The “Budget vs. Actual” distinction is vital to make if you want to manage the finances of your business accurately and strategically. We all set budgets in our daily lives to keep our spending in check, and the same is true on a larger scale for CFOs and other finance leaders.
However, our plans don’t always align with reality. To account for potential differences in the agreed-upon budget and the actual amounts out in the field, businesses study a concept in financial analytics known as the budget vs. actual variance.
If you want an accurate look at your budgeting status at the end of every quarter, knowing more about this figure will help you make more informed financial plans.
What is Budget Vs. Actual?
Budget vs. actual is the process of comparing your organization’s predicted budget to the amount you actually have, in order to find the variance, or difference. Your business’ static budget is the predicted number you’re expected to reach based on historical income and expenses. The actual budget is the true revenue you are achieving, usually varying slightly from the static budget prediction due to unforeseeable variations in spending and financial activity from quarter to quarter.
Bookkeepers perform a budget vs. actual variance analysis to monitor the difference between the static budget predicted at the beginning of each fiscal period, and the actual amount after. This budget vs. actual variance helps to identify errors in the original budget and can be expressed as a percentage, or simply as the difference between the budget and actual numbers.
Why is it Important?
It is simply impossible to stick to your budget down to the dollar, as even small changes in unforeseen spending can drive you off your path. However, smart financial managers understand this fact and can still take advantage of a budget as an expectation to compare actual performance against.
By knowing the difference between your projected budget and the amount you end up actually spending, you can:
- Adjust your data to make more accurate budget predictions in the future (as part of your recurring budgeting process.)
- Discover new ways to save on the budget or increase it later if necessary.
- Reduce risk in the financial planning process.
- Improve your financial reporting capabilities.
- Take advantage of growth opportunities promptly.
In the event of an unfavorable variance, an analysis is key to understanding the causes and what you can do to fix the issues. For instance, perhaps the cost of maintaining internal operations went up for whatever reason, or your sales have dropped significantly. Knowing the “why?” is the first step in determining next steps.
In other words, this process unlocks business intelligence that will help you make better data-driven decisions in the future. You can get the most out of budget variance analysis by generating budget vs. actual reports and comparing your key performance indicators.
What Causes the Variance?
One might ask at this point what exactly causes actual expenses to differ from the budgeted amounts. Whether within your control or not, budget variance is inevitable and can be caused by a variety of factors.
- Market dynamics: As much as CFOs try to accommodate future changes in market values into the budget prediction, the actual figures are far from predictable. Regular operating costs may be unexpectedly higher if the price of a certain raw material or SaaS subscription your business relies on heavily changes. Likewise, demand from consumers ultimately shapes your revenue variances every period.
- Poor predictions: Our financial forecasts are based on our expectations driven by information from previous periods. CFOs occasionally miss the mark in this regard and end up undercutting or overestimating, resulting in a variance.
- Incorrect data: Sometimes the culprit is simply errors in your actual numbers. If there was a typo in the data entered, or data that wasn’t entered at all, your accounting software would return misleading insights, leading to inaccurate expectations. For instance, a CFO might have the wrong idea regarding revenue projections for a certain quarter thanks to a mistype or missing data, however slight.
Another difficult factor to work with involves major shifts in the business environment. Events like the COVID-19 pandemic and the trend of digital transformations are making finances even more difficult to predict accurately. It seems that we’re always going to be tracking the budget vs. actual variance well into the future.
Types of Budget Variances
It’s worth knowing the types of expense variances, as they can tell you where to look when it comes to making budget adjustments.
- Materials and services: What happens when the raw materials, software systems, or other necessities your organization relies on change in price? Check where your budget lies relative to the costs of those materials. You have some degree of control over material expenses if you can negotiate better trade terms or find alternate suppliers or products without compromising on quality.
- Labor: Labor expenses can go up as a result of overtime pay. Management teams often look to streamlining internal operations to reduce these extra hours or look to contractor outsourcing for certain tasks.
- Variable overhead: This type of variance combines the material and labor costs together to give you a general overview of how your projected costs compared to the actual expenses.
One can also categorize variances based on their amounts. The actual figures can end up either higher or lower than your static budget. CFOs generally prefer a positive variance, where the sales might be higher than forecasted, the expenses are lower, and the general KPIs are tilted more in their favor.
Variances aren’t inherently bad or good. Both a negative variance and a favorable variance can mislead your decision-making if unaccounted for, and we perform a variance analysis to make adjustments accordingly.
How to Perform a Budget Variance Analysis
The actual variance analysis, like many data-driven processes, starts with the creation of financial reports. In a typical example, the CFO would create an Excel spreadsheet containing a list of income and expenses along with their budgeted amounts. Once the actual amounts are reported, they are included as well in the next column.
From there, it’s a simple matter of adding them together to generate the variance and using a formula to calculate the variance percentage (i.e. the variance over the budget for each line item on the list). This spreadsheet is usually recreated every month or other period to track changes in the variance calculations.
At each iteration, you want to check for:
- Large variances: Significant discrepancies between your budgeted amounts and the actuals can point to key areas of improvement for your business.
- Recurring losses: Are you suffering from larger expenses than expected every period? If so, they could point to insufficient financial reporting processes in the business or just a lack of sufficient planning in general.
- Increasing losses: Comparing multiple variance reports in succession is also worth doing. Are unfavorable variances getting larger every period? Consider checking for growing problems in your financial management.
Variance reports are meant to give you actionable insights into changing the business’s cash flow for the better. At the end of each reporting period, think about which variances are helpful or harmful for the company. Have the actions you’ve taken in response been enough to address these issues?
Developing Strategies Based on Your Variance Report
How do you optimize your organization’s next steps in response to your findings? Whether they’re favorable or not, variances should be reduced so that your financial predictions are in line with reality. This way, you can be more confident in your planning efforts and properly address weak areas in your financial strategy.
Multiple mechanisms in a business can contribute to a noticeable variance between budget vs actuals. Determining the cause of a variance can be a challenge for this reason, as multiple sources can contribute to a variance.
You can take a dive into each category of expenses to see where such differences come from. For instance, did you expect a higher income than you actually received this period? Are you not taking advantage of cheaper options for internal services on the market over a more expensive alternative?
Either way, keep in mind that small variances are always expected. It’s only when you have an uncomfortable or large discrepancy should you start looking into the “why” of it.
Tailor Solutions to the Cause
Because a budget vs. actual report specifies where a variance is occurring, you know where to start when it comes to developing solutions.
Take, for instance, a larger customer service cost than expected this quarter. Look to find out why this department is responsible for such an unexpected expense. Perhaps you have too many representatives, or your current staff need more resources and documentation to do their jobs more efficiently.
The longer you create variance reports, the more financial data you’ll have and the more accurate you can make future budget forecasts.
Having a clear grasp on the state of your business budget goes a long way to making more informed decisions down the road.
Repeat Every Month
CFOs should aim to repeat the budget vs. actual analysis every month at least. Regular analyses will ensure that you catch financial issues early on and can solve them before they become larger problems.
Look to Digital Tools and Software
Since you’re planning on repeating this budget vs. actual analysis regularly, think about ways to make the process less time-consuming. For example, software tools are now available to track your variances and automate tedious calculations every period.
Most of these software solutions come with automated analysis and reporting features too so that you can have a firm grasp on cash flow and expenses throughout the business. They help to eliminate manual error, provide more insightful data, and identify areas that need improvement. Almost two thirds of organizations have adopted automation tools for business processes like this, so it’s a no-brainer to adopt them into your financial workflows.