A small-business owner and his finance staff prepare an annual business plan that includes a financial forecast -- a month-by-month prediction of what the company’s revenues and expenses will be. At the end of each month, when actual results become available, these are compared to what was forecast, line item by line item. Comparisons are also done between the current year’s actual results and the same period in the previous year. These comparisons are called variance analysis.

Focus Attention on Significant Variances

Variances are expressed in dollar terms and percentage terms. The owner and his finance staff focus on the largest variances first. A $100,000 negative variance in revenues might seem significant unless it was compared against forecast revenues of $10 million. A negative variance of $10,000 in labor costs might not seem significant until it is compared to a forecast of $100,000. A 10 percent variance warrants further investigation.

Differentiate Short-Term and Long-Term Issues

The management team needs to know whether significant negative variances are long-term trends or the result of a one-time event such as a hurricane that keeps shoppers away from stores for a week. The owner may determine that a persistent variance is evidence that aspects of her business strategy are not working as well as she expected, so she might revise her strategic plan and implement new strategies. Variance analysis does not mean looking at only negative variances. Positive surprises in sales, for example, can change a strategy as well. The owner may allocate more resources to marketing the products or services that are outperforming forecasts.

Detect Changes in the Business Environment

Variance analysis provides clues about what is happening in the economic and competitive environments in which the company operates. The onset of an economic slowdown may show up in negative variances in statistical categories the company monitors. A vacation rental company, for example, may see a drop in the number of email inquiries it receives, which could indicate that consumers are cutting back on travel plans. These cutbacks may not show up in the company’s actual revenue figures for several months.

Uncover Inefficiencies in Planning

Over time, a company owner hopes that he and his financial staff become more proficient at accurately forecasting results. Consistently missing the forecast revenue targets, for example, can result in the company experiencing cash shortages that force the owner to cut back on expenditures. If the owner sees large dollar and percentage variances in key categories such as revenues and gross margin, he should review the process he and his staff use to develop the forecasts. The financial models he uses to generate revenue forecasts may not be based on real-world assumptions. The revenue model may assume unrealistic growth in the number of website visitors. He and his staff will work on making the revenue and expense forecasts more in line with reality.

Hold Managers Accountable

The variance analysis is often written up in report form by the finance staff with explanations of why the major variances occurred. The business owner may discuss the results with each of her managers individually, or she may gather them together for a monthly meeting and go over the results of all departments. These discussions allow the owner to get more detailed explanations about why variances occurred and discuss what each department manager intends to do to address more serious variances by revising strategies or making changes to operations.