What Is a Budget Variance?
A budget variance is a periodic measure used by governments, corporations, or individuals to quantify the difference between budgeted and actual figures for a particular accounting category. A favorable budget variance refers to positive variances or gains; an unfavorable budget variance describes negative variance, indicating losses or shortfalls. Budget variances occur because forecasters are unable to predict future costs and revenue with complete accuracy.
Budget variances can occur broadly due to either controlled or uncontrollable factors. For instance, a poorly planned budget and labor costs are controllable factors. Uncontrollable factors are often external and arise from occurrences outside the company, such as a natural disaster.
- A budget variance is an accounting term that describes instances where actual costs are either higher or lower than the standard or projected costs.
- An unfavorable, or negative, budget variance is indicative of a budget shortfall, which may occur because revenues miss or costs come in higher than anticipated.
- Variances may occur for internal or external reasons and include human error, poor expectations, and changing business or economic conditions.
Understanding Budget Variances
There are three primary causes of budget variance: errors, changing business conditions, and unmet expectations.
- Errors by the creators of the budget can occur when the budget is being compiled. There are a number of reasons for this, including faulty math, using the wrong assumptions, or relying on stale or bad data.
- Changing business conditions, including changes in the overall economy or global trade, can cause budget variances. There could be an increase in the cost of raw materials or a new competitor may have entered the market to create pricing pressure. Political and regulatory changes that were not accurately forecast are also included in this category.
- Budget variances will also occur when the management team exceeds or underperforms expectations. Expectations are always based on estimates and projects, which also rely on the values of inputs and assumptions built into the budget. As a result, variances are more common than company managers would like them to be.
Significance of a Budget Variance
A variance should be indicated appropriately as "favorable" or "unfavorable." A favorable variance is one where revenue comes in higher than budgeted, or when expenses are lower than predicted. The result could be greater income than originally forecast. Conversely, an unfavorable variance occurs when revenue falls short of the budgeted amount or expenses are higher than predicted. As a result of the variance, net income may be below what management originally expected.
If the variances are considered material, they will be investigated to determine the cause. Then, management will be tasked to see if it can remedy the situation. The definition of material is subjective and different depending on the company and relative size of the variance. However, if a material variance persists over an extended period of time, management likely needs to evaluate its budgeting process.
Budget Variance in a Flexible Budget Versus a Static Budget
A flexible budget allows for changes and updates to be made when assumptions used to devise the budget are altered. A static budget remains the same, however, even if the assumptions change. The flexible budget thus allows for greater adaptability to changing circumstances and should result in less of a budget variance, both positive and negative.
For instance, assuming production is cut, variable costs are also going to be lower. Under a flexible budget, this is reflected, and results can be evaluated at this lower level of production. Under a static budget, the original level of production stays the same, and the resulting variance is not as revealing. It is worth noting that most companies use a flexible budget for this very reason.
Example of Unfavorable Variance
As an example, let's say that a company's sales were budgeted to be $250,000 for the first quarter of the year. However, the company only generated $200,000 in sales because demand fell among consumers. The unfavorable variance would be $50,000, or 20%.
Similarly, if expenses were projected to be $200,000 for the period but were actually $250,000, there would be an unfavorable variance of $50,000, or 25%.