When preparing a budget, predicting the future financial performance of a business is a difficult task to execute with precision. Once the budget is approved by senior management, actual results are compared to what had been budgeted, usually on a monthly basis. A negative variance means results fell short of budget, and either revenues were lower than expected or expenses were higher than expected.
Why They Occur
A budget is prepared using assumptions about the business environment the company will be operating in over the course of the year. If the assumptions are wrong, chances are that actual results will vary from budget. The company might assume the economy will grow modestly, but then it slips into a full-blown recession. Over optimism can also cause negative variances. Companies often believe that the process of acquiring new customers will be faster and less costly than it turns out to be. Start-up companies in new industries or market niches often have negative variances because they did not have any real-world historical data to use as a basis for their projections.
A company's finance staff tries to determine the causes of the variances. This research may involve going back through journal entries prepared by the accounting department. They look at the percentage variance as well as the dollar amount of each variance. For example, a $15,000 variance might seem significant unless it is regarding an expense category with a budget of $1 million. They also compare current results to those of the same month the previous. Suppose revenues were 10 percent lower than plan. This negative variance would be seen as a less serious situation if in fact revenues were up 15 percent compared to the same period last year.
Knowing why the variances occurred gives managers a basis for deciding whether any adjustments need to be made to strategies or expenditures. If variances recur each month, the company may elect to do the whole budgeting process over to try to come up with more realistic figures. This is often called doing a reforecast. One of the major benefits of variance analysis is that it helps management identify which strategies are working and which ones aren’t. Negative expense variances can be addressed by looking for ways to operate the company more efficiently.
In some companies the budget variances reports are used by top management to harshly and unfairly criticize the managers below them whose departments had negative variances. Managers may come to dread the day that the finance staff distributes the monthly variance analysis. Negative variances are a fact of business life. The environment companies operate in is constantly changing, and competition can become more intense. It can be argued that variances show the budget process works. The revenue targets in the budget were aggressive and the expense budget was tight. Consistently positive variances often occur in companies that pad their expense budgets and set revenue goals too low.
- "Financial Management 101: Get a Grip on Your Business Numbers"; Angie Mohr; 2007
Brian Hill is the author of four popular business and finance books: "The Making of a Bestseller," "Inside Secrets to Venture Capital," "Attracting Capital from Angels" and his latest book, published in 2013, "The Pocket Small Business Owner's Guide to Business Plans."