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One of the key elements of the budgeting or financial planning process is estimated revenue/expenses. It’s important to be as accurate as possible, but in many cases, the budgeted figures will end up differing from the actual figures, sometimes by a relatively significant margin. This is known as variance. There are two forms of variance: favorable and unfavorable. Carry on reading our guide to favorable vs. unfavorable variance for a little more information.
What does favorable and unfavorable mean in accounting?
In the field of accounting, variance simply refers to the difference between budgeted and actual figures. Higher revenues and lower expenses are referred to as favorable variances. Lower revenues and higher expenses are referred to as unfavorable variances. Favorable and unfavorable variances can be caused by a wide range of factors, including errors in the original budget (i.e., faulty calculations, bad data, etc.), changes in business conditions (i.e., economic downturn, new competitor entering the market, etc.), or simply exceeding/underperforming with regard to expectations.
It’s also important to note that budget variances are likely to be a greater issue with static budgets than they are with flexible budgets, which allow for updates and changes to be made when assumptions change. For this reason, many companies choose to use a flexible budget, rather than a static budget. Now, let’s explore favorable variances and unfavorable variances in a little more depth.
What is favorable variance?
Favorable variance is a difference between planned and actual financial results that is in favor of the business. For example, if a business expected to pay around $100,000 for equipment maintenance, but was able to contract a price of $75,000, they’ll have a favorable variance of $25,000.
What is unfavorable variance?
Unfavorable variance is a difference between planned and actual financial results that is not in favor of the business. For example, if a business expected to pay around $75,000 for equipment maintenance, but was only able to contract a price of $100,000, they’ll have an unfavorable variance of $25,000.
Understanding favorable vs. unfavorable variance
The differences between favorable and unfavorable variances are relatively self-explanatory. Favorable variances are positive (although may indicate that you’ve been too cautious when drawing up your budget) and unfavorable variances are negative (although, again, it may simply be an indication that you haven’t been cautious enough with regard to your financial planning).
In some cases, budget variances are the result of external factors which are impossible to control, such as natural disasters. However, if you encounter consistent budget variances over an extended period of time, whether unfavorable or favorable, it’s a good idea to evaluate your budgeting process, as it could be an indication that fundamental errors are skewing your projections.
Next steps: dealing with unfavorable variance
If you’ve encountered a favorable variance in your budget, there’s a limited amount that you need to do – simply analyze where the difference is coming from and whether you can take advantage of it in the future to boost your bottom line. With unfavorable variance, it’s a different story. There are many different steps you can take to rectify an unfavorable variance.
Firstly, you may decide to adjust your budget to ensure it remains realistic. You can also attempt to boost customer demand (perhaps by introducing new features to your product or overhauling your marketing strategy). Finally, you could adjust internal processes to eliminate inefficiencies and wastage, thereby improving your bottom line.
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