the calculation and interpretation of variances

5.5 Budgets – Variance Analysis

5.5.1 Purpose of Budgets and Types of Budgets

Budgets are prepared to:

• Measure performance – compare actual results with the budgeted (or flexible‑budget) figures.
• Allocate resources efficiently – highlight where resources have been over‑ or under‑used.
• Control and monitor activity – identify deviations early so corrective action can be taken.
• Support strategic decision‑making – the choice of budget type (incremental, flexible or zero‑based) reflects the organisation’s environment and the level of control required (see the table below).

Budget type	Key feature	Typical use (why it matters for performance measurement)
Incremental budget	Based on the previous period’s figures with adjustments for inflation, growth, etc.	Useful in stable environments where change is modest; deviations are mainly due to price or volume changes.
Flexible budget	Prepared for a range of activity levels; the actual activity level is inserted to obtain a “flexed” figure.	Essential when output volume varies (e.g., seasonal business); provides a more realistic benchmark for variance analysis.
Zero‑based budget	Every expense must be justified from scratch; no reference to past budgets.	Adopted by cost‑conscious organisations seeking efficiency improvements; highlights wasteful spending.

5.5.2 Meaning of Variance, Favourable and Adverse

• Variance – the difference between an actual result and the budgeted (or flexible‑budget) amount.
• Favourable (F) – the variance improves the objective (e.g., higher revenue, lower cost).
• Adverse (A) – the variance worsens the objective (the syllabus prefers “adverse” to “unfavourable”).
• Variance analysis – the process of calculating, classifying and interpreting variances to support decision‑making.

5.5.3 Categories of Variance

Variance category (as named in the syllabus)	What it measures
Sales‑price variance	Effect of the selling price differing from the budget.
Sales‑volume variance	Effect of the quantity sold differing from the budget.
Variable‑cost‑price variance	Effect of the variable cost per unit differing from the budget.
Variable‑cost‑efficiency variance	Effect of the actual quantity of input used (e.g., labour hours) differing from the standard.
Fixed‑overhead expenditure variance	Difference between actual fixed overheads and budgeted fixed overheads.
Fixed‑overhead volume variance	Effect of the level of activity on the absorption of fixed overheads.
Profit variance	Overall impact on profit after all revenue and cost variances are considered.

5.5.4 Standard Variance Formulas (LaTeX)

Variance type	Formula
Overall variance	$$\text{Variance}= \text{Actual} - \text{Budget}$$
Sales‑price variance	$$\text{SPV}= (\text{Actual Price} - \text{Budgeted Price}) \times \text{Actual Quantity}$$
Sales‑volume variance	$$\text{SVV}= (\text{Actual Quantity} - \text{Budgeted Quantity}) \times \text{Budgeted Price}$$
Variable‑cost‑price variance	$$\text{VCPV}= (\text{Actual VC/unit} - \text{Budgeted VC/unit}) \times \text{Actual Quantity}$$
Variable‑cost‑efficiency variance	$$\text{VCEV}= (\text{Actual Quantity Used} - \text{Standard Quantity Allowed}) \times \text{Standard VC per Unit}$$
Fixed‑overhead expenditure variance	$$\text{FOEV}= \text{Actual Fixed OH} - \text{Budgeted Fixed OH}$$
Fixed‑overhead volume variance	$$\text{FOVV}= (\text{Actual Activity Level} - \text{Budgeted Activity Level}) \times \frac{\text{Budgeted Fixed OH}}{\text{Budgeted Activity Level}}$$
Profit variance	$$\text{Profit Variance}= \text{Actual Profit} - \text{Budgeted Profit}$$

5.5.5 Step‑by‑Step Calculation Process

1. Decide whether a static (original) budget or a flexible budget is the appropriate benchmark (the syllabus stresses this choice).
2. Identify the relevant budget figures for the period under review.
3. Obtain the actual results for the same period.
4. Select the appropriate variance formula(s) from the table in 5.5.4.
5. Calculate the numerical variance.
6. Classify the variance as Favourable (F) or Adverse (A).
7. Analyse the underlying cause(s) – price, volume, efficiency, external factors (e.g., exchange‑rate movements, regulatory changes).
8. Judge the materiality of the variance – a £100 variance may be immaterial, whereas a £10,000 variance is likely material.
9. Recommend corrective actions or adjustments to future budgets.

5.5.6 Worked Example 1 – Manufacturing Business (Product X)

Budget and actual data for June:

Item	Budgeted	Actual
Units sold	5,000	5,400
Selling price per unit (£)	20.00	19.50
Variable cost per unit (£)	12.00	12.30
Fixed overheads (£)	15,000	16,200

5.5.6.1 Sales‑price variance

$$\begin{aligned} \text{SPV} &= (\text{Actual Price} - \text{Budgeted Price}) \times \text{Actual Quantity}\\ &= (19.50 - 20.00) \times 5,400\\ &= -0.50 \times 5,400 = -£2,700 \; (\text{A}) \end{aligned}$$

5.5.6.2 Sales‑volume variance

$$\begin{aligned} \text{SVV} &= (\text{Actual Quantity} - \text{Budgeted Quantity}) \times \text{Budgeted Price}\\ &= (5,400 - 5,000) \times 20.00\\ &= 400 \times 20.00 = £8,000 \; (\text{F}) \end{aligned}$$

5.5.6.3 Variable‑cost‑price variance

$$\begin{aligned} \text{VCPV} &= (\text{Actual VC/unit} - \text{Budgeted VC/unit}) \times \text{Actual Quantity}\\ &= (12.30 - 12.00) \times 5,400\\ &= 0.30 \times 5,400 = £1,620 \; (\text{A}) \end{aligned}$$

5.5.6.4 Variable‑cost‑efficiency variance

Standard input: 1 labour‑hour per unit at £12 per hour (i.e., £12 variable cost per unit). Actual labour used = 5,800 hrs.

$$\begin{aligned} \text{Standard Quantity Allowed} &= 5,400 \text{ units} \times 1 \text{ hr/unit}=5,400 \text{ hrs}\\ \text{VCEV} &= (\text{Actual Hours} - \text{Standard Hours}) \times \text{Standard VC per hour}\\ &= (5,800 - 5,400) \times 12 = 400 \times 12 = £4,800 \; (\text{A}) \end{aligned}$$

5.5.6.5 Fixed‑overhead expenditure variance

$$\text{FOEV}= 16,200 - 15,000 = £1,200 \; (\text{A})$$

5.5.6.6 Fixed‑overhead volume variance

$$\begin{aligned} \text{Budgeted OH rate per unit} &= \frac{15,000}{5,000}=£3.00\\ \text{FOVV} &= (5,400 - 5,000) \times 3.00 = 400 \times 3.00 = £1,200 \; (\text{F}) \end{aligned}$$

5.5.6.7 Overall profit variance

$$\begin{aligned} \text{Budgeted Profit} &= (5,000 \times 20) - (5,000 \times 12) - 15,000 = £40,000\\ \text{Actual Profit} &= (5,400 \times 19.5) - (5,400 \times 12.30) - 16,200 = £38,880\\ \text{Profit Variance} &= 38,880 - 40,000 = -£1,120 \; (\text{A}) \end{aligned}$$

Interpretation (Manufacturing)

• SPV (A £2,700) – lower selling price reduced revenue.
• SVV (F £8,000) – higher volume more than offset the price drop.
• VCPV (A £1,620) – rise in variable cost per unit eroded margin.
• VCEV (A £4,800) – inefficiency in labour usage added to cost.
• FOEV (A £1,200) – actual fixed costs were higher than planned.
• FOVV (F £1,200) – spreading fixed overhead over more units reduced the per‑unit charge.
• Overall profit variance (A £1,120) – despite a favourable volume effect, the combined adverse price, cost‑price, efficiency and overhead variances led to a shortfall.

5.5.7 Worked Example 2 – Service‑Oriented Business (Consultancy Firm)

Budget and actual data for the quarter:

Item	Budgeted	Actual
Billable hours	2,000 hrs	1,800 hrs
Hourly charge (£)	150.00	155.00
Variable cost per hour (£)	30.00	32.00
Fixed overheads (£)	25,000	27,500

5.5.7.1 Sales‑price variance (hourly charge)

$$\text{SPV}= (155.00 - 150.00) \times 1,800 = £9,000 \; (\text{F})$$

5.5.7.2 Sales‑volume variance (hours)

$$\text{SVV}= (1,800 - 2,000) \times 150.00 = -£30,000 \; (\text{A})$$

5.5.7.3 Variable‑cost‑price variance

$$\text{VCPV}= (32.00 - 30.00) \times 1,800 = £3,600 \; (\text{A})$$

5.5.7.4 Variable‑cost‑efficiency variance

Standard input: 1 hour of staff time per billable hour (i.e., 1:1). Actual staff hours used = 1,950 hrs.

$$\begin{aligned} \text{Standard Hours Allowed} &= 1,800 \text{ hrs}\\ \text{VCEV} &= (1,950 - 1,800) \times 30 = 150 \times 30 = £4,500 \; (\text{A}) \end{aligned}$$

5.5.7.5 Fixed‑overhead expenditure variance

$$\text{FOEV}= 27,500 - 25,000 = £2,500 \; (\text{A})$$

5.5.7.6 Fixed‑overhead volume variance

$$\begin{aligned} \text{Budgeted OH rate per hour} &= \frac{25,000}{2,000}=£12.50\\ \text{FOVV} &= (1,800 - 2,000) \times 12.50 = -200 \times 12.50 = -£2,500 \; (\text{A}) \end{aligned}$$

5.5.7.7 Overall profit variance

$$\begin{aligned} \text{Budgeted Profit} &= (2,000 \times 150) - (2,000 \times 30) - 25,000 = £215,000\\ \text{Actual Profit} &= (1,800 \times 155) - (1,800 \times 32) - 27,500 = £191,900\\ \text{Profit Variance} &= 191,900 - 215,000 = -£23,100 \; (\text{A}) \end{aligned}$$

Interpretation (Service)

• Higher hourly charge gave a favourable price variance, but lower utilisation caused a large adverse volume variance.
• Variable‑cost‑price and efficiency variances were adverse, reflecting higher staff rates and overtime.
• Both fixed‑overhead variances were adverse because fewer billable hours meant less absorption of fixed costs.
• The net result is a substantial adverse profit variance, signalling the need to improve utilisation and control staff costs.

5.5.8 Common Causes of Variances (including external factors)

Variance type	Favourable causes	Adverse causes
Sales‑price	Successful price increase, premium branding, favourable exchange‑rate movement.	Discounts, price wars, reduced perceived value, adverse exchange‑rate movement.
Sales‑volume	Effective promotion, seasonal peak, new market entry, favourable economic conditions.	Economic slowdown, stronger competition, supply constraints, regulatory restrictions.
Variable‑cost‑price	Better supplier terms, bulk buying, lower freight costs.	Raw‑material price rise, increased freight, tariffs, adverse commodity price swings.
Variable‑cost‑efficiency	Improved labour productivity, reduced waste, upgraded equipment.	Machine breakdowns, overtime, training gaps, lower staff morale.
Fixed‑overhead expenditure	Cost‑control measures, renegotiated leases, energy‑saving initiatives.	Unexpected repairs, higher utilities, added admin staff, regulatory compliance costs.
Fixed‑overhead volume	Higher output spreads fixed costs.	Under‑utilisation of capacity, production shutdowns.

5.5.9 Using Variance Analysis for Management Decision‑Making

• Identify where performance deviates from plan and quantify the impact.
• Separate price, volume and efficiency effects – this prevents opposite variances from masking problems.
• Investigate root causes, including internal (process, staffing) and external (market, exchange‑rate) factors.
• Take corrective actions – e.g., renegotiate supplier contracts, adjust pricing strategy, improve production processes, revise capacity utilisation.
• Update future budgets to reflect realistic assumptions and lessons learned.
• Link favourable variances to incentives and adverse variances to performance reviews.

5.5.10 Common Pitfalls to Avoid

1. Ignoring the **size** (materiality) of a variance – a small £100 variance may be immaterial, whereas a £10,000 variance is likely material.
2. Focusing only on favourable variances – adverse variances often reveal hidden risks.
3. Failing to separate **price** and **volume** effects – they can offset each other and mask underlying issues.
4. Using a static budget when activity levels have changed – a flexible budget provides a more accurate benchmark.
5. Not revising the budget when assumptions (e.g., exchange rates, market conditions) change.

5.5.11 Summary Checklist for Exam Candidates

• State the purpose of variance analysis (performance measurement, control, resource allocation).
• Identify the appropriate budget type (static or flexible) and justify the choice.
• Calculate each relevant variance using the standard formulas (5.5.4).
• Label each result as **Favourable (F)** or **Adverse (A)**.
• Break down revenue and cost variances into price, volume and efficiency components.
• Analyse causes – internal (process, staffing) and external (market, regulatory, exchange‑rate).
• Judge the materiality of each variance.
• Recommend corrective actions and indicate how future budgets should be adjusted.

5.5.12 Additional Note (A‑Level Finance Link)

When the syllabus later requires the calculation of depreciation for fixed‑overhead analysis, only the straight‑line depreciation method is required (see 10.1.4). This simplifies the fixed‑overhead volume variance calculation for assets that are depreciated.