How Variance Analysis Can Help Your Business
Being a CPA, I may be a little partial towards the importance of financial reporting for all businesses, including small and medium sized firms. I feel monthly financial reporting, such as a P&L, balance sheet, or statement of cash flows, are important for business leaders to create to maintain control and proactive management. Many business leaders do have reports created, however, often these are snapshots that do not provide a lot of context. They may see profits are up or down over last month or last year, but it may not be easy to understand the drivers of these trends. That is why I am a big proponent of the use of variance analysis as a regular part of financial reporting. To summarize, variance analysis is a method that highlights the key drivers in trends.
What is Variance Analysis?
Let's say you are looking over your P&L from last month and you notice that sales were up 10% over prior year net earnings were down -5%. The report tells you what happened, but it gives you know insight into why. Now let's say that you were also handed a report that itemizes the drivers of each P&L element. This report shows that sales were up due to price increases and new product offerings compared to last year, however, earnings decreased due to an increase in fixed costs related to additional investments and staff needed to support the new products. Now you know what happened AND why, and now you can quickly focus on the drivers of the variance. This variance analysis provides a standardized way to view the trends of your financials in proper context to facilitate discussion of next steps.
How Can You Add Variance Analysis To Your Business Reporting?
Your financial analyst, accountant or CPA will sit down with business leaders to compile the drivers for the different elements on your financial report. For example, this person would meet with the appropriate person in the sales department to quantify a simple model to present the variances for each P&L element. In this case, the appropriate model may be average price x average quantity x number of products, and it can be made as granular as needed (i.e. product level, category level, etc.). After creating a model for each element, an equation is applied to each variable to quantify the dollar or percentage impact on the P&L element based on the change of each variable. For example, the equations created for the sales variables indicate the sales impact from the increase in average prices is 6% and the sales impact from new products is 4%. Once the overall variance analysis model is created, it is summarized in the desired format for the business leaders. I like to keep it simple, for example a Microsoft Excel worksheet that highlights the main drivers and allows for comments compiled from the business leaders to add color. I especially love visualizations like quad charts that can quickly group drivers into four categories from great to needs attention.
I feel strongly that a Variance Analysis Report is an effective, proactive tool for business leaders to monitor performance and manage their businesses. A quick snapshot of the drivers can be a great way to steer discussions towards the most important factors of performance for the business.