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How to Build a Financial Model: Budget Variance [Template Included]

Nov 13, 2017 / by Borislava Baeva

You want to grow your business, so what’s your plan? Throw a bunch of stuff against the wall and see what sticks? While this strategy may work at startups still defining product-market fit, more established businesses need a more structured approach.

Enter budgeting and budget variance.

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Budget variance from 30,000 feet

Budget variance is nothing more than the difference between your budgeted expenses and revenue and your actual expenses and revenue. Your budget variance provides a quick picture of how you are doing in comparison to your budget: for example, when your actual revenue is higher than budgeted, you’re on a positive trend. When your actual expenses are more than what you budgeted, you have a clear indicator that you need to reduce spending unless it helped, or it will help you generate more revenue.

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Both the budget and the budget variance rely on sound accounting practices, in which you record and report all your financial transactions. Without good data, you won’t get an accurate picture of your business’s performance. If you do not have accurate accounting, your company has no clear picture of its financial state, and therefore no basis for further analysis.

Assuming your data is solid, a budget variance enables you to determine if you are on target to meet your sales and profitability objectives by regularly evaluating your company’s budget.

New to budgeting? Consider reading these budget basics first:
How to Build a Basic Financial Model [Template Included]
Financial Model Vs. Budget: What’s the Difference?
How Often Should I Review My Business Budget? A Mid-year Guide

Budget variance: what can we learn?

While budget variance inherently looks at past performance, the insights gathered provide guidance for future decisions. Here are a few examples:

Are your budget assumptions correct?

To create a budget, you need to make assumptions about client acquisition, churn, revenue per client, product sales per category, etc. Doing a budget variance enables you to see whether your growth assumptions were correct. Did that additional sales person pay for him or herself in three months? Did your clients spend as much with you as you thought (and if not, figure out why)? Did more clients churn than expected? There is a lot of learning to do from assumptions not holding true!

Do you have control over spending?

Having financial discipline as a business is important so do take the time to understand Expense budget variances. If a vendor provided a service that cost more than quoted and budgeted speak with them to understand why. Having Travel & Entertainment Policy can help you control expenses and keep employees accountable for their spending. But don’t sweat the small stuff and keep in mind whether the expense was justified and added incremental revenue or benefited the company in any other way.

Are expenses as a percentage of revenue what you expected?

Don’t focus on the actual numbers here, but evaluate variable expenses such as cost of goods sold (COGS), sales commissions, and royalties as a percentage of revenue. As an example, if you budgeted revenue of $1 million with COGS of $0.3 million, but the actual revenue was $1.2 million with COGS were of $0.4 million, don’t spend time investigating COGS in terms of absolute dollar variance. Both the actual and budgeted COGS as a percentage of revenue are the same, so you have correctly budgeted for that category.

Using a percentage of revenue budget versus actual comparison can be useful for other expenses, such as sales, marketing, and payroll.  Any reduction in the percentage indicates that the company is becoming more efficient and profitable as the top line grows. That type of economy of scale is one indicator that helps investors determine the long-term profitability of a business.

Should you be focusing on different products or services?

Maybe you budgeted revenue of $1M for product line A and $2M for product line B, but actually ended up with the reverse on equal marketing budgets. This is a great time to evaluate your sales and marketing focus.

Are your margins consistent?

The following scenario demonstrates how doing a regular budget variance can provide concrete steps to help your company save money, improve efficiencies, and contribute to business growth:

As sensor technology was becoming a game changer in home environment control, an engineering company that specializes in consumer products decided to invest in a new product line to up their competition. Using their existing competencies and expanding their portfolio provided a good opportunity to increase profitability. Management recognized, however, that success would be based on proper budgeting for the new product line and the use of variance analysis to consistently monitor performance.

By reviewing budget variance on a monthly basis, the company was able to track a concerning trend. While the new product was well-accepted and sales were great, the budget variance was showing a decrease in profit margins. This triggered a discussion about whether the business could absorb a lower profit margin or whether it was more suitable to reduce efforts to market the new product and refocus on other areas of growth. Because sensor-based products were becoming more of a commodity, the company decided to stay in a quick-growing market and accept a lower profit margin.

Without thorough analysis of their budget variance, the company very well could have relied on sales numbers only, and overlooked the fact that profits were not hitting target. By being consistent in their analysis, they were able to maintain growth in product sales and bring budgeted and actual revenue into alignment.

Other concrete applications of variance analysis might look like one of the following:

  • Project Cost Expense Variance - A company that consistently spends more labor cost than planned on a client project might decide whether it is best to improve efficiency, increase prices, or accept lower profitability.
  • Payroll Cost Variance - When increased hiring costs result in higher labor costs, companies might have to determine whether it is better to reduce project volume or outsource non-essential work.
  • Revenue KPI Variance - If analysis reveals that revenue is up because the company is exceeding conversion goals, there is time for a team celebration before increasing benchmarks to promote continuous improvement and growth.

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Gathering information for budget variance analysis

The more sophisticated and detailed your existing budget process is, the easier it will be to pull together the information needed for a meaningful budget variance. To begin with, you will need the data for all Profit & Loss (P&L) and Cash Flow and Balance Sheet accounts. If most of your accounting is done in-house or if you are using an accounting software, you will be able to identify actual expenses categorized by account - as long as the budget was loaded into the system.

If you outsource payroll or other services, you will need to collect monthly data from your CPA and compare it your budget.

Another consideration when preparing a budget variance is to allow time to collect actual non-financial information; this is especially important if your budget was built using key inputs like the number of new customers, market growth, or conversion rates. Having this data on hand will help you understand why you did or didn’t meet your budget expectations.  

Budget variance best practices

A worthwhile budget variance analysis depends on the quality of your existing budget, as well as how quickly you can collect actual data for comparison. The following best practices will help you prepare for a useful budget variance analysis:

  • Build your budget in a way that makes sense for your business.
  • Gather details and record them at consistent intervals. Don’t rely on hurriedly piecing information together at a later time.
  • Standardize and automate your process of gathering and recording financial data; this allows you to spend less time organizing your information and more time analyzing it.
  • Review budget variances with your executive team. Keep cost center department heads accountable for their spending.
  • If your revenue is seasonal, invest the time to break your annual budget into months. This will help you manage cash flow and ensure that what you’re spending throughout the year is aligned with your cash inflow.
  • Update your budget on a quarterly basis at minimum. Otherwise, you will have a static budget that provides no basis for variance analysis.
  • Case in point: If a product launch is delayed by six months, it is difficult to compensate for the missed revenue opportunity for the remaining part of the year. It is also unfair to hold a sales team accountable for missing sales goals for a product that is not yet available. For this reason, it is important to update your budget on a quarterly basis, at minimum.

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Borislava Baeva has significant experience in Financial Analysis, a chosen focus that allows her to stay engaged in the growth of client businesses by establishing reporting tools that provide actionable information. Borislava is experienced in building complex financial models to evaluate new products, international expansions, divestitures and acquisitions. Her industry experience includes retail, manufacturing, hospitality, fitness, and sports entertainment. In her free time, she strives to balance the demands of her professional life with other favorite activities that include yoga and the exploration of Chicago's rich music and cultural scene.

Want to hire Borislava for your next financial planning & analysis project? Email sales@paro.io.