Even the best budgets rarely turn out exactly the way that planners expect. Whenever you're planning in advance for a period of time, you'll inevitably make some mistakes in your estimates, and it's important to look closely at the financial variances that result in order to learn from those mistakes and prevent them from happening again in the future. Below, we'll go through the simple process of calculating financial variance and the more difficult question of how to work with the results.
A simple definition of financial variance
Understanding financial variance isn't as hard as the term might sound. The variance is equal to the difference between the budgeted amount you had planned for and the actual amount spent. Positive variance means that you spent less than you budgeted, while a negative variance shows overspending.
Financial analysts often look at variance in two different ways. Sometimes, the raw dollar amount of the financial variance is the important number. For instance, if your primary goal is to figure out how much cash you need to come up with from elsewhere in order to meet a shortfall in one key area, then the dollar amount is the figure you need. The other way to look at financial variance is as a percentage of the budget for that item. To get the percentage, divide the raw dollar-amount difference by the amount budgeted and then subtract 1 from the result.
What to do with variance
Once you've figured out the financial variance, the harder question is what to do with it. In cases involving projected losses, you'll often need to figure out how to handle the added spending beyond the initial budget. That can require spending cuts elsewhere or a boost in overall revenue sources. If it's late in the budget cycle when the variance occurs, it can be difficult to find enough savings to overcome a large negative financial variance. That's why it's important to monitor budgeted vs. actual spending frequently.
Financial variance also plays a role in improving the budget process in the future. Actual data can inform budgeting decisions much better than pure estimates, and although many items will differ greatly from year to year, you can still typically get a better read on spending by looking at recent history.
Related investing topics
Budget planners strive to keep financial variance to a minimum. However, you shouldn't panic just because you have a financial variance that could result in a loss. You can usually take steps to remedy the situation and stop it from occurring in the future.
