For a better understanding of how much your business actually spends on a planned expense, you’ll need to assess its variance. Regardless of niche or industry, all businesses have expenses; it’s something that comes with the territory of operating a business. Unfortunately, it’s difficult to predict exactly how much an expense will cost, which is where variances come into play.
The Basics of a Variance
The term “variance” refers to the cost difference between a budgeted or planned expense and the actual amount for which your business pays. For each planned expense, you’ll have a variance – assuming you follow through with the expense by purchasing it. Variance simply denotes the difference between the expense’s expected cost and its actual cost.
Businesses typically budget money for specific types of products or services before purchasing. A manufacturing company, for example, may budget $3,000 per month for raw materials. Of course, the manufacturing company may spend more or less than this planned amount when purchasing the raw materials. By conducting a variance analysis, the manufacturing company can see the cost difference between the budgeted amount and actual cost of the raw materials.
Using this same example, if a manufacturing company budgeted $3,000 for raw materials but spent $2,700 on them, the variance of that expense would be $300. Variances can be analyzed for all types of business-related expenses. It just involves analyzing the difference between the budget amount and actual cost of an expense.
Favorable vs Unfavorable Variances
Variances can be classified as either favorable or unfavorable. What’s the difference between them exactly? A favorable variance means there’s a positive price difference, whereas an unfavorable variance means there’s a negative price difference.
You should obviously strive for favorable variances. With a positive price difference, favorable variances signal that your business made more money than what you had expected to. If you think an expense will cost more than what it actually does, your business’s total expenses will decrease. In turn, your business will make more money in the period in which the expense was realized.
It’s impossible to predict how much money your business will spend on planned expenses. An expense may end up costing more or it may end up costing less. Regardless, you can gain insight into the difference between these amounts by conducting a variance analysis. If an expense has a positive difference, it’s considered a favorable variance. If an expense has a negative difference, it’s considered an unfavorable variance.
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