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Understanding variances

In this video we'll look in more detail at how variances work in practice.
We have established that calculating and investigating variances between the budgeted and actual performance of a business is an important control mechanism. How does it work in practise? Let’s look at an example. Sally has a flower shop and has bought 100 bouquets of flowers at an average cost of 8 pounds each. She intends to sell all of them during the week for 20 pounds each. Therefore, Sally has a budgeted profit of 1,200 pounds. Sales revenue– 100 times 20, 2,000 pounds. Purchase costs– 100 times 8, 800 pounds. Budgeted profit, 1,200 pounds. As it turns out, Sally only sells 80 bouquets during the week, but she manages to sell them for 25 pounds each.
She has to recycle the remaining 20 bouquets as they are dying. Sales revenue– 80 times 25, 2,000 pounds. Purchase costs– 100 times 8 pounds, 800 pounds. Actual profit– 1,200 pounds. It would appear as if Sally achieved her profit target of 1,200 pounds. So should she do anything different in future weeks? An accountant would split the business performance into two elements– the price of the goods sold versus the quantity sold and analyse these separately. In terms of price, Sally has made an extra five pounds profit on each bouquet sold. We call this a favourable variance of five pounds extra profit per bouquet times 80 bouquets, which gives us 400 pounds.
It is favourable because by itself, it would mean that the actual profit would be greater than budgeted. In terms of the quantity sold, she’s sold 20 bouquets fewer than she planned. That is an unfavourable variance of 20 pounds lost on each sale times 20 bouquets, which again equals 400 pounds. It is unfavourable because by itself, it would mean the actual profit will be less than budgeted. The accountant would therefore suggest to Sally that she should buy fewer bouquets each week and charge the higher price. She would make more profit, as there would be fewer bouquets thrown away.
If she only ordered 80 bouquets but sold them for 25 pounds each, her profit will be 1,360 pounds– an increase of 160 compared with the actual profit achieved by Sally this week. Sales revenue– 80 times 25 pounds, 2,000 pounds. Purchase costs– 80 times 8 pounds, 640 pounds. Profit– 1,360 pounds. In the next step, you will be able to do your own variance calculations.
We saw in the last step that comparing budgets with actual performance is vital for any business to identify problems.
As a result, financial teams are always on the look-out for variances, which are differences between the budgeted and actual performance of a business.
In this video we’ll look in more detail at how variances work in practice. As Alice explains, there are two kinds of variance:
  • a favourable variance is when the actual profit is greater than the budgeted profit;
  • an unfavourable variance is when the actual profit is less than the budgeted profit.
In the downloads section below there is a document you can use to review in more detail the example business Alice walks through in this video.

What’s next?

In the next step there’ll be an opportunity for you to practise calculating and analysing variances, just as Alice did in the example in this video.
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