The Power of Variance Analysis

  Estimating   PMO  

A very useful concept was drilled into me early in my career: An important aspect of success is to understand costs.

A very dramatic story was told to me wherein it was explained that Andrew Carnegie built the successful U.S. Steel Company not by building the best steel, but by carefully understanding his cost per pound. At the time, this was a very novel concept. Whereas his competitors guessed as to what they could charge, Carnegie knew exactly how low he could go and still make money.

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This knowledge meant that he could under-bid competitors and decide when to "walk away from the table" (meaning he knew when to exit the bidding process because he couldn't make a profit). Let's discuss the power of variance analysis in modern business at a high level.

What is a variance?

Let's start with the basic concept of a variance. It is simply the difference between what you expected and what you really received. If you expected something to cost $1 and it, in fact, cost $1.25, then you have a variance of $0.25 more than expected. This, of course, means that you spent $0.25 more than what you planned.

Materiality

When you are calculating your variances, take materiality into consideration. If you have a variance of $0.25, that isn't a big deal if the quantity produced is very small. However, as the production run increases, then that variance can add up quickly. Most projects generate tons of variances every day. To avoid a tidal wave of numbers that are inconsequential, instead focus on the large variances. For example, it is far more important to find out why there is a $10,000 cost variance than to spend two days determining why an expense report was $75 over budget.

Types of Variances

As mentioned, there are many different types of variance analysis. Three high-level views that I tend to focus on are:

Estimate to Planned. This is the difference between what we quoted and how we actually planned to do the work. I look at what has changed and why. It may be that there are new processes, vendors, materials, technology, laws, etc. If the variances are significant, I search for alternatives before work commences whenever possible. If alternatives are not possible, then I learn from the situation and communicate what not to do for subsequent work. You may wonder why there is a difference between planned and estimated. This is due to situations where projects are quoted based on best guesses and black magic. In other words, the quote is created without formal detailed planning often by a group who will not actually do the work. As you can imagine, it is advantageous to keep the quoting and planning teams in synch over time.

Planned to Actual. This variance looks at the difference between how work is planned and how it actually is executed. By comparing planned to actual, we can see how the work changed once in progress. There may be changes brought on by the project team, by the customer, by vendors or by a change in the environment, such as new regulations. Regardless, the changes need to be analyzed so issues can be identified and mitigation strategies can be developed to protect future work.

Estimate to Actual. Here, we compare what we quoted to what we actually did. This is a crucial comparison. If jobs are estimated in a manner that operations cannot support, then there are substantial risks including profit losses and even project failures. Again, by analyzing the numbers, we can determine what changed, why and then take corrective action. For subsequent work, we may need to change vendors, processes, materials, contractual stipulations, etc.

Alternatively, unplanned customer change requests may be fully billable, in which case we need to identify those changes as such and invoice accordingly. It is very important to point out that some of the most financially successful groups I have worked with are very adept at writing detailed quotes, assembling solid plans and then capturing customer change requests and billing for them.

Why do we do this?

In short, we want to do variance analysis in order to learn. One of the easiest and most objective ways to see that things need to change is to watch the financials and ask questions. Don't get me wrong: You cannot and should not base important decisions solely on financial data.

You must use the data as a basis to understand areas for further analysis. For example, if a bandsaw is a bottleneck, then go to the department and ask why. The reasons for the variance may range from the normal operator being out sick, to a worn blade, to there not being enough crewing and a great deal of overtime being incurred. Use the numbers to highlight areas to investigate, but do not make decisions without first investigating further.

Power of trends

Point in time variances, meaning singular occurrences, can help some. To make real gains, look at trends over time. If our earlier variance of $0.25 is judged as a one-time event, is that good or bad?

We cannot tell with just one value, so let's look at the trend over time. If we see that the negative variance over time was $0.01, $0.05, $0.10, $0.12 and $0.25, then we can see that there apparently is a steady trend of increasing costs and, if large enough to be material, should be investigated. Yes, this can take a lot of time if done manually. However, spreadsheets and computer systems can be used to generate real-time variance reports that are incredibly useful with little to no work to actually run the report.

Getting help

This article is very high-level. Variance analysis and cost accounting in general are very interesting fields with a great deal of specialized knowledge. For example, we discussed three high-level comparisons in this article. A person versed in cost accounting can drive down into the variances to identify quantity, cost and time variances. If you really want to make gains by using variance analysis, at least get trained--or someone else trained--in the skills necessary. To put some power here, bring in a formally trained and experienced cost accountant or Certified Management Accountant (CMA) to either own the ongoing process or at least set up the process for your organization's subsequent use.

Summary

By using variance analysis to identify areas of concern, management has another tool to monitor project and organizational health. People reviewing the variances should focus on the important exceptions so management can become aware of changes in the organization, the environment and so on. Without this information, management risks blindly proceeding down a path that cannot be judged as good or bad.

George Spafford is a project management consultant and instructor living in saint Joseph, Michigan. In total, George has more than 10 years of experience in information technology and project management. His areas of personal interest include project management, software engineering, organizational learning and maximizing the value added by information technology to an organization. He can be reached at [email protected].