The good, the bad, and the how-to for budget variance analysis.
What’s covered in this blog:
- What is a budget variance?
- How often should you run budget variance analysis?
- Favorable vs unfavorable budget variances
- What causes budget variance?
- How to calculate budget variances.
- What’s more important, revenue or expense variances?
- Budget variance and forecasting.
What is a budget variance?
Put plainly, budget variances are any difference between an actual amount and a planned or budgeted amount.
How often should you perform budget variance analysis?
We recommend performing budget variance analysis on a quarterly basis at the very least. And in more tumultuous climates, more often than that. In the wake of COVID-19 restrictions in Q2 of 2020, we increased our forecasting and analysis to a weekly basis. So, you have to find the right cadence for your company’s needs in response to the industry and market environment.
Favorable vs. unfavorable budget variances.
A favorable budget variance is any actual amount differing from the budgeted amount that is favorable for the company. Meaning actual revenue that was more than expected, or actual expenses or costs that were less than expected.
An unfavorable budget variance is, well, the opposite. A variance from the budgeted amounts that has a negative effect on your company.
The reasons and volatility behind budget variances. (And why you should pay attention).
While you might assume that a favorable variance deserves only a quick assessment before moving on, it’s important to understand what’s causing the variance(s) no matter whether they’re good or bad for your company. By performing budget variance analysis, you can better understand your business operations. And, of course, if you’re noting unfavorable budget variances you want to determine the source ASAP.
Causes of budget variances can include:
- Inaccurate budgeting: If this is a recurring issue you might want to consider revising your budget, or look to get help with your budgeting and forecasting.
- Changes in the market economy: Make plans to monitor and adjust your business plan to adapt. Maybe you simply missed a sale. Is it time to use a new sales channel? Perhaps you could improve your customer service?
- Client/Customer Acquisition: Related to the market economy, increased competition often comes into play, directly affecting your client and customer acquisition rates.
- Employee fraud: Unfortunately, this could be one cause of unfavorable variances. It goes without saying that employee or expense-related fraud is something you want to identify and prevent. Putting the right workflows and policies in place will help mitigate your risk.
- Changes in costs: This variance might be expected if suppliers have let you know about price hikes after you’ve set your budget. If your costs do increase we’ve seen some of our most innovative clients tackle cost-cutting by going to their existing suppliers and competitors to negotiate a better price. Swapping fixed costs for variable costs can be a strategic play to offset other expenses. We cover one way to do this and cut costs as you grow.
- Improved operations: Maybe your employee turnover has been at an all-time low, or your team has new, more efficient procedures. Whatever the reason for improved operations they’re as important to note and build on as inefficient operations. Whether good or bad, the reasons behind a variance are essential to your business operations.
How to monitor and perform budget variance analysis.
The most important thing most business owners want to know is whether they’re going to hit, miss or exceed the budgeted targets. Yet another reason why it’s important to dig into budget variances. So, how do you monitor these unexpected up and down swings?
First, you should determine what program you will use to track your budget variances. Hands-down, our favorite approach to budget variance analysis is with either dashboards or dynamic spreadsheets customized for your company.
Next, you should calculate your budget variances using this very simple formula.
How to calculate budget variances.
To calculate budget variances, simply subtract the actual amount spent from the budgeted amount for each line item.
Budget vs. Actual Example
So, in the sample budget vs. actual below, under revenue, for product sales you would subtract the actual from budget, $125,000-$109,750 = $15,250.
Many entrepreneurs will be familiar with your classic budget to actual in monthly reporting. It helps to add in some conditional formatting to quickly hone in on the most important areas to dissect.
In the example below, we’ve used red for unfavorable variances and green for favorable ones. We’ve built in formulas that show all unfavorable variances as negative numbers in both revenue, COGS and expenses.
To calculate the percentage budget variance, divide by the budgeted amount and multiply by 100.
The percentage variance formula in this example would be $15,250/$125,000 = 0.122 x 100 = 12.2% variance.
You can also easily set this up in dynamic spreadsheets and dashboards to automatically calculate your variances each month.
Tip: Pay attention to sizeable budget variances in both dollar amounts and percentage.
Pay attention to sizeable variances in both dollar amounts and percentage. Say you spend $200 in office supplies compared to $100 budgeted. The variance percentage will be 100% off, but who cares? It’s a mere $100, compared to salaries which may be only 5% off but could mean tens of thousands of dollars over or under budget.
What’s more important, expense or revenue variances?
Especially in high-growth companies, executives tend to spend a lot of time budgeting and looking at expense variances. A good rule of thumb is to consider anything over 10% as unusually volatile for expenses.
A good rule of thumb is to consider anything over 10% as unusually volatile for expenses.
Business owners are inclined to focus on expenses because you can control them; however, when you are halfway through the year, your revenue is always the most volatile number. You could be off by 50% because revenue is so choppy. While it’s true you can’t fully control revenue, you gain valuable insight by pinpointing the root cause of the revenue variance.
The key to budget variance analysis is to dig into your revenue to determine why you are off to improve business operations.
Ideally when you are budgeting revenue, you’re not just picking a number based on last year’s revenue. It’s important to be budgeting revenue based on a key driver.
For example, say you offer a subscription service with a flat monthly fee. Budget in your revenue monthly according to customer acquisition rates and your new monthly recurring revenue (MRR). Next, add in any anticipated new clients and the additional income each month in a sort of waterfall effect.
When reviewing the revenue variance, your waterfall revenue should provide a month-by-month recap of your budget. Then you can quickly see any red flags. Did you have negative customer churn? Didn’t sign up as many new customers as anticipated? Or maybe had the expected number of customers correct but were averaging less income per month than forecasted.
Budget Variances and Forecasting.
Budget variance analysis can create a more accurate forecast for year to date (YTD) and end of year (EOY). Your summary YTD shows how you have performed and how you will perform compared to budget for the remaining part of the year. This becomes especially important in Q3 and Q4 as you prepare your budget for the following year.
The methodology behind budget variance analysis is not to make you feel like you are doing something wrong; which, as an entrepreneur, it can sometimes feel like. Budget variance analysis builds accountability and provides insight into your operations. Understanding budget variances places you in a better position to know whether it’s time to scale your company. This financial insight will only help you make smarter business decisions moving forward.
Need help understanding your budget variances? Contact us for help.