Variance Analysis

Budgeted costs

Among other questions, an investor would ask about the project costs. The management would need to not only get numbers that are close to what the business will spend but also adhere to these projected numbers to the best of their ability. To be completely honest, though, it is almost never possible to correctly guess the future prices. Thus, the exact answer is received only after the project is completed. During the process, though, only assumptions about the cost of the final result are known and the business is trying to stay within the budget limits.

Assumptions about the cost of the project and the necessary funds for its implementation are usually presented in the form of a clearly structured document that answers the questions: how much, when, and for what money will be spent. These numbers are compiled into a budget that is typically signed before the start of the work. In the future, the project manager will have to make a lot of effort to ensure that the work is completed within the approved budget.

Depending on how the accounting and other functions are organized in the business, it is possible to make adjustments to plans based on the newly available data. In some companies, these costs are not accounted for until the invoice is received or paid. In this case, the current state of the project budget is available to the manager in a distorted form and does not provide a full picture for making the best decisions.

Budgets are not prepared for projects alone. Businesses regularly draw up budgets for the upcoming quarter, year, and even several years. They set up standards based on various data. These standards can be calculated using historical accounting data. They can also be obtained by looking at similar projects or companies. The advantage of the method is the ability to obtain more accurate estimates.

Actual costs

Actual costs show the actual cash outflow during the project. The actual cost report contains information about the actual costs of the project. They can arise before and during the execution of the project. The business might pay for the expenses incurred during the project even after the work is done.

As the name says it all, actual costs are what the business had to pay its suppliers, lenders, and other entities to keep on operating and make its products, sell goods, or provide services. These are the numbers you will see in bookkeeping records and based on which the company will calculate its profit and prepare financial statements. Actual costs are also used when calculating how much the company should pay in taxes.

Variance and Variance Analysis

The difference between the standards or planned estimates and the actual costs can give the manager additional information to think about and adjust business plans and strategies accordingly. These differences are also known as variances. Variance analysis, the comparison of standards/planned and actual indicators is used to achieve numerous goals. Let’s list the most typical situations when variance is used.

1. Comparison of standard and actual indicators to assess the effectiveness of budget implementation.
2. Comparison of actual indicators with standards ones allows to control costs and promotes the introduction of resource-saving technologies.
3. Comparison of actual indicators with standard indicators allows determining trends in the development of the business.

Note that although we talked about costs when explaining budgeted/standard and actual financial indicators, variance analysis can also be applied to business revenue. It simply looks at what actual costs or revenues turned out to be and why and what can be done if the actual figures differ a lot from the standards or budget.

The actual figure can vary from the budgeted in two ways. The changes can be favorable and adverse. In the first case, the company might have planned for bigger expenses or did not expect to earn as much revenue. In case of adverse variances, the company was not able to stay within the budgeted costs or it overestimated its revenue streams. Thus, we can talk about favorable cost variances when costs are lower and adverse changes when costs are higher than standards set before the business. Similarly, for sales revenue or profit budget, favorable means revenue or profit is higher, and adverse means sales or revenue is lower.

Example

Looking at the information presented above, we can tell that the company expected to receive $800 in Sales Revenue, but it actually did better. Thus, there is a $150 favorable variance. The wage costs were also lower than expected. However, spendings on materials were somewhat higher than planned, which is an adverse variance.

We can also look at the profit variance. Despite the higher costs for materials spent to manufacture the goods, the company managed to earn more in profit than it expected. Given higher profits, it is no wonder that the company had increased material spendings. The management can dig in deeper to see what exactly caused was the reason for such changes (and how it can repeat better performance).