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Unfavorable Variance: Definition, Types, Causes, and Example

Definition

Unfavorable variance refers to a financial situation where actual costs exceed the budgeted or projected costs. There are typically two types of unfavorable variance: cost variance, where actual costs are greater than the budgeted costs, and sales variance, where actual sales are less than projected. This can be caused by a range of factors including changes in market conditions, unexpected expenses, or poor management.

Phonetic

The phonetics of the phrase “Unfavorable Variance: Definition, Types, Causes, and Example” is:ʌnˈfeɪvərəbəl vəˈriːəns: ˌdefɪˈnɪʃən, taɪps, kɔːzɛz, ænd ˈɛgzæmpl

Key Takeaways

  1. Definition: Unfavorable Variance refers to a financial metric that indicates if a company’s actual expenses or financial performance is worse than its projected or budgeted amounts. It is an essential tool in financial analysis and budget monitoring, helping companies identify areas of overspending or underperformance and take corrective actions.
  2. Types: There are primarily two types of unfavorable variances – cost (or expense) variance and sales variance. Cost variance arises when the actual cost is more than the expected cost, whereas sales variance results when actual sales are less than the projected sales. Both types provide insights into a company’s financial health and efficiency.
  3. Causes: Unfavorable variances can be caused due to a variety of reasons. Some common causes include unexpected price changes, inefficient use of resources, increased material costs, lower than expected sales volumes, poor management decisions, or changing market conditions. Identifying the root cause of an unfavorable variance is vital in formulating a strategic response.
  4. Example: Suppose a company budgeted for production expenses of $1,000,000 but ended up spending $1,200,000. This results in an unfavorable variance of $200,000, signaling possible overspending or inefficiency in the company’s production process. The company then needs to investigate this discrepancy and devise strategies to improve its financial performance.

Importance

Unfavorable variance is a crucial concept in business and finance as it aids in identifying discrepancies between projected and actual performance, which is critical in managerial decision-making and strategizing. It falls under the umbrella of variance analysis, an essential aspect of management accounting, being the difference between a budgeted, planned, or standard amount and the actual amount incurred or earned. This term helps pinpoints areas of inefficiencies or incorrect budget forecasting that might adversely affect profit margin. Awareness of types (like sales, direct labor, direct materials, variable overhead, and fixed overhead unfavorable variance) and underlying causes (such as changes in the market environment, inaccurate forecasting, improper budget allocation, or operational inefficiencies) allows companies to adjust their strategies and operations accordingly. Moreover, understanding ‘Unfavorable Variance’ through real-time examples helps businesses manage risks, control costs, and navigate towards achieving their financial goals efficiently. Therefore, the importance of this term lays essentially in financial planning, control, and performance analysis.

Explanation

Unfavorable variance, in finance and business, is a pivotal concept used for budgeting, planning, and performance evaluation. It is indispensable as it facilitates an understanding of the financial performance of a business, thereby assisting managers in making informed decisions concerning operations and future business strategies. Unfavorable variance occurs when actual costs are higher than the budgeted or standard costs, or when actual revenue is less than the projected revenue. It is an indication of inefficiencies or problems within a business operation or process.The purpose of tracking unfavorable variance is to efficiently assess the effectiveness of business strategies and operations. It serves as an early warning system, enabling managers to promptly identify and address issues that cause shortcomings in achieving planned objectives. For instance, an increase in production cost might result in an unfavorable variance, prompting a review of the procurement process for raw materials, labour efficiency, or machinery operations. Thus, managing unfavorable variance ensures budgetary control, promotes operational efficiency, and contributes to improved profitability and growth of a business.

Examples

1. Manufacturing Company:Let’s say a chair manufacturing company budgets $50 to produce a single chair, including the costs of materials, labor, and overhead. If, during a given month, the company notices that the cost of producing a single chair rises to $55, this reflects an unfavorable variance of $5 per chair. This could be due to various factors such as an increase in the cost of raw materials, increased labor costs, or unexpected overhead costs. 2. Retail Business:A retail store expects to sell a specific brand of shoes for $100 each, and aims to sell 500 pairs monthly. However, due to changes in customer preferences or increased competition, there’s a drop in demand. The store ends up selling only 400 pairs in a month. The decrease in sold pairs creates an unfavorable sales variance of ($100 x 100 pairs) = $10,000.3. Service Industry:A consulting firm budgets 5 hours of work for a client’s project at a rate of $200 per hour. But, unexpected complications arise, and the project takes 7 hours to complete. This additional two-hour work represents an unfavorable labor variance, costing the firm an additional $400—that it couldn’t bill to the client. This variance may be due to a range of reasons, such as insufficient planning, unexpected changes in the project, or the consultant’s inexperience.

Frequently Asked Questions(FAQ)

What is an Unfavorable Variance?

An unfavorable variance refers to a negative difference between the actual cost or revenue and the forecasted cost or revenue in business or finance. It is often seen as a warning signal indicating that a company may not meet its performance targets.

What are the Types of Unfavorable Variance?

The two primary types of unfavorable variance include cost variance and revenue variance. Cost variance is unfavorable when actual costs exceed the budgeted costs, while revenue variance is unfavorable when actual revenues fall short of budgeted revenues.

What Can Cause an Unfavorable Variance?

Several factors can cause unfavorable variances, including unexpected price increases for materials, higher labor rates, lower productivity, and lower sales prices or volumes. Unfavorable variance might also result from incorrect forecasting or sudden disruptions like natural disasters.

Can you provide an example of Unfavorable Variance?

Sure, for example, if a company budgeted $200,000 for its material costs but ends up spending $250,000, the material cost variance is $50,000 unfavorable. This means the company spent $50,000 more than what it expected.

How Can Unfavorable Variances be Managed or Reduced?

Companies can reduce unfavorable variances by monitoring their budgets closely and making adjustments as needed. They can also set realistic budgets, negotiate better prices with suppliers, increase efficiency, and price their products or services appropriately to meet revenue targets.

What are the consequences of an Unfavorable Variance?

Unfavorable variance can lead to lower profit margins, reduced business reliability, and potential financial loss. It can also cause significant concerns for stakeholders and may require changes in operational or strategic planning.

Is Unfavorable Variance always negative?

While the term unfavorable usually signals a negative aspect, this is not always the case. Unfavorable variances provide a learning opportunity for companies to investigate the discrepancies, understand their causes, and take corrective measures to improve their future performance.

Related Finance Terms

  • Definition: An unfavorable variance in business/finance refers to the difference between the actual cost and the standard cost when the actual cost exceeds the standard. This indicates a discrepancy between the planned/budgeted amount and the actual amount spent or earned.
  • Types: There are two main types of unfavorable variance: Direct and Indirect. Direct variances are a result of direct factors like labor and materials, while indirect variances consist of overhead costs that diverge from the standard.
  • Causes: Unfavorable variance can be caused by a number of factors, including fluctuations in market prices, increased labor costs, inefficiency in operations, or improper budgeting.
  • Example: For instance, if a company budgeted $100,000 for labor costs but actually spends $120,000, the unfavorable variance is $20,000.
  • Implications: Unfavorable variances can signal problems in a business’s efficiency or financial management, demanding immediate attention for corrective actions.

Sources for More Information

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