As a business owner, you’re in charge of steering your company toward long-term growth and profitability. To achieve your goals, you need a clear outline of where you want to go and a solid understanding of where you are now.
Business budgets are essential financial planning tools that help you map out your company’s future. The budget process involves forecasting revenue and predicting upcoming expenses.
Budgets are also helpful for understanding your current performance. With a budget analysis, you can compare your actual performance to the predictions in your operating budget.
A budget analysis allows you to see if you’re on track or veering off course. Once you have that information, you can adjust your strategy and make decisions that help you maximize growth while keeping costs under control.
What is a budget analysis?
A budget analysis is the process of looking at your actual income and expenditures and comparing them to your budget to see if you’re on track. Conducting a budget analysis gives you a chance to correct overspending and update your forecasts.
Benefits of conducting a budget analysis
Conducting regular budget analyses helps you improve your company’s financial management.
Ben Walker, owner of transcription company Ditto Transcripts, explains, “A budget analysis can highlight areas of high spending, identify opportunities for cost savings, and help prioritize investment initiatives.”
Budget analysis is especially useful for startups that rely on a fixed amount of investment capital. Entrepreneurs need to be in touch with their company’s revenue and expenses to ensure they don’t run out of funds before they start generating profits.
You can also use your findings to inform future budget decisions and financial projections.
How to do a budget analysis
1. Choose your analysis frequency
You should conduct budget analyses regularly throughout the budget cycle, such as monthly, quarterly, or biannually.
Kamyar Shah, CEO of management consulting firm World Consulting Group, recommends startups analyze their budgets monthly. This lets you adapt to changes in your business and helps correct overspending before it grows into a serious issue.
Not to mention, startups and high-growth companies often experiment with tactics and strategies, so it’s harder to predict revenue and expenses.
Once your business starts earning steady profits and it’s easier to forecast sales or predict expenses, you can switch to a less frequent schedule.
2. Gather data and calculate budget variance
Once you know your schedule, you can gather the data you need to analyze.
Specifically, you want to gather:
- Master budget numbers: The overall projections outlined in your budget, including breakdowns for monthly or quarterly performance.
- Departmental budget numbers: Expense limits for each department and revenue projections, if they apply.
- Your current performance metrics: Year-to-date totals for your budget line items.
Next, it’s time to identify budget variances. A budget variance is the difference between your expected performance (budgeted number) and your actual performance.
For instance, say you predicted $20k in monthly expenses, but in January, you spent $23k. That’s an expense variance of $3k.
In the next step, you’ll use variance analysis to figure out if any of the discrepancies you found are cause for concern.
3. Analyze budget variances
Variance analysis means collecting more information about the differences between your expected and actual performance. The process of analyzing variance involves three steps:
- Qualify the variance. Is the difference favorable or unfavorable?
- Quantify the variance. Is the variance significant?
- Identify the cause. Why is the variance happening?
The first step is simple. You’re figuring out if the variance is good or bad for your business.
Here’s how to tell:
Using the previous example, you predicted $20k in expenses for January, but your actual expenses were $23k.
Since your actual expenses were higher than expected, this is an unfavorable variance.
Now that you’ve categorized it, the next question is, “Is this variance significant?” In other words, should you be concerned that your expenses were higher than expected?
As a general accounting guideline, variances of 10% or less are tolerable. That means you don’t have to start worrying about a variance until it goes over 10%.
However, you can set a lower budget variance threshold (like 5%) if you want to be stricter about sticking to your budget.
To calculate variance as a percentage, you can use the following formula.
Budget variance (percent) = (Total difference / Expected amount) x 100
Budget variance (percent) = ($3k / $20k) x 100 = 15%
Your actual expenses in January were 15% higher than expected. At this point, you’ve identified a significant unfavorable budget variance, which you’ll want to investigate further.
You need to identify the source of the variance to know how to fix it.
Budget variance often results from one of three causes:
4. Make necessary adjustments
The whole point of budget analysis is to make informed decisions that will improve your performance. There are two main types of changes: adjusting tactics and managing expectations.
Adjusting tactics can help improve your performance and adapt to changes in the external environment. For instance, if you’re overspending, you may look for possible cost reductions. You can also adjust to take advantage of new industry trends, like selling through social media.
Managing expectations refers to adjusting your budget forecasts based on new information. This works for businesses that use a flexible or rolling budget that lets them periodically update their forecasts. (You can skip this step if you use a static budget.)
Say your costs are significantly higher because of something out of your control, like inflation. You can’t reduce them, but you can adjust your budget forecasts to reflect the change.
Budget analysis example
Here’s an example to get a better idea of how this works. This example includes total revenue, total expenses, and net profit. However, you can break these numbers down into different categories, such as departments, when doing your own analysis.
Step 1: Choose a frequency
Say your business has started generating profits, and your expenses have become more predictable. You decide to do a quarterly budget analysis.
Step 2: Gather data and calculate variances
You’re reviewing your budget at the end of Q1, so you gather your Q1 forecasts and actual performance. From there, you calculate the variance for each line item.
Step 3: Variance analysis
In the next step, you can use green to highlight favorable variance and red for unfavorable. Add a column for variance percent, which will help determine which variances are significant.
You can bold text to identify any variance over 10%.
From the analysis, you can see the unfavorable variance in variable expenses is significant and requires further investigation.
A root-cause analysis reveals two causes:
- Your packaging supplier increased prices, costing you $5k more.
- Rising gas prices increased the cost of shipping by $10k.
Step 4: Make adjustments
Based on your budget analysis insights, you can now make adjustments. First, you realize you can reduce costs by $5k if you switch to a different packaging material and smaller sizes.
Next, you research gas prices and see they’re likely to stay high. There’s not much you can do about shipping costs, so you update your budget to reflect higher variable expenses for the rest of the fiscal year.