Most companies prepare an annual business plan that includes a financial forecast, also called a company budget. The plan or budget is a management tool to provide strategic direction for the company. It shows what steps are required to implement the strategies that have been chosen -- and how much these steps or actions will cost -- and forecasts the revenues and profit that are expected to result from their implementation. When actual financial results become available, usually at the end of each month, these results are compared to the budgeted figures in budget comparison reports.
Actual financial results are prepared by the accounting department of a company. The budgets may be prepared by accounting as well, or there may be a specialized financial planning and analysis department that is in charge of budget preparation. The budgets are designed to be in the same format as the monthly accounting statements, so comparisons of actual results to budget are easier. These systems are typically automated so once the budget figures are input, the comparison reports are automatically created as soon as the accounting information becomes available.
Variances between budgeted and actual figures reveal important information to company management about how the business is performing. Ideally the budget was carefully prepared so it could be as accurate as possible a prediction of what the company will be able to achieve in the upcoming year. When the budget comparison reports show significant variances, it means either the assumptions used to prepare the budget were in error, or the business environment changed from what had been expected. The budget comparison reports allow the management team to quickly identify where the problems are occurring.
Analysis and Interpretation
In large companies with many departments and multiple divisions, the volume of accounting statements produced can be enormous, which means the volume of budget comparison reports is also large. Accounting or finance personnel take this data and prepare summary reports for senior management to review. These reports, prepared each month, include a narrative discussion of results and analysis of the reasons for the most significant variances. The report has charts and graphs to illustrate the key trends that top management needs to review and discuss. In the case of expenses being higher than budget, the analysts in charge of preparing the budget comparison reports many times have to go back to the accounting journal entries for that period to uncover the specific reasons for the variances. Analyzing revenue variances involves determining whether unit sales were lower than budgeted or the average price earned per unit was less than anticipated.
After reviewing the budget comparison reports, senior management must determine if the variances are significant enough to warrant corrective action being taken. One issue is whether the variances were one-time unusual events or part of a recurring pattern. If sales for one product fall below budget for a number of months, a change in marketing strategy may be made to get sales back on track. Alternatively, the revenue shortfall may be due to factors beyond the company’s ability to control, such as a general economic downturn. The response in that case might be to cut back on budgeted expenditures to narrow the gap between budget and actual results in upcoming months. Top management addresses higher than budgeted expenses by meeting with the managers whose departments were responsible for the variances and asking why they occurred.