Question

When creating a budget, how much should you factor variances into such an analysis?

Answer 1

Variance analysis is a process of identifying causes of variation in the income & expenses of the current year from the budgeted values. It helps the organization to understand the reasons for fluctuations and what should be done to reduce the adverse effect on the budget. This helps to create a more efficient budget.

Variance = Actual Income/Expense – Budgeted Income/Expense

Application of variance analysis:

Most of the organizations follow the below steps while preparing business plans and meeting their financial commitments.

• By considering previous year actual results and current year’s budget. It helps them in planning budget as a part of the budgeting process.
• By taking existing budget and current year actuals, which helps them in meeting their commitments. This activity is performed at regular intervals throughout the year usually at the end of every quarter and at year end.
• By considering previous year actuals and current year actuals for analyzing the growth. This practice is done at year end only.

Most commonly used variances:

• Purchase price variance:

This variance helps in understanding the difference between the actual price paid for the materials with the budgeted cost for those materials. This process helps the organization to identify the lagging in the procurement function.

Purchase price variance = (Actual cost – standard cost) * Number of units.

• Labor rate variance:

This variance helps to understand the variance between the actual price paid to the labor in the production process and standard labor cost. Favorable variance means actual cost for labor is less than standard cost, Similarly unfavorable variance means actual cost is more than standard cost. It helps to understand the future planning of budget and turns as a feedback for the employees who engage in the direct production process.

Labor rate variance = (Actual cost – standard cost) * Number of units.

• Material yield variance:

This variance is used to identify the difference between actual quantity of material used and the standard quantity expected to be used in course of production. It helps to understand the production efficiency of the plant.

Material yield variance = (Standard quantity – Actual quantity) * Standard price per unit

• Volume variance:

This analysis helps the organization to understand the difference between actual quantities sold/consumed and budgeted quantity sold/consumed. It is a general measure of whether the business is generating the volume of products that it had planned or not.

Volume variance = (Actual quantity – Standard quantity) * Standard price per unit.