Cost and Profit Reconciliation

Favourable = 8,000 + 2,000 = $10,000. Adverse = 5,000 + 1,000 = $6,000. Net = 10,000 − 6,000 = $4,000 Favourable.

Actual profit = budgeted profit − net adverse variance = 70,000 − 4,000 = $66,000.

Favourable: sales price 15,000 + sales volume 8,000 + material price 3,000 + labour efficiency 5,000 = $31,000. Adverse: material usage 9,000 + labour rate 4,000 + fixed overhead expenditure 2,000 = $15,000. Net variance = 31,000 − 15,000 = +$16,000 (F). Actual profit = budgeted 100,000 + 16,000 = $116,000.

Total variance required = actual − budgeted = 97,000 − 90,000 = +$7,000 (F). Other variances net to $1,000 A. Sales price variance = required total − other = 7,000 F − (−1,000) = 7,000 F + 1,000 = $8,000 Favourable.

Favourable variances are added to the budgeted profit, because they arise when actual costs are lower (or revenue higher) than standard, which increases profit. Adverse variances are deducted, because they arise when actual costs are higher (or revenue lower) than standard, which decreases profit. Applying the net of all variances to the budgeted profit gives the actual profit.

An operating statement reconciles the budgeted (standard) profit to the actual profit by listing all the variances, so management can see exactly why the actual result differed from the plan — not merely that profit was above or below budget. By grouping the variances (sales, materials, labour, overheads) and showing their net effect, it highlights the largest favourable and adverse items, enabling management by exception — managers concentrate on the significant variances. They can then investigate the causes of the major adverse variances and take corrective action, while seeking to sustain the favourable ones. In this way the statement turns the variance calculations into a practical tool for control and decision-making.

The combination of a large favourable material price variance with a large adverse material usage variance strongly suggests that the business bought cheaper, lower-quality material: it paid less than standard (favourable price) but the poorer material was wasted more (adverse usage). The adverse labour efficiency variance may be linked — the inferior material could be harder to work with, so production took longer than standard. These variances are therefore interdependent and should be investigated together rather than in isolation.

The favourable sales volume variance shows that more units were sold than budgeted, which is positive and may reflect strong demand or good selling — management should consider whether this is sustainable.

Management should: investigate the material purchasing decision, weighing the price saving against the extra wastage, rejects and slower production it caused — it may be that the cheaper material reduced overall profit. If so, it should revert to the standard-quality material or find a better supplier. It should also focus on the controllable adverse variances (usage and efficiency) for corrective action, while being careful not to blame staff for problems actually caused by the material decision.

If the statement begins with the budgeted profit, this is based on the budgeted sales volume, so the sales volume variance must be included to adjust for the difference between budgeted and actual volume. If, however, it begins with the standard profit for the actual output, the volume difference is already built in, so the sales volume variance must NOT be added again. Using the wrong starting point would cause the student to double-count (or omit) the volume effect, so the reconciliation would not agree with the actual profit. Reading the starting point carefully avoids this error.

Controllable variances result from decisions and performance within the business — for example, an adverse material usage or labour efficiency variance — and management can act to correct them. Uncontrollable variances arise from external factors beyond the business's control — for example, an adverse material price variance caused by a market-wide price rise. Distinguishing between them matters because management should focus its corrective action on the controllable variances, where action can make a difference, and should not waste effort trying to control external factors. It is also a matter of fairness: holding staff responsible for uncontrollable variances would be unjust and demotivating.

When the variances are applied to the budgeted profit (adding favourable and deducting adverse), the reconciled figure must equal the actual profit. If it does not equal the actual profit, then at least one variance has been calculated incorrectly or given the wrong favourable/adverse sign. The reconciliation therefore acts as a built-in check on the accuracy of the whole set of variance calculations.