Unfavorable variance

What Is Unfavorable Variance?

Unfavorable variance occurs in financial analysis when an actual financial outcome is worse than a planned or budgeted amount. This typically means that actual costs or expenses are higher than anticipated, or actual revenues or income are lower than projected.⁴⁸, ⁴⁹ Understanding and addressing unfavorable variance is a core component of [cost accounting] and [management accounting], falling broadly under the umbrella of [financial control] and [performance management].⁴⁵, ⁴⁶, ⁴⁷ It highlights deviations from financial plans, signaling potential operational or strategic issues within an organization.⁴⁴

History and Origin

The roots of modern accounting practices, including those that led to variance analysis, can be traced back to the need for businesses to track and control costs, especially during and after the Industrial Revolution. Early forms of [cost accounting] were crucial for businesses to understand product costs for pricing and to bid on contracts.⁴², ⁴³ By the late 19th and early 20th centuries, as mass production became more prevalent, predetermined, norm-based standard costs emerged as a means to control operations and reduce waste.⁴¹ This shift facilitated the development of tools like variance analysis to compare actual results against these predetermined standards.³⁹, ⁴⁰ The increasing complexity of industrial enterprises and the need for more sophisticated [financial control] spurred the adoption of management accounting systems to provide information for internal decision-making, moving beyond just inventory valuation.³⁷, ³⁸ The emphasis on efficiently using labor, a significant cost in early manufacturing, led to techniques for measuring and controlling production costs. For instance, even as early as the turn of the 20th century, the New York Times discussed evolving accounting methods to provide businesses with crucial financial insights needed for operations.³⁶

Key Takeaways

• Definition: An unfavorable variance indicates that actual results are worse than planned, typically due to higher costs or lower revenues than budgeted.³⁴, ³⁵
• Identification: It is calculated by comparing actual financial figures against established budgets or standards.³³
• Significance: Unfavorable variances alert management to areas requiring attention and investigation, as they can negatively impact [profitability].
• Actionability: Identifying an unfavorable variance is the first step; further [variance analysis] is required to determine the root causes and implement corrective actions.³¹, ³²
• Context is Key: An unfavorable variance in one area (e.g., higher expenses) might be offset by a favorable variance elsewhere (e.g., significantly higher revenue), requiring a holistic view.³⁰

Formula and Calculation

The basic formula for calculating a variance is the difference between the actual value and the budgeted or standard value. For an unfavorable variance, this typically means:

• For Expenses/Costs:
  $\text{Unfavorable Expense Variance} = \text{Actual Expense} - \text{Budgeted Expense}$
  A positive result indicates an unfavorable variance, meaning actual expenses exceeded budgeted expenses.²⁹
• For Revenue/Income:
  $\text{Unfavorable Revenue Variance} = \text{Budgeted Revenue} - \text{Actual Revenue}$
  A positive result indicates an unfavorable variance, meaning actual revenue fell short of budgeted revenue.²⁸

To express the variance as a percentage, the dollar variance is divided by the budgeted value and multiplied by 100.²⁷ This calculation is a fundamental part of [budget variance] analysis.

Interpreting Unfavorable Variance

Interpreting an unfavorable variance goes beyond merely identifying a numerical difference; it involves understanding the underlying reasons and their implications. A large unfavorable variance signals that a company's financial performance deviated significantly from its [budgeting] plan. For instance, an unfavorable production cost variance could point to inefficiencies in operations, increased material prices, or higher labor costs than projected.²⁶

Management uses this information for [financial control] through a process known as "management by exception," where attention is focused on significant deviations, whether favorable or unfavorable.²⁵ The goal is to determine the root cause of the variance, assess its controllability, and assign responsibility to a specific division or individual for resolution.²³, ²⁴ For example, if direct material costs are higher than planned, it could be due to purchasing materials at a higher price (a price variance) or using more materials than expected (a usage variance).²² This detailed breakdown helps in taking targeted corrective actions.

Hypothetical Example

Imagine "GreenGro Inc.," a company that manufactures organic fertilizers. For the upcoming quarter, GreenGro's [budgeting] department sets a [standard cost] for raw materials at $0.50 per pound, expecting to use 10,000 pounds of raw materials to produce its fertilizers, totaling a budgeted material cost of $5,000.

At the end of the quarter, the production report shows that GreenGro actually used 12,000 pounds of raw materials, and the [actual cost] of these materials was $0.60 per pound.

Let's calculate the total unfavorable material variance:

1. Budgeted Material Cost: $0.50/pound * 10,000 pounds = $5,000
2. Actual Material Cost: $0.60/pound * 12,000 pounds = $7,200

Total Material Variance: Actual Cost - Budgeted Cost = $7,200 - $5,000 = $2,200 Unfavorable Variance

This $2,200 unfavorable variance indicates that GreenGro spent $2,200 more on raw materials than planned. To understand why, the company would further break this down into a material price variance and a material quantity (or usage) variance, which are key components of [variance analysis]. This could reveal issues such as unexpected increases in supplier prices or inefficiencies in the production process leading to excess material usage.

Practical Applications

Unfavorable variance is a critical metric across various aspects of business and [financial analysis], providing actionable insights for management.

• Budgeting and Forecasting: Businesses use unfavorable variances to identify inaccuracies in their [budgeting] and [forecasting] processes. Consistent unfavorable variances may indicate that budgets are overly optimistic or that underlying assumptions need revision.²¹
• Cost Control: In manufacturing and service industries, unfavorable variances in [direct materials], [direct labor], or overhead signal higher than expected costs, prompting investigations into efficiency, waste, or supplier pricing. This is a core function of [cost accounting].²⁰
• Performance Evaluation: Management teams analyze unfavorable variances to evaluate the performance of departments, projects, or individual managers against their targets.¹⁸, ¹⁹ For instance, a persistent unfavorable [production variance] might lead to a review of production processes or equipment.
• Strategic Planning: Recurring or significant unfavorable variances can influence future strategic decisions, such as rethinking pricing strategies if [sales variance] is consistently unfavorable due to lower-than-expected revenue.¹⁷
• External Reporting and Investor Relations: Public companies may discuss significant variances in their financial reports, particularly in the Management's Discussion and Analysis (MD&A) section of their [financial statements], to explain deviations from expected results to investors. The U.S. Securities and Exchange Commission (SEC) provides guidance emphasizing the importance of discussing material changes and the underlying reasons, which often involve variance analysis.¹⁴, ¹⁵, ¹⁶

Limitations and Criticisms

While a powerful tool for [financial control] and [management accounting], unfavorable variance analysis has certain limitations and criticisms:

• Reactive Nature: Variance analysis is inherently reactive, identifying problems only after they have occurred. This means that losses or inefficiencies may have already been incurred before the issue is detected.¹³ Consequently, it should not be the sole basis for performance grading.
• Focus on Short-Termism: An overemphasis on achieving favorable variances (or avoiding unfavorable ones) can lead to managers making short-term decisions that may not align with long-term strategic goals. For example, cutting corners on quality to reduce material costs might create an immediate favorable variance but damage brand reputation in the long run.
• Incentive Misalignment: Linking executive compensation too directly to variance outcomes can create perverse incentives. Managers might manipulate reporting or delay necessary investments to meet targets, potentially leading to dysfunctional behavior.¹²
• Assumption of Standards: Variance analysis heavily relies on the accuracy and relevance of [standard cost] data and budgeted figures. If these standards are outdated, unrealistic, or based on flawed assumptions, the resulting variances may not provide meaningful insights.¹⁰, ¹¹
• Lack of Context: A variance, by itself, does not explain why it occurred. An unfavorable variance might be due to uncontrollable external factors (e.g., unexpected raw material price increases) or internal controllable factors (e.g., inefficient labor). Without further root cause analysis, the variance figure offers limited actionable intelligence.⁸, ⁹ Critics suggest that simply identifying a variance doesn't provide enough information for effective decision-making, emphasizing the need to understand the underlying causes rather than just the numerical deviation.⁷

Unfavorable Variance vs. Favorable Variance

The distinction between unfavorable variance and [favorable variance] lies in their impact on a company's financial well-being. Both terms are used in [variance analysis] to describe the difference between actual financial results and planned or budgeted figures.

While an unfavorable variance always implies a negative impact on [profitability] (e.g., less profit or a larger loss than anticipated), a favorable variance implies a positive impact (e.g., more profit or a smaller loss). However, a favorable variance isn't always good; for example, a significantly favorable materials usage variance could indicate a reduction in product quality. Both types of variances require further investigation to understand their root causes and implications for the business.⁶

FAQs

What does an unfavorable variance mean in simple terms?

An unfavorable variance means that something cost more than you expected, or you earned less money than you planned. It indicates that your actual financial performance was worse than your budget or plan.⁴, ⁵

Is unfavorable variance good or bad?

Generally, an unfavorable variance is considered "bad" because it means your actual results are less desirable than your planned ones. For instance, higher costs reduce profits, and lower revenues mean less money coming in. However, context is crucial; sometimes, an unfavorable expense variance might be offset by a larger favorable revenue variance, leading to a net positive outcome.³

How is unfavorable variance calculated?

For expenses, it's calculated as Actual Expense - Budgeted Expense. If the result is positive, it's unfavorable. For revenue, it's calculated as Budgeted Revenue - Actual Revenue. If this result is positive, it's an unfavorable revenue variance.² This process is a key part of [budgeting] and financial reporting.

What causes an unfavorable variance?

Causes can vary widely. For expenses, it might be due to higher prices for materials, inefficient use of resources, unexpected repairs, or increased labor rates. For revenue, it could be lower sales volume, reduced selling prices, or unexpected market competition. Identifying the specific cause is part of [variance analysis].

How do companies respond to an unfavorable variance?

Companies investigate the root cause of the variance. They might then take corrective actions, such as implementing [cost accounting] measures to reduce spending, adjusting future [forecasting], revising sales strategies, or reallocating resources. The goal is to understand why the deviation occurred and how to prevent or manage similar issues in the future.¹