Budget variance analysis

Budget variance analysis explains the gap between budgeted and actual profit by splitting it into price, cost and volume effects. The key step is to flex the budget to the actual level of activity first, so that each variance measures one cause rather than a mixture of several. Each variance is then labelled favourable if it raises profit and adverse if it reduces it.

Why compare actual results with a flexed budget?

A fixed budget is set for one planned level of activity. If the business sells 20% more than planned, its material and labour costs will naturally be higher than budget, and comparing them with the original figures would show large adverse cost variances that are really caused by success on sales.

ACCA’s article on flexible budgeting draws the distinction clearly. A flexible budget, prepared at the start of the period, forecasts revenue and costs across a range of activity levels. A flexed budget is then prepared at the end of the period for the actual level of activity, and answers the question of what the results should have been at that level. Comparing actual results with the flexed budget isolates price and efficiency, while comparing the flexed budget with the original budget isolates volume.

The same approach underlies standard costing, where each unit has a preset standard cost and the flexed budget is simply actual output multiplied by those standards. Building the original budget is covered in budgeting for small businesses.

How do you calculate sales variances?

There are two main sales variances:

• Sales price variance: (actual selling price less budgeted selling price) multiplied by actual units sold. Selling above budget price is favourable.
• Sales volume variance: (actual units sold less budgeted units sold) multiplied by the standard margin per unit. Selling more than budget is favourable.

The margin used for the volume variance depends on the costing system. Under marginal costing it is standard contribution per unit, because selling one more unit adds its contribution and nothing more. Under absorption costing it is standard profit per unit, which includes a share of fixed overhead. Use one basis consistently; mixing them is a common source of reconciliations that do not balance. Our page on absorption vs marginal costing explains why the two give different profits.

Where several products are sold, the volume variance can be split further into a mix element (selling a richer or poorer blend of products than planned) and a quantity element (selling more or fewer units in total).

How do you calculate cost variances?

Each direct cost splits into a price element and a quantity element.

Cost	Price element	Quantity element
Materials	Price variance: (standard price less actual price) x actual quantity bought or used	Usage variance: (standard quantity for actual output less actual quantity used) x standard price
Labour	Rate variance: (standard rate less actual rate) x actual hours paid	Efficiency variance: (standard hours for actual output less actual hours worked) x standard rate
Variable overhead	Expenditure variance: (standard rate x actual hours) less actual cost	Efficiency variance: as for labour, at the variable overhead rate

ACCA’s article on materials mix and yield variances describes the usage variance in the same terms: the difference between actual material used for the output achieved and the amount expected at standard usage, valued at standard cost. Where a product uses several materials that can be blended in different proportions, the usage variance can be split into a mix variance (inputs) and a yield variance (output).

Fixed overhead variances

Fixed overheads do not vary with output, so they need different treatment. The fixed overhead expenditure variance is simply budgeted fixed overhead less actual fixed overhead. Under absorption costing there is also a fixed overhead volume variance: the difference between the overhead absorbed by actual output at the standard rate and the budgeted overhead. ACCA’s article on fixed overhead absorption shows that over absorption is equivalent to a favourable variance and under absorption to an adverse one, and that the volume variance can be divided into capacity and efficiency elements where overhead is absorbed on labour hours. Under marginal costing there is no volume variance for fixed overheads.

What does a worked example look like?

Illustration only. A business using marginal costing budgets to sell 1,000 units at £50, with standard variable cost of £30 per unit (2 kg of material at £6 and 1 labour hour at £18), and fixed costs of £12,000. Budgeted profit is £8,000.

Actual results: 1,100 units sold at £48; 2,300 kg of material bought and used for £13,340 (£5.80 per kg); 1,150 labour hours paid at £18.40 (£21,160); fixed costs £12,500. Actual profit is £52,800 less £34,500 less £12,500, which is £5,800.

Item	Calculation	Variance
Budgeted profit		£8,000
Sales volume	(1,100 less 1,000) x £20 contribution	£2,000 favourable
Sales price	(£48 less £50) x 1,100	£2,200 adverse
Material price	(£6.00 less £5.80) x 2,300	£460 favourable
Material usage	(2,200 less 2,300) x £6	£600 adverse
Labour rate	(£18.00 less £18.40) x 1,150	£460 adverse
Labour efficiency	(1,100 less 1,150) x £18	£900 adverse
Fixed cost expenditure	£12,000 less £12,500	£500 adverse
Actual profit		£5,800

The variances net to £2,200 adverse, which reconciles budgeted profit of £8,000 to actual profit of £5,800. The story is that a price cut sold 100 extra units, but the extra contribution did not make up for the lower price, and production used more material and labour than standard.

How should you interpret a variance?

A variance is a question, not an answer. Some points to work through:

• Look for links between variances. Cheaper material (favourable price) often means poorer quality, which shows up as extra waste (adverse usage) and slower working (adverse labour efficiency). ACCA’s mix and yield article shows how a favourable usage variance can hide an adverse yield caused by a change in the input mix.
• Ask who controls it. Purchasing usually owns price variances, production owns usage and efficiency, sales owns price and volume. A variance should be reported to the person who can act on it.
• Check the standard. A large variance may mean the budget or standard was wrong, for example a supplier price rise known before the year started. Separating planning errors from operational performance avoids blaming managers for bad forecasts.
• Set a threshold. Investigating every small variance wastes time. Many businesses only investigate variances above a set percentage or amount, or those that repeat month after month.
• Favourable is not always good. A favourable fixed cost variance from skipping maintenance, or a favourable labour rate variance from using less qualified staff, can cost more later.

How does variance analysis fit with management accounts?

Variance analysis is a management tool. There is no legal requirement to produce it, and it does not appear in statutory accounts. It works best as part of a regular management accounts pack: a one page operating statement reconciling budgeted to actual profit, followed by brief commentary on the three or four variances that explain most of the gap. For service businesses the same logic applies with hours instead of kilos: fee rate variances, chargeable hours variances and staff cost variances.

What mistakes come up most often?

• Comparing actual costs with the original budget instead of the flexed budget, so volume effects are misread as cost overruns.
• Using actual output instead of standard quantity for actual output when calculating usage and efficiency variances.
• Valuing the sales volume variance at selling price rather than contribution or standard profit.
• Mixing marginal and absorption figures in one reconciliation.
• Calculating the material price variance on material bought in one place and material used in another, so stock movements distort the figures.
• Reporting variances without commentary, so nobody acts on them.
• Treating every adverse variance as a failure. Using contribution as the measure keeps attention on whether a decision added profit overall.

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Related Accountapedia entries

• Flexed budgets explained
• Overhead absorption rates
• Break even analysis
• Fixed, variable and semi variable costs
• Make or buy decisions
• Cost, profit and investment centres

Sources

• ACCA: www.accaglobal.com
• ACCA: Mat yield
• ACCA: Overhead absorption

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.