Understanding Business Performance Through Budget Variance Analysis
Budget variance analysis is a helpful tool that allows the finance department to gauge actual performance against expectations. Variance analysis reports allow company decision-makers to guide the company along the path.Download NowWatch Now
Budgets are the guideline for helping businesses plan for the future, create meaningful sales targets, and ensure sufficient cash flow to keep the business alive. But creating a budget is only one step, usually occurring early in the year or quarter.
Regularly performing budget variance analysis is critical to check if prior assumptions and conditions remain valid. And while the formula for budget versus actuals is simple, the implications can lead to difficult decisions.
We'll cover setting the stage for variance analysis with top tips for reading your findings accurately and adapting for success.
Basics of Budget Variance Analysis
Budget variance analysis is a helpful tool that allows the finance department to gauge actual performance against expectations. Variance analysis reports allow company decision-makers to guide the company along the path.
If a budget is the planned path, then variance analysis is regular check-ins to see if the company is on the path. And if actuals depart from budgets, it allows for clear decisions to get back on track.
Finance departments need to track variances across multiple categories in Balance Sheets and Profit & Loss reports, including:
- Net Income
- Cost of Goods Sold (COGS)
- Operating Expenses
- Gross Profit
These categories can be broken down into subcategories, zooming in on spending patterns.
Calculating Variance Analysis
The math behind variance analysis is simple: subtract the actual expenditure for a particular category in a defined period from the budgeted amount. The difference is the variance amount.
For example, let's say you budgeted $7,000 for product development for the first quarter. The actual cost was $8,100 during the first quarter.
7,000 - 8,100 = -1,100
The variance here is negative ($1,100).
Create Meaning from Variance Analysis
Far more complex than the equation is correctly interpreting the cause of the difference between forecasts and actual expenditures. The purpose of variance analysis is to take informed action to improve performance. Therefore, understanding the "why" behind discrepancies is critical.
For example, reporting a $1,100 overage in first-quarter product development does not give management clues on how to correct the problem.
Was the $1,100 difference because the company underestimated a realistic amount of needed supplies? Or did they make a mistake in the number of supplies purchased? What if the difference was due to supply chain or inflation?
Our simple product development example reveals the nuanced challenges that variance analysis presents. Common reasons for negative variances include:
- Improper or unrealistic forecasts, including optimism bias.
- Economic changes, like national inflation or industry-specific supply chain failures.
- Changes in client base, like lower sales or acquiring new clients too quickly.
Budgets and forecasts should be updated regularly throughout the year, using interpreted data from variance analysis to inform the changes.
Methods and Tools to Protect the Future
Cash flow management is a simple principle but takes a lot of work to do well, especially in start-ups or large companies. If your organization continuously struggles to meet forecasts or budgets within an acceptable margin, here are some tips to help increase your accuracy.
Check Your Systems
Finance feels like it should be straightforward, using relatively simple math to create predictable outcomes. However, the reality of finance is that success depends on the actions of many individuals.
If you are dissatisfied with your variance margins, check your company systems wherever money is involved. Ideas include tracking the success of:
- Expense tracking systems.
- Expense approval policies.
- Frequency of budget meetings.
- Quality of data and financial reports.
You may find multiple solutions embedded in company policies and habits.
Improve Your Tools
Another common reason for expenditure frustrations is that companies use ineffective tools to track their finances. Excel is widely used for business finance, and it is a beneficial tool. But there are many more powerful, streamlined, and mistake-averse programs available.
Proper software can:
- Create more detailed, flexible forecasts.
- Automatically integrate expenses from bank accounts for live updates.
- Prevent mistakes in data input or formula generation.
- Reduce dependency on a single employee or team to maintain finances.
- Allow for custom access to reports, increasing department participation.
Upgrading your financial software can make massive improvements in accountability and quality of the information quickly– making it a high ROI investment.
Company success depends on cooperation across the entire employee base. Therefore, keeping budget variance low depends on employee understanding of expectations and maintaining accountability.
Use polls or interviews to ask questions like:
- Do you feel you can ask for the money you need to do your job, or do you feel you need to lowball to be approved?
- Do you know what your team/department budget is?
- Do you feel like your actions impact the organization's bottom line?
Addressing employee concerns can significantly improve financial accuracy. First, ensure your company has a strong culture of asking for employee feedback. Then, require high levels of accountability for financial actions.
Use the Best Tools to Empower Your Financial Forecasting
While understanding correct principles and methodologies is essential to valuable forecasts and reports, using the best tools will vastly improve your success rates. Great financial analysis software will use robust reporting, real-time updates, quality and access controls, and clear reports for empowered decision-making.
At Cofi, is a one-stop platform for all of your budgeting, analysis, forecasting, and reporting needs, allowing finance teams to easily conduct their budget to actual variance analysis and derive fast and reliable business insights.
Request a demo today!