Budgetary Control and Variance Analysis: A Comprehensive Guide

A budget is a financial plan in which companies allocate income and expenses, typically over a year. It helps them manage money and ensure they have enough to cover expenses and invest for the future. But simply making budgets is not enough. After the financial year is over, companies calculate the budgetary control and perform variance analysis. This article explains the concept of budgetary variance analysis and how the budgetary variance model is important for an organisation.

Budgetary Control and Variance Analysis

Before understanding budgetary control and variance analysis, let’s understand the terms frequently used in this discussion.

Budgetary Variance

When the financial year begins and the actual income and expenses pour in, most companies calculate the difference between budgeted and actual figures in a particular accounting category. This difference is called budgetary variance.

Budgetary Variance Analysis

The practice of comparing actual values to the budgeted values for the same period and analysing the variances using various tools is called budgetary variance analysis.

Budgetary Variance Reports

Budgetary variance reports allow organisations to compare budgeted revenue and expenses with the actual ones. A standard report includes variance with an arrow highlighting whether the variance has increased or decreased, and green and red colours showing whether the variance is favourable and unfavourable, respectively.

Having established a basic understanding of what a budget is, let us delve into the concept of budgetary control and variance analysis.

Budgetary control refers to the process of preparing, implementing, and monitoring budgets to ensure that an organisation's financial resources are being used effectively and efficiently. It involves comparing actual performance against budgeted goals, and taking corrective action if necessary.

On the other hand, variance analysis involves the examination of differences between actual results and budgeted or planned amounts. This analysis provides valuable information for decision-making and helps organisations to identify areas where improvements can be made.

Both budgetary control and variance analysis are important tools for effective financial management and are crucial for organisations in achieving their financial objectives.

Understanding Budgetary Variances

Let’s understand this with an example. Assume that your firm budgeted £1,00,000 for sales in the first quarter. But the actual sales were £80,000. In this case, the budgetary variance is £20,000. There are three primary causes of budgetary variance — errors, dynamic business environment, and unmet expectations.

• Errors: Various forms of errors, including mathematical inaccuracies, flawed assumptions, and utilisation of inappropriate data sets, can lead to inaccuracies in the budget preparation process, thereby resulting in an increase in budgetary variance.
• Dynamic Business Environment: The business environment is inherently dynamic and is subject to constant fluctuations. However, significant or unforeseen shifts can result in significant variances between the expected and budgeted values.
• Unmet Expectations: It is a common occurrence for budgetary variances to be substantial when management fails to meet expectations. These expectations are typically based on comprehensive analysis and estimations, which are influenced by the other two factors.

These errors can impact the validity of the budget and hinder effective financial management, making it crucial to identify and address them in a timely manner.

Depending on its value, budgetary variance can be either favourable or unfavourable. A favourable variance is when the actual values are higher than the budgeted ones. This often means high revenue. Conversely, an unfavourable variance is when revenue falls short of the targets.

Calculating Budgetary Variance and Conducting Analysis

In big-sized organisations, FP&A analysts are responsible for calculating budgetary variance, creating budgetary variance reports, and conducting variance analysis. They use spreadsheet software to perform the calculations and carry out the analysis in five steps:

1. Gathering Data

To effectively analyse budget variances, gather and centralise data in one location. Centralising the data facilitates the production of the report, but also allows for better version control.

Additionally, incorporating data from various time periods enables the display of broader trends and insights. It is crucial to include the budget in the data as well.

2. Calculating Budgetary Variance

To calculate variances using Excel, create a template with budgeted values in one column. Then use the VAR formula. It returns the variance of a sample data set.

The budgeted values could be for various data points such as total sales, labour costs, cost of goods sold, and fixed costs.

The level of detail should be determined by the data that was centralised in the previous step. For multiple revenue sources, separate the budgeted and actual values for every source. When dealing with costs, examine every component separately rather than aggregating them.

3. Analysing Variance

When analysing variances, set a threshold for materiality. The materiality threshold is the level at which a particular item is considered to be significant enough to affect the financial statements. It is a level of significance used to determine which events should be disclosed in financial statements or reported in the auditor's opinion.

The next step is to perform a thorough analysis, which is the most time-consuming aspect of the process. It requires careful investigation into the root cause of any variances, including working with various departments to fully understand the underlying factors.

4. Reporting

The results of the analysis are then curated into a budgetary variance report and presented to the management.

5. Adjusting Forecasts

Forecasts serve as a guide for the business in reaching its goals and a gauge to measure progress. Therefore, the forecasts should not only incorporate insights from the variance analysis but also reflect any decisions made by management.

Key Takeaways on Budgetary Control and Variance Analysis

The budgetary variance model involves comparing actual results to budgeted or planned amounts, identifying the causes of any differences, and taking corrective action if necessary.

The purpose of budgetary control and variance analysis is to identify areas for improvement, adjust future forecasts, and make informed business decisions. Without taking action based on the insights gained from the variance analysis, it is merely a passive exercise and fails to impact a company’s bottom line.