A budget variance is a periodic measure used by governments, corporations, or individuals to quantify the difference between budgeted and actual figures for a particular accounting category. A favorable budget variance includes positive variances or gains; an unfavorable budget variance describes negative variances, indicating losses or shortfalls. Budget variances occur because budgets cannot predict future costs and revenue with complete accuracy.
Budget variances can occur due to either controlled or uncontrollable factors. For example, a poorly planned budget and labor costs are controllable factors. Uncontrollable factors are often external, stemming from occurrences such as natural disasters.
Key Takeaways
- A budget variance measures the differences between actual costs and projected costs in predefined categories.
- Unfavorable, or negative, budget variances indicate budget shortfalls, which may result from underachieving revenues or higher than anticipated costs.
- Variances can arise for internal or external reasons, including human error, unforeseen business conditions, or changes in the economy or regulations.
Understanding Budget Variance
There are three primary causes of budget variance: errors, changing business conditions, and unmet expectations.
- Errors: Errors by the creators of the budget can occur during compilation due to faulty math, incorrect assumptions, or stale data.
- Changing Business Conditions: Fluctuations such as changes in the cost of raw materials or new market competitors can cause variances. Political or regulatory shifts are also contributing factors.
- Unmet Expectations: Management may exceed or fall short of performance expectations, as initial budgets often rely on estimates that incorporate certain assumptions and inputs.
Significance of a Budget Variance
A variance is considered either favorable or unfavorable. A favorable variance occurs when revenue exceeds expectations, or when expenses are lower than predicted, resulting in higher income than forecasted. Conversely, an unfavorable variance arises when revenue falls short of budgeted amounts or costs exceed predictions, leading to lower net income.
When variances are significant or material, they are investigated to determine their causes, and management may take corrective actions. Persistent material variances should prompt a review of the budgeting process.
Budget Variance in a Flexible Budget vs. a Static Budget
A flexible budget allows for adjustments based on alterations to assumptions, providing adaptability to changing circumstances and often resulting in fewer variances. A static budget, however, remains the same regardless of changes in the conditions that were initially assumed.
For instance, if production is lowered, variable costs will likely also decrease. A flexible budget would reflect these changes, whereas a static budget would not, leading to less useful variance information. Most companies prefer flexible budgets to better manage and evaluate financial results.
Example of Unfavorable Variance
Suppose that a company’s sales were budgeted to be $250,000 for the first quarter. However, actual sales were $200,000 due to a demand drop, leading to an unfavorable variance of $50,000 or 20%. A further analysis of the sales mix might reveal specific product lines contributing to the shortfall.
Similarly, if expenses were estimated to be $200,000 but were in fact $250,000, this would accrue another unfavorable variance of $50,000, or 25%.
Related Terms: budgeting, variance analysis, financial control, revenue variance.
