Truly understanding what the financial statements of your company are telling you in real time can sometimes be more of an art than a science. Without the right tools, it may be difficult to understand what the impact of a particular time period or event will have on your company’s long term goals and strategy. It’s important to know how to identify and understand meaningful variances from your financial results, as compared to a plan or versus a comparable time period in order to help you adjust future strategy in response. A proper variance analysis will go a long way keeping you on target with your organization’s goals.
How to Perform a Variance Analysis:
Step 1: Gather All Data into a Centralized Database
Ideally, this data will be trended (shown over consecutive time periods), and displayed at some level of detail (potentially also subtotaled by relevant groupings for a higher level review at a later point.)
Gather a similar set of data points that you would like to compare your results to. (Typically this would be a budget or comparable prior year/month, etc.) Ensure that the data you are using in comparison to your financial results is “apples to apples”. This means that the two set of data points are both representative of the same business and similar time period.
Step 2: Create a Variance Report
Create a variance report by comparing the two different data points against each other, at the lowest level possible to proactively assist with variance research. (Examples of low level comparisons include comparing results at an entity or cost center level, usually by general ledger account. However, many plans are built at a higher level, and therefore if you are using a plan as your comparison point, you may have to create a variance report at a higher level, and research any material variances afterwards.)
Typically this would be as simple as subtracting one data point from the other. In general, favorable results are represented as a positive number and unfavorable results are represented as a negative number (i.e. actual minus plan or current period minus prior period for revenue, sales, assets, gains, etc. and plan minus actual or prior period minus current period for expenses, liabilities, losses, etc.).
Step 3: Evaluate your variances.
A good idea is to set a materiality threshold for variance review, such as 5% of plan by general ledger account. Many companies may focus on larger variances first, while other companies may have certain general ledger accounts that they would like to monitor more carefully than others. (Examples of this would be a company that has historically had issues with high employee overtime and needs to monitor this type of spend, or a company that has a low profit margin and needs to carefully monitor G&A overhead.)
This is the step of the process where the “art” comes into play. Researching variances can become much more intuitive once you have gotten to know how your company’s financials behave. However, even with an unfamiliar set of financials, a good financial analyst will try to isolate the variances in question to the lowest possible level, such as transaction date, cost center, vendor, location, etc., in order to identify the root cause of the variance. Once you have accomplished this, a good next step would be to determine if this variance was caused by a one-time event, or if it seems to be trending. This is why it would be helpful to begin the variance analysis with trended data, but if that is not possible, then this is the point where you will need to obtain trended data for at least the particular general ledger account in question. Some points to look for are; has this variance been slowly trending towards the variance that exists today? Does it seem to spike with seasonality? Was the entire variance driven by one particular event?
Step 4: Compile an explanation of the variances and recommendations for senior management.
In my opinion, this is where the value of the financial analyst comes into play. This is where you will need to show senior management that you fully understand the issue and have recommendations to either capitalize on a favorable variance or correct an unfavorable one.
For example, perhaps revenue has spiked at a particular location, and based on your variance research, you understand that this is an event that typically occurs in late fall, but has been particularly significant in recent years. You may provide a recommendation of hiring temporary employees at that location for that time period, or perhaps shifting employees from slower locations to busier ones.
Also, the responsibility of creating budgets and forecasts (updates to an original budget usually done multiple times throughout the year) for a company may typically fall under the role of the financial analyst. During the creation/updating of the budget/forecast, the financial analyst will want to pay close attention to variances that have occurred throughout the year. You may need to adjust an updated plan to take these variances into account.
Step 5: Plan for the future.
Lastly, during the plan update, be sure to keep in mind that there is more to accounting for variances than capturing the immediate impact. You will most likely need to make assumptions about how these new financial trends will act in the future, that way, you’ll be well-prepared for the next variance analysis exercise. Will they continue to trend as they have been? If the variance was due to a one-time event, is there any reason to think it may occur again in the future? Do these variances affect other general ledger accounts? Would senior management want to make strategic changes based on these variances, and if so, how will this affect the next plan?
Variance analysis is much more than simply identifying outliers. It involves analytical research, proactive planning, strategic decision making, and the foresight to understand how your company’s financials behave, in addition to what is most important to senior management. However, if you follow the steps provided, you will be well on your way to developing your own method of comprehensive variance analysis. Hopefully you now feel prepared to tackle the important task of financial variance analysis on your company’s financials. Can you think of any important tasks that should be added?