In this video, learn about variance analysis in finance.
- [Narrator] Now that we understand how to make forecasts and the roll that price play in our forecasts over time and their profitability, it's useful to go through and understand one of the most common tools in corporate finance, variance analysis. Variance analysis often relies on what we call walk charts or waterfall charts. If you work in a corporate FPNA position, you've probably seen these charts somewhere along the way. These types of charts are used to identify where a business is meeting its financial plan commitments and where it's falling behind.
In fact, walk charts can be used for operating margin, for net income, for revenue, for a variety of different income statement variables that we care about, and they're a great tool for understanding whether our price increases or decreases have lead to overall better performance. There's three major types of variance analysis. The first and probably most common is forecast variance. This really looks at how a business is performing compared to its forecast.
For example, we might look at plan operating margin versus prior period operating margin and examine what we call plan variance. If we had a plan operating margin of 120 million and our prior operating margin was 100 million, well that means we have a variance of 20 million, 120 minus 10. We also have what we call a commitment plan variance. This is our actual operating margin for example, minus our plan operating margin, which is equal to our meeting commitment variance.
If we have, for example, 110 million in actual operating margin, minus planned operating margin of 120 million, well then we have a variance of negative 10 million. We were still up versus the prior period, but we planned to hit 120 million in operating margin and we only got to 110. We were short by 10 million. We also have growth variances. This might be, for instance, our actual operating margin minus our prior periods operating margin and that would be equal to our growth variance.
We had an actual operating margin of 110 million, our prior periods operating margin was 100 million, meaning we had a variance of 10 million overtime, and that's our growth variance. These types of variances and walk charts can help a firm to really drill down and understand the impact of pricing. It's key to remember. Pricing decisions are always a trade-off between price and volume and variances tell us if the choices we made were good ones.
Here's an example of a variance chart. In this case, the firm has a 34 million dollar operating margin plan, but their actual was 41 million, so where did they end up making that leap from operating margin plan to operating margin actual? It wasn't on price, they actually suffered price inflation, meaning pricing fell, but that pricing fall was more than offset by an increase in volume.
The firm also had higher than expected cost inflation, but again, productivity more than made up the balance. Putting all of these things together helps us to see how the firm got from its planned figure to its actual figure and lets us focus our resources better in the coming quarter.
- Reviewing the pricing strategies available to firms
- Analyze pricing relationships
- Identifying different types of price discrimination
- Using pricing and revenue drivers to maximize profits and revenues
- Assessing the impact of competition and the competitive landscape
- Using variance analysis walks to analyze price and do cost analysis
- Gathering data to build pricing models and assess profit impact