the meaning of adverse variances and favourable variances

5.5 Budgets – Variances

1. What is a Budget?

A budget is a written financial plan that sets out the expected income, expenditure and resource requirements for a specified period (normally one year). It is the foundation of the budgeting‑control cycle.

1.1 The budgeting cycle

1. Preparation – forecasting sales, estimating costs and agreeing resource needs.
2. Approval – senior management signs off the plan, often linking it to performance targets.
3. Implementation – departments operate according to the approved figures.
4. Monitoring – actual results are recorded and compared with the budget.
5. Review & revision – variances are analysed, corrective actions are taken and the next budget is prepared.

2. Purpose of Budgets

• Provide a clear benchmark for measuring performance.
• Facilitate planning of future activities and allocation of resources.
• Coordinate the work of different departments and functions.
• Control costs by highlighting where actual spending diverges from the plan.
• Motivate staff through incentive schemes linked to achievement of budget targets.

3. Benefits and Drawbacks (linked to performance measurement)

Benefits (how they support performance measurement)

Drawbacks

Clear benchmark → enables variance analysis and objective performance appraisal. Cost‑control focus → highlights areas where efficiency can be improved. Improved communication → departments understand expectations and can be held accountable. Strategic alignment → budgets translate long‑term goals into measurable short‑term targets. Link to incentives → rewards can be tied to meeting favourable variances.

Can be rigid – may discourage flexibility in a changing market. Time‑consuming to prepare and maintain. Risk of “budgetary gaming” (e.g., understating costs to look efficient). May become outdated quickly if external conditions shift.

4. Types of Budgets (ordered as in the Cambridge syllabus)

• Incremental budget – based on the previous period’s figures with adjustments for inflation, growth or known changes. Most useful when the business environment is stable.
• Flexible (or variable) budget – prepared for several activity levels; costs are expressed per unit of output. Ideal when costs vary directly with production volume.
• Zero‑based budget – every department starts from “zero” and must justify each expense. Effective for cost‑reduction programmes or when a fresh start is needed.
• Static (fixed) budget – set for one level of activity and not altered during the period. Useful for short‑term control where activity is expected to remain constant.
• Rolling (continuous) budget – constantly updated (e.g., a 12‑month rolling horizon). Best for dynamic environments where forecasts need regular refreshing.

5. Variance – Meaning and Calculation

A variance is the numerical difference between what was budgeted (planned) and what actually happened.

Formula:

$$\text{Variance} = \text{Actual amount} - \text{Budgeted amount}$$

The sign of the result alone does not indicate whether the variance is favourable or adverse; interpretation depends on the nature of the item being measured.

6. Types of Variances

• Favourable variance (F) – the actual result is better than the budget (adds to profit or reduces cost).
• Adverse variance (A) – the actual result is worse than the budget (reduces profit or increases cost).

7. Interpreting the Sign of a Variance

Item type	Positive variance	Negative variance
Revenue / Sales	Favourable (more than expected)	Adverse (less than expected)
Cost / Expense	Adverse (higher than expected)	Favourable (lower than expected)
Profit	Favourable (higher than expected)	Adverse (lower than expected)

8. Example of Variance Calculations

Budgeted and actual figures for a small manufacturing firm (one month):

Item	Budgeted (£)	Actual (£)	Variance (£)	Interpretation
Sales Revenue	50,000	55,000	+5,000	Favourable
Production Volume (units)	5,000	4,800	-200	Adverse (lower output)
Direct Materials Cost	20,000	22,500	+2,500	Adverse
Direct Labour Cost	10,000	9,200	-800	Favourable
Variable Overheads	5,000	5,500	+500	Adverse
Fixed Overheads	8,000	8,000	0	Neutral
Operating Profit	7,000	6,000	-1,000	Adverse

9. Common Causes of Variances

• Changes in market demand or selling price.
• Unexpected fluctuations in raw‑material, energy or freight costs.
• Labour efficiency differences (overtime, absenteeism, skill levels).
• Production inefficiencies or equipment breakdowns.
• Errors or unrealistic assumptions in the original budgeting process.
• External factors – economic recession, new legislation, competitor actions.

10. Investigating an Unfavourable Variance – A Structured Approach

1. Verify data accuracy – confirm that figures relate to the correct period and units.
2. Identify the variance type – price variance, usage/efficiency variance, volume variance, etc.
3. Analyse root causes – use techniques such as the “5‑why” method or a fishbone diagram.
4. Allocate responsibility – pinpoint the department or individual accountable.
5. Quantify financial impact – express the effect on profit, cash flow or key performance indicators (KPIs).
6. Decide on corrective action
   • Revise selling price or launch a promotion.
   • Implement cost‑control measures (supplier renegotiation, waste reduction).
   • Improve processes or adjust capacity.
7. Update future budgets – incorporate the new assumptions to prevent repeat variances.

11. Using Variance Analysis in Decision‑Making

• Cost control – isolate over‑budget items and launch reduction programmes.
• Pricing strategy – a favourable sales variance may allow a price increase; an adverse variance may signal the need for a discount.
• Capacity planning – volume variances reveal under‑ or over‑utilisation of resources.
• Strategic review – persistent adverse variances can trigger a review of product lines, market positioning or supply‑chain arrangements.
• Performance appraisal – variances are often linked to managerial bonuses or other incentives.

12. Links to Other Syllabus Areas

• Costing (5.4) – variance analysis builds on standard costing, absorption costing and activity‑based costing.
• Financial performance (10.2‑10.4) – profit variances feed directly into ratio analysis and cash‑flow assessment.
• Strategic planning (6.2) – insights from variance analysis help refine strategic objectives and resource allocation.

13. A‑Level Extension – Strategic Relevance of Variance Analysis

At A‑Level students should evaluate how variance analysis integrates with broader performance‑management frameworks such as the Balanced Scorecard or KPI systems. Suggested discussion points:

• How do favourable and adverse variances influence long‑term strategic decisions?
• Can variance analysis be used to monitor non‑financial objectives (e.g., quality, sustainability, employee safety)?
• What are the limitations of relying solely on financial variances for strategic planning?

14. Suggested Diagram

15. Key Points to Remember

• A variance is the numerical difference between actual and budgeted figures.
• Favourable variances improve profit (or reduce cost); adverse variances do the opposite.
• The sign of the variance must be interpreted in the context of the item measured.
• Regular variance analysis supports effective control, informed decision‑making and strategic alignment.
• Investigating adverse variances requires a systematic, evidence‑based approach and often leads to revisions of future budgets.