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Accounting

There Is Way Too Much Variance In Variance Analysis

By Tom Conine Jr. and Michael B. McDonald IV
 
There is near unanimity among senior-level financial executives that variance analysis is an important accounting tool for business decision-making. Understanding variances can enhance a company’s competitive advantage, demonstrate effective risk management, and increase the probability of meeting commitments, all of which can help create and sustain shareholder value.
 
However, a survey we recently conducted revealed that while the value of variance analysis may not be in question there is significant variation on its actual use. Our survey of financial planning and analysis (FP&A) professionals found deviation in variance analysis practices for everything from what variances are being measured to how they are being measured.
 
Most Use Variance Walks, But In Different Ways
 
Our survey shows that the vast majority of survey participants are familiar with variance walks/bridges and use them to some degree in their professional roles. Naturally, the majority of use is for internal reviews are used in operational assessments of the firm by company executives. Externally, these walks/bridges are often used in investor relationship presentations in a graphical versions.
 
Executives analyzing operational firm performance typically want to understand how the firm is
executing based on key performance indicators, or KPIs. Our survey shows that they use variance walks in at least two of the following: gross margin, operating margin, and net income.
 
Fewer respondents use variance walks in analyzing net income than in gross margin and/or operating margin. This may seem contradictory, since net income is arguably often viewed as the critical KPI (along with cash flow) from a shareholder’s perspective. The reality is, from an operational and business review framework, the focus is on execution risk and drivers of profitable growth with emphasis on gross margins (internal contribution margins) and operating margins.
 
We did find from our open-ended questions that approximately 60 percent of our sample companies routinely do utilize cash flow variances. This is surprising given the growing emphasis on free cash conversion in a lower growth environment. We would say that in IR presentations even when a business presents walks, bridges, waterfalls, and/or floating bars, it is on operating margin. We know of very few that present cash variances during IR presentations.
 
Cash flow typically is harder to forecast than margin because it requires writing on both the balance sheet and income statement. There are simply more places to go wrong and some of those potential errors may be in the uncontrollable arena.

 
What’s Driving the P&L?
 
The generally accepted primary drivers of margins at the operating income level of a P&L are price, volume, mix, cost, productivity and foreign exchange. In this area, the survey revealed a few surprises. Primary among these was the response rate on productivity variances. This may be due to cost variances being in nominal terms (as opposed to taking cost out, which is the correct thing to do). Cost variances are the inflation/deflation associated with input prices (e.g., labor rates).
 
Productivity variances should be reasonably within your control and would represent the summation of all initiatives on improvements in processes and procedures. Some businesses will breakdown productivity into variable and fixed (base) cost to really isolate who is contributing or not. To isolate the impact of lean manufacturing success and/or failure would require a true productivity variance without cost embedded.
 
Another surprise was that many felt these variances are independent. This could not be further from the truth. Because we have a known beginning and end point in variance analysis, any change in basic assumptions will shift the allocation from one bucket to another.
 
A Missed Opportunity
 
Survey respondents were asked “for which of the following applications -- prior year to budget, budget to actual, and prior year to actual -- do you utilize variance analysis?” Surprisingly, only half of respondents reported they use variance analysis in the prior year to budgeting framework.
 
This is a large missed opportunity from a risk management perspective. Why? Because determining the percentage of a variance bucket to the whole V for the year can reveal a risk or potential pain point (for example, a price variance of 70 percent in a competitive market would indicate a risky plan). And that can’t be determined by simply lining up the associated P&Ls. It requires performing a variance analysis. That’s why we recommend always including variance analysis as part of a pre-mortem process.
 
The Takeaway
 
FP&A professionals have a responsibility to help others in their sphere of influence make sound business decisions with the goal of creating shareholder value. Variance analysis is at the heart of business performance and requires an understanding of the entire value chain and cross-functionality at its best.
 
FEI member Tom Conine Jr  is President of TRI Corporation and Professor of Finance at Fairfield University.
 
Michael B. McDonald IV, Ph.D., is an Assistant Professor of Finance at Fairfield University’s Dolan School of Business.