Variances Are The Differences Between Budgeted and Actual Figures
- You know when you planned to finish your assignment in two hours but end up spending eight on it?
- Maybe you watched a little YouTube, got up for a snack, or simply underestimated how hard it would be to just "write that conclusion."
- That's kind of like variance.
- In business specifically, variance refers to the differences between your planned and actual expenses.
Definition
Variances
The difference between budgeted (planned) figures and actual financial performance, which can be either favourable or adverse.
Types of Variances
- Variance helps managers understand how actual performance aligns with expectations, guiding strategic decisions.
- There are several types of variance:
Favorable Variance
- Occurs when actual performance exceeds expectations.
- For instance:
- Higher Revenue: Sales are higher than forecasted.
- Lower Costs: Expenses are less than budgeted.
Note
Notice how variance is not always a bad thing.
Adverse Variance
- Occurs when actual performance falls short of expectations.
- For instance:
- Lower Revenue: Sales are below forecasted levels.
- Higher Costs: Expenses exceed the budget.
Hint
Always analyze the reasons behind variances. A favorable variance might not always be positive if it results from underestimating costs or overestimating revenue.
Definition
Favourable Variances
These occur when actual revenue exceeds budgeted revenue or when actual costs are lower than budgeted costs, leading to improved profitability.
Calculating Variances
The formula for calculating variances is straightforward:
$$\text{Variance} = \text{Actual Figure} - \text{Budgeted Figure}$$
- Positive Variance: Indicates a favourable outcome for revenue but an adverse outcome for costs.
- Negative Variance: Indicates an adverse outcome for revenue but a favourable outcome for costs.
Common Mistake
- Don’t assume that a positive variance is always favorable or a negative variance is always adverse.
- It depends on whether you’re analyzing revenue or costs.
Causes of Variances
1. Positive Variances
- Revenue Variances
- Higher Sales Volume: More units sold than expected.
- Price Changes: Selling at a higher price than budgeted.
- Market Conditions: Economic booms or increased demand.
- Cost Variances
- Efficiency Improvements: Lower labor or material costs.
- Negotiated Discounts: Savings from suppliers.
- Currency Fluctuations: Favorable exchange rates for imports.
2. Adverse Variances
- Revenue Variances
- Lower Sales Volume: Fewer units sold than expected.
- Price Reductions: Discounts or lower prices than budgeted.
- Increased Competition: Loss of market share.
- Cost Variances
- Rising Material Costs: Higher prices for raw materials.
- Wage Increases: Unexpected salary hikes.
- Operational Inefficiencies: Waste or delays in production.
Note
Variances can result from external factors (e.g., economic changes) or internal factors (e.g., poor forecasting or inefficiencies).
Interpreting Variances
- Favorable Variances: Generally positive but require analysis.
- Adverse Variances: Often negative but not always bad. Higher costs could result from strategic investments in growth.
Hint
- Understand that lower costs is not always a good thing.
- For example, this could indicate underinvestment in quality, which ultimately impacts reputation and brand loyalty.
Theory of Knowledge
How do cultural differences influence the interpretation of variances in multinational companies? Could a variance considered adverse in one region be viewed differently in another?
Practical Examples
Example question
Let's go back to our example on Jojo Ltd. who initially budgeted the following for its stress ball production:
- Revenue Forecast: \$30,000,000 (40,000 units at \$750 each)
- Materials Cost: \$13,500,000 (45% of revenue)
- Wages: \$5,400,000 (18% of revenue)
- Fixed Costs: \$3,600,000 (Rent & R&D)
- Total Expenses: \$22,500,000
- Net Income: \$7,500,000
However, actual performance may differ due to various factors. Let’s examine some possible variances.
Solution
Example of Variances in Jojo Ltd.
| Category | Budgeted ($) | Actual ($) | Variance ($) | Type |
|---|---|---|---|---|
| Sales Revenue | 30,000,000 | 29,500,000 | (500,000) | Adverse |
| Materials Cost | 13,500,000 | 13,200,000 | 300,000 | Favorable |
| Wages | 5,400,000 | 5,500,000 | (100,000) | Adverse |
| Fixed Costs (Rent + R&D) | 3,600,000 | 3,600,000 | 0 | No Variance |
| Total Expenses | 22,500,000 | 22,300,000 | 200,000 | Favorable |
| Net Income | 7,500,000 | 7,200,000 | (300,000) | Adverse |
Why Do These Variances Matter?
- Sales Revenue Variance (-$500,000, Adverse): Jojo Ltd. sold fewer units or had to discount prices.
- Materials Cost Variance (+$300,000, Favourable): Lower raw material costs saved money.
- Wages Variance (-$100,000, Adverse): Higher labor costs may indicate overtime or wage increases.
- Overall Impact: Although expenses were lower than expected, reduced sales led to lower profits.
Using Variance Analysis for Decision-Making
- If sales were lower than expected, Jojo Ltd. might adjust pricing or marketing strategies.
- If labor costs were higher, they may review staffing efficiency.
- If material costs were lower, they could renegotiate long-term supplier contracts.
Example question
Case Study: Budget Variances at Zenith Electronics
Background
- Zenith Electronics is a mid-sized consumer electronics manufacturer specializing in high-end smart home devices.
- The company operates in a competitive market, where pricing and cost efficiency are key to maintaining profitability.
- At the beginning of the fiscal year, Zenith Electronics’ finance department prepared a detailed budget for the production of their flagship smart speaker, the "Zenith Echo."
- However, as the year progressed, several unforeseen factors affected actual performance.
Budgeted vs. Actual Figures (for Q4 2024)
| Category | Budgeted ($) | Actual ($) | Variance ($) | Type |
|---|---|---|---|---|
| Sales Revenue | 2,000,000 | 1,850,000 | (150,000) | Adverse |
| Raw Materials Cost | 600,000 | 630,000 | (30,000) | Adverse |
| Direct Labor Cost | 400,000 | 380,000 | 20,000 | Favourable |
| Marketing Expenses | 250,000 | 275,000 | (25,000) | Adverse |
| Fixed Overheads | 300,000 | 300,000 | 0 | Neutral |
| Net Profit | 450,000 | 265,000 | (185,000) | Adverse |
Reasons for Variances
- Sales Revenue: Demand for the product was lower than expected due to increased competition and a weaker holiday season.
- Raw Materials Cost: Global supply chain disruptions led to higher material prices.
- Direct Labor Cost: The company improved efficiency by investing in automation, reducing the need for overtime pay.
- Marketing Expenses: Zenith Electronics had to increase spending on promotional campaigns to boost sales.
Questions
- Variance Analysis:
a) Identify and explain the two most significant adverse variances in the budget. [5]
b) Suggest two strategies Zenith Electronics could implement to minimize these variances in the future. [5] - Decision-Making [8]
a) If Zenith Electronics’ management wants to improve profitability in the next quarter, should they focus on cost-cutting or increasing sales? Justify your answer. - Impact on ROCE [12]
- Zenith Electronics had total capital employed of $3,000,000 at the beginning of Q4 2024. Calculate the Return on Capital Employed (ROCE) based on the actual net profit. Compare this to a budgeted ROCE and analyze the impact of the variances on the company’s financial performance.
Solution
1. Variance Analysis (10 Marks)
(a) Identify and explain the two most significant adverse variances in the budget. (5 Marks)
- 1–2 Marks: Basic identification of two adverse variances without explanation.
- 3–4 Marks: Identification of two adverse variances with a brief explanation of their impact.
- 5 Marks: Identification and clear explanation of two significant adverse variances with reference to the case data and possible business implications.
(b) Suggest two strategies Zenith Electronics could implement to minimize these variances in the future. (5 Marks)
- 1–2 Marks: Simple suggestions with little connection to the case study.
- 3–4 Marks: Two relevant strategies with some explanation of how they address the variances.
- 5 Marks: Two well-explained strategies with clear application to Zenith Electronics, including potential benefits and risks.
2. Decision-Making (8 Marks)
Should Zenith Electronics focus on cost-cutting or increasing sales to improve profitability? Justify your answer.
- 1–2 Marks: Simple statement of preference with minimal justification.
- 3–4 Marks: Basic reasoning with some application to the case.
- 5–6 Marks: Well-structured argument with clear reference to the budget data and short-term vs. long-term considerations.
- 7–8 Marks: Balanced evaluation of both cost-cutting and sales growth strategies, considering financial and strategic implications, with a justified conclusion.
3. Impact on ROCE (12 Marks)
Calculate ROCE and analyze the impact of the variances on financial performance.
- 1–3 Marks: Correct formula for ROCE but incorrect or missing calculations.
- 4–6 Marks: Correct calculation of ROCE with a basic comparison to budgeted performance.
- 7–9 Marks: Accurate ROCE calculation, comparison with budgeted ROCE, and some discussion of business impact.
- 10–12 Marks: Detailed analysis of how budget variances affected ROCE, consideration of short-term vs. long-term performance, and a well-justified conclusion with potential management actions.
Self review
- Try and identify one favorable and one adverse variance in your personal budget or a business case study?
- What caused these variances?
