Budget Variance: Forecasting, Control, and Benchmarking

Introduction

Managing budgets and keeping within their boundaries is a difficult task that requires a steadfast approach and practical strategy. Budget forecasts are often used as important guidelines to keep organizations aligned with their corporate strategy. Although this may seem straightforward, in practice it is not. This essay discusses and highlights specific strategies that can be applied to assist in managing a budget within a given set of forecasts. It also compares expense results that have fallen outside the variance range and examines the possible reasons for those discrepancies. Finally, the essay discusses benchmarking techniques that can contribute to improving budgeting and forecasting accuracy.

Nayab (2011) suggested that "both budgets and forecasts provide estimates, and construct models of how a business might perform financially if the expected events and plans play out as desired. The difference between forecasts and budgets is that forecasts gaze into an uncertain future whereas a budget bases itself on planned events." Establishing a relationship between these two figures requires management to look beyond face value and examine what the numbers are really saying about the performance of the firm.

Budgeting and Forecasting

The most important aspect of budgeting and forecasting is that they align with the corporate strategy presented by organizational leadership. Because the budget expresses how resources will be allocated and what measures will be used to evaluate progress, budget development is more effective when linked to overall corporate strategy. Linking the two gives all managers and employees a clearer understanding of strategic goals. This understanding, in turn, leads to greater support for those goals, better coordination of tactics, and, ultimately, stronger company-wide performance.

Setting goals before budgeting begins makes it easier for budget developers at all levels. When this happens, developers create budgets from the outset that support strategic goals and therefore require fewer revisions. Budget development then becomes not only faster and less costly, but also far less frustrating. The purpose and strategy behind the budget is what drives it and the forecasting methods used to support that strategy — not dictate it.

Westland (2011) offered four ways for managers to take control of this challenge and use budgeting and forecasting to their advantage. He suggested that the budget should be continually reforecast to provide a sense of direction: "A project run without frequent budget management and reforecasting will likely be headed for failure. Why? Because frequent budget oversight prevents the budget from getting too far out of hand. A 10% budget overrun is far easier to correct than a 50% overrun."

Many companies evaluate managers primarily on how closely they hit budget targets. While this may seem logical, in reality this type of one-dimensional evaluation tempts managers to "win" by gaming budget targets — behavior that is not always in the company's best interest. For successful companies, meeting budget targets is secondary to other performance measures. Such companies use a balanced set of performance measures to chart progress toward strategic goals and apply the same measures in their incentive programs. This reinforces the importance of key strategies and communicates what results will be rewarded.

By developing budgets that accommodate change, companies can respond to competitive threats or opportunities more quickly and with greater precision. They can deploy resources efficiently to take advantage of the most promising opportunities. Furthermore, knowing that budgets have some flexibility frees budget developers from the need to pad budgets to cover a wide variety of possible developments, leading to leaner and more realistic budgets. One way to build flexibility into budgets is to prioritize, according to strategic importance, action plans that were previously rejected due to resource limitations. By doing this, organizations can act swiftly and decisively if additional resources become available.

Companies typically review budgets quarterly, monthly, or even weekly. By including in these reviews reports on changes in business conditions, companies alert managers that new tactics may be required if they are to meet their targets for the year. While it is important that budgets not be revised simply to cover up poor performance or poor planning, well-managed companies choose to revise budgets rather than adhere to budgets that no longer reflect current conditions.

The best strategy for keeping budgets and forecasts useful is clear communication. Communication is the most important aspect of all business interactions and should be treated as the primary method for discussing improvements within the firm. Westland (2011) agreed, writing: "An informed team is an empowered team that takes ownership of the project. By keeping the team informed of the budget status, they will be more likely to watch their project charges and far less likely to charge extra 'gray area' hours to your project — those are the hours that they know they worked but aren't sure what they were working on."

To truly understand the importance of budgeting and forecasting, it is necessary to examine variance within a budget and identify possible sources of discrepancy. A variance arises when there is a difference between actual and budgeted figures. Some variances are favorable; others are not. Cost variance can monitor the financial progression of business operations. When cost variances are low, an organization has controlled its risks well and has retrieved and analyzed operational data sufficiently. Ideally, actual costs should match budgeted costs and the cost variance should be zero, but in practice this is difficult to achieve.

Types of Budget Variance

Direct material variance shows the difference between the actual cost of materials for actual units produced and the standard cost of materials for standard units. This type of variance may be resolved by implementing better purchasing techniques.

Labor variance reflects the difference between the standard cost of labor for actual production and the actual cost of labor for actual production. This is a difficult issue to resolve due to the human error associated with labor costs, but a combination of experience and technology should best inform forecasting for labor costs.

Overhead variance shows the difference between the standard cost of overhead for actual output and the actual cost of overhead for actual output, capturing the variance in all indirect costs. Market fluctuations are most responsible for this type of discrepancy.

Sales variance shows the difference between actual sales and standard sales. In an unfavorable sales variance, actual sales fall below the standard. This is caused by many factors related to sales performance numbers.

Miscellaneous variances occur when certain unpredictable events significantly affect the budget. There is little that can be done about these types of discrepancies, as they are by nature unexpected and largely outside human control.

Conclusion

Benchmarking begins with identifying what is to be benchmarked — whether a service, process, or practice. It is important for leadership to understand exactly what is being compared in order to best serve the needs of the company. Next, a benchmarking team should be created to define the responsibilities and tasks necessary for understanding the problem. The following step requires identifying the firm or organization against which the benchmark is to be measured. Selecting the right data and units of measurement is also critical, as the goal is to compare equivalent items. Once an action plan has been put into effect following correct benchmarking procedures, it is important to continually recalibrate the benchmarks and fine-tune them to the desired level. Organizations that follow these steps consistently are better positioned to keep budget management practices aligned with strategic objectives.

Managing a budget is complex work and requires more than just the ability to add and subtract numbers. Budget forecasts will almost inevitably deviate from actual results in some way, but using this information strategically can help firms and organizations increase their competitive advantage. Taking the extra steps of analyzing how business is conducted — and why variances occur — provides meaningful insight. When variances are paired with proper benchmarking techniques and applied to the overall strategy of the organization, they become a powerful tool rather than simply a measure of failure. Strategic alignment remains the most important part of any organization's approach to financial planning.

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