FINANCIAL REPORTING
Budget Variance Analysis
A financial report comes to life when comparative information is included. In the previous article we looked at types of income statements and their various uses for board reporting. We saw that the board could learn a lot about our fictional organization, Farm Haven Animal Rescue (FH), and its midyear financial picture by comparing the consolidated year-to-date (YTD) budget with the YTD actual results. Now we will look at variance analysis as a management tool.
Example 3 in The Income Statement provided explanations for variances of $10,000 and greater. As a consolidated report for FH’s board’s use, this threshold is adequate. Board members are looking for high-level trends that could significantly impact the bottom line by the end of the year. It is up to management to be intimately familiar with the data that underlies the consolidated numbers.
To drill down to those underlying numbers, the individual program budget-to-actual report used by management employs more stringent criteria for explanations. It also examines every account that makes up the groupings you see on the board report. For example, “salary and fringe” is comprised of sub-accounts such as “salaries,” “overtime,” “health insurance,” and other fringe benefits. “Animal care supplies” might be made up of “food,” “hygiene supplies,” “medical supplies” and so on.
Example 4, below, shows the six-month report for the animal care program, one of two programs operated by FH. Restricted contributions are amounts that the donors specified were to go to the animal care program. Unrestricted contributions are zero because they are not recorded in the animal care program’s individual income statement.
Now we are explaining budget variances of $5,000 and over, and/or 10% and over. For simplicity, we have kept the high-level groupings. How did we arrive at the dollar threshold of $5,000 with a second criteria of 10% for explanation? There is no hard and fast rule. Our goal here is to wring as much information out of this report as possible. You can see in the example above that the total 20×1 budgeted deficit for FH is only $34,000. A negative midyear variance of $5,000 would increase the deficit by 14% and it might increase to $10,000 by year-end. A 10% variance is often worth investigating even if it is a small dollar amount because it may signal that something has gone wrong operationally. Suppose the CFO sees that office supplies are $2,500 over budget, a 20% increase. While the $2,500 will not break the bank, the CFO might ask why the actual is so far off from the budget. Was something classified incorrectly? Were the budget assumptions wrong? Are unauthorized purchases being made? There is a good chance that this line of questioning will turn up an important insight into the program’s operations.
Now let’s look at example 4, the animal care program’s midyear report. As the CFO, the executive director, and the program manager read this report they will be asking if operations are running according to plan, will timing differences work themselves out, and have unexpected issues arisen that require action. Ultimately, the question is: What do we have to do to make the budget by year-end?
FH’s challenge in assessing budget variances is understanding how the numbers behave. Some variances can be reliably projected to year-end, some will work themselves out by year-end, and others are a warning signal that the budget is no longer predicting where FH will end the year.
These variances have different characteristics:
- Restricted contributions $28,000 unfavorable: A look at past years will determine if the variance is of concern. Action is probably not required.
- Grants $12,500 unfavorable: This is due to a permanent reduction in the awarded amount. We know that this variance will be exactly $25,000 by year-end.
- Salary and Fringe $9,175 favorable: Staff resignations and terminations, while a problem for smooth operations, result in favorable budget variances. We can only guess how the actual will compare to budget for the rest of the year.
- Repairs and maintenance $1,675 and 33.5% favorable: Spending has been under budget so far but a project is planned for the third quarter. The variance should disappear by year-end.
- Animal care supplies $20,000 and 40% unfavorable: Factors out of FH’s control including inflation and supply chain issues have caused these expenses to jump. This trend will continue if left unchecked.
As of June 30, the animal care program has a YTD deficit of $121,591 compared to a YTD budgeted deficit of $73,164—an unfavorable variance of $48,428. Let’s add up the known year-end variances. Small variances such as telecommunications, office supplies/postage, and veterinary services, and temporary variances such as repairs and maintenance and restricted contributions are not included in this calculation.
Increase in anticipated deficit $35,825
Looking closely at the nature of the variances, we can see that as of 6/30 the program has a net unfavorable variance of $35,825 that will have to be made up. Of course, the year-end deficit will be determined by future events occurring in July through December. Additionally, FH will have to turn around trends that are going in the wrong direction, and head off new threats and/or take advantage of new opportunities.
WHERE DOES FH GO FROM HERE?
This variance report suggests some strategies for the program manager to consider:
- The reduction in grant revenue is a known quantity. The $25,000 might be made up with additional fundraising. Longer term solutions may also be pursued.
- Salary savings are tricky to predict because spending depends on staff turnover. If the vacant positions are not filled, and no other changes occur, the additional salary savings will be calculated at the monthly cost of the vacancies times six. Delays in filling vacant positions, though not an ideal strategy, can help to manage the bottom line, perhaps avoiding permanent staff reductions.
- The increase in animal care supply expense is a troubling trend. The program manager may look at changing vendors, renegotiating contracts, or even reducing spending by taking on fewer animals.
At this point, executive management will have input into the decision-making process, taking into account the performance of the rest of the organization as of June 30. If other programs are reporting net favorable budget variances, perhaps Animal Care can avoid the more drastic options.
TO CONCLUDE
We have seen that variance analysis is a powerful tool for monitoring operations and managing change. Time will be your friend if you spot trends early and act quickly to stem the tide. If you reduce your vehicle fleet, consolidate office space, or declare a hiring freeze in the second quarter instead of the fourth, you will see the results in your year-end financial statements. Of course, it is not always possible to head off unbudgeted deficits by the end of the year. We cannot control the timing of events that require action. One could argue that measuring performance over a twelve-month cycle is itself a bit arbitrary, but that process is the foundation of GAAP; it is what we do.
Over time you will see good years and bad years. The CFO’s job is to provide the tools and analysis to achieve the best possible results.