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Budget vs Actual: 5 Key Benefits of Variance Analysis

Seldom is a business going to be successful without using proper managerial tools to evaluate how the business is performing. At the most basic level, every business needs to prepare an annual budget. A budget is often used as a road map, outlining the organization’s performance objectives for a given period of time.

Defining Budget vs Actual Variance Analysis

In order for a budget to be considered useful, it needs to be used as a comparison tool when the business results start rolling off the computer. This is referred to as budget vs actual variance analysis. By comparing a line item budget to actual line item results, managers can learn a lot about their business. This will enable them to make key adjustments and business decisions that might make the company more profitable in the future. It’s important to note that a variance analysis does not answer questions about business performance. Instead, it gives accounting personnel and managers an indication of where they can look for possible material issues.

Deciding Which Budget vs Actual Variances are Material

Budgeting is not an exact science. It’s an estimate of expected results based on certain criteria. Even experienced business managers can have difficulty preparing a budget. Once a variance analysis has been completed, the task at hand is to focus on investigating “material” variances. Every organization is going to use different parameters to decide what they believe is material. As a good rule of thumb, any 20% or greater line item variance should be subject to further investigation and explanation.

Budget vs Actual: 5 Key Benefits of Variance Analysis

As should be expected, the process of preparing a budget vs actual variance analysis should bring with it several key benefits for the organization. Here are five key benefits of a budget vs actual variance analysis.

List of 5 benefits of variance analysis

1. Identifying Budgeting Problems

If a variance analysis renders a set of results that create large variances throughout the report, it might be an indication there are significant issues with the way the budget is being prepared. The issues might relate to the use of bad data or input or perhaps there are formula mistakes in the spreadsheet being used to prepare either the budget or the actual variance analysis. In essence, a variance analysis becomes a good method for evaluating the company’s budgeting process. By taking the time to improve the budgeting process, the company should become more efficient.

2. Identifying Revenue/Expense Issues

In the case where only one to several line items indicate a material variance, further investigation of each of those items becomes necessary. If a revenue item is out of whack, it is critically important to determine if the source of the problems relates to sales volume or perhaps to pricing issues. Either way, a responsible manager would want to sit down with the company’s revenue generators (salespeople) and figure where the actual problems lie.

As variances relate to expenses, the results could be an indication of careless spending. It might necessitate accounting personnel working closely with those who are making purchasing decisions to find ways to secure better volume discounts or improving the bidding process in order to secure the best prices in the marketplace.

Note: Sometimes, variances in both revenues and expenses might be related. If revenues show a positive variance while expenses show a negative variance, the explanation of both variances could be that business is better than expected. If the profit margins are close to budget, there might not be a problem at all.

3. Identifying Needed Changes in the Overall Business Strategy

In some cases, budget vs actual variances might point out the need to reevaluate the company’s product line or target customer base. A lot of assumptions go into preparing a budget. If those assumptions are causing the budget to blow up, it might be because related projections are simply wrong for a variety of reasons. It might be as simple as a change in the economy or as complicated as delays in getting products out to customers. At the end of the day, necessary changes within the business might be indicated.

4. Identifying the Managerial Issues

At times, a variance analysis can provide insight as to how well or poorly the company is being managed. In the purchasing example mention above, the inability to lock down reasonable volume discounts or secure competitive bids might indicate personnel problems in the purchasing department. Furthermore, weak sales might be an indication of salespeople being improperly trained or motivated. By addressing these types issues, the variances might disappear as the company gets on track.

5. Identifying Possible Criminal Issues

It’s not something people want to think about, but employee theft is likely to rear its ugly head where and when business managers least expect it. More often than not, theft issues tend to appear as variances in the expense categories. If employees are stealing product, sales numbers won’t match inventory levels when cost of sales calculations are done. If money is being embezzled, cash expenditures will exceed expenses reported. It’s not fun, but variance analysis has long been one of the most effective ways to identify possible internal crime issues.

Summary

While a budget vs actual variance analysis might not provide all the answers, it has certainly proven time and again to be an important tool for management to use when making decisions about the business. Without a variance analysis, a budget ceases to be a working document and becomes little more than a presentation slide for the benefit of business owners and/or prospective investors.

Adrian

I'm Adrian, a chartered management accountant with many years of practical experience. I studied strategy, financial controlling and entrepreneurship in Switzerland and England.

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