Accountants use abstract words and phrases like unfavorable variance, amortization, extraordinary items, and preferred dividends that are difficult to understand. Understanding financial statements, budgets, and general financial performance require knowledge of these terms and several others, however. Learning about these topics requires time, effort, and the assistance of someone experienced in accounting and finance to be willing to show you the proverbial ropes.

Herein is an explanation of an unfavorable variance and how it is used in business. While the concept isn’t overly troublesome to grasp, one must first understand what a budget is, how budgets are used in business, and organizations’ reasons for utilizing them.

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What is a budget?

While ordinary households aren’t necessarily strangers to budgets, businesses use budgets far more frequently than their at-home, personal-use counterparts. Although virtually everybody understands what a budget is, defining budget is necessary to understanding unfavorable variances.

The Merriam-Webster Dictionary defines “budget” as used in several capacities, though this discussion’s definition is related to the field of finance; here’s how the go-to dictionary defines it: a statement of the financial position of an administration (as of a nation) for a definite period of time based on estimates of expenditures during the period and proposals for financing them.

How Budgets are Used

Businesses generate money by offering customers and clients products and services. No business has an unlimited pool of money to make expenditures from, unfortunately; spending too much money can certainly result in major problems like disgruntled shareholders or business closure. Creating budgets is useful for businesses, non-profit organizations, and governments alike.

Budgets are used for several reasons:

  • Companies are inherently interested in their performance. Budgets of current and past years alike can be used to determine whether operations have improved or not.
  • A majority of all shareholders of every company’s public stock don’t work for the companies they own stakes of. As such, virtually the only insight shareholders get into companies they’re invested in is through financial statements and budgets. In short, budgets keep shareholders happy.
  • Governments receive limited sums of money to spend, unlike businesses. Local, state, and federal bureaus alike must carefully plan expenditures to make sure they can serve the populations they exist for.
  • Employees are often evaluated using budgets. When employees are aware of how much money they and their departments have been granted via budgets, they typically try to remain within the limits of them to best please their managers.

One of the most common uses of budgets is to evaluate performance. During the evaluation process – this either happens on an annual, quarterly, or monthly basis – organizations compare actual results taken from a period’s performance to any and all relevant budgets.

Unfavorable Variance

An unfavorable variance refers to an unfavorable – which means they’re bad or unwanted – deviation from what a budget predicted. If sales were projected at $1 million and a company only earned $900,000, the variance between the two is unfavorable.

Unfavorable variances aren’t restricted to revenues – they can be used to compare any metrics.

Take a look at any major company’s financial statements – accounting is unarguably difficult to understand. However, unfavorable variances are relatively simple to grasp the concept of once you learn about them in the context of budgets.