The good, the bad and the how-to for budget variance analysis.
What is a budget variance?
As the first quarter wraps up for most companies, it is a perfect time to perform an in-depth analysis on your budget to and all that work you put into building your perfect budget.
Related Read: “Budgeting and Forecasting for High Growth Companies”
Put plainly, budget variances are any difference between an actual amount and a planned or budgeted amount.
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 it may seem that a favorable variance is something to give a quick nod to and then move on, it is important to understand what is causing the variance(s) and whether it is good or bad for your company. By performing a budget variance analysis, you can better understand your business operations and better plan your future budgeting efforts. If you are experiencing unfavorable variances, you want to determine the source as soon as possible. Your budget variances could be attributed to a plethora of causes:
- Inaccurate Budgeting
If this is a recurring issue, you might want to consider revising your budget.
- Changes in the Market Economy
Make plans to monitor and adjust your business plan to adapt. Maybe you simply missed a sale. Do you need to innovate, find a new platform to market and sell your product on or improve customer service?
- Client/Customer Acquisition
Related to the market economy, increased competition is one thing that often comes into play, which directly affects your client and customer acquisition rates.
- Employee Fraud
Unfortunately, this could be one cause of unfavorable variances, and it goes without saying that employee or expense-related fraud is something you want to source and prevent. Put workflows and policies in place to mitigate your risk.
Related Read: “How to Tackle Expense Report Fraud”
- Changes in Costs
This kind of variance might even be expected if suppliers have let you know costs will increase after you have set your budget. However, if your costs do increase, we have seen some of our most innovative clients tackle cost-cutting by going to their existing suppliers and competitors to negotiate a better price.
- 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 are 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 are going to hit, miss or exceed the budgeted targets (et another reason why it is important to both monitor and explain budget variances). Hands down, our favorite approach to budget variance analysis is to use dashboards or dynamic spreadsheets customized for your company.
Many entrepreneurs will be familiar with your classic budget to actual in monthly reporting. Add in some conditional formatting to quickly hone in on the most important areas to dissect. In the example below, we have used red for unfavorable variances and green for favorable ones. We have built into the spreadsheet formulas that show all unfavorable variances as negative numbers in both revenue, COGS and expenses.
A Cloud CFO Tip – 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%. It is 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—people 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. As for expenses, a good rule of thumb is to consider anything over 10% as unusually volatile. While you cannot fully control revenue, a lot of insight can be derived from figuring out what is causing the revenue variance. The key with budget variance analysis is to dig into your revenue and determine why you are off by so much in order to improve business operations.
Ideally when you are budgeting revenue, you are not just picking a number based on last year’s revenue. It is important to be budgeting revenue based on a key driver.
For example, a subscription service with a flat monthly fee should budget revenue monthly, according to customer acquisition rates and your new monthly recurring revenue (MRR). While adding in any anticipated new clients and the additional income each month in a sort of waterfall effect.
When you are reviewing the revenue variance, your waterfall revenue should provide a month-by-month recap of your budget. This will allow you to quickly determine where you had a negative customer churn, did not sign up as many new customers as anticipated or had the expected number of customers correct, but were averaging less income per month than forecasted.
Variances and forecasting for the future
After digging into your budget variances by comparing actuals to budgeted for the month, it is advisable to use that variance analysis to create a more accurate forecast for year to date (YTD) and end of year (EOY). Your summary YTD shows how you performed against the budget and how you will do compared to budget for the remaining part of the year.
The methodology behind budget variance analysis is not to make you feel like you are doing something wrong. It builds accountability, to gain insight and make changes moving forward. Understanding your budget variances will better prepare you to know if it is an appropriate time for your company to scale or whether it is smarter to wait, build more consistent recurring revenue and revisit scaling when your company (and revenue) is ready to support that growth.