How to Monitor and Understand Budget Variances

The good, the bad, and the how-to for budget variance analysis. With examples!

Key takeaways for understanding budget variance:

What is a budget variance?

Put plainly, budget variances are any difference between an actual amount and a planned or budgeted amount. This could refer to material or labor cost variance, or alternatively any sales price variance or any other budgeted line item variance. Variance analysis helps to uncover reasons behind any failure and to identify trends for success.

Causes of budget variances:

  • Inaccurate budgeting: If this is a recurring issue you might want to revise your budget, and get help with your budgeting and forecasting as included in our outsourced CFO services.
  • Changes in the market economy: Make plans to monitor and adjust your business plan. 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 market economy, increased competition often comes into play. To stay on budget, read more about how to lower customer acquisition costs (CAC) and learn about allowable CAC.
  • Employee fraud: Unfortunately, it happens. And it goes without saying that employee or expense-related fraud is something you want to identify and prevent. Having the right workflows and policies will help mitigate your risk.
  • Changes in costs: This might be expected if suppliers implement price hikes after you’ve set your budget. 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 also be a strategic move to offset other expenses and cut costs as you grow. Learn more about how to cut business expenses. This one of the reasons to ensure you understand your landed cost calculation.
  • Improved operations: Maybe employee turnover has been at an all-time low. Or perhaps, 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.

Favorable vs. unfavorable budget variances.

A favorable budget variance is any actual amount differing from the budgeted amount that is good 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. Jump ahead to our budget vs actual example.

The reasons and volatility behind budget variances. (And why you should pay attention).

You might assume that a favorable variance deserves only a quick nod before moving on. But it’s important to understand what’s causing the variance(s) no matter whether they’re good or bad for your company. Budget variance analysis helps you uncover the drivers behind operations. And, if you’re noting unfavorable budget variances you want to determine the source ASAP.

How often should you perform budget variance analysis?

You should perform budget variance analysis on a quarterly basis at the very least. And in more tumultuous climates, more often than that. For example, 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.

Example: In 2022, we switched one of our clients to weekly meetings with their outsourced CFO to track financial reporting like budget variances and customer channel profitability. Their revenue has jumped by 120%.

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. So, how do you monitor these unexpected up and down swings?

First, determine what program or method you will use to track your budget variances. Our favorite approach to budget variance analysis is using either dashboards or dynamic spreadsheets customized for your company.

Next, calculate your budget variances using this very simple formula: Actual Amount – Budgeted Amount

How to calculate budget variances.

To calculate budget variances, use this simple formula: Actual Amount – Budgeted Amount

Budget vs. Actual Example

So, in the sample budget vs. actual below, under revenue, for product sales you would subtract the actual from budget, $109,750 – $125,000 = $ -15,250 or a negative variance compared to the predicted (or budgeted) sales.

Many entrepreneurs will be familiar with your classic budget to actual in monthly reporting. It helps to add 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.

Excel spreadsheet example of budget variance analysis using conditional formatting to compare monthly budget vs. actual and variance %

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% negative variance.

You can also easily set this up in dynamic spreadsheets and dashboards to automatically calculate your variances each month.

Cloud CFO Tip: Pay attention to sizeable budget variances in both percentage and dollar amounts.

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.

Cloud CFO Tip: 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 you can’t fully control revenue, you gain valuable insight by pinpointing the root cause of the revenue variance.

Budgeting revenue.

To improve business operations, use budget variance analysis to dig into revenue to determine why you are off.

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. Don’t make the mistake with financial projections of picking some arbitrary percentage to grow your revenue by. Instead, consider how you acquire a customer, the conversion percentage and the length of your sales cycle. If you have recurring revenue you might consider your CAC into your projections and budget.

Net Monthly Recurring Revenue (MRR) Formula = Expansion MRR + New MRR + Churned MRR

For example, say you offer a subscription service with a flat monthly fee. Budget in your monthly revenue estimates 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.

Spreadsheet showing the waterfall effect when budgeting new monthly recurring revenue.

Reviewing 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 the expected number of customers was correct but they were generating less income per month than forecasted. This budget variance analysis can provide useful insight into places you might need to dig in further like your customer lifetime value (LTV) for example. Follow these four steps to increase LTV. For other clients, they can quickly see when the cost of one sales channel has inflated and whether they should focus their efforts on more economical channels instead to drive more revenue and ultimately profit.

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. It also shows how you will perform compared to budget for the remainder of the year. This becomes especially important in Q3 and Q4 as you prepare your budget for the following year.

For example, in the sample YTD budget vs. actual below, you can see that sales were overpredicted by 16%, and ultimately net income by 48%. That is a drastic difference and highlights exactly why it helps to monitor budget variance throughout the year to tighten up both the budget for next year and issues with sales.

Excel spreadsheet example of budget variance analysis using conditional formatting to compare budget vs. actual YTD and EOY and variance %

The Bottom Line

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. (Speaking from experience here!) Variance analysis not only provides insight into your operations but it also builds accountability. Understanding budget variances places helps you know whether it’s time to scale your company.

Need help understanding your budget variances or the difference between a balance sheet vs P&L or cash flow forecasts? Hire an outsourced financial controller that is dedicated to helping businesses do just that. Contact us for help.

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