What is Budget Variance?
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, meaning losses and shortfalls. Budget variances occur because forecasters are unable to predict the future costs and revenue with complete accuracy.
Budget variances can occur from 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.
Understanding Budget Variance
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/bad data. Changing business conditions, including changes in the overall economy and even global trade, can cause budget variances. There could be a change in the cost of raw materials or a new competitor could have entered the market to create pricing pressure. Political and regulatory changes that were not accurately forecast are also included in this category. Of course, budget variances also occur when the management team exceeds or underperforms expectations.
Significance of a Budget Variance
A variance should be indicated as favorable or unfavorable. A favorable variance is one where revenue comes in higher than budgeted or 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. Hence, 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 when assumptions used to devise the budget are altered. A static budget remains the same, even if the assumptions change. The flexible budget allows for greater adaptability to changing circumstances and should result in less 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. Most companies use a flexible budget for this very reason.