Question

Discuss the purpose of a budget and cost variance analysis. Why is it important for companies to create a budget then determine if they met budgeted costs? For example, is it always a negative variance if a company exceeds budgets? Give me an example of why a cost falling below expectations (actual cost below budgeted cost) may still be a problem even if it appears to increase profit.

Answer 1

Purpose of a budget and cost variance analysis:

The purpose of budgeting is basically to provide a model of how the business might perform, financially speaking, if certain strategies, events, plans are carried out. In constructing a Business Plan, the manager attempts to forecast Income and Expenditure, and thereby profitability.

The cost variance analysis is the most common performance evaluation tool when evaluating a cost center. A cost center is a sub-unit of an organization that has control over costs but not revenues and investments. Examples of cost centers are production department, maintenance department, finance and accounting, etc. Variance analysis of costs is performed by comparing actual costs and budgeted costs. With sufficient data, the variance may be split into price variance and quantity variance. In production departments, variance analysis may be done for different cost components, i.e. direct materials, direct labor, and factory overhead.

The benefits of budgeting should never be underestimated when running a business:

• budgeting estimates revenue, plans expenditure and restricts any spending that is not part of the plan
• budgeting ensures that money is allocated to those things that support the strategic objectives of the business
• a well communicated budget helps everyone understand the priorities of the business
• the process of creating a budget provides opportunities to involve staff, resulting in them sharing the organisation’s vision; and
• engaging the team in reviewing and comparing the budget with actuals can provide information that highlights the strengths and weaknesses of the business.