Budgets are the foundation for thriving businesses and a key tool for understanding performance. It is one of the best financial tools in a company’s toolbox-- but sadly too often proposed, discussed, accepted, and then forgotten.
Instead, business leaders should review and update a company’s budget as well as any differences (or “variances”) on a regular basis.
Having this information in hand can help better identify points in a company’s profit and loss statements where it either performed really well or went completely off the rails. Especially as a company's financial situation will fluctuate over time.
Good managers look at what that difference means to the business to identify problems, control spending, and form more accurate forecasts and key performance indicators. Utilized correctly, a regular budget variance analysis can provide concrete steps to help a company save money, improve efficiencies, and contribute to business growth.
What is budget vs. actual variance?
The term "budget vs. actual" is shorthand for a budget to actual variance review. It refers to the difference between the estimated amount of expense or revenue and the actual amount. Variances fall into two major categories:
- Favorable variance: When actuals are better than budgeted (e.g., when revenue is better)
- Negative variance: When actuals are worse than budgeted (e.g., when revenue is worse).
Budgets are only an approximation of what the future holds, and a little variance is to be expected. It’s when actuals deviate exceedingly from estimates that business leaders should take a harder look at the numbers to uncover fact from fiction. This is where variance analysis comes in.
Variance analysis typically begins with variance reports at the end of each month, quarter, or year, showing the difference between actual spending and forecasted spending. Sometimes this is as simple as subtracting one data point from the other.
Truly evaluating and understanding budget variances takes careful thought, and can sometimes be more of an art than science.
Come to grips with your financials
Business planning and budgeting
Once a business is operational, it's vital to plan and oversee its financial performance. Creating a budgeting and planning process is the most effective way to keep a business on track -- enabling a business to concentrate resources, improve profits, manage costs and increase revenues.
In simplest terms, the aim of a business plan is to set out a strategy and action items for a company. A business budget is the company’s plan for spending items and incoming revenue to help achieve its strategy over a specific time.
Understandably, many business owners find budget planning to be frustrating and time-consuming. Predicting operating costs over the course of a year, as well as any unforeseen financial challenges that may pop up, is challenging.
Breaking a financial budget down into a hierarchy is also often helpful. Common types of budgets include an operating budget, capital budget, department budget and a master budget (which pulls each separate budget into one document). Budget amounts are typically updated quarterly after managers analyze a budget to actual report.
New to budgeting? Follow our six steps to starting a budget
Once a business plan is in place, supported by sound accounting and budgeting, leaders will need to review and revise them frequently. This is particularly true for growing businesses or those looking to move into new areas.
Evaluating budget vs. actual variance reports not only looking at the past budget, but also what caused a difference between a plan vs. actual figures, and what those differences could mean for the future of the business.
If it seems like a huge hassle to create a budget and then create a Budget vs. Actual Report every month, you may be happy to know that you can set up Custom Reports in Quickbooks and run them any time you want with just the click of a button.
Creating, monitoring and managing a budget is key to business success, however. A living, breathing budget is well worth the effort when the outcome is a clear understanding of a company’s overall financial health and viability.
Business forecasting and variance analysis
Variance is a sign that revenues or spending did not go according to plan. Variance analysis attempts to find the reasons that actual figures were over or under forecast so that either.
Keep in mind that there is more to accounting for variances than capturing the immediate impact. It involves analytical research, proactive planning, and strategic decision-making to properly evaluate the significance of any variances.
Moreover, while reviewing budgets inherently looks at past performance, the insights gathered provide guidance for future decisions. For example:
- Are budget assumptions correct?
- Is spending under control?
- Are expenses (as a percentage of revenue) where they should be?
- Are margins consistent?
- Is revenue exceeding conversion goals?
- Does the timing of income meet with projections?
If there are significant variances between operating and actual budgets, there are some steps that you should take.
First, examine which business activities didn’t perform to the expectations set forth in your budget. Some occurrences are simply beyond our control, such as a natural disaster or downturn in the economy. Other times, losses are related to an internal process or decisions that can be adjusted.
Depending on the nature of the budget variance, it presents leaders with two options:
- Either adjust the future budget to conform to revenue or spending realities
- Recommend changes to bring forecast and actual figures closer together.
Understanding budget discrepancies help business leaders become better forecasters. The more you review your budget and actuals, the better you can become at forecasting your expenses and evaluating business results.
Now that you know where to start, it’s time to put your plan to work.