A variance is the difference between actual results and expected results. The expected performance of a company is found in the company’s budget for the period. To better illustrate the concept of variances, let’s look at the following scenario:
Suppose you are CEO of a food-processing company. The company’s accountant, Bob, just prepared the Income Statement for the year. The Income Statement showed an operating income of $238,000. Is this a good result or not? A simple way of telling is to compare it with the budget that has been set at the start of year. Suppose studying the budget revealed that the budgeted operating income is $426,400.
|Actual Operating Income||$238,000|
|Static Budget Operating Income||$426,400; planned output level = 12,000 units|
In this case, the company is said to experience an unfavorable static-budget variance. A static budget refers to a budget developed abound a single planned output level (12,000 units in this case). An unfavorable variance (denoted by “U”) means the actual operating income (OI) is lower than that of the budgeted amount.
Static Budget Variance For OI = Actual OI – Static Budget OI
This looks like bad news. You want to investigate the reasons causing the discrepancies – was it the marketing department that did not do enough to promote the products? Or was it the sales team that gave too much discounts to the wholesalers? Or was it the inappropriate management of materials? Or the inefficiency of the workers? As you will see, variance analysis helps to answer much of our questions. In fact, variance analysis is an important tool in facilitating management by exception, where managers focus more on areas that do not perform as expected and less on areas that do.
To gain more insights on what went wrong with the company, you obtain a breakdown of the data from Bob:
Notice that the budgeted output volume is 12,000 units while the actual output volume is only 10,000 volume. This itself can explain why our actual operating income falls short of the budgeted one – you expect the company to earn less if it sells less.
Therefore, the first thing we do in variance analysis is to separate out the effect of the difference in budgeted and actual output volume. In essence, we come up with two factors that account for the unfavorable variance for operating income: volume-related and non-volume related. Non-volume related factors include a difference in selling price, direct material and labor cost and usage etc.
We ask the question: if we reduced the volume from 12,000 in the static budget to 10,000 in the actual results, keeping all other things constant (say selling price per unit, material cost per unit), how much would we have earned?
So here we create a flexible budget. A flexible budget calculates budgeted revenues and costs based on actual output (10,000 units in this case).
Here is how things look now:
As you can see, even if we kept all other variables constant, our actual results still fall short compared to the flexible budget (operating income $312,000 compared to $238,000). We see that there are two factors that led to the unfavorable variance: (1) that production and sales volume were not as high as expected (sales-volume variance), (2) other factors (flexible-budget variance).
Note that we have split the static-budget variance into two parts now: sales-volume variance and flexible-budget variance. We can come to the following conclusions:
Sales volume variance + Flexible budget variance = Static budget variance
Sales volume variance = Flexible Budget OI – Static Budget OI
Flexible budget variance = Actual OI – Flexible Budget OI
We will focus on the sales-volume variance for now.
You may notice that the difference in operating income between the two is the same as the difference in contribution margin. The rationale behind this is simple:
(1) By definition,
Operating Income = Contribution Margin – Fixed Cost
(2) Fixed cost does not change even with a change in volume (that is why it is fixed in the first place
(3) It follows that
Therefore, the blue formula above for sales-volume variance can be rewritten as
Sales-volume Variance = Flexible budget contribution – Static budget Contribution
This can be also be rewritten as follows:
Recall that the flexible budget is based on actual volume. Also, the contribution margin per unit is the same for the flexible budget and static budget (we want to keep things other than volume constant).
We will look more at the other factors in future articles.
Horngren, C., Datar, S., Rajan, M. (2015). Flexible Budgets, Direct-Cost Variances, and Management Control. In Cost Accounting: A Managerial Emphasis (Fifteenth ed.).