The Variance Profit Cycle—the process of analyzing and remediating budget variances—is one of the most important ways to identify business opportunities and risks, and to create predictable, profitable growth. Yet in all too many companies it is severely undermanaged. This is one of the most vexing, chronic issues that senior executives, especially CFOs, face.
Every month, managers throughout many companies are asking, “Why did we miss our budget?” and “What are we going to do about it?” This reflects the reality that all too many companies, even those with sophisticated business information systems, have enormous amounts of data, but not enough focused budget-variance information. Importantly, this creates severe problems throughout a company’s sales and operating departments because their monthly departmental operating reviews are based on this deficient budget variance information.
I remember attending a meeting at a major public company at which the top managers and several board members reviewed the company’s budget variance report. Some elements were on target, a few surpassed their goals, but the sales area was seriously underperforming its objectives, causing profits to miss their budgeted expectations. When we asked the SVP of sales what the problem was, he replied that he had spoken to his regional managers. They assured him that some new strategic initiatives were taking longer than expected to produce results, but that they would be producing better results shortly. We found this assessment vague, troubling and certain to raise red flags in the company’s upcoming earnings call—yet there didn’t seem to be anything we could do about it.
When I dug into the situation after the meeting, I discovered that the real problem was a set of specific issues that were causing sales to underperform, and that these were largely unrelated to the strategic initiatives that the regional managers had cited. In fact, it turned out that, once identified, some of these difficulties were unpredictable, but several important ones were both predictable and fixable. The underlying problem was that the company had budgeted sales by product family and region, and these categories were too broad to allow the regional sales managers to identify the specific problems that were causing the sales and profit variance from budget, and to fix the most important ones that were, indeed, fixable.
Manage Your Variance Profit Cycle
A typical, traditional Variance Profit Cycle has three components: (1) a budget, which specifies and predicts how your company’s core elements (e.g. sales, products/services, operations) and the company as a whole will perform; (2) a monthly variance report, which matches the actual periodic performance of the overall company and each of the company’s core elements with the budget; and (3) a set of operating reviews in which the company’s managers throughout the company review their budget variances and, where possible, identify actions that will accelerate their gains and remediate their deficiencies.
Three core problems characterize this cycle in all too many companies: (1) the revenue budget categories (e.g., product families and regions) are too broad, (2) departmental costs are often not tightly linked to budgeted revenues, and (3) many of the most important problems stem from interdepartmental inconsistencies and coordination issues (many of which are unmeasured).
Consider the case of a major distributor. The company budgets sales by brand and branch, while it budgets operations costs by branch and market type. Some market segments are stable and predictable, while other major segments are very difficult to predict. The problem is that if sales lag in a particular brand/branch, the CFO and FP&A group do not have systematic access to information on why this happened, and have to fall back on vague assurances or time-consuming one-off investigations. This makes the variance identification process unworkably time-consuming and complex, the companion operating reviews unfocused and unproductive, and the remediation actions at the field sales and operating level spotty and unprioritized.
This frequent need to investigate monthly variances is frustrating and burdensome. It often leads to a chronic syndrome in which managers fall back on a vague feeling that things are basically OK and will correct themselves—until the variances get too big to ignore.
Identify Opportunities for Midcourse Corrections
An Enterprise Profit Management solution (EPM) is the key to developing an effective, data-driven Variance Profit Cycle at both the whole-company and sales/operating manager levels. EPM is a SaaS software solution that creates a full, all-in P&L on every transaction (every invoice line) assigning the relevant general ledger costs to every transaction. With embedded machine learning techniques, an EPM solution can be configured in a few weeks, and can produce accurate, detailed variance reports 24 hours after each monthly financial closing.
Virtually all companies budget in relatively broad categories like product family and branch or store. In the first step, EPM transforms a traditional company budget into a set of transaction-level budgets. This EPM-transformed budget reflects the company’s forecasts (used to construct its budget) of revenue and cost growth or reductions, along with the company’s forecasts of new and lost business. This creates a very detailed version of the company’s budget (e.g., each customer and each product) that is fully consistent with the company’s original budget (in its original broad categories).
At the end of each financial period, EPM creates a full set of transaction-level actuals. The EPM solution compares the transaction-level actuals with the EPM-transformed budget, and uses advanced data techniques (including AI) to determine the most significant sources of budget variance. The top managers can inspect this list and determine whether to send an alert about each high-priority variance to the responsible manager. Each responsible manager can investigate to assess whether it is fixable and/or forecastable. If so, the budget will be updated, and the EPM system will track the results.
This process provides a systematic, effective lever to precisely explain budget variances, to bring actuals into alignment with budgets, and to quickly identify opportunities for midcourse corrections. It also enables managers to closely track and monitor the results of their monthly corrections at both the whole-company and specific-manager levels, making operating reviews in every department much more effective and timely.
Create Grassroots-Level Variance-Action Reports
An EPM-enabled Variance Profit Cycle has a strong, direct positive impact not only at the company and manager levels, but importantly, it provides critical profit-improvement information at the working level throughout your company. EPM can provide monthly grassroots-level variance-action reports with systematic, prioritized trend and variance analysis on selected customers, product/services, suppliers, operations units (e.g., stores, branches, inventory product/locations) or other key dimensions. This will directly improve the profit productivity of each sales rep, product manager, supplier manager and inventory manager in your company.
For example, a grassroots-level variance-action report for a specific customer might show a number of key trend and variance factors, including all-in customer P&L for the relevant period(s), with line-item variances relative to budget (e.g. price, volume, product mix profitability), early alerts on emerging competitor encroachment and customer interest in additional product lines, results of promotions and loss leaders, and so on—along with accurate estimates of potential upsides of the possible variance remediation actions.
The EPM information can be configured to reflect the specific circumstances and needs of each rep, each manager or the whole company (e.g., tracking new regional or company-wide initiatives). In addition, the EPM system can gauge and track the rate of remediation by individual, by department, by causal factor and/or along any other salient dimension at a company-wide, departmental or individual manager/rep level.
These grassroots-level variance-action reports produce a complete monthly volume, margin, product/service mix and operating cost review for each operating-level sales rep and manager. These include comprehensive variance significance testing and prioritization that allows the system to do the analysis, and your team to make focused, high-impact data-driven decisions.
The Holy Grail of Financial Management
The EPM Profit Variance Cycle is a critical tool for the Office of the CFO, and for every sales and operating manager in a company.
When you use EPM to turbocharge your Variance Profit Cycle, even with your traditional budgeting categories, you will gain the critical ability to avoid the most common and troubling budget problems: missing budget and not being able to explain why, and failing to give clear direction and relevant information to operating teams on how to address their issues. Conversely, it enables you to quickly and accurately explain budget variances, to respond rapidly to business threats and opportunities, and to generate predictable profits.
Your EPM-enabled Variance Profit Cycle will not only produce rapid, sustained profit growth, but it also will have a direct, substantial impact on your company’s market capitalization for two critical reasons that are particularly important to your board of directors, your C-Suite executives, your investors and the analysts who evaluate your company:
- You will have much better clarity on the granular composition of your earnings which will strongly enhance your ability to create and achieve accurate and compelling earnings forecasts;
- You will have a much better ability to identify and explain any needed remedial actions (both strategic and tactical), to predict your pace of improvement, and to track their effectiveness.
In this way, EPM enables you to vastly improve your Variance Profit Cycle’s effectiveness both by directly raising your profitability, and by strongly increasing your ability to reliably forecast, explain and grow your earnings. Together, these will enable you to systematically and rapidly raise your company’s market capitalization—the holy grail of financial management.