An unfavorable variance is encountered when an organization is comparing its actual results to a budget or standard. The variance can apply to either revenues or expenses, and is defined as:
- Unfavorable revenue variance. When the amount of actual revenue is less than the standard or budgeted amount. Thus, actual revenues of $400,000 versus a budget of $450,000 equals an unfavorable revenue variance of $50,000.
- Unfavorable expense variance. When the amount of actual expense is greater than the standard or budgeted amount. Thus, actual expenses of $250,000 versus a budget of $200,000 equals an unfavorable expense variance of $50,000.
In general, the intent of an unfavorable variance is to highlight a potential problem, which is then corrected. In reality, the concept does not work that well. The problem is that there is only an unfavorable variance in relation to a standard or budgeted amount, and that baseline amount may be impossible or at least very difficult to attain. For example:
- Purchase price variance. The purchasing staff sets a standard purchase price for a widget of $2.00 per unit, which it can only attain if the company buys in volumes of 10,000 units. A separate initiative to reduce inventory levels calls for purchases in quantities of 1,000 units. At the lower volume level, the company can only buy widgets at $3.00 per unit. Thus, an unfavorable purchase price variance of $1.00 per unit cannot be corrected as long as the inventory reduction initiative is continued.
- Labor efficiency variance. A company that operates with long production runs sets a low labor-cost per unit produced. Midway through the year, it switches to a pull-based manufacturing system where units are only produced if there is a customer order. In total, the company experiences a massive decline in costs, even though there is a large unfavorable labor efficiency variance that is caused by the employees working on fewer units.
Thus, it is necessary to review the underlying reasons for a unfavorable variance before concluding that there is actually a problem. Usually, the best indicator of an actual unfavorable variance that requires remediation is when the baseline is historical performance, rather than an arbitrary standard.
The concept of an unfavorable variance is used in exception reporting, where managers want to see only those unfavorable variances that exceed a certain minimum amount (such as, for example, at least 10% of the baseline and greater than $25,000). If an unfavorable variance exceeds the minimum, then it is reported to managers, who then take action to correct whatever the underlying problem may be.
The unfavorable variance concept is of particular use in those organizations that adhere rigidly to a budget. In these companies, a financial analyst reports variances that are unfavorable in relation to the budget. Managers are then responsible for bringing the variance back into conformity with the budget.
Conversely, if adherence to budgeted expectations is not rigorously enforced by management, then the reporting of an unfavorable variance may trigger no action at all. This is particularly likely when the budget is used only as a general guideline.