Profit variance is the difference between the actual profit experienced and the budgeted profit level. There are four types of profit variance, which are derived from different parts of the income statement. They are:
- Gross profit variance. This measures the ability of a business to generate a profit from its sales and manufacturing capabilities, including all fixed and variable production costs.
- Contribution margin variance. This is the same as the gross profit variance, except that fixed production costs are excluded.
- Operating profit variance. This only measures the results of operations; it excludes all financing and extraneous gains and losses. This variance provides the best view of how the core operations of a business are functioning.
- Net profit variance. This is the most commonly-used version of the profit variance. It encompasses all aspects of a company's financial results, without exception.
A profit variance is considered to be favorable if the actual profit is greater than the budgeted amount. A profit variance is considered unfavorable if the actual profit is lower than the budgeted amount.
For example, a company budgets for $50,000 of net profits. Actual net profits are $60,000. This is a favorable variance of $10,000.
There are many reasons for a favorable or unfavorable profit variance, including the following:
- Differences between actual and expected product pricing
- Differences between actual and expected unit sales
- Changes in the amount of overhead costs incurred
- Changes in the amount of scrap incurred
- Changes in labor costs
- Changes in the cost of materials
- Changes in the incremental tax rate (if applicable)
- The budgeted profit was incorrectly formulated