What is the Purpose of Variance Analysis in Budgeting?

Managerial accounting is an accounting branch that covers the flow of information internally. It does not focus on financial figures and reports, unlike financial accounting. Instead, managerial accounting allows companies to enhance the quality of information.

It includes both quantitative and qualitative data to support the decisions made by managers. Managerial accounting provides various tools that managers can use during the process.

One of the primary tools that managerial accounting provides is a budget. Most companies prepare a budget for every fiscal period. While it is helpful on its own, managers can enhance its benefits even further. Companies can use variance analysis with budgeting to reap maximum rewards from the process. For most companies, these processes complement each other.

Variance analysis has a crucial purpose in budgeting. A budget can be beneficial on its own. However, the variance analysis process usually requires a budget to provide benefits. Before discussing the purpose of variance analysis in budgeting, it is crucial to understand what each of these is.

What is Budgeting?

Budgeting is the process companies use to prepare a plan for future income and expenses. It involves estimating revenues from various sources. Similarly, it includes predictions for the expenses incurred in different areas. Companies prepare different types of budgets.

Usually, companies compile these budgets after regular intervals. After every period, they reevaluate it and make changes accordingly.

Essentially, budgeting involves creating a plan on how companies intend to make money. Similarly, it includes details on how it plans to spend that money. 

This plan allows companies to determine if they have enough resources to continue their operations. If they don’t, companies can create a plan to finance their activities. However, the budget doesn’t only provide that benefit.

Budgeting also helps companies create a guide on how to operate. This guide allows managers to understand what senior managers expect of them. Consequently, they can plan their activities within their respective departments accordingly.

Budgeting also details the resource allocation to various departments. Therefore, it plays a crucial role in defining how managers use those resources efficiently.

Overall, budgeting is a tool in managerial accounting that helps managers plan for future activities. It includes details of all expected income and expenses for the future. Budgets help companies and managers establish a plan for that period. 

Simultaneously, it synchronizes the activities between several departments to achieve the best results. Essentially, a budget includes an estimation of future performance.

What is Variance Analysis?

A budget only provides details on how managers intend to operate in the future. However, it does not consider the actual performance in various areas. Companies use variance analysis to compare budgeted and actual results. 

Consequently, it allows companies to establish whether those results match. In most cases, differences will exist between both. Variance analysis identifies the areas where those differences occur.

Variance analysis considers the difference between budgeted and actual figures. It can report any discrepancies that exist as favorable or adverse. Essentially, a favorable variance is any difference that benefits the company. For example, more sales than expected are usually better.

Therefore, any positive difference in sales falls under a favorable variance. In contrast, an adverse discrepancy has unfavorable implications for the company.

Variance analysis helps companies manage their operations better. By comparing actual and planned costs, companies can identify inefficient processes. Consequently, they can take corrective actions to improve those areas. 

On the other hand, it also identifies areas where managers perform better than expected. In those cases, companies can motivate them to enhance their performance even further.

Essentially, variance analysis involves comparing predicted and actual results. However, the process does not end at that. It also helps companies analyze any difference between those results. 

Once they do so, companies can take action to eliminate any weaknesses. Companies perform variance analysis regularly. The more often they do so, the better they can identify and manage their performance.

What is the purpose of Variance Analysis in Budgeting?

Variance analysis and budgeting complement each other. A budget is a planning tool that companies use to prepare for future activities. Similarly, it allows them to set goals and objectives for managers. 

However, it does not consider the actual results on its own. Companies must use variance analysis to determine how managers have performed to achieve their objectives. In this case, variance analysis enhances the benefits of budgeting.

On top of that, variance analysis promotes responsibility in various areas. Budgets create expectations for each manager in their respective manager. Usually, companies establish responsibility centers for each area in their operations.

For those areas, they set budgets to help managers understand their roles. Variance analysis holds responsible for their performance according to the specified plan in the budget.

Variance analysis can also identify any errors in a budget. This process involves checking actual and planned figures against each other. Consequently, it requires companies to investigate the differences existing in those areas. 

In some cases, variances may exist due to errors in the budgets. Therefore, variance analysis can help identify any inefficiencies in the underlying budgeting process.

Similarly, variance analysis can provide information to prepare budgets in the future. In that case, it acts as feedback to the budgets that companies make every period. Without variance analysis, they cannot understand if the budget varies from actual performance. 

Therefore, the budget may not be realistic for future periods. However, variance analysis fixed that by establishing actual performance. Based on that, companies can create standards for the future.

Overall, variance analysis plays a significant role in budgeting. Budgets act as a monitoring and control tool within most companies. However, they cannot achieve those without using variance analysis. In most cases, companies use both together to achieve maximum benefits. If companies don’t consider variance analysis, they cannot compare how managers performed according to the set standards.

What are the importance and limitations of Variance Analysis in Budgeting?

The purpose of variance analysis in budgeting is highly crucial. However, it also plays an important role in the process. Despite that, there are several limitations of variance analysis in budgeting. Managers must understand all of these to use the tools together. Some of the reasons variance analysis is important in budgeting include the following.

• Variance analysis allows companies to control their actual activities. If any differences exist in actual and planned figures, they can compare the difference. If that difference is material, companies can investigate the reasons that cause them.
• Variance analysis helps create an efficient budgeting process. Usually, companies aim to have the lowest possible deviations from the planned budget. Therefore, they require detailed information on how to reduce them, which variance analysis provides.
• Variance analysis facilitates the process of assigning responsibility to managers. It divides differences into several types. Based on that, companies can decide which managers are responsible and require explanations.

However, variance analysis can have several limitations in budgeting as well. Some of those limitations include the following.

• Variance analysis requires actual performance for comparison with the budgeted amounts. This data becomes available once the company knows its financial results. Consequently, it may be too late to take corrective actions after identifying any inefficiencies. Essentially, variance analysis takes a reactive approach, while budgeting is proactive.
• Without a realistic budget, variance analysis cannot fetch productive results. Therefore, deviations between actual and planned activities will always exist. Variance analysis requires companies to prepare realistic budgets, or else they will fail.

Conclusion

Budgets allow companies to plan for future income and expenses. However, they can provide limited benefits on their own. Usually, companies use variance analysis along with budgets to maximize those benefits. 

Variance analysis compares actual performance with budgeted amounts. It plays a crucial purpose in the budgeting process.