One of the benefits of flexible budgeting is that it helps you to understand the reasons for your company’s variances, the differences between actual and budgeted amounts.
Always indicate whether a variance is favorable or unfavorable. A variance is usually considered favorable if it improves net income and unfavorable if it decreases income. Therefore, when actual revenues exceed budgeted amounts, the resulting variance is favorable. When actual revenues fall short of budgeted amounts, the variance is unfavorable.
On the other hand, when actual expenses exceed budgeted expenses, the resulting variance is unfavorable; when actual expenses fall short of budgeted expenses, the variance is favorable.
Accountants usually express favorable variances as positive numbers and unfavorable variances as negative numbers. However, some accountants and managerial accounting textbooks avoid expressing any variance values as negative but always notate whether a variance is favorable or unfavorable. Still other accountants (and textbooks) call variances positive when the actual amount exceeds budget and negative when the actual amount falls short of budget.
Here, a positive variance for sales would be favorable because sales were higher than expected. However, a positive variance for costs would be unfavorable because costs were higher than expected (hurting net income). Express variances as positive when they are favorable to income and negative when they are unfavorable to income. Even so, take special care to indicate whether each variance is favorable or unfavorable to net income.
Management should investigate the cause of significant budget variances. Here are some possibilities:
Changes in conditions: For example, a supplier may have raised prices, causing the company’s costs to increase.
The quality of management: Special care to reduce costs can result in favorable variances. On the other hand, management carelessness can drive up unfavorable variances.
Lousy budgeting: An unrealistically ambitious budget is likely to cause negative variances.
Don’t be fooled into thinking that favorable budget variances are always good news. Cost-cutting measures reflected in a favorable variance may actually hurt the quality of finished products. Senior managers may have preferred that the company had spent more for better materials and sold higher-quality goods.
Many managers use a system called management by exception. They investigate the largest variances, whether favorable or unfavorable, and ignore the rest. This strategy helps focus managers on potential problem areas in operations.