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Unfavorable Favorable Variances
Hi, it’s CJ Gustafson and welcome to Looking for Leverage.
Today’s term: the unfavorable favorable variance. This is when someone comes in under budget, is pumped they are in the black, but you’re frustrated because they were supposed to spend that money to drive some forecasted result. Oh, and it’s really awkward to have to walk them through it because they think they did a good thing. Never a conversation I enjoy.
Setting the scene
A few years back an engineering leader came into planning with an aggressive roadmap and an aggressive headcount to go with it. We funded it, and built a corresponding sales ramp for the second half of the year to help sell this new product, as we were going from a one product company to a platform. Flash forward six months and he’d hired less than 10% of the people he’d asked for. To say he was behind would be an understatement. He’d barely left the start line.
When the second quarter closed and we were reviewing his budget to actuals, he talked about his cost discipline like he was saving for a family vacation. It was completely tone deaf to what the rest of the company was trying to collectively accomplish… he wanted both a cookie and a small trophy.
As you might expect, the release slipped, sales spent a quarter selling the old thing, revenue came in under plan and profit came in over (since we spent less than anticipated). At that point in that company’s life, revenue growth was worth multiples more than margin. Oddly enough… I didn’t want my profits to be higher! The P&L was upside down from what we wanted.
The dumb version
Favorable variances, at first glance, are thought of as a good thing. We’ve got money left over for a rainy day!
But as any financially literate budget owner will tell you, there are nuances to “underspend”, and they often have knock-on consequences that impact other groups.
While we typically think of overspending as the cardinal sin, when you have a small window of opportunity to capture your market, not spending appropriately into it can set you back years.
Making it real
The P&L is connected across every department like a living organism. The worst version of this is marketing coming in under budget, because marketing underspending in Q1 means sales is underfunded at the top of the funnel in Q2, and if your sales cycle runs four or five months, that shortfall doesn’t appear in bookings until Q3 or Q4.
I’ve been at multiple companies before where this happens, and unfortunately it’s the sales leader six months later attempting to explain the shortfall, as few remember that marketing spent 84% of its program budget two quarters ago. Tough place to be.
Money is finite. The dollars sitting unspent in one cost center are dollars that could ben moved to someone with a plan for them. In my case, I could have moved them to sales to hire more BDRs and pound the phone to generate their own pipeline starting in March. Instead, in October, we were flat footed.
I’d be remiss if I didn’t point out that there’s also a version of this that follows you to exit. Sell-side quality of earnings work will normalize for underinvestment, so a buyer’s diligence team looks at two years of underspent marketing and adds the cost back into the run rate. You don’t get to keep the savings in the multiple.
The math (with numbers)
Say marketing is budgeted at $6.0M for the year and comes in at $5.04M. That’s 84% utilization and a $960K favorable variance, and might get presented to your board as cost discipline. On the surface, it’s not wrong. They are creatures of EBITDA.
Now walk where the $960K was supposed to go. Call it $700K of demand gen at a blended $12K per qualified opportunity, which is about 58 opportunities that never entered the funnel. At a 25% win rate and a $90K average contract value, that’s roughly 14 deals and $1.3M of ARR.
Net net, you saved $960K in one time cost, against $1.3M of recurring revenue you don’t get this year and don’t get next year or the year after either (you have an average customer lifetime of 3 years). And because the sales cycle is five months, none of that is visible in the quarter where the underspend happened. In fact, the quarter where the underspend happened looks great.
When it clicked
The thing that changed for me after the engineering hiring set back was that I stopped automatically reading the favorable column as good news and started making the owner answer a second question: is this underspend due to timing, price, or a decision not to do the thing?
Price is the only one of the three that's actually good news.
The other two need more investigation and context. And they might call for reshuffling the spend.
I also started verbalizing these expectations during planning meetings, not after the fact.If you ask for it, I expect you to deploy it. Handing it back in Q4 does less damage than blowing through the number, but it's a worse “look”, because it means you asked for something you couldn’t use and get ROI on.
What to do Monday
Three things.
Change the question in your variance review: Any favorable line over 10% or [$50K], whichever is smaller, gets the owner on record: timing, price, or decision.
Say it at planning, not at close: Tell every budget owner that the budget is a commitment in both directions. People who haven’t held a budget before need to be told this.
Reallocate in public: When someone gives money back, move it to a department that has a use for it and tell both of them you did it. That’s the only way anyone learns that the pool is finite.
Wishing you a variance column that’s boring in both directions,
CJ
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