Planning a budget and sticking to it is becoming increasingly challenging given the current economic environment. As interest rates rise and inflation balloons, business margins are under threat. In such times, optimizing budgets is paramount. Budget variances help you to discover spending inefficiencies and plug expense leaks in your financial statements.
In this guide, you'll learn what budget variances are along with the following:
What is a budget variance?
A budget variance refers to the difference between recorded and planned expenses in your budget. For example, if your budgeted amount of marketing expenses was $10,000 last month but spent $20,000, you have a variance of $10,000.
While a budget variance seems undesirable on paper, not all variances are equal. There are two types of budget variances.
A favorable or positive variance occurs when your actual spending is lower than planned. For example, if you outlined $5,000 this month towards sales training expenses but spent $3,000, you have a favorable variance of $2,000.
A favorable variance leaves you with more cash than planned. However, a favorable variance isn't a good thing by itself. From the previous example, if you paid less for sales training, you're left with more cash on your balance sheet.
However, if the training was of poor quality, any cash you saved will be offset by your team's inability to close more sales. In this scenario, investing in higher-quality sales training would have been better for your business.
An unfavorable or negative variance occurs when your actual spending is more than planned. For example, if you allocated $5,000 to sales training but your actual costs were $10,000, you have created a negative variance of $5,000.
As with favorable variances, you must examine unfavorable variances within the business context. In this example, you might have spent $5,000 more for better training that might increase future sales.
Alternatively, the additional $5,000 you spent might not generate the expected ROI.
Why is budget variance analysis important?
As you can see from the examples above, budget variance reports offer you a starting point to dig deeper into the quality of your expenses. A variance report help you answer the following questions:
- Where are you over or underspending?
- What is the quality of your spending?
- Is your capital allocation right for your business' goals?
- Can you increase profits by reducing expenses?
Budget variance analysis helps you dissect where your cash is flowing. A good variance analysis requires you to track business expenses accurately. Budget variance analysis unearths whether you're allocating business capital efficiently when done correctly.
Variance analysis also gives you insights into which forces affect your business' bottom lines.
What causes budget variance?
On the surface, you might think budget variance reveals improper planning or a lack of expense controls. These conclusions only cover a part of the picture. Often, budget variances might be outside your control.
Here are the five leading causes of budget variances.
How accurate were your assumptions when planning your budget? Unrealistic assumptions or a lack of foresight are the most common reasons for budget variances. Often, the lack of foresight results from following wrong timelines.
For example, projecting business expenses a year from now is challenging. You can predict costs a month or quarter ahead more accurately. If your company is creating annual static budgets in a dynamic market, you might be introducing variances.
Not every faulty assumption occurs due to wrong expectations or poor foresight. The data you're using to create budget limits might be low quality. For instance, you might receive incorrect supplier prices when estimating next quarter's procurement costs, leading to a variance when receiving market prices.
Examine every source of data you're using and incorporate it properly. For example, data formatting errors such as misplaced decimal points or missing zeros will introduce errors in your budgeting process.
Changes in economic conditions
Macroeconomic changes can wreck even the best financial management strategies. If the economic conditions in your sector change, you might be hit with variable costs. Alternatively, you might have to pay higher raw material costs and salaries if inflation rises dramatically.
Broader conditions can therefore create budget variances. These variances are not in your control. However, build a margin of safety in your budget to mitigate them as much as possible.
Regulation changes will introduce budget variances if your business reports to a regulatory panel or is subject to stringent laws. For example, enhanced compliance needs when handling customer data will increase your IT costs.
Several other reasons might create a budget variance. For instance, employee fraud might result in a temporary unfavorable variance. Customers demanding additional features in your goods might strain your budget.
Changes in industry competition will also create budget variances. More competition means higher marketing expenses and product investment, leading to a potentially unfavorable variance.
How to conduct a budget variance analysis
Here's the formula to calculate a variance:
Let's see how this works via an example:
- Projected costs = $100,000
- Actual expenses = $80,000
- Variance = actual - projected = $80,000 - $100,000 = -$20,000
While the formula to calculate a budget variance is simple, planning and executing a budget variance analysis is more complex. Here is a step-by-step process.
Step #1: Gather data
Gather financial data from all sources. This step is standard in all financial planning and analysis processes. Remember to gather data from every revenue source and standardize data formats. For example, sales data might be expressed differently if you sell goods online and through physical outlets.
Standardize all data before analyzing it.
Step #2: Define variance thresholds
Budget variances are not undesirable by themselves. Some degree of variance will always occur since you cannot accurately predict the future. It's best to introduce a variance threshold in your analysis to account for insignificant variances.
For example, if your projected furniture costs were $20,000 and your actual amount was $20,010, this unfavorable variance is negligible. It's just 0.05 percent of your projected spend, and you can ignore it.
Remember that every expense item must have a threshold percentage that accounts for the amount of money spent. In the furniture example, a one percent variance is $200. However, if your projected spend is $200,000, that amount balloons to $2,000.
The correct variance thresholds will help you ignore inconsequential variances and focus on what matters most.
Step #3: Calculate variances
Calculate the variances of every line item in your budget by applying the variance formula. This step is relatively simple.
Step #4: Conduct root cause analysis
You will now have a picture of which items led to a favorable or unfavorable variance. Remember that favorable variances aren't always good news. Favorable variances are great if you aim to cut costs above all else.
However, chronic underspending in developing business assets will lead to a sub-par product. Always question every variance, whether it's favorable or not.
3 tips for analyzing budget variance
Here are some handy tips to help you analyze budget variances quickly.
Always consider amounts
When calculating variances, you might fixate on percentages and lose track of amounts. Some expenses are a larger proportion of overall costs than others. Seemingly small percentage changes in them will lead to outsized effects on your actual results.
Because of this, you should always list variance amounts along with percentages. This will help you keep your financial picture in perspective.
Unify data sources
Most businesses have several sales channels these days. All these channels impose different costs, and you must account for them accurately. Make sure your financial data sources are unified and remove any data silos. This step ensures you’re receiving accurate actual revenue numbers.
Consider budget types
Your budget type often determines the degree of variance you will encounter. Static budgets in highly dynamic environments produce large variances. Rolling or flexible budgets might be a better choice for your business in these circumstances.
However, rolling budgets demand more resources. If your business sector is relatively sedate, this budget option might not be an ideal choice.
Ultimately, budget variances are a starting point for you to conduct a deeper cash flow analysis. Look at all the factors that affect your costs and examine the ROI your expenses are generating. Most importantly, do not assume that favorable variances are automatically good or that unfavorable variances are bad.