Budgeting and Variance Analysis: Favourable and Adverse Variances
A budget is a financial plan setting a target figure, such as sales revenue, costs, or profit, for a future period, used to control spending and measure performance. Once the period has passed, the actual figure achieved is compared with the budgeted figure to calculate a variance, the numerical difference between them. A variance is described as favourable when it has a positive effect on profit, which for revenue means actual is higher than budget, but for costs means actual is lower than budget; a variance is described as adverse when it has a negative effect on profit, which for revenue means actual is lower than budget, but for costs means actual is higher than budget. Managers investigate significant variances to find their cause, which may be controllable (e.g. poor cost management, correctable internally) or uncontrollable (e.g. a rise in global raw material prices, requiring the budget itself to be revised rather than blame assigned).
Before you start
Make sure you're comfortable with these topics first:
Method
- Identify whether the figure in question is a revenue item or a cost item, since the same-sized numerical difference is interpreted in opposite ways for each.
- Calculate the variance as actual minus budget for both revenue and cost lines, keeping the sign.
- Label a revenue variance: positive (actual higher than budget) is favourable; negative (actual lower than budget) is adverse.
- Label a cost variance the opposite way round: positive (actual higher than budget, i.e. cost overrun) is adverse; negative (actual lower than budget) is favourable.
- Where profit is involved, calculate budgeted profit and actual profit separately (revenue minus costs for each) and take the variance between the two profit figures to see the net effect.
- Explain a likely cause of a significant variance and whether it is controllable, since this shapes what management should do next, such as tightening cost control internally versus revising the budget for a factor outside the business's control.
Worked example
A business budgeted for sales revenue of 50,000 pounds and costs of 30,000 pounds for the month. Actual sales revenue was 54,000 pounds and actual costs were 33,000 pounds. Calculate the revenue variance, the cost variance, and the overall profit variance, stating whether each is favourable or adverse.
- Budgeted profit: 50,000 - 30,000 = 20,000 pounds.
- Actual profit: 54,000 - 33,000 = 21,000 pounds.
- Revenue variance: 54,000 - 50,000 = +4,000 pounds. Since actual revenue is higher than budgeted revenue, this is a favourable variance.
- Cost variance: 33,000 - 30,000 = +3,000 pounds. Since actual costs are higher than budgeted costs, this is an adverse variance, even though the number is positive.
- Profit variance: 21,000 - 20,000 = +1,000 pounds, a favourable variance overall.
- Check: the 4,000 pound favourable revenue variance, minus the 3,000 pound adverse cost variance, equals a net 1,000 pound favourable effect on profit, which matches the profit variance calculated directly.
Practice questions
Try each question, then tap to reveal the answer.
Q1Define a favourable variance for a revenue budget line.Show answer
Answer: When actual revenue is higher than the budgeted revenue figure, which has a positive effect on profit.
Q2A business budgets for costs of 10,000 pounds but actual costs are 8,500 pounds. Calculate the variance and state whether it is favourable or adverse.Show answer
Answer: Variance = 8,500 - 10,000 = -1,500 pounds. Since actual costs are lower than budgeted costs, this is a favourable variance.
Q3State one uncontrollable reason a cost variance might be adverse.Show answer
Answer: A rise in global raw material or energy prices outside the business's control.
Q4Budgeted revenue is 20,000 pounds and actual revenue is 17,000 pounds. Calculate the variance and state whether it is favourable or adverse.Show answer
Answer: Variance = 17,000 - 20,000 = -3,000 pounds, an adverse variance, since actual revenue is lower than budgeted revenue.
Q5Explain why the same numerical variance can be favourable for one type of budget line but adverse for another.Show answer
Answer: Because for revenue, a higher-than-budgeted actual figure benefits profit and is favourable, but for a cost, a higher-than-budgeted actual figure reduces profit and is adverse, so the interpretation depends on whether the line is revenue or cost, not just the size of the number.
Q6State one benefit to a business of setting budgets.Show answer
Answer: Budgets give managers a clear target to work towards and a benchmark against which actual performance can later be measured and controlled.
Exam-style questions
Written in the style of a A Level Business exam paper, with a full mark scheme.
Analyse the benefits to a business of carrying out regular variance analysis.
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GreenBranch Nurseries budgeted for quarterly sales revenue of 120,000 pounds and quarterly costs of 90,000 pounds. Due to an unexpected summer heatwave increasing demand for garden plants, actual sales revenue was 138,000 pounds. However, a shortage of imported plant pots pushed actual costs up to 101,000 pounds. Using variance analysis, evaluate whether GreenBranch Nurseries' quarter should be considered a success.
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