Comparison of actual and forecast results – variances

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Comparison of actual and forecast results

Look at these figures:

It is clear that profits are better than expected, but relatively little else can be concluded from these figures. For example, you cannot say that production has been too expensive, because you have not been told how many units have been made and sold.

You can draw valid conclusions only by comparing actual results to a flexed budget, not a fixed budget drawn up for completely different level of activity.

Example

The actual level of for the actual results above was 2,200 units produced and sold.

Using the above information, draw up a budget flexed to that level.

Answer to Example

Now that the budget has been flexed (think of this as scaling the budget) to the actual level of activity, valid comparisons about performance can be made. The comparisons are known as variances and they can be

• favourable (F) or
• adverse (A), also known as unfavourable (U)

Favourable variances imply higher sales revenues or lower costs than expected; unfavourable mean worse than expected.

Variances usually consist of two components:

• A difference based on activity
• A difference based on price and efficiency of usage

This allows total variances to be investigated further in order to see what effect might have caused them.

Sales variances

The total variance between original budget and actual sales is $5,000 (F)

This has been caused by:

1. Sales volume (activity) variance. 200 more fewer items were sold
   200 x $40 = 8,000 (F) ($88,000 – 80,000)
2. Sales price variance. Instead of earning $88,000 on sales of 2,200, only 85,000 was generated. This must be because of a drop in selling price. The sales price variance is therefore $3,000 (A)

Note that the net of these two variances is 8,000 F – 3000 A = 5,000 F, the total sales revenue variance.

Variable cost variances

Total variance between original budget and actual results = $3,000 Adverse.

1. Activity variance. $55,000 – $50,000 = $5,000 A
2. Usage/price/efficiency variance. The actual output should have cost $55,000, but did cost only $53,000. So the price/usage/efficiency variance is $2,000 favourable.

Note that the net of these two variances is 5,000 A – 2,000 F = 3,000 A, the total revenue variance.

The favourable usage/price/efficiency variance means that the business has managed to buy more cheaply and/or used it more efficiently than expected (or some net effect).

Fixed cost variances

Fixed costs are fixed so no flexing is required to account for different activities. The overspend of $1,000 is an adverse effect.

Potential causes of variances

Some potential causes of sales volume variances

Some potential causes of sales price variances

Some potential causes of material price variances

Some potential causes of material usage variances

Some potential causes of labour rate (price) variances

Some potential causes of labour efficiency variances

Exception reporting

Exception reporting is the concept of directing managers’ attention to areas of operations which seem to be performing either exceptionally badly or exceptionally well.

If operations are going more or less as planned, then it is assumed that not much management care is needed there. Managers should concentrate their efforts where operations seem to be diverging from what is expected.

Variances indicate where actual results differ from budgets and so indicate where there are exceptions to expected behaviour and where management should pay some additional attention.

The investigation of variances

Typical criteria used to decide whether to investigate a variance are:

• The size of the variance (as a percentage of the budget figure). Small variances are usually of little consequence and attention should first be given to the material variances.
• The sign of the variance. Adverse variances are usually looked at with more urgency than favourable to see if the deterioration in performance can be halted.
• The likelihood that the variance can be controlled. If it can’t be controlled (for example, an inflationary effect), then the investigation will not yield any benefits.
• The nature of the cost. Some costs will vary a lot (for example heating costs), but other are expected to be more stable (for example, rent). If there is natural variation then investigation is likely to be less useful