Variance analysis and the difficulties of budgeting

Calculating variances

Variance = actual figure - budgeted figure.

• Favourable (F): better for profit than planned: income above budget or costs below budget.
• Adverse (A): worse for profit: income below budget or costs above budget.

The sign alone does not tell you: a positive variance on a cost is adverse. The January 2021 WBS12 mark scheme described income above budget as a 'favourable income variance', worked out as actual income minus budgeted income.

Variance statement for one quarter

Interpreting variances

In the table, budgeted profit was $63,000 and actual profit $50,500, so the profit variance is $12,500 adverse.

Think about causes and links:

• A favourable materials variance may simply reflect lower sales (fewer units made), not efficiency.
• An adverse wage variance could come from overtime, a pay rise or a new hire.
• Lower sales revenue may reflect a competitor's price cut, a recession or a poor marketing campaign.

Managers should investigate significant variances, often expressed as a percentage of budget, and act: change prices, control costs or revise the budget if conditions have changed.

Difficulties of budgeting

• Budgets rely on forecasts, which may be inaccurate, especially for new products or volatile markets.
• Unrealistic targets demotivate; targets set too low encourage slack.
• Rigid budgets can stop managers responding to opportunities; departments may overspend at year-end to protect next year's budget.
• Setting and monitoring budgets takes time and skill.
• External changes (inflation, exchange rates) can make budgets out of date quickly.
• Managers may pad budgets to make them easier to hit.

Worked example

Budgeted sales revenue was $85,000 and actual was $97,870. Wages were budgeted at $40,000 and were actually $43,000. Calculate and label each variance.

1. Sales: 97,870 - 85,000 = $12,870, favourable (income above budget)
2. Wages: 43,000 - 40,000 = $3,000, adverse (cost above budget)
3. Higher sales may explain some of the extra wages (more hours worked).

Answer: Sales $12,870 F; wages $3,000 A

Check yourself

1. Budgeted materials cost $32,000; actual cost was $35,600. Calculate the size of the variance.
   Show answer

   $3600. 35,600 - 32,000 = $3,600 (adverse, because a cost is above budget).

2. Budgeted sales revenue was $140,000 and actual was $131,600. By what percentage of the budget did actual revenue fall short?
   Show answer

   6 %. (140,000 - 131,600) / 140,000 x 100 = 6%, an adverse variance.

3. Budgeted profit was $28,000. Revenue had a $6,000 adverse variance and costs had a $2,500 favourable variance. Calculate actual profit.
   Show answer

   $24500. 28,000 - 6,000 + 2,500 = $24,500.

4. Using the variance table in step 1, calculate the total of the adverse variances.
   Show answer

   $18500. Add the variances marked A.

5. Actual rent was $500 less than budgeted. This is
   • an adverse variance
   • a favourable variance
   • not a variance
   • a revenue variance
   Show answer

   a favourable variance. Spending less than planned helps profit.

6. Raw material costs were $4,000 below budget, but sales volume was 20% below budget. The best interpretation is that
   • the purchasing manager deserves a bonus
   • the business is more profitable than planned
   • the budget was set using zero-based budgeting
   • the favourable cost variance may result from making fewer units, not better efficiency
   Show answer

   the favourable cost variance may result from making fewer units, not better efficiency. Fewer units need fewer materials; always look for links between variances.

7. Which is a difficulty of budgeting?
   • Budgets allow managers to compare actual with planned figures
   • Budgets set too high can demotivate staff who cannot meet them
   • Budgets help coordinate departments
   • Budgets set targets
   Show answer

   Budgets set too high can demotivate staff who cannot meet them. Unrealistic targets backfire.

8. Explain what is meant by an adverse variance.
   Show answer

   An adverse variance is when actual results are worse than budgeted for profit, meaning costs are higher than budgeted or revenue is lower than budgeted.. Actual worse than budget: costs above or revenue below.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)
• Pearson Edexcel IAL Business WBS12 Unit 2 mark scheme, January 2021

Last updated 8 November 2026. Spotted a mistake? Tell us.