IB Docs (2) Team
Variances
A variance refers to a discrepancy between the planned (budgeted) item of expenditure or revenue and the actual amount. For example, if Warner Bros. Studios planned to spend $150m on producing a Hollywood movie, but ended up spending $180m, then there would be an unfavourable variance of $30m. Similarly, if Foxconn, Taiwan’s largest manufacturer, planned to produce 50m smartphones but higher than expected sales meant it needed to produce 60m units, there would be a favourable variance of 10m smartphones.
Case study - The most over-budgeted movie ever?
James Cameron’s epic movie Avatar, released in 2009, was delayed by eight years due to budget issues. The final budget for Avatar was $237 million (surpassing the $200m that Cameron spent on his previous movie, Titanic), although an extra $150m was spent on promoting the movie. Avatar 2 was scheduled for release in December 2018, but has been further delayed by another 4 years.
Watch the movie trailer of Avatar here:
However, did James Cameron and his crew learn anything from this expensive experience? Avatar 2: The Way of Water was scheduled for release in December 2018 with a budget of $250 million, but was delayed by 4 years. The second Avatar movie was released in December 2022, with an estimated budget of up to $460 million, making it one of the most expensive films ever made. Nevertheless, the movie grossed over $2.32 billion at the box office, making it the third-highest-grossing film of all time (after Avatar and Avengers Endgame). Unsurprisingly, perhaps, the planned release of Avatar 3 has been delayed - partly due to the ongoing strike by Hollywood writers, thereby having an impact on release timelines.
Variances can are categorised as favourable variances or adverse variances. A favourable variance occur when profits are higher than expected (due to lower than expected costs and/or higher than predicted revenues). An adverse variance occur when profits are lower than expected. This is due to costs being higher than expected and/or revenues being lower than predicted.
Variance analysis (comparing planned and actual costs and revenues) gives a benchmark for businesses to measure and compare the degree of budgetary success. By measuring variances, on a regular basis, budget holders can monitor and control their costs and/or revenues in order to meet organizational goals. It also enables managers to improve accountability and performance in the workplace.
A variance exists is there if there is a difference between actual and budgeted figures for costs or revenues. The formula for calculating a variance is therefore:
Variance = Actual figure – Budgeted figure
Worked Example
Item | Budgeted ($) | Actual ($) | Variance ($) |
Sales revenue | 75,000 | 72,450 | 2,550 (A) |
Staff salaries | 26,500 | 25,500 | 1,000 (F) |
Marketing | 21,700 | 20,800 | 900 (F) |
Net profit | 19,150 | 18,800 | 350 (A) |
- Sales revenue is lower than expected (budgeted) by $2,550, i.e. there is an adverse variance.
- Staff salaries are lower than expected by $1,000, i.e. there is a favourable variance.
- Marketing expenditure was budgeted at $21,700 but the firm only spent $20,800 so there is a $900 favourable variance.
- Net profit is $350 less than budgeted, so there is an adverse variance.
Note from the above that managers refer to favourable and adverse variances, rather than (mathematically) negative or positive variances. For example, in the example above, the staff salaries budget is mathematically -$1,000 but this is a favourable variance as the actual spending (cost of staffing) is lower than planned.
Of course, it is possible to have a zero variance, if the budgeted figure equals the actual figure.
Alternatively, variances can be expressed as the percentage difference between the budgeted and actual amounts:
Item | Budgeted ($) | Actual ($) | Variance ($) | Variance (%) |
Sales revenue | 75,000 | 72,450 | 2,550 (A) | 3.4% |
Staff salaries | 26,500 | 25,500 | 1,000 (F) | 3.78% |
Marketing | 21,700 | 20,800 | 900 (F) | 4.15% |
Net profit | 19,150 | 18,800 | 350 (A) | 1.83% |
Top tip!
Whilst variance analysis can provide decision makers with insightful data, it is important for managers to look at the bigger, or overall, picture. For example:
A firm might have a favourable variance for its sales revenue, but this might be the results of having an increase in its advertising spending which resulted in an adverse variance.
A rise in cost of sales, resulting in an adverse variance for costs, could be due to the unexpected rise in sales revenue (which in itself causes a favourable variance for sales revenues).
A rise in a firm's spending on wages (resulting in an adverse variance for labour costs) may be due to an increase in output or sales (both of which results in favourable variances).
To test your understanding of variances, have a go at these exam practice questions.
Exam Practise Question 1
With reference to adverse and favourable variances, explain the value of variance analysis in the budgeting process. [4 marks]
Teacher only boxAnswer
A favourable variance occurs when the actual outcome for a variable in a budget (such as budgeted sales revenue) is better than the budgeted (planned) outcome.
By contrast, an adverse variance occurs when the actual outcome is worse than the budgeted plan for an item in the budgeting process.
Variance analysis can therefore enable managers to investigate and examine the reasons for the differences (variances) that occur to improve the organization's financial performance. Hence, variance analysis can be a useful analytical planning and decision-making tool.
Award [1 - 2 marks] for an answer that shows some understanding of the demands of the question. The explanation of variances is likely to be vague / incomplete, and there may not be any specific reference to adverse and favourable variances.
Award [3 - 4 marks] for an answer that shows good understanding of the demands of the question. The explanation of variances is clear and complete, with appropriate and specific reference to adverse and favourable variances.
Exam Practice Question 3 - Saka Toys
Saka Toys had budgeted 300 hours of labour at an hourly rate of $8 for an order to create 3,000 units of output. By the end of the project, the operations manager confirmed Saka Toys required 312 labour hours to produce the 3,000 units.
Calculate the variance for Saka Toys' labour costs for this order. [2 marks]
Teacher only boxAnswer
Budgeted labour costs = 300 hours × $8 per hour = $2,400
Actual labour costs = 312 hours × $8 per hour = $2,496
Variance = Actual costs – Budgeted costs = $2,400 – $2,496 = $96
As the actual costs for this order are greater than budgeted costs, this variance is adverse.
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
Exam Practice Question 3 - Xhaka Inc.
Xhaka Inc. has budgeted $18 of labour costs per unit of output. The total annual output produced by workers at Xhaka Inc. is 20,000 units. The company has an average number of 12 employees during the year, who earn an average salary of $25,000.
(a) Calculate the labour cost per unit of output. [2 marks]
(b) Comment on your answer to Question 2(a). [2 marks]
Teacher only boxAnswers
(a) Calculate the labour cost per unit of output. [2 marks]
Labour cost per unit of output = ($25,000 × 12) ÷ 20,000
300,000 ÷ 20,000 = $15 per unit
Award [1 mark] for the correct answer and [1 mark] for showing appropriate working out.
(b) Comment on your answer to Question 2(a). [2 marks]
Xhaka Inc. has a favourable variance on its budgeted cost of labour per unit of output. This is because the company had budgeted for $18 per unit but the actual amount was only $15, i.e., it has a favourable variance of $3 per unit of output.
Award [1 mark] for a limited understanding of the demands of the question.
Award [2 marks] for showing good understanding of the demands of the question, similar to the example above.
Exam Practice Question 4 - Burgers R Us
(a) Complete the missing figures in the table below for Burgers R Us. [6 marks]
Variable | Budgeted ($) | Actual Outcome ($) | Variance ($) | Variance (F/A) |
Wages | 3,000 | 3,200 | Adverse | |
Salaries | 4,500 | 4,500 | - | |
Stock (inventory) | 1,500 | 1,850 | ||
Revenues | 12,350 | 300 | Adverse | |
Cost of sales (COS) | 9,700 | 50 | Favourable |
(b) Suggest two examples of stock (inventory) that are likely to be held by Burgers R Us. [2 marks]
(c) Suggest two examples of costs of sales likely to be incurred by Burgers R Us. [2 marks]
Teacher only boxAnswers
(a) Complete the missing figures in the table below for Burgers R Us. [6 marks]
Variable | Budgeted ($) | Actual Outcome ($) | Variance ($) | Variance (F/A) |
Wages | 3,000 | 3,200 | 200 | Adverse |
Salaries | 4,500 | 4,500 | 0 | - |
Stock (inventory) | 1,500 | 1,850 | 350 | Adverse |
Revenues | 12,350 | 12,050 | 300 | Adverse |
Cost of sales (COS) | 9,750 | 9,700 | 50 | Favourable |
(b) Suggest two examples of stock (inventory) that are likely to be held by Burgers R Us. [2 marks]
Burgers, buns, cheese, tomatoes, onions, sauces (ketchup, mustard etc.), gherkins, fries, fizzy drinks etc.
Mark as a 1 + 1
(c) Suggest two examples of costs of sales likely to be incurred by Burgers R Us. [2 marks]
Wages of hourly paid staff, stocks / inventory (such as those in the answer for Question c), fat /oil for frying, electricity etc.
Mark as a 1 + 1
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