Decisions for Quarter One and Quarterly Business Review

profileclw0dq8
TranscriptofVarianceVideo.pdf

EXPRESS_17600 | Variance

As you prepare for your first Quarterly Business Review, this is the proper time to learn one of the most relevant

tools in business for analyzing performance. This is variance analysis, a tool at the heart of companies, both

private and public, across all industries and geographies. As the business leader of HISCO, you will be looking at

variances from the perspective of planning, meeting commitments, and growth. Careers have been made and lost

over the ability to meet commitments, and variance analysis is the primary tool in the business world for analyzing

the ability to meet commitments.

Variance analysis is a tool all business leaders have to have working knowledge of. Sit back and enjoy the

presentation. A copy is available in the supplementary reading materials, as is TRI Equation # 2, which is devoted

to variance analysis.

A great place to start is to share a real world example. And our question is, have you ever seen an OM variance

walk? This is a tool any business leader, regardless of function, needs to have a working knowledge of. The

example here is from Ingersoll-Rand. You will be using very similar models in your management leadership of the

HISCO Corporation. Our goal is to take you from the academic world of standard break-even analysis to the

corporate world of variance analysis tools that are useful for planning variances, meeting commitment variances,

and growth variances.

A very relevant question is what exactly is an accounting variance. There are three types of accounting variances

that you will be exposed to as the leader of HISCO. The first are plan variance. OM is operating margin, and in

this particular case, the plan OM was $120. The prior period OM was $100. So in your plan, you are expecting a

positive $20 variance.

The second type is meeting commitment variances, or how well you do relative to the plan. In this case, the actual

OM was $110. The plan OM was $120. We had seen that before. And the meeting commitment variances is thus

minus $10, $10 behind plan.

The third type are the growth variances. In this case, the actual OM was $110 from above. The prior period OM

was $100, and we did grow the business by the positive $10. Please note that the sum of the plan variance of $20

and the meeting commitment variance of ($10) does equal the growth variance of $10. As the leader of HISCO,

again, you will be looking at all three of these variances.

This is an example of how to construct a variance walk. There is a significant amount of calculation necessary,

along with a variety of assumptions to complete a variance walk, whether it is for planning, meeting commitment,

or growth purposes. This sample example is to demonstrate the process. The actual calculation takes place within

the FP&A area of finance. FP&A is financial planning and analysis. The key for any business leader is the

interpretation of the variances. This example is what would be called growth variances as we go from year-to-year

actuals.

We are not going to go into all the detail, but we'll leave that for your review in the supplementary review

materials. You can also see TRI Equation # 2 in the supplementary review materials that has this exact example

for your perusal. The basic variances are price, volume, cost, and productivity. And in this example, based upon

the assumptions on the left hand side of the screen, this is what incremental value of each would contribute to the

overall growth from year to year. And in this example, you can see it was a tough pricing environment. We did

grow our volume. Costs increased, and productivity was the real winner.

Nothing beats seeing real world examples. We'll now be taking a look at a variety of companies across global

industries and geographies. While their variances may subtly differ, all of the variances tend to cluster under the

four aforementioned headings of price, volume, cost, and productivity. Our first is Cooper Standard, a supplier to

the light vehicle marketplace. Our second is Delphi, another supplier to the automotive marketplace. Our third is

Ingersoll-Rand, the company we had seen early on. Ingersoll-Rand goes from golf carts to Thermo King to Trane

to American Standard.

BHP Billiton, an Australian commodity business. What's very neat about their variance analysis is how they

decompose the variances in a risk management framework into uncontrollable and controllable. Please note that

price is an uncontrollable variance from their perspective. Pentair. Pentair runs from water filters and pump

systems, and is a wide user of variance analysis. And if you look specifically at their variances, revenue growth

there would be volume. There's price, inflation, what we call cost. And then there is, finally, productivity. And there

is a final bucket called strategic investment.

Toyota is neat because of how they bring in the impact of foreign exchange. Toyota, of course, is a very global

company impacted by exchange rates as everything, whether its euros and dollars, getting converted back into

yen. And foreign exchange can have the same degree of leverage as price. And finally there is GE. In this

particular example from their 10-K, you can see the increase in their operating profit from year to year. And the

drivers of all of their variances, and how they break it down into the aforementioned buckets. All terrific examples,

and for you folks to see that this is a tool applicable to all types of businesses across all geographies and industrial

sectors of the global economy.

Every quarter, you will see from a meeting commitments perspective where you are relative to plan. In this

example, we will delve into the specific drivers you will be dealing with and the primary decisions you make each

quarter of those drivers. It all starts with your pretax income plan, or your commitment. The total volume variance,

the incremental volume relative to plan, can be split between growth and market share. Volume impacts both

sales and cost. The growth variance assumes that market share is the same as in plan. The market share

variances is the component of the overall volume variance when actual market share deviates from plan.

In this example, the volume variance when growth and share are combined was very close to the plan because

the sum is close to zero. The price variance is actual price relative to plan. In this example, actual price was higher

on average than the price in plan across all volume. Note, however, that this could negatively have impacted

market share. Cost inflation is driven by labor rates and / or the price of raw material chips cost relative to plan. In

this example, the negotiated price of the raw material was, on average, less than planned, a positive variance.

Cost productivity can be driven by plan time, yield on inspection lines, and labor effectiveness relative to plan. In

this example, productivity was negative relative to plan and should have been controllable. The base cost is the

sum of all discretionary costs relative to plan. In this example, additional monies may have been invested in

quality, marketing, and / or R&D relative to plan to provide for future growth and maintenance of competitiveness.

The interest variance is actual interest relative to plan. In this example, the business did not borrow on average as

much as the credit line was in plan, resulting in a positive variance. When everything is added up, we currently are

at an actual pretax income of $204,000, and that is less than the plan commitment of $545,400.

Cash flow walks, while less frequent in practice than operating margin variance analysis, are often used, and you

will experience them as the leader of HISCO. Cash flow can be reviewed in the TRI Critical Equation # 9 in the

supplementary reading material. As before, nothing beats seeing real world examples. We will not delve into the

specific cash flow variances, but all follow the basic logic of operating, investment, and financial cash flows as set

out in the TRI Critical Equation on cash flow.

Our first example is from the aforementioned Pentair. In fact, this picks up where the operating margin actually

had left off. Our second example is from Adecco, an HR business very global in nature. The third example is from

SunEdison, a fairly detailed cash flow walk. But what is very neat is how they divide it into the operating, and

investment, and financing activities. Finally, you will be seeing the cash flow walks every quarter within your model

as the leader of HISCO. You will see the beginning cash and / or debt situation as it walks to the ending cash or

debt situation. If you have positive cash, it will be above zero. If you are utilizing your credit line, it will be below

zero.

So in this particular example, the beginning cash was about $48,400. And through all the activities for the quarter,

the ending cash ended up at negative $48,900. And that was the ending balance on the credit line.

One of the great questions on the drivers of profitability is the following. Would you rather have a 1% increase in

price on your product service, or a 1% increase in volume? Assuming your primary concern was next quarter's net

income, that is, short term. Number two, that price and volume are independent at the low levels of 1%. And that

3, you have the capacity for the 1% increase in volume. As the graphic shows with numerical assumptions below,

nothing beats price.

In this example, and with the cost structure in the assumptions, a 1% increase in price would result in a 10%

increase in operating margin in dollars. Volume has great leverage because 3% exceeds 1%. But with volume

comes cost-- specifically, incremental variable cost. And when you lose price, there can be nothing worse. The

mathematics is perfectly negative symmetric. In this example, the 1% drop in price reduces OM in dollars by 10%.

This is not to suggest it is easy raising price, but to demonstrate the potential power of price. It can be your most

powerful lever of profitability, at least in the short term.

In your business simulation, HISCO, you will be seeing your OM levers on a quarterly basis. Always recognize

they are in the absence of competitive reaction. Imagine that you were in an operational review, and you were on

the firing line to explain your results. Here you see the plan data. Your plan was for sales of $100 with a net

income of $20. The actual, or year rolled around. You could see you are off $10 on your sales. Your net income is

off $10 as a variance. And when expressed in percent, the minus 10% reduction in sales results in a 50%

reduction in net income. And if you had to explain why you lost, the example is price. And when you lose on price,

small changes in sales can result in a very significant reduction in the net income of the business, as this example

shows.

This is a real world example of the linkage from P&L leverage to an OP variance walk. The example is from

Petrobras, the Brazilian oil and gas corporation. The 5.4% drop in net revenue results in a minus 26.2% change in

operational profit, extreme negative leverage that comes from price decreases, as seen in our prior example.

Note, when we add the variance walk, the vast majority of the drop in profit is indeed from price, referred to as

price effect on net revenue in the walk. This is not unusual in commodity type environments.

In the aforementioned question, on 1% in price versus 1% in volume, there was, as stated, an underlying

assumption of independence between price and volume. Of course, this can be questioned. And concepts like

price elasticity of demand certainly can hold true in the real world. We have also stressed the importance of

meeting commitments, and as the leader of HISCO, you do have a net income target which you are working hard

to meet or exceed. The mathematics behind this graphic we consider to be one of the most important equations in

business. It is found in TRI Equation 1 on pricing in the supplementary reading material.

The essence is to determine the increase in volume needed to offset a price reduction to meet your original

commitment. We have observed over the years the absolute shock many senior executives have when seeing this

graphic. Naturally, the implication is initiatives to protect price. Though many with a low cost advantage might use

price deflation potentially to their advantage. Holding price certainly is not an easy task in competitive market

places. The left hand axis reflects price reduction, or deflation. The x-axis reflects the volume needed to offset the

price reduction to meet your original commitment. The right hand y-axis reflects your original contribution margin

or close to gross margin in the process.

So for example, with the cost structure of a 50% CM, or gross margin, a 20% reduction in price requires a little

under 70% increase in volume to meet your original target. This is where the shock comes in. With a 40% gross

margin, or CM, as an approximation, a 20% price reduction would require a 100% increase in volume to offset the

price reduction. There is an underlying assumption of zero variable cost in the mathematics of this graphic.

In the simulation, we already talked about the OM levers-- that's the four bars at the very top. At the bottom of the

OM levers each quarter, you will see the results of this graphic in the following form. And the way you read this is

that is the volume percentage increase that is necessary to offset a 1% reduction in price based on your current

cost structure. Or alternatively, the variable cost reduction that is necessary to offset a 1% price reduction.

Every quarter, you will find significant application of all of the aforementioned variance analysis. In this particular

example, it is assumed that you have completed Q1 and Q2. You do see the actual results, and you're about to

play Q3. In the upper left hand corner is your market forecast, which is revised every quarter and does drive

nearly all of your decisions.

In the middle block is information on where you are on plan for the year versus the actual and the short range

outlook. The way you would read this-- for example, if you were to look at the net income. Your plan net income

for the year was approximately $331,000. If you achieved your short range outlook, which is Q3 and Q4, head on,

and the actual already known from Q1 to Q2, your net income for the year would be $122,000, approximately.

Certainly less than planned. You will see this information for sales and cash flow as well.

In the upper right hand graphic variance walk, you will see the pretax income year plan versus actual and SRO.

The middle block of information had been on an after tax net income basis. On the lower left hand graphic, this is

the variance walk for Q3 relative to where you would be on net income for the quarter relative to the prior quarter.

The all important cash flow, where you would be on ending cash and / or debt relative the beginning cash or debt

based on your assumptions for Q3, the current assumptions. Finally, the expected OM levers that we had

discussed. And naturally, if you change your assumptions and model that short range outlook, all of these

graphics will be continually updating to provide you with new information to help in your decision making.

We have now reviewed the tool entitled variance analysis that is widely used in practice. Your next challenge is to

prepare your QBR for your quarter 1 results. You may want to review TRI Equations 1, 2, and 9 on pricing,

variance analysis and cash flow, respectively, and / or the copy of this video in the supplementary review

materials. Excellent supporting materials for the QBR can be found in the emails, Business Intelligence Dashboard

with comparative competitive data, and the variance graphics.

Finally, when you proceed to playing quarter 2, you will find the planning variances very useful at the top of the

Decisions page. To reiterate, the entire variance analysis pitch can be found in the supplementary review

materials along with TRI Equations 1, 2, and 9.