If you could accurately predict the future, running a business would be much easier. Instead, business owners and entrepreneurs have to make plans and decisions with ever-changing factors like market conditions and consumer preferences.
When it comes to financial management and planning, budgets are valuable tools that help you anticipate costs and plan for growth.
But business budgets are just plans.
Your company’s actual performance will differ from your expectations. This is known as budget variance, and it’s an essential budgeting concept for business owners to understand.
What is budget variance?
Budget variance refers to the differences between the figures you projected in your budget and your business’s actual performance. You can calculate variance for any of the line items in your budget, such as revenue, fixed costs, variable costs, and net profit.
Favorable vs. unfavorable budget variance
There are two types of budget variance: favorable and unfavorable. A favorable budget variance happens when your actual figures are better than expected. Higher revenue or lower costs both count as favorable variances.
Unfavorable variance, on the other hand, occurs when your real performance is worse than you anticipated. If you have higher actual costs or lower revenue than expected, then you have unfavorable variance.
Budget variance explanations
Understanding the causes of budget variance can help you figure out why your performance numbers differ from your projections and what those differences mean for your business.
The most common causes of budget variance include inaccuracies in your budget, changes in the business environment, and over- or underperformance.
Budgeting errors
Budgets are forward-looking tools that use financial modeling to predict your business’s future. These projections are based on research, historical data, and assumptions.
Poor-quality information can lead to budgeting errors that result in variance from actual performance. Inaccurate budget figures can come from calculation errors, incorrect assumptions, or outdated data.
Variance from budgeting errors can be a sign to review your budgeting process to remove errors and look for more accurate methods to forecast sales and expenses.
Changes in the market or economy
External factors, such as changes in economic conditions, can also account for budget variances. If one of your main competitors goes out of business, that may lead to favorable variance where you gain customers and have higher revenue than expected.
In contrast, an economic recession or supply shortage may lead to unfavorable variance where revenue declines or costs increase.
Variance caused by shifts in the business environment is mostly out of your control. But it can still inform your strategy by showing you which changes had the biggest impact on your business’s results.
Overperformance and underperformance
Variance can occur because your business performed better or worse than expected. Overperformance — such as more efficient operations, better customer conversion rates, or improved lead generation — can contribute to favorable budget variance.
Alternatively, underperformance, such as operational inefficiencies or low talent retention, may lead to unfavorable variance.
Overperformance variance can be a sign of a competitive advantage that you can capitalize on, and underperformance tells you where you need to improve your operations.
Why does budget vs. actual variance matter?
According to accountant Antonette El Baz, “Analyzing budget variance helps businesses control spending, maximize profitability, and make more informed decisions about long-term growth.”
Budgets are valuable decision-making tools for any business. If you have a high budget variance, that means you’re using less accurate information to make strategic choices.
For instance, drastically overestimating your income may lead to overspending, which can drain your cash reserves. This can be especially damaging to startups and small businesses with limited resources.
How much variance is too much?
Ultimately, your budget is made up of guesses about what will happen in the future. That means there’s bound to be some difference between your budget and actual performance.
But when does variance switch from normal to too high?
In accounting, a budget variance of 10% or less is usually considered tolerable.
For instance, if you budget $20k for a project, and it ends up costing $22k, most financial planning professionals wouldn’t consider that a significant problem.
But if your project ends up costing $28k (40% higher than expected), then you may want to dig deeper and figure out what caused the difference.
While 10% represents the industry standard, that doesn’t mean you have to use that threshold. If you don’t have a lot of cash reserves, you may choose to stay on the safe side and aim to keep your variances under 5%.
Either way, establishing a threshold for your budget variance helps with analysis. You can spend more time investigating and addressing the variances that were higher than you wanted.
Budget variance formula
To calculate budget variance, you can use one of two formulas.
Variance = Actual Value - Projected Value
or
Variance = Projected Value - Actual Value
The size of the budget discrepancies is the most important factor here. Whether the amount you calculate is positive or negative doesn’t matter as much, since favorability depends on the line item.
In addition to measuring the actual amount, you can calculate budget variance as a percentage using this formula:
Variance % = ([Actual Value - Projected Value] / Projected Value) x 100
Once again, the goal is to focus on the size of the percentage difference. Positive percentages aren’t automatically favorable, and negative percentages aren’t automatically unfavorable.
Budget variance analysis example
Say you have the following numbers and you want to analyze budget variance.
The first step is to calculate the variance for each line item.
In this example, use the first formula: Variance = Actual Value - Projected Value.
Next, interpret the variance of each line item to see if it’s favorable or unfavorable.
- Total revenue: Your actual revenue was $0.5m higher than your expected value, which is a favorable variance.
- Total costs: Your actual expenses were $1.2m higher than the budgeted amount, which makes this an unfavorable variance.
- Net profit: You have a negative variance of -$0.7m, and your actual profit was lower than expected, making this an unfavorable variance.
Now that you’ve interpreted each line item, it’s time to calculate the budget variance percentages to flag any significant variances for further investigation.
For this example, use a threshold of 10%.
Your total revenue variance is in the normal range of 10%. However, your cost and net-profit variances are higher than your threshold of 10%.
At this point, you should prepare a detailed variance report explaining why your costs were much higher, and your profits were much lower. You can look at common root causes: inaccurate budget numbers, changes in the business environment, or unexpected performance.
Tips for controlling budget variance
In an ideal world, you want to avoid unfavorable budget variances above your threshold. Below are some tips to consider.
First, you can improve the quality of your projections by double-checking your math and removing data errors. And once you are able to make better projections, make sure you stick to them.
Frederick Lansky, owner of travel consultancy Points Panda, recommends continually “monitoring your spending so you can identify trouble spots early on and make adjustments.” By doing so, you can catch variances when they’re small and take action to prevent them from becoming significant.
Then, if you’re using a static budget, consider switching to a flexible budget that lets you adapt your projections based on external factors and actual performance. Adjusting your budget based on new information can lead to more accurate projections and less variance at the end of the year.
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