As a business startup or accounting expert, you most likely will hear of budget variance very often. No serious business operates without a budget, but budgeting itself relies on predictions and estimates.
Since no one can always predict future costs and market dynamics accurately, sometimes, divergence occurs between predictions and actual results. When this happens, experts talk about budget variance.
But what is budget variance in simple terms and how do you calculate and analyze it? An excellent starting point will be to look deeply into this concept and Its causes.
Continue reading this article to discover more about this crucial concept.
Budget variance refers to the difference between a budget's forecast in terms of expenses and revenues and the actual results. It is the difference between a budget's predicted cost and the actual cost. This difference can be either positive or negative. It is negative when there is a shortfall and positive when there is a surplus.
Accountants refer to positive variance as a favorable budget variance. It occurs when the actual revenue of a company surpasses its budgetary projections. It can also be that the predicted expenses fall below the actual spending. Whichever way, the result is always more income for the establishment.
The reverse, also known as unfavorable budget variance, happens when the company's actual revenue falls short of the budgeted amounts. It can be a consequence of budgeted expenses surpassing actual expenses. Most times, higher labor costs and changes in the price of raw materials mediate increased budget expenses.
Several internal and external factors are responsible for budget variances. But put together, these factors fall under three broad categories.
Accounting errors during budget computation and compilation can give inaccurate expectations leading to budget variance. Such errors include reliance on invalid historical data, arithmetic mistakes in line items, or a wrong assumption about future costs.
In another scenario, employee fraud can be the human error accounting for budget variances. Even with the best business operations and economic conditions, fraudulent practices from workers can lead to unfavorable budget variances. It can block the potential of a new sales channel, thereby causing revenue variances.
Whatever the specific is, this variance results from inaccurate budgeting or human inadequacies and not directly related to market dynamics.
Sometimes, unexpected changes in market conditions such as price hikes and economic conditions account for budget variances. For instance, a spike in the price of office supplies or raw materials can greatly increase the expense budget, leading to a negative variance.
Increased competition can also put pressure on prices, resulting in a drastic drop in projected revenue. If your company's competitor decides to adjust its price, you may also feel the need to respond to keep your customers, and that may tell on your predicted income.
Other changes in this category that give rise to budget variances include changes in regulatory policies, political instability, and unforeseen change in the company's management team. Most companies are unable to accurately forecast these changes, and that is why many accountants group it as one of the uncontrollable budget variances.
A company's management team can be the thin line between unfavorable and favorable budget variances. If the team decides to put in extra time, effort, and dedication, there's a high chance of recording tremendous income leading to a favorable variance.
Conversely, an indolent team will most likely struggle to meet targets, causing the business to experience shortfalls. Since budgets thrive on assumptions that everyone will give their best, anything short of this can trigger a negative variance.
Moving from the causes of budget variances, let's consider how you can calculate this vital accounting concept.
Budgets belong to two broad categories: flexible and static. A flexible budget accommodates conditional formatting or change from the outset. Therefore, it doesn’t respond sharply to variance as does static budgets, and that is why most companies prefer it.
But unlike flexible budgets, static ones still hold to its initial assumptions regardless of its actual numbers. As such, it often witnesses sharp negative or positive variances.
Business experts and accountants use the cost variance of a project to estimate its budget variances. Cost variance is an arithmetic subtraction of the projected cost of the project from the actual cost.
BV = budget variance
CV = cost variance
BC = budget cost
As a practical example, let's say your company or startup decides to embark on a marketing campaign. Of course, this is a project that requires budgeting. If the marketing department proposes a budget of $60,000 after considering everything they need for it, this amount is the budget cost.
However, during execution, let's say they discover that the printing price and other expenses have increased, necessitating $70,000 for the project's completion. This amount is the AC in the formula above. To calculate the BV, you will subtract $70,000 from $60,000. The result will be -$10,000, which represents a negative variance.
You can represent this figure in percentage by dividing the variance by the initial budget and multiplying it by 100. That would mean 10,000/60,000 x100 or 16.67%.
In this budget variance example, it is apparent that the cause is an incorrect estimation of the operational cost, which is a type of human error. The preparer probably relied on obsolete historical data in computing the budget, leading to a shortfall.
During budget variance analysis, the analyzer can recommend data overhaul or an update to forestall future occurrences.
Please note that every budget variance calculation gives a negative, positive, or zero value. When the value is negative, it means the actual costs are greater than the budgeted amounts, signifying a negative budget variance. The reverse is true for a positive value. A zero value means the budget tallies with the amount spent.
In reality, you hardly get a zero value BV because of factors beyond your control. However, the goal of every business is to hit a positive value, as this signifies more revenue or fewer expense variances. The greater the actual figures of this positive value, the better the company's performance.
Budget variance analysis is an effort to ascertain the factors responsible for budget deviations and control them. You can do it before or after the project's execution.
When you perform budget variance analysis before the project, you are projecting or predicting the likely factors to cause a deviation in the proposed budget. It is a strategic move to mitigate these factors before they affect your budget.
When your startup or company understands the actual causes of budget variations, it can help to guide it on what to do next. For instance, a recurrent human error in the budget compilation may suggest that your accounting team needs a refresher course or update.
While there are fixed costs of operations, an actual variance analysis can provide useful insights into variable costs and how to modify them for better budget performance. For instance, while planning a marketing campaign, a budget variance analysis can help you spot uncontrollable factors such as industry regulations ahead of time.
With this knowledge, you can make allowances for this in your budget and avoid poor performance.
If there is something you are doing right or a sector that is yielding more positive results than projected, an analysis will reveal it. You can adopt this approach, if possible, to other non-performing sectors of your company's budget to improve business operations.
Yes, budget variance is essential in appraising your business's budget performance within a financial reporting period. Depending on your company and budget size, you can do it yourself or contract it out to a professional agency.
Consider a budget variance analysis as a report card that reveals your performance in plans, initiatives, and processes as it relates to your company's financial planning. Besides helping to improve revenue, you can your business planning with it.
