Budgeting and Variance Analysis
A budget sets out the assumptions behind a plan. Comparing it with actual results reveals variances, but those differences need investigation before they can explain causes or responsibility.
For receipts, payment lags and funding needs, first work through Cash Budgets and Payment Timing. Return here to compare actual costs with a budget at the same activity level.
Static versus flexible comparison
Northstar planned 900 bikes but produced 1,000.
| Input standard | Per bike | Static budget at 900 | Flexible budget at 1,000 |
|---|---|---|---|
| Material | 4 kg × £8 = £32 | £28,800 | £32,000 |
| Labour | 2 hours × £18 = £36 | £32,400 | £36,000 |
Comparing the actual input cost for 1,000 bikes with a static budget for 900 bikes mixes the effect of higher output with differences in cost control. First flex the budget to actual output, then examine price/rate and quantity/efficiency differences.
What stays fixed when the budget flexes?
Keep the standard input per bike and standard input price; change the allowed quantity to match actual output. For materials, SQ is 1,000 bikes × 4 kg = 4,000 kg. It is neither the 3,600 kg originally budgeted for 900 bikes nor the 4,200 kg actually used. Otherwise the comparison either penalises extra output or treats extra consumption as automatically acceptable.
Flex the costs that vary with activity. Total fixed costs remain unchanged within their relevant range; if extra capacity changes those costs, revise the assumption explicitly.
Material variances
Actual material: 4,200 kg at £8.50 = £35,700.
Total material variance is £3,700 adverse, reconciling actual £35,700 to flexible standard £32,000.
Read the decomposition as three cost totals: 4,000 kg × £8 = £32,000 → 4,200 kg × £8 = £33,600 → 4,200 kg × £8.50 = £35,700. The first step isolates extra material use at the standard price; the second isolates the price change on actual quantity. Their sum reconciles exactly, with no overlapping effect. This example measures price variance on material used; if a question measures it on purchases, use purchased quantity and reconcile the inventory difference separately.
The two variances point to different possible causes:
- price: supplier market, rush order, quality grade, purchasing terms;
- usage: scrap, design, training, machine settings, material quality.
A cheaper material can create a favourable price variance and an adverse usage or warranty outcome.
Labour variances
Actual labour: 1,900 hours at £19 = £36,100.
Net labour variance is £100 adverse. Paying a higher rate may have enabled experienced staff to finish 100 hours below standard. The two variances should be interpreted together.
Reconcile the whole budget difference
| Materials and labour, £ | Amount | Meaning |
|---|---|---|
| Static budget | 61,200 | 900 bikes at standard inputs/prices |
| Flexible budget | 68,000 | 1,000 bikes at the same standards |
| Actual cost | 71,800 | Actual inputs at actual prices |
| Activity difference | 6,800 | Flexible minus static |
| Cost-control difference | 3,800 U | Actual minus flexible |
| Total difference | 10,600 | Actual minus static |
The £10,600 total increase is not all inefficiency. £6,800 is the standard cost of the extra 100 bikes; the remaining £3,800 equals material £3,700 U plus labour £100 U. Even that residual needs investigation before assigning responsibility.
Favourable is not automatically good
| “Favourable” result | Possible harmful explanation |
|---|---|
| Low material price | Poor quality and rework |
| Low labour cost | Understaffing and late delivery |
| Low maintenance spending | Deferred failure |
| High sales volume | Deep discounts or weak credit |
The favourable or unfavourable label describes a variance against its benchmark. To judge performance, you also need evidence about quality, timing, customers and safety.
Planning error or execution error?
Before holding a manager responsible, ask:
- Was the standard current and attainable?
- Did market prices change outside the manager’s control?
- Did product mix or specification change?
- Which manager controlled purchase, use, scheduling or design?
- Was the action rational given information available at the time?
Revise a standard when the operating model genuinely changes, not merely to erase an adverse result.
Budget design
A useful budget connects:
- sales and capacity assumptions;
- production and resource requirements;
- operating expenses;
- cash collection, payment and financing;
- forecast financial statements;
- named risks and trigger points.
Sales, production, purchases and payments are different
In a separate planning illustration, expected sales are 900 bikes, desired closing finished goods are 120 and opening finished goods are 100. Required production is 900 + 120 − 100 = 920 bikes. At 4 kg per bike, production uses 3,680 kg of material. With desired closing material of 200 kg and opening material of 180 kg, planned purchases are 3,700 kg.
Neither 920 bikes nor 3,700 kg tells you cash payments yet: apply input prices, credit terms and opening payables. Equipment cash payments also belong in the cash budget, while depreciation does not. Use the monthly cash-budget case to build that timing bridge, then use the variance exercise to practise the control comparison.
Forecasting software or AI can update scenarios quickly, but it does not make biased targets, fabricated drivers or hidden overrides acceptable. Keep a record of each version's assumptions and the evidence of approval.
Quick check
Why is the £1,800 favourable labour-efficiency variance not proof that production improved?