As many financial executives have sadly discovered, careers can be damaged or even lost when financial commitments are not met. Fortunately, at many companies a big change in the analysis of financial performance is offering their CFOs a brighter ray of hope for keeping their promises.
Performance is typically assessed in two ways: against plan and against a prior period. In both cases, the accounting tool known as “variance analysis” has historically tended to be used reactively, or after the fact.
In recent years, however, the global financial crisis and the rise of enterprise risk management have increasingly moved CFOs to require that their teams bring disciplined, critical thinking and a holistic approach to the financial-planning-and-analysis (FP&A) process. For many, part and parcel of that new mind set is balancing reactive with proactive analysis in order to shape a continuous process that augments “bean counting” with “bean growing.” That solidifies finance’s seat at the table, because it makes the company more competitive, demonstrates effective risk management, and increases the probability of meeting commitments and growing, upon which shareholder value is ultimately based.
The reactive nature of variance analysis is often shown in what’s known as a walk chart, bridge chart, or floating bar chart (see example, left). Such a format is typically used to visually portray the decomposition of a financial measure, most often operating margin (OM), into its fundamental drivers. The variances here are price, volume, cost (inflation or deflation associated with input prices), and productivity. Of course, different business models and industries can have their own buckets to reflect divergent realities. Other common variances include mix (for example, the business mix of manufacturing products versus servicing them) and foreign exchange.
It is not unusual for volume to be subdivided into share and growth, and productivity into variable and fixed (depending upon the internal financial system). Productivity, if measured correctly, is inflation-adjusted and represents the sum of all process improvements, such as Lean activities, Six Sigma applications, labor and equipment efficiency, IT improvement, removal of waste, and redundancy.
Integrating Reactive and Proactive Variances
There are three major types of variance, but the above graphic relates to only one of them: meeting financial commitments. In fact, that type of variance is entwined with two other types, related to planning and growth. The planning aspect of variance analysis is very important from a risk-management perspective and will force close alignment of decisions with strategy. When variance analysis is applied during the planning process, it is possible to increase the probability of successfully meeting commitments, and, therefore, moving the business needle in a positive direction — in other words, toward growth.
The chart below shows the linkage among planning, meeting commitments, and growth variances. The value of planning variances is seeing where risks may lie in a plan. The “meeting commitments” column is all about execution risk and the ability to deliver on a plan. That column shows numerically what was represented graphically above. Note that the sum of the planning and meeting commitments columns equals the growth column, showing how all are interrelated. For example, net volume was expected to contribute $2.20 to OM. The business actually came in $4.56 ahead of plan for a sum of $6.76, the year-to-year net volume variance. This framework can be a format for presentation during an operational review.
Applying variance analysis to planning is where the proactive portion of the process begins. Ask yourself the following question: If you only had P&Ls for 2011 Actual and 2012 Plan, could you see through the math and know that price is driving 25% ($1/$4) of your plan for the year? Imagine the case of a business in a competitive industry whereby the variance analysis applied to the planning process showed price at 75% as a percentage of variance for the year. If you managed that business, would you be concerned? Of course.
Variance analysis applied proactively during the planning process can yield significant insights into risk incubation (or buildup of risk that you did not even see with basic P&Ls). The volume is expected to contribute 55% ($2.20/$4) of OM growth for the year. The analysis should ask: Is this realistic given the industry, macro GDP growth, new products and services, capabilities of the sales organization, customers, competition, and the current sales pipeline? Perhaps the volume variance is attributable to a sales backlog or sales projections that are not realistic.
The vast majority of companies we deal with in executive education have very good applications of meeting commitments and growth variances. But while some conduct the analysis as depicted above, others do not. The latter may be missing opportunities for early risk identification and improved probability of meeting commitments. Failure to think of planning variances could result in a significant opportunity cost.
The graphic below is an example from one of our competitive business simulations that visually summarizes the linkage among the three types of variance. The numerical values tie directly to the numbers in the Holistic Variance Analysis chart above.
Among eight equations that TRI Corp. believes every business leader should know at a working level, the one that relates to variance analysis is the most vital to a company’s ability to plan, grow, and understand how to get where it wants to go. For more on variance analysis and the additional seven equations, click here.
The bottom line is this: make sure your finance team is not only reactive but also proactive in variance analysis. Underscore the need to integrate a cross-functional team and risk management into the planning process and watch what happens. Finance will get a seat at the table.
Tom Conine, Ph.D., is president of TRI Corp., which specializes in corporate education, experiential leadership, and simulation programs to help clients develop leaders, sharpen financial acuity, improve executive business acumen, and enhance shareholder value. He is also a professor of finance at Fairfield University in Connecticut.