Variance Analysis - 3 Crucial Questions to Ask

Prior to the beginning of a financial reporting period, which is often a fiscal or calendar year, most organizations develop budgets. The annual operating plan, which combines the company's decision-makers, is supported by all divisions and leadership.

If life were a faultless simulation, budgets would be very precise. This would entail firms realizing their maximum operational efficiency potential.

Why?

If the sales prediction was accurate, the company's cash flow would be more predictable and its liquidity would increase. On the expenditure side, it may benefit from more efficient use of capital to maximize the return on its assets.

Nevertheless, budgets are set and only look forward. You do not update budgets over time to accommodate for economic fluctuations, accounting errors, too-optimistic sales estimates, etc.

Comparison between Budget to Actual data

Static budgets serve as a benchmark against which real expenses and revenue may be measured. As the fiscal year progresses, analysts must compare actual data to the assumptions used to develop the expenditure budget and revenue projections. Variance refers to the difference between these predictions and actual outcomes, and a new or small business needs to maintain this variance as little as feasible.

The difference between anticipated and actual expenditures may be seen as either a good or negative predictor of future performance. A negative variance suggests real results fell short of expectations, whereas a positive variance shows actual results exceeded expectations.

Budget overruns are unavoidable. Budget to actual variance analysis is the process of assessing the magnitude of these differences and exploring their primary causes. It is a monthly iterative technique that increases budget accuracy and, more importantly, allows for speedy course adjustment if performed properly.

What is Variance Analysis?

Variance is the actual difference between two data points. Say, for example, the actual v/s budget. Variance Analysis is the process of examining each variance in detail and determining the reasons why the budget was not met.

In other words, the variance is the difference between actual and expected spending. Using variance analysis, it is possible to understand more about the reasons and potential remedies for these outliers. It is an iterative procedure that, when executed properly, enhances the accuracy of budgeting and, more importantly, permits fast modifications.

Examples of Variance Analysis:

Sales Volume vs Price Variance & Cost Variance

• Sales Volume v/s Price Variance: Did the variance in Revenue occur due to a change in quantity (Sales Volume Variance) sold or a change in price (Sales Price Variance)?
• Cost Variance: Did the variance occur due to a change in usage (Material/Labor usage variance) or a change in price (Material price/ labor rate variance)?

Variance Analysis: 3 Crucial Questions to Ask

1. Why did this happen? What could be the source of the difference? Common explanations include:

• To avoid price increases.
• It’s a timing difference and will reverse.
• The assumption we made in the plan turned out to be incorrect.
• To avail quantity discounts

2. How far apart are the actual and what action should be taken?

• What can we do now to ensure we do not continue to go over budget?
• How could we reverse the harm done (cover up the overspending or make up the lost revenue by accelerating the run rate)

3. Is it a matter of scale or direction??

• Maintain a Budget journal and make a note of things we forgot to Budget.
• Did we overestimate/underestimate current usage or cost?
• If we did go directionally wrong – update our assumptions for the next cycle.

Classifications of variances?

A variance study between a budget to actual variance analysis may lead to two alternative conclusions:

1.????Positive Variation

Positive variance refers to situations when actual results are more favorable than predicted. For instance, if a firm's revenue is more than anticipated or its costs are lower than anticipated, the company will have a positive variance.

A shoe shop, for example, may have projected sales of $275,000 for the current year. This year, more people visited the shop due to the extraordinary weather conditions that made news throughout the season. The shop closes the year with a real revenue of $350,000 due to the rising demand. Because actual revenue is more than anticipated, this number indicates a $75,000 positive variation.

2.??Negative Variation

This is regarded as an unfavorable variance when actual results are inferior to the intended or expected quantity. A corporation might have a negative variance if its revenue is lower than expected or if its costs are higher than anticipated.

For example, annual overhead expenses for a shop were projected to be $20,000. Due to the exceptionally cold winter, its pipes froze and burst. Due to this unanticipated issue and the required repairs, the store's total overhead expenses for that year amounted to $30,000. The variance is negative because the store's actual expenses exceeded the budgeted amount by $10,000.

Additional Tips:

1. Don’t assume a variance is good or bad before considering timing differences.
2. Analyze team wise / department / cost center wise to avoid spending someone else’s savings.
3. If you identify an overspend, suggest cutting back on the expenses if possible until you are back in line or have a good reason to continue to overspend.
4. Create awareness and discipline that the budget is the guideline for every significant expenditure and managers should know that substantial variances will always need explanations.
5. Reward good performance with recognition and unfavorable performance with guidance to improve.

Final Thoughts

Budget to actual variance analysis process is valuable for company planning, management, and evaluation. With correct implementation, several good results are achievable, including enhanced risk management as a result of new knowledge that narrows the gap between planned and accomplished expenditures and helps enhanced decision-making.

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