Why firms budget and what a variance tells you
A budget turns strategy into numbers. It forces managers to plan, sets targets, coordinates departments, allocates resources and gives a benchmark to judge performance. After the period, actual results are compared with the budget. The differences, called variances, point managers to what needs attention.
A variance is labeled favorable if it increases profit compared with the budget and unfavorable if it reduces profit. The label tells you the direction, not whether it is good or bad. A favorable material price variance caused by buying cheaper, poorer quality material may lead to waste and complaints, so it is worth investigating whichever way it falls.
Types of budgets
| Budget | What it is | When it is used |
|---|---|---|
| Master budget | The complete set of linked budgets for a period, ending in budgeted financial statements | Annual planning |
| Operating budgets | Sales, production, materials, labor, overhead and expense budgets | Day-to-day planning of activity |
| Financial budgets | Cash budget, capital budget and budgeted statements | Planning funding and liquidity |
| Static budget | Prepared for one expected level of activity and not changed | A baseline for comparison |
| Flexible budget | Recalculated for the actual level of activity | A fairer comparison of costs and profit |
| Rolling budget | Updated regularly by adding a new period as one ends | Uncertain or fast-changing conditions |
| Zero-based budget | Every item must be justified from scratch each period | Controlling overhead |
The master budget starts with the sales budget, because everything depends on expected sales. Production, purchasing, labor and overheads then flow from it, and the cash budget and budgeted income statement and balance sheet sit at the end.
Static versus flexible budgets: a worked example
Compare actual results with a static budget and you may be misled, because the volume was different. A flexible budget fixes this by recalculating revenue and variable costs at the actual volume. The example below separates the volume effect from everything else.
A company budgeted to sell 10,000 units at $20 each, with variable cost of $12 a unit and fixed costs of $50,000. In reality it sold 11,000 units for $214,500 in total (an average of $19.50), variable costs were $140,800 and fixed costs were $52,000.
| Static budget (10,000 units) | Flexible budget (11,000 units) | Actual (11,000 units) | |
|---|---|---|---|
| Revenue | 200,000 | 220,000 | 214,500 |
| Variable costs | 120,000 | 132,000 | 140,800 |
| Contribution margin | 80,000 | 88,000 | 73,700 |
| Fixed costs | 50,000 | 50,000 | 52,000 |
| Operating profit | 30,000 | 38,000 | 21,700 |
| Variance | Calculation | Amount | Label |
|---|---|---|---|
| Sales volume variance | Flexible minus static: 38,000 - 30,000 | 8,000 | Favorable |
| Revenue (price) variance | Actual minus flexible: 214,500 - 220,000 | 5,500 | Unfavorable |
| Variable cost variance | Flexible minus actual: 132,000 - 140,800 | 8,800 | Unfavorable |
| Fixed cost variance | Flexible minus actual: 50,000 - 52,000 | 2,000 | Unfavorable |
| Flexible budget variance (total) | Actual minus flexible: 21,700 - 38,000 | 16,300 | Unfavorable |
| Total variance from static budget | Actual minus static: 21,700 - 30,000 | 8,300 | Unfavorable |
The reconciliation is the key check: the volume gain of 8,000 less the flexible budget variance of 16,300 gives the total shortfall of 8,300. The story the numbers tell: selling more was good, but the company gave away price ($0.50 a unit) and spent more per unit on variable costs ($12.80 instead of $12.00), so profit finished below plan despite higher volume.
Standard costs: price and quantity variances
When a company uses standard costs, it can split material and labor variances into a price (or rate) effect and a quantity (or efficiency) effect. This shows whether the gap came from paying more or using more.
Material price variance = (actual price - standard price) x actual quantity. Material quantity variance = (actual quantity - standard quantity allowed) x standard price. A positive result means actual was higher than standard, so it is unfavorable for costs.
Direct materials (hypothetical)
Each unit should use 2 kg of material at a standard price of $5 a kg. The company made 1,000 units, so the standard quantity allowed is 2,000 kg. It actually bought and used 2,150 kg at $4.80 a kg.
- Price variance: (4.80 - 5.00) x 2,150 = -$430, which is $430 favorable.
- Quantity variance: (2,150 - 2,000) x 5.00 = +$750, which is $750 unfavorable.
- Total: $320 unfavorable. Check: actual cost 2,150 x 4.80 = 10,320, and standard cost allowed 2,000 x 5 = 10,000, a difference of 320.
Direct labor (hypothetical)
Each unit should take 1.5 hours at $18 an hour, so for 1,000 units the standard is 1,500 hours. The company actually worked 1,600 hours at $18.50.
- Rate variance: (18.50 - 18.00) x 1,600 = $800 unfavorable.
- Efficiency variance: (1,600 - 1,500) x 18.00 = $1,800 unfavorable.
- Total: $2,600 unfavorable. Check: actual cost 29,600 minus standard 27,000.
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Get an instant quoteExplaining variances: causes and links
Calculation is half the task. The other half is explaining the reasons and recommending action. Variances are often linked, so look for connections.
| Variance | Possible causes | Possible links |
|---|---|---|
| Favorable material price | Bulk discount, cheaper supplier, favorable exchange rate | Cheaper material may increase waste (adverse quantity variance) or cause quality problems |
| Unfavorable material quantity | Waste, poor quality material, machine faults, untrained workers | May follow from buying cheap material |
| Unfavorable labor rate | Overtime premiums, more skilled workers than planned, wage rise | Skilled workers may reduce the efficiency variance |
| Unfavorable labor efficiency | Poor supervision, breakdowns, low morale, bad material | May be due to poor material or machine downtime |
| Favorable sales volume | Demand higher than expected, successful promotion | May require more overtime and cost more per unit |
| Unfavorable price variance | Discounting, competitor pressure, change of mix | May have driven the higher volume |
Not every variance deserves investigation. Managers look at the largest ones, those that recur and those outside a tolerance, such as 5 percent of budget. In your write-up, say who is responsible, whether the variance is controllable and what action you recommend, for example renegotiate with the supplier, retrain staff or review the discounting policy.
A simple cash budget
A cash budget forecasts cash receipts and payments month by month, so management can plan borrowing and surplus investment. Profit and cash are not the same, and a profitable business can run out of cash, which is why this budget matters.
Three-month cash budget (hypothetical)
The company wants to keep at least $20,000 in the bank. It can borrow in multiples of $1,000 and repay when it can.
| Month 1 | Month 2 | Month 3 | |
|---|---|---|---|
| Opening cash | 20,000 | 20,000 | 20,000 |
| Cash receipts | 80,000 | 90,000 | 100,000 |
| Cash payments | 85,000 | 88,000 | 95,000 |
| Cash before financing | 15,000 | 22,000 | 25,000 |
| Borrowing (repayment) | 5,000 | (2,000) | (3,000) |
| Closing cash | 20,000 | 20,000 | 22,000 |
| Loan balance at end of month | 5,000 | 3,000 | 0 |
Month 1 needs a $5,000 loan to reach the minimum balance. In months 2 and 3 the company repays while holding the minimum, and the loan is cleared. Show the opening balance, receipts, payments, the balance before financing, the financing action and the closing balance, and carry closing cash forward as next month's opening cash.
Practice problem with solution
Budget: 5,000 units at $30, variable cost $18 a unit, fixed costs $40,000. Actual: 5,400 units sold for $159,300 in total, variable costs of $100,440 and fixed costs of $41,500. Prepare the variance analysis.
| Static budget (5,000) | Flexible budget (5,400) | Actual (5,400) | |
|---|---|---|---|
| Revenue | 150,000 | 162,000 | 159,300 |
| Variable costs | 90,000 | 97,200 | 100,440 |
| Fixed costs | 40,000 | 40,000 | 41,500 |
| Operating profit | 20,000 | 24,800 | 17,360 |
Solution
- Sales volume variance: 24,800 - 20,000 = 4,800 favorable.
- Revenue variance: 159,300 - 162,000 = 2,700 unfavorable (the average price was $29.50 instead of $30).
- Variable cost variance: 97,200 - 100,440 = 3,240 unfavorable ($18.60 a unit instead of $18).
- Fixed cost variance: 40,000 - 41,500 = 1,500 unfavorable.
- Flexible budget variance: 17,360 - 24,800 = 7,440 unfavorable, the sum of 2,700, 3,240 and 1,500.
- Total variance from static budget: 17,360 - 20,000 = 2,640 unfavorable, which equals 4,800 favorable less 7,440 unfavorable.
The story: higher volume added profit, but lower prices and higher unit and fixed costs more than wiped it out. A recommendation might be to review discounting and the cost increase per unit.
Writing the analysis
- Separate calculation from interpretation Show the working in a table, then explain in prose.
- Label favorable and unfavorable And explain what each means for profit.
- Reconcile totals Show that your variances add up to the total difference.
- Link related variances For example, a favorable price variance and an unfavorable quantity variance.
- Recommend action Say who should do what, and what you would monitor next.
- Note limits Standards can be out of date, and not all variances are controllable.
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