000 + £3,000 = £12,000 (favourable)

Causes of variances

Variances arise from a range of internal and external factors that affect how closely actual performance matches the budget.

External causes of variances

• Competitor actions and market trends - Rivals might lower prices or changing customer preferences could boost or reduce product demand.
• Economic changes - Shifts in the wider economy, such as rising wage levels, can increase business costs.
• Supply issues - Increases in raw material prices, for instance due to poor harvests, can lead to higher expenses.

Internal causes of variances

• Efficiency improvements - Introducing new technology, like automated systems, can reduce costs and create favourable variances.
• Misjudgements in planning - Overestimating savings from process changes or underestimating the expense of organisational adjustments.
• Pricing decisions - Altering the selling price after the budget is set can affect revenue.
• Communication problems - Poor internal coordination often leads to variances, highlighting the need for better information sharing within the business.

The importance of variance analysis

Variance analysis involves identifying variances and investigating their causes to enable corrective action. It is essential for understanding deviations from the budget and improving future performance.

Reasons to investigate variances

• Spotting issues early - Adverse variances must be detected quickly to identify responsible departments and implement fixes, preventing larger problems.
• Learning from success - Favourable variances should be examined to check if budgets were too easy or to replicate effective practices across the business.
• Impact on motivation - Small variances can encourage staff to improve performance independently, while large ones may demotivate teams by seeming unachievable or unnecessary to address.

Responding to variances

When variances are identified, businesses must decide whether to adjust operations to match the budget or revise the budget to reflect reality. Frequent budget changes should be avoided, as they reduce certainty and can lower staff motivation by making targets seem flexible.

Responses to adverse variances

• Adjust marketing - Lower prices if demand is price elastic, update products, seek new markets, or revise promotion strategies.
• Improve efficiency - Streamline production processes or motivate staff to increase productivity.
• Control costs - Negotiate better deals with suppliers or conduct more market research for accurate future budgets.

Responses to favourable variances

• Revise targets - If budgets were too cautious, set more challenging goals next time.
• Spread best practices - If productivity gains caused the variance, apply them business-wide and raise future expectations.
• Scale up operations - For higher-than-expected sales, increase production or hire more staff to capitalise on demand.