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Budgets represent management's expectations of financial revenues and costs during an accounting period. Periodically, management will compare budgeted projections to actual results and analyze the differences. This is referred to as budget variance analysis. Analyzing budget variances allows management to evaluate company performance and set future expectations.
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Types of Budget Variances
Variances typically are labelled as either price variances or quantity variances. Price variances occur because the purchase price or selling price of an item wasn't what management expected. The selling price variance is calculated by finding the difference in the actual and expected selling price and multiplying it by the number of units sold. For example, if a company sold 100 widgets for $90 instead of $80, the variance would be $1,000 -- the $10 price difference multiplied by 100 widgets.
Quantity variances occur when a different amount of materials, labor or overhead expenses were needed to manufacture an item. For example, the labor efficiency variance is the difference between budgeted hours needed for manufacturing and actual hours needed multiplied by the labor rate. If a project took 50 labor hours instead of 40 and the workers cost the company
$60 an hour, the variance is $600 -- 10 extra hours multiplied by $60 an hour in costs.
Analyzing Budget Variances
After examining variances in each part of the budget, managers evaluate how significant the variance is. A company may have a policy to investigate variances that are 10 percent more or less than the budgeted figure. for example. Inc.com points out that, by only researching significant variances, managers can have more impact and not get bogged down in minutiae.
When investigating variances, managers will talk with supervisors and employees in the offending department to try to determine the root cause. For example, a labor variance may occur if the product specifications changed and required more labor hours.
Once a manager discovers the reason for the variance, he'll try to determine the variance happened because of temporary issues or if it reflects a more permanent change in the price and cost of the product. If it's a permanent change that reflects changing conditions, the manager will incorporate the information into budget planning for the next accounting period. Inc.com notes that it's better to revise budgets frequently based on new information to avoid budgets that don't reflect current conditions.