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budget vs actual

Budget vs Actual Review

In Stephen Covey’s bestselling book, The 7 Habits of Highly Effective People, his first habit is to “Be Proactive.”

This habit can be applied to many aspects of our personal lives. However, it is also a foundational habit for the business world.

One of the most proactive areas a business can influence is the yearly budget.

The budget is the tool used by management to indicate where they want the business to be financially after one year. However, just having a budget will not necessarily get a business to where management wants to go. 

There must be an analysis of what management wants achieve and where the company currently stands. This is where the budget vs actual analysis comes into play.budget analysis

This analysis allows for quick identification of revenue short falls and cost overruns. It gives management the tools needed to react to variances in expenses, revenues, production, etc.

Additionally, the budget vs actual analysis can be used as a reactive tool for internal control. All industries should utilize a budget vs actual analysis—either in a financial summary form or in a detailed account by account set up. 

In this post we will broadly define budget vs actual, show a few examples of how it is used in business today, and provide tips for management.

What is Budget vs Actual?

Budget vs actual is an analysis of revenues and expenses that were budgeted for a timeframe and compared to actual results. The quality of the analysis depends on how detailed and accurate the budget is when constructed. The analysis comparison allows for management to react to trends affecting the company, both internally and externally.

Why is this analysis important?

Per a survey conducted by Clutch.co, “Nearly two-thirds of small business (61%) did not create an official, formally documented budget for 2018” 

A budget is important because it provides the management with a financial designation for the year. The destination is just the first aspect.

The second is comparing the direction, or actual financial results, with the destination. 

If a company does not have a budget, how would management and employees know if resources are being used properly?

If the company has net income for the year, without a budget how would management know if that was a good year?

Without a budget how can management forecast and react to revenue short falls and cost overruns?

Going without a budget is like taking off from one airport and hoping you land somewhere you want to go—all without a flight plan.

Components of Budget vs. Actualcomponents of budget

For a successful analysis of budgeted amounts compared to actual, there first needs to be an accurate budget. Setting up an accurate budget takes time, both in years of experience and in the actual compilation.

The formal title of the person who sets up the budget each year is the budget analyst. 

This individual usually will work in the accounting department or works directly with the chief operating officer. 

They have knowledge of all factors, both financial and non-financial, that affect the company.

Budget Analyst

When the budget analyst sets up the budget they will pull from various sources. The actual compiling of the budget can take anywhere from a couple of weeks to a couple of months depending on the complexity and detail level. When they compile the budget, they consider the following:

    • Properly set up: They will ensure all items have been accounted for and there is a logical flow of information into the budget.
    • Items such as revenue production will be triggered by total production hours or units to complete.
    • Capacity of both employees and machinery is brought into this set up. For example, if the company is a professional service organization and charges by the hour, a budget of 4,000 hours per employee will not be feasible and will cause issues with the set up.
    • They will perform an in-depth review of financial data and will:
      1. Examine the prior year budget to actual to see if any accounts or items were missed.
      1. Review accounts had adjustments after the previous year’s budget set up. These adjustments could be accruals that did not get posted when the budget was completed.
      1. Review the prior year budget to see if any revenues or expenses need to be broken out in more detail. Some budgets can get too generic on items and need additional detail to be useful.
      1. Finally, they will determine how close was the company is in their overall budget? Was the prior year unrealistic? Too pessimistic and allowed management to pad the budget?
Validity and assumptions
    • Validity of data: The budget analyst needs to make sure that the data used for the budget is correct. This verification happens through examining source documents, comparing information to audit reports or tax returns, and comparing actual prior year results to known department performance. The best budgets will be of little use if the underlying data is not correct.
    • Department and management assumptions: The analyst will examine each assumption that management uses to create budgetary numbers. The assumptions need to be based on reasonable data to be reasonably accomplished. Again, if management assumes each production worker will work 4,000 chargeable hours per year, that is not feasible due to capacity limitation.

Variance Analysis

The variance analysis is where the true comparison between budget vs actual takes place. When management compares the budgeted results to actual results, they need to analyze the fluctuation. A fluctuation on budget to actual will be broken down by differences in dollar amounts and percentage difference. A simple example is:

variance analysis

A couple of things to note in the above budget vs actual.

First, the sample company has broken out their budget on a monthly basis. Because of this break out, they can do a year to date analysis for any month. 

The next item to note is rarely will an account or financial line item match up between the budget vs actual. The important item for management to note is they need to have a pre-set criteria for fluctuations, or variances, in the comparison. 

If an account is over by $10,000 in expenses, but the percentage is less than 1%, then does management need to focus on this account? See the video below for a walk through on dollar and percent considerations.

As noted, sometimes there may be a small dollar change, but the percent change is concerning.

Regardless of the criteria that management sets, the variances need to be examined to determine the causes.

Sometimes the cause can be a simple mis-posting in the accounting records, and sometimes the variance can indicate a negative trend on production.

Once management has investigated the differences, appropriate action should be taken to prevent additional fluctuation or correct the current variance. The timing of the review of budget vs actual needs to be within two days of the close of the monthly books, but management should be reviewing a simpler form of budget to actual every week.

 The sooner a variance is discovered the sooner the CFO can react.

Internal controls

Another benefit to budget vs actual variance review is it is an indirect form of internal control.

When an employee commits embezzlement, they predominately focus on accessing cash of the company.

From an accounting standpoint, when cash is removed, the entry is to credit cash and debit another account. Most of the time the fraudster will hit an expense account.

Because of this, the fraudster will cause a legitimate account, such as office supplies, to increase faster than budgeted. When management sets not only dollar variance thresholds, but percentage thresholds, they should be able to catch material theft.

 This process allows for an additional tool for internal control over the expenses. 

Tips and recommendation

    • Once variance levels are established, develop an automated report to notify management when those variances are in danger of being reached.
    • Review budgets consistently. Not all budgets are perfect. Adjust if flaws are discovered.
    • React to variances once they are known. The sooner variances are identified the quicker the company can save money.
    • Perform the budget vs actual analysis timely and at a minimum monthly.

Conclusion:

It is said that a goal without a plan is just a wish. Once there is a plan, or budget, the company needs to monitor their progress toward that goal. A company’s profitable year should be a goal, not a wish.

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Post Author: Steve