Individuals and business owners alike set budgets to keep their spending under control and to manage their finances better.
CFOs and others who work with financial reporting especially know that the proposed budget does not always match the actual numbers. That’s where a budget variance analysis can help with financial analysis and forecasting. It can give you a clear picture of whether you met your financial goals for the month, year, or quarter.
What is Budget Vs. Actual Variance
The term “budget vs. actual” refers to the difference between your static budget and the actual figures for your company’s income and expenses. The phrase budget v. actual is bookkeeping shorthand for budget vs. actual variance analysis.
Your static budget does not change. It is typically determined before the start of the fiscal year based on projected income and expenses. However, line items may come in over or under their budgeted amount over a given period of time. That’s where your actual data comes from.
Reviewing both types of financial reports and reviewing the differences between them in a budget vs. actual variance analysis can help you:
- Adjust your budget for the next year for more accurate financial reporting
- Spot areas where you can cut expenses or increase income
- Determine if you may need to seek additional financing and how much.
What are the Types of Actual vs Budget Variances?
Actuals are defined as the – the actual expenses and actual income generated throughout the year that contribute to actual revenue and cash flow. The difference between the actuals and your budget reflects your budget variance.
A favorable variance shows positive numbers for your key performance indicators. For instance, favorable variances may include:
- Greater sales than forecasted
- Higher income than projected
- Lower expenses than predicted in your static budget
On the other hand, an unfavorable variance may show:
- Lower sales than predicted in your financial forecasts
- Missed goals for specific KPIs
- Higher actual expenses than budgeted for
Why Budget Variances Happen
Variances can occur for many reasons, some that remain within a business owner’s control and others that are harder to avoid. Let’s explore some of the reasons for a budget variance.
- Errors – A static budget containing errors or faulty projections can lead to a budget variance from your actual results. Similarly, errors in your actual numbers can cause discrepancies in your actual comparison.
Errors may stem from typos in the budget or actual reports or incorrect data entered in your accounting software. False assumptions about the costs of goods and services or about your company’s manufacturing capabilities can also lead to incorrect revenue projections. Inaccurate lifecycle stage predictions – where the sales cycle takes more time or less time than expected – can also affect sales and, as a result, create a difference in projected income or cash flow vs. the actual amount.
- Changes in the business climate or manufacturing costs – As much as CFOs work hard to predict accurate sales figures and expenses, some unforeseen factors can create a budget variance.
For instance, raw materials or labor costs could go up or down, leading to higher or lower manufacturing costs than reflected in the static budget. Economic changes and global trade policies may lead to different sales figures than expected or a reduction in sales growth. Technology disruption or innovations in the marketplace can also affect your sales as an unexpected competition.
- Inaccurate expectations – CFOs sometimes miss the mark on sales forecasting, which can lead to a budget variance. Not meeting sales KPIs can result in a negative variance. On the other hand, if the sales team exceeds expectations, you’ll face a favorable variance in your financial statements.
Benefits of Budget Variance Analysis
As with any type of financial analysis, completing a budget variance analysis can help you make the right decisions for your business. Reviewing financial transactions to create an actual report and then comparing KPIs to your static budget provides many benefits and insights.
For instance, performing an actual vs budget variance analysis may help business owners recognize a need to cut costs and manage expenses or to adjust sales goals to reflect reality better. In some cases, you may have to adjust your budget to reflect major corporate changes.
A budget variance analysis can help businesses:
- Discover ways to increase profitability
- Mitigate risks
- Be proactive about business growth opportunities.
Recognizing some of the most common budget variances can alert you of what to watch out for and areas where you may need to make budget adjustments moving forward. Remember, variances are not inherently good or bad; they just mean predictions were incorrect at any given point in time.
A favorable variation refers to one in which your KPIs turned out better than predicted. An unfavorable variance could mean you want to adjust your expectations, or you may need to reduce costs or find ways to increase revenue to hit sales goals or profitability targets. Experimenting with new sales and marketing strategies may help get your actual figures where you want them to be.
Let’s review some of the most common expense variances. Since expense variances can lead to revenue variances, accounting for these factors can bridge the gap between your budget vs. actual reports.
- Variable overhead variance – Your variable overhead variance relates to a difference in projected variable overhead costs vs. actual costs. Variable overhead refers to production costs, sometimes reflected as “labor hours” or “machine hours.” It does not refer to fixed costs such as rent.
Variable overhead combines material costs and labor costs. For a more clear picture of your budget variance, look at material variances and labor variances individually.
- Material variance – A material variance may cause a rise or drop in manufacturing costs. If your financial statements show an expense variance, check budget line items related to production materials’ costs.
Can you negotiate better trade terms to improve cash flow? Or perhaps you can shop around to find lower prices on the materials you need. Is there a less expensive way to manufacture your products while maintaining quality control?
- Labor variance – Likewise, a labor variance can lead to revenue variances. Can you streamline operations to reduce overtime costs? Can certain functions be outsourced to independent contractors, reducing the costs of employee benefits?
You may find you don’t need to adjust labor costs, but just account for these costs in your budget moving forward.
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