How to do a variance analysis

business.gov.au treats the budget as the plan for the coming year and puts weight on setting actual income and costs beside it. Each difference between the two is a variance. Variance analysis is the habit of working those differences out line by line and asking why each one happened.

Direction matters more than sign. Sales above budget leave more profit than planned, so the variance is favourable. A cost above budget leaves less profit, so the variance is unfavourable. Labelling each variance this way stops a positive number on a cost line being read as good news.

1. Bring the books up to date for the period and reconcile the bank and card accounts.
2. Run the profit and loss statement for the same period as the budget. business.gov.au points to it as the source of your actual figures.
3. Check that the budget and the statement use the same account headings, so each actual line has a budget line to sit beside.
4. Check that both are on the same accounting basis. business.gov.au explains that accrual accounting records income and costs when they take place, while cash accounting records them when money changes hands. Compare like with like, and leave questions of payment timing to your cash flow forecast.

Counting favourable variances as additions to profit and unfavourable ones as deductions, the line variances add up to the variance in the net result, which is a useful check on the arithmetic. On a first look, cost of goods sold and marketing came in under budget. The next steps test whether that is really good news.

Not every gap deserves an hour of your time. Set a rule before you look at the figures, so the choice isn't swayed by which numbers you like:

• any variance above an amount you set for your business
• any variance that is large compared with the size of its line
• any line that has gone the same way for several months, even if each month is small
• any line where the year-to-date actual is drifting away from the year-to-date budget.

Spending over budget is one of the things business.gov.au says to look for in a financial health check, and it suggests a monthly check of spending against the budget as first set.

A sales variance has two possible parts: selling a different quantity than planned, and selling at a different price. Costs that rise and fall with sales, which business.gov.au calls variable costs, should be judged against the quantity actually sold, not the quantity budgeted.

The split changes the story. The lower cost of goods sold was entirely the result of selling fewer units, and each unit actually cost a little more than planned. Fewer units explain most of the sales gap, but lower prices account for a sizeable part of it. The two questions to take further are why fewer units sold and why prices came in below budget.

For each variance you chose, work through the likely causes in order, starting with the ones that mean nothing has really changed:

1. Recording: an amount entered in the wrong account or the wrong month.
2. Timing: a cost budgeted in one month that fell in another, such as an annual renewal.
3. One-off events: a repair, a lost day of trading or an unusual order.
4. Activity: more or fewer sales, hours or jobs than planned.
5. Rate or price: a supplier's price rise, overtime instead of ordinary hours, or discounting.
6. The budget itself: an estimate that was never realistic.

Write a line against each investigated variance: the cause, whether it will repeat and what you will do. business.gov.au's guidance on tracking performance names cutting costs, chasing overdue invoices and revising the budget as possible responses, and its budgeting guide treats the budget as something to adjust when income or costs move off course.

If you do revise the budget, keep the original alongside it. Comparing actual results with both shows how the year went against your first plan and how far the plan itself had to move. Over a few months, the written causes also show which estimates in next year's budget need the most care.