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Even the most seasoned financial forecaster can’t predict future costs and revenues with 100% accuracy. When expectations diverge from reality in accounting, it’s called budget variance. Here’s a closer look at how this happens.
Budget variance explained
When a project’s actual costs are higher or lower than its predicted costs, this is referred to as a budget variance. The term is typically used in accounting for individuals and corporations but can also apply to other organisations and governments. There are a variety of factors that impact a planned budget, from unplanned labour costs to unexpected natural disasters. When looking at the meaning of budget variance, you’ll see both favourable and unfavourable variances mentioned, which we’ll discuss below.
Positive vs. negative budget variance
Budget variance equals the difference between the budgeted amount of expense or revenue, and the actual cost.
Favourable or positive budget variance occurs when:
Actual revenue is higher than the budgeted revenue
Actual expenses are lower than the budgeted expenses
By contrast, unfavourable or negative budget variance occurs when:
Actual revenue is lower than expected
Actual expenses are higher than budgeted expenses
An unfavourable variance leads to a lower net income than expected, which businesses want to avoid.
You can express the variance as a percentage. For example, if a company’s sales for the last quarter of the year were projected to be $400,000 but the company only generated $300,000 in reality, this leads to a shortfall of $100,000. As a result, the unfavourable variance would be 20%.
Causes of budget variances
While businesses look at multiple factors to create an accurate financial forecast or budget, there are many things that can go wrong. Here are a few of the main causes of budget variances:
Changing economic conditions: Any changes to usual business conditions at the time of creating a budget can cause variances. For example, a new competitor might enter the market, or the cost of raw materials might increase due to shortages. Political changes and government regulations can also lead to variances.
Accounting errors: Simple human error is also one of the main causes of budget variances. For example, mathematical errors or reliance on outdated data could lead to issues with the budget.
Inaccurate expectations: When a management team puts together a budget, they use certain expectations including estimates and assumptions. If these are over or understated, variances can occur.
Employee fraud: This isn’t as common as some of the other budget variance explanations, but fraud unfortunately does still happen. It’s important to build checks into your budgeting system to mitigate potential risks.
Changes to operations: Any changes in your operational systems could lead to positive or negative budget variances. Perhaps you purchase new machinery that makes your workflow more efficient, or a turnover in staff improves output.
How can variances be corrected?
Whether positive or negative, it’s crucial to correct budget variances when they pop up. However, it’s also important to note that variances fall into two categories:
Controllable variances can be easily corrected, as the budget variance explanations often can be chalked up to simple mathematical errors or inflated expenses. Discretionary expenses can be eliminated or reduced to keep the budget in line with original predictions.
Uncontrollable budget variances, on the other hand, are more difficult to correct. These are usually due to marketplace changes or unmet customer expectations. These will take further analysis to bring the next budget in line with reality.
As you can see, when looking at how can variances be corrected the best course of action will depend on the root cause of the variance. Controllable variances can often be corrected with some tweaks to expenses or line items, while uncontrollable causes might be out of your hands.
One final way to prevent budget variance is to use a flexible budget model. This allows you to change or update your budget as needed, correcting both positive and negative variances as you go along.
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