Understanding Budget Variance Analysis: A Key to Financial Control

Close-up of woman using small calculator.

Most firms prepare a budget for every activity they engage in, as well as their normal operations. At the end of the time period or project, the budget is compared with the actual costs and income and any differences between the budget and the actual costs and expenses analyzed. This practice, called "variance analysis," is important in management accounting, which focuses on producing forward-looking information, such as developing budgets and measuring performance, to assist managers in formulating business strategies, planning business activities and evaluating business results.

Creating Budget

Based on information from financial accounting, management accountants often create budget plans for various aspects of a business's operations, and managers can then use them as a guide to make more informed decisions. While financial accountants stress compliance and record keeping, management accountants forecast and plan future business developments and suggest courses of action. Budget planning provides the basis against which actual results can be measured and evaluated.

Measuring Results

Measuring actual results against budget is aimed at monitoring and recording business activities, the results of which are used for further performance evaluation. The comparison of actual vs. budget often shows a difference, or "variance," that can be either favorable or unfavorable. For example, in a cost budget, a lower actual number than the budgeted figure would be considered favorable, while in a sales budget, a higher actual number than the budgeted figure would be seen as favorable.

Analyzing Variance

Variance is analyzed to find out what caused the variation between actual and budget. Planning budgets and measuring results are only the start of the process of comparing actual vs. budget. Management uses the budget report to identify the reasons for any variation so that it can recommend appropriate corrective actions. Potential causes for unfavorable variances may include unrealistic budget or subpar performance.

Taking Actions

Variance analysis better informs managers about current business operations. Knowing what has performed and what has not, managers can take reinforcing measures or corrective actions. The purpose of comparing actual vs. budget is to add value to the business through better planning, monitoring, evaluating and controlling. Management may adjust a budget upward or downward to better reflect reality and implement new cost-cutting or sales-promoting measures.