Budgeting and variance analysis

What budgeting and variance analysis are

Budgeting is setting a quantified plan for revenue, costs, cash and resources over a period. Variance analysis is comparing actual results with that plan and splitting each difference into its causes, such as price, volume, mix and efficiency. It matters because a single profit shortfall can hide several opposite effects, and only the split tells managers which decision to change.

The most common failure is comparing actual results with the original fixed budget and calling the difference a variance. If sales volume changed, every variable cost line will show a variance that is really volume in disguise. The fix is the flexible budget, and the worked example in this guide reconciles every euro from budgeted to actual profit.

Budget types and the master budget

A master budget is a set of linked budgets: sales drive production, production drives materials, labour and overhead, and together with the capital expenditure budget they produce a budgeted income statement, balance sheet and cash flow. The cash budget is the one most often skipped and most often needed, because profitable growth consumes cash, as our guides on working capital and cash flow versus profit explain.

The method used to set the numbers matters as much as the structure. Most organisations combine methods: zero-based for discretionary overhead, driver-based for revenue and variable cost, incremental for stable fixed costs.

• Incremental: last year plus or minus an adjustment; quick, but carries forward past inefficiency
• Zero-based: every cost justified from nil each cycle; thorough, but time-consuming
• Activity-based: costs built from the activities and cost drivers that cause them
• Driver-based: key drivers such as units, headcount or price feed formulas, so the budget can be re-run quickly
• Fixed: set for one level of activity and not changed
• Flexible: recalculated for the actual level of activity, separating fixed from variable cost
• Rolling: extended by a period each time a period ends, so there is always a twelve to eighteen month horizon

Building a budget you can actually analyse

A budget can only be analysed at the level at which it was built. Budget on the same accounts and cost centres that actuals are posted to, or the comparison will need a manual mapping every month; our guide on designing a chart of accounts explains why dimensions such as cost centres beat extra accounts. Phase the budget by month using real seasonality, not an annual figure divided by twelve, or every month will show timing variances that mean nothing.

Record the assumptions behind each line in an assumptions log: volumes, prices, exchange rates, headcount and start dates. When a variance appears, the log tells you whether the assumption was wrong (a planning variance) or the execution was (an operational variance). Separate standard costs for products, such as kilograms of material and hours of labour per unit, are what make the efficiency variances below possible.

Worked example: fixed budget, flexible budget and actual

A manufacturer budgets to sell 10,000 units at EUR 50. Standard variable cost per unit is materials 2 kg at EUR 6 (12), labour 0.5 hours at EUR 24 (12) and variable overhead 0.5 hours at EUR 8 (4), a total of EUR 28, leaving a contribution of EUR 22 per unit. Fixed overheads are budgeted at EUR 120,000, so budgeted profit is 10,000 times 22, minus 120,000: EUR 100,000.

Actual results: 11,000 units sold at EUR 48, revenue EUR 528,000. Materials used 23,100 kg costing EUR 145,530; labour 5,800 hours costing EUR 136,300; variable overhead EUR 45,820; fixed overhead EUR 126,000. Actual profit is 528,000 minus 327,650 of variable cost, minus 126,000: EUR 74,350. Profit is EUR 25,650 below budget.

The flexible budget restates the plan for 11,000 units: revenue 550,000, variable costs 308,000 (11,000 times 28), fixed overheads 120,000, profit EUR 122,000. The EUR 25,650 shortfall therefore has two parts: a sales volume variance of EUR 22,000 favourable (fixed budget 100,000 to flexible budget 122,000, or 1,000 extra units times the EUR 22 contribution) and a flexible budget variance of EUR 47,650 adverse (flexible budget 122,000 to actual 74,350).

Splitting the flexible budget variance

Every line of the flexible budget variance is split into a price element and a quantity element, each valued on a consistent basis: price variances on actual quantities, quantity variances at standard prices. The standard quantities allowed for 11,000 units are 22,000 kg of material and 5,500 labour hours.

The eight variances below add up to EUR 47,650 adverse, exactly the flexible budget variance, and adding the EUR 22,000 favourable volume variance gives the EUR 25,650 total. A reconciliation that does not close to the euro has an error in it. The story is now visible: a EUR 2 price cut bought 1,000 extra units, and the volume gain was exactly given away in price, while materials cost more per kilogram and more kilograms were used, and cheaper labour worked more slowly.

The example uses marginal costing, so fixed overhead shows only an expenditure variance. Under absorption costing the same facts look different but reconcile to the same total. Fixed overhead is absorbed at a budgeted EUR 12 per unit (120,000 divided by 10,000), the sales volume variance is valued at standard profit of EUR 10 per unit (22 minus 12), giving 10,000 favourable, and a fixed overhead volume variance of 1,000 units times 12, EUR 12,000 favourable, appears alongside it. Because production equalled sales, 10,000 plus 12,000 equals the 22,000 marginal-costing volume variance; with inventory movements the two methods report different profits. Our guide on cost accounting basics explains overhead absorption in more detail.

• Sales price: (48 minus 50) x 11,000 = 22,000 adverse
• Material price: (6.30 minus 6.00) x 23,100 kg = 6,930 adverse
• Material usage: (23,100 minus 22,000) kg x 6 = 6,600 adverse
• Labour rate: (23.50 minus 24.00) x 5,800 hours = 2,900 favourable
• Labour efficiency: (5,800 minus 5,500) hours x 24 = 7,200 adverse
• Variable overhead expenditure: 45,820 minus (5,800 x 8 = 46,400) = 580 favourable
• Variable overhead efficiency: (5,800 minus 5,500) hours x 8 = 2,400 adverse
• Fixed overhead expenditure: 126,000 minus 120,000 = 6,000 adverse

Sales mix and quantity variances

When a business sells more than one product, the sales volume variance hides a second effect: the mix. A second company budgets 6,000 units of product A at a contribution of EUR 20 and 4,000 units of product B at EUR 35, a budgeted contribution of 260,000 and a weighted average of EUR 26 per unit. It actually sells 7,700 of A and 3,300 of B, 11,000 units in total.

The total sales volume variance, at standard contribution, is (7,700 minus 6,000) x 20 plus (3,300 minus 4,000) x 35, which is 34,000 minus 24,500: EUR 9,500 favourable. The quantity variance is the extra 1,000 units at the budgeted average of 26, EUR 26,000 favourable. The mix variance compares actual sales with the same 11,000 units in the budgeted 60:40 mix (6,600 of A and 4,400 of B): (7,700 minus 6,600) x 20 plus (3,300 minus 4,400) x 35, which is 22,000 minus 38,500, EUR 16,500 adverse. Quantity 26,000 favourable plus mix 16,500 adverse equals the 9,500 total. The sales team sold more units, but of the wrong product, and a commission plan based on units would have rewarded it.

Deciding which variances to investigate

Not every variance deserves a meeting. Most finance teams set an investigation threshold combining a percentage and an absolute amount, for example variances above 5% of the line and above a fixed sum, but thresholds are a matter of policy, not a standard. Beyond size, look at the factors below before spending time on a variance.

• Controllability: report each variance to the manager who can act on it, not to whoever owns the cost centre
• Interdependence: cheaper labour and lower efficiency, or cheaper material and higher usage, are often one decision
• Planning versus operational: if the standard was unrealistic, revise it and report the planning variance separately
• Trend: a small adverse variance that grows every month matters more than one large one-off
• Accounting noise: a missing accrual or a late invoice creates a variance that reverses next month
• Cost of investigation versus the likely saving

Rolling forecasts and reforecasting

An annual budget is out of date within months. A rolling forecast keeps a constant horizon, typically twelve to eighteen months, updated monthly or quarterly with the latest drivers. Many organisations keep the annual budget as the fixed target for performance evaluation and use the rolling forecast for decisions on cash, hiring and investment, reporting three columns: budget, latest forecast and actual.

Keep the forecast driver-based and light. If updating it takes a fortnight, it will be updated rarely and trusted less. Forecast accuracy itself is worth tracking: a forecast that is consistently optimistic by 8% is telling you something about the people and incentives behind it.

Reporting variances that people act on

A useful monthly pack shows a bridge from budgeted to actual profit (the eight variances plus volume in the example above, in a fixed order), variances in both amount and percentage with favourable and adverse marked consistently, a short commentary that states cause, action and owner, and the year-to-date and full-year forecast impact. Avoid commentary that merely restates the number, such as sales were lower than budget.

The quality of variance analysis depends on the quality of the close. If accruals are missed or costs land in the wrong period, the variances reflect bookkeeping rather than performance; our month-end close checklist guide covers the discipline that makes monthly variances meaningful. Watch the behavioural side too: budget slack, spend-it-or-lose-it at year end, and targets that double as forecasts all distort both the budget and the variances.

Budgets and Budget vs Actual in Skyline Nexus ERP

In Skyline Nexus ERP, budgets live under Fiscal Authority > Budgets. A new budget has a Budget Name, Fiscal Year, Budget Type (annual, quarterly or monthly) and an optional Cost Center, with Budget Lines per account across the year's periods; Distribute Evenly spreads an annual figure, though phasing by real seasonality is usually better. Budgets are submitted and approved or rejected, and can be imported from XLSX, XLS or CSV using a template.

The Budget vs Actual report filters by Fiscal Year, Account and Cost Center and shows Total Budget, Actual Spent, Variance (Over or Under), Utilization and a status of Over Budget, Warning or On Track, while Cost Center Analysis breaks revenue and expenses down by cost centre. For the flexible budget and the price, volume and mix split described in this guide, export the actuals from the Income Statement or General Ledger to Excel and build the bridge there.