What’s it all about?
You said you were going to do something, and it didn’t happen. Why?
An analysis of your budget compared to what really happened that allows you to work out why you didn’t actually meet what you said you were going to do. Techniques for determining what the quantity and price changes were that affected you and considering what you might be able to do about it next time.
In reality, you are very unlikely to sell/make/buy as many of something as you said you would for the cost/income you said you would.
We need a technique that allows us to work out what the difference in £ between what you said would happen and what actually happened was caused by.
This is part of the four steps of a control cycle.
1. Set (or Revise) the Budget –
2. Record Actual Results –
3. Compare actual results with the budget (that’s Variance Analysis) –
4. Take action if necessary (which could be back to stage 1. to revise the budget).
Why our actual results might be different from our Budget.
There are actually only two things that can cause the difference. Either the quantity used/sold/bought and/or the £ that came in/went out per unit.
Really, it all boils down into how many units were used compared to what you expected and what they cost individually compared to what you expected.
Q and £.
I am going to teach you my method, as it is better than all the rest. It is unique to me, so you won’t find it in textbooks or in the Youtube video clips, but that doesn’t matter as my method is better than all the rest.
If you know another method, by all means use it. Nobody I have taught has ever at the end said to me that the traditional methods are better. I am not even going to explain them, as my method is better than all the rest.
Variance Analysis taught in two stages.
I normally teach this topic across two classes so that we can deal with simple situations first and then deal with more realistic (i.e. complicated) scenarios once we have got to grips with the basics.
The second stage is to include Flexing of Budgets.
If it all falls into place very quickly, there is no reason why you can’t go straight to the process involving Flexing. Some classes are very happy to progress quickly, some need a bit more time to get the basics right.
I am not going to hide Flexing from the materials, we just won’t need to do it in the first examples.
So, which variances are we going to look at?
My personal view is that you probably can have a good enough recording system so that you can detect and consider every variance. I say that because it is the things that you are not looking at that can give you the nastiest slap around the side of the head.
Clearly if your organisation is vast, this might be problematical. However, I do think that most variances are usually easily identifiable if you are keeping tabs on your activity and expenditure.
Text books will normally say that you should prioritise on scale of the variance (how big the difference in £s is from what you expected), the likelihood of you being able to control the variance, the costs of investigating the variance and the chance it might happen again.
But there are risks with taking these approaches.
The overall variance might seem small, but it could be a big positive offset by a big negative. Don’t assume that a small variance on a large amount of expenditure doesn’t hide a problem. However a few pounds variance on a small total is not going to be a priority.
Can you control it? An example might be the fuel for your vehicles. Naturally you are going to have to pay the price at the pump, and that as we all know, varies frequently. It would be easy to shrug your shoulders and just pay the bill, but does it actually reflect increased use of fuels by a poorly maintained fleet, buying fuel at the wrong petrol stations where the price is higher*, is there fraudulent use, mean it is time to change how we use our delivery fleet or the vehicles we employ? Just saying you can’t do anything about it could mean that you miss opportunities to do something about it.
Uncontrollable variances do exist though. When I was responsible for the parks Department of a Local Council I was givena report every month of the cost of mowing grass in the parks. This never matched the budget, and almost certainly never would. It was based on an average monthly cost across the year and the weather isn’t the annual average so the figures were never going to be the same. It had value as an annual figure, but not for monthly monitoring.
*I came across an example once where employees were filling the company vehicles up at the petrol stations nearest to their homes rather than at the ones where the company had an arranged discount leading to much higher fuel bills.
The cost of investigating certainly could be a consideration, but if you use it as an excuse not to do the work you might end up with a nasty surprise. You should be aiming to have a recording system that quickly and easily (therefore cheaply) gives you the information you need. If the expenditure is genuinely tiny and unlikely to happen again, then you might want to ignore it, if it is a small but regularly expenditure you could of course just look at it periodically. Why not review it once a year just to see what is going on? Those who investigate fraud are often looking at small repeating expenditure, if you are monitoring your budget you should be taking the same approach, there could be a correctible error in your processes.
I would have thought that most items in your budget are likely to happen again, so you have to make sure that this isn’t another excuse for not checking. If you say that the unusual size of the expenditure is unlikely to happen again, are you sure? It would be prudent to do some analysis so that you can determine that with some certainty. Should you have a contingency in case it does happen again, how can you make sure it never does actually happen again?
My view is that you should endeavour to check everything as this is the only way to make sure your budget assumptions are correct. If they are not correct, you may miss opportunities because of not having adequate resources. If in your view it isn’t worth checking on a monthly basis (e.g. the cost of mowing grass in the parks), then at least check periodically to make sure that it is not out of line with the expected overall cost.
Do remember though that the whole process is not about finding someone to blame, it is about making sure that the next version of the budget is even better. You will inevitably find some problems that arise from errors in execution, but again the process is about making sure the good things happen again and the bad things don’t, not punishing errors.
In some situations the budget will be wrong because it was based on a ‘best guess’ at the time. Now we know what the right figures should be we revise the budget. See the four step cycle above. Revising budgets s easier when you work with Rolling Budgets (see Budgeting page).
The process of Variance Analysis.
I teach my own method, not the one you are going to find in the textbooks.
See what the ACCA say about the standard method. And panicking.
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This document has the steps we are going to go through. Take a quick read so that you have the context, we will then go through the ‘whys’.
Quantity and Price Variances.
If we said we were going to make a £ million and we didn’t, we will want to know why.
If we made more, we want to encourage the positive changes so that we do it again next time.
If we made less, we want to prevent the negative changes from happening again so that we make more money next time.
To do this we have to investigate the changes in every line of our budget. Not only do we need to know what the difference was between, say, our budgeted expenditure on Material A and the actual expenditure on Material A, we need to know how much of that difference was caused by a change in the amount of Material A we used (Quantity Variance) and how much was caused by a change in the cost per unit of Material A (Price Variance).
Only by knowing the Q (Quantity) and £ (Price) variances can we make any plan to do better next time.
This is a live demonstration. The green text means this pdf has audio. You need to download it to Livescribe at the url in the document to get it to work. It’s worth it. If it doesn’t immediately work, try another browser.
Understanding the Flexed Budget stage.
This is the part that usually causes confusion for students. Let’s look at why we (sometimes) need to do it and what we have to do.
The simplest situation is we say we are going to make ten units and we actually do make ten units. Any Variance in the total cost from the budget is entirely due to changes in the quantities and prices of the materials etc. that we used to make the ten units.
If we said we were going to make ten but actually made eleven, then the Variance in the total cost is not just due to changes in quantities and prices as above BUT ALSO because we made an extra unit.
In explaining the £ and Q variances (so we can change our plans) we also now need to unpick the effect on the total costs of making the extra unit (or fewer units if we made fewer).
We could do it in every line of the budget, but that would be tedious. The easiest thing to do is write a Flexed Budget.
Once we have the Flexed Budget we can do the variance analysis as normal using Budget @ Budget etc. as in my method. Once we have a Flexed Budget, the Budget @ Budget is the figures from the Flexed Budget, not the original Budget.
This is the one thing that you might get wrong, writing the Flexed Budget.
Writing a Flexed Budget.
Take the original budget and adjust for the real number of units.
10 Table Tops @ £10 = £100 in our original budget becomes
We made 11 tables
11 Table Tops @ £10 = £110
Or we made 9 tables
9 Table Tops @ £10 = £90
Notice that the cost per table top (£10) is the number that we used in the original budget. We just take the real number of tables from our Actual records of what we have done to rewrite the budget. It’s the budget we would have written if we had known in advance how many units we were going to make.
Watch out for the common error.
Because we have taken the number of units of the product from the Actual information recorded, there is a temptation to make the mistake of taking the actual number of units or the actual cost per unit.
If we made eleven tables we should have needed eleven table tops and they should have cost £10 each, so those are the numbers we use. It’s the ‘should have’ budget.
If we actually used 12 table tops and spent £9 per table top, that is irrelevant at this point. We don’t put the 12 or the £9 in the Flexed Budget, they are not what we ‘should have’ done.
We will resolve the number of table tops actually used and the price actually paid when we do our Q and £ variances using my ‘Budget@Budget’ etc. method.
The Planning Variances
This is Planning Variances as opposed to Operational Variances. Operational Variances are those that happened because you used to much material or were quicker doing the job. We deal with those as our standard ‘budget @ budget’ approach above.
PLanning Variances happen because we got the plan wrong overall. These only occur if we have a Flexed Budget, that is , if we have produced/sold/bought a different total number of units from the original budget.
Remember, it’s not that there were a different number of table tops as they are not the unit of production (Operational Variances), it is if you have a different number of tables, the actual product.
We discussed with the Flexed Budget how we could work out the impact of the change in units on every line in the budget, but this would be tedious. By writing a Flexed Budget we produce something we can compare to the original Budget to see what the impacts of the change in number of units is on the total variance. We deal with the change in the plan in just two lines, the Planning Variances.
Simple example:
We budgeted to make 20 loaves of bread but actually made 40. A loaf should have cost £2 each to make. We were going to sell the 20 loaves for £5 each, we sold all 40 loaves that we did make.
There are two Planning Variances. Planning Production Variance. Planning Sales Variance.
Planning Production Variance.
Budget 20 @ £2 = £40. Flexed (not the Actual) 40 @ £2 = £80.
You can see the planning variance by taking one from the other = £40 Adverse (because we spent more). The other way of doing it (probably easier) is to say we made an extra 20 @ £2 each = £40 extra.
Planning Sales Variance.
Budget 20 @ £5 = £100. Flexed (not the Actual) 40 @ £5 = £200.
You can see the planning variance by taking one from the other = £100 Favourable (because we received more). The other way of doing it (probably easier) is to say we sold an extra 20 @ £5 each = £100 extra.
Watch this.
This video use the traditional formula based approach instead of my ” Budget at Budget” version. Compare the two methods. Mine is easier isn’t it.
Includes Flexed Budget.
Labour Variances
Uses slightly different terminology to me, but remember, all variances are either quantity or price whatever they are called.
Efficiency = quantity
Rate = price
Overhead Variances when we are using Absorption Costing
All overhead variances (comparing Budget to Actual) are Price Variances only. The nature of Fixed Costs is that they don’t change with activity after all. The only change is when we are looking at the Fixed Costs Absorbed when we are using Absorption Costing.
Because we have absorbed Factory Overhead in to the units we are making on the basis of per unit or per hour, if we make a different number of units or work a different number of hours we will have Absorption Variances.
Here I give a worked example and a handout from PQ Magazine which gives an explanation of what is going on.
The caution I always give is that, just because a variance here seems Favourable, it doesn’t always mean it is a good thing.
Working more hours will give a Favourable variance because theoretically the more hours we work the more overhead we end up charging to customers. the problem is though, we don’t sell hours of work, we sell units of product.
If we have worked more hours without producing more units then actually we won’t get that overhead back from the customers. And we will have paid more in Labour to make the units.
This is shown in the working, where we work more hours (get a Favourable variance), but haven’t made the extra units we should have done with the extra hours.
Variances that occur under Absorption Costing only.
Worked Examples.
Don’t forget, you can use any method of Variance Analysis that gives you the correct answer, you don’t have to follow the method I use and teach.
Here are examples of questions worked using different methods. You should be able to get the same answer by following my method too.
A basic approach, a basic question, but it does include discussion of possible written answers. I often think these are too simplistic, but then, in exams we often have to be.
A straightforward explanation of quantity and price variances using the traditional (not my) method.
Here is an example using the more traditional methods, not my ‘patented’ Rooks’ Method. A long example and particularly useful if you don’t like my approach. You could either follow this through to compare methods, or use the data and my method and see how that they give the same answer.
How you can set up a budget to show variances in Excel.
The variance calculated in this video is the total variance (the equivalent of my ‘line by line’ variance), so there is no consideration of how to analyse into Quantity and £ variances in this video. But it may be useful to you in setting up a process for identifying variances.
Remember though, that my advice is to look at every line for variances, not just big differences. There can be equal and opposite variances that give a small or no overall variance, but that are significant in themselves.
Quantity variance £1 million Adverse, £ variance £999,999 Favourable would give a £1 Adverse variance. You don’t want to not be aware of the underlying variances just because the overall variance is insignificant.
Possible Written Questions.
(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.
Define Variance Analysis.
Explain in what circumstances is it necessary to flex a budget when conducting a variance analysis and why.
A company made 70 units more than it had budgeted for. Explain why it cannot use the budget to compare to the actual costs of producing the units and what it should do.
Explain the function of a Flexed Budget in Variance Analysis.
Discuss the problems that can arise from using standard costs in a rapidly changing business environment.
Practice Questions.
(These are other people’s, so they may use different methods to me. Plus, if there is an error in the answer, it’s not my fault!). Bear in mind that they might also use slightly different terminology.
Try these multiple choice questions. They don’t show the answers, but you may get them if you submit your answers at the end. Note that they use the formula approach to answering variance analysis questions – a different method to mine. You will be able to get the same answers to all of the calculations. The only questions you probably won’t get right, are the ones that specifically ask about the formulas.
Do be aware of the different use in terminology. The ideas are the same, but some people all them different things…
http://wps.pearsoned.co.uk/ema_uk_he_wood_busaccuk_1/90/23240/5949601.cw/content/
http://wps.pearsoned.co.uk/ema_uk_he_davies_busacc_1/205/52631/13473567.cw/index.html
http://wps.pearsoned.co.uk/ema_uk_he_dyson_accnas_8/145/37242/9534128.cw/content/index.html
Done in a different way to me, but straightforward Quantity and £ variances for you to do (with answers).
http://accountinglectures.com/variance-analysis-practice-question.html