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Author:Alton Shader,James BakerVariance AnalysisMarch 19981Variance AnalysisAgenda What is variance analysis?Linear variance Ice Cream Co.Two component variance analysis Jesses BreweryVariance analysis with more than two components Boston VideoKey takeaways2Variance AnalysisWhat is Variance Analysis?Variance analysis is used to understand and assess the drivers of change in measured variables.Variance analysis helps explain and understand what drives the difference between two measures of the same variable(e.g.,1998 profit vs.1995 profit)Variance analysis explains differences between measures by breaking those measures into their base components(e.g.,1998 revenue and 1998 OPEX as components of 1998 profit)and quantifying the impact of each componentBain frequently uses variance analysis to quantify and identify true profit drivershelp drive future analysis on the most leveraged issues3Variance AnalysisThe Value of Variance Analysis Why do we need to perform variance analysis?Gives business insight as to what drives revenue/cost/profitLeads to actionsBain uses variance analysis to gain business insight and to identify the most effective and valuable action steps.Why does profit change?What driver has the most impact?What explains differences in relative cost position?Used to determine product line profitabilityIdentifies areas of focus for cost reductionIndicates impact of lowering priceDrives customer segmentation strategies4Variance AnalysisDefinitions in Variance Analysis Most situations fall into one of three categories of variance analysis.Description:Two ComponentUnderstanding individual impact of two variable on a single measureLinearSimple comparison of one component against anotherMore than Two ComponentUnderstanding individual impact of more than two variables on a single measureExample:1998 revenue increases driven by 1998 price increase and unit sales1990 total cost per unit versus 1995 total cost per unitDifferences in customer revenue driven by number of transactions,product mix and other fees5Variance AnalysisAgenda What is variance analysis?Linear variance Ice Cream Co.Two component variance analysis Jesses BreweryVariance analysis with more than two components Boston VideoKey takeaways6Variance Analysis Situation:Orit and Toms Ice Cream Co.produce ice cream which they sell in gallon-sized containers at supermarkets around the countryThey have tracked their cost to produce ice cream per gallon over time and have seen it decline over five years by 25%Question:What has driven costs downward?What might Orit and Tom focus on to achieve better cost savings going into the future?Linear Variance Example(Ice Cream Co.)7Variance Analysis 19951990VarianceProduction costs:(includes sales,labor,admin)$220,500$210,000$10,500Raw materials costs:$63,000$60,000$3,000Advertising expenses:$31,500$30,000$1,500Total gallons sold:70,00050,00020,000Linear Variance Example8Variance Analysis Unit production costs:$3.15$4.20($1.05)Unit raw materials costs:$0.90$1.20($0.30)Unit advertising costs:$0.45$0.60($0.15)Total per unit costs:$4.50$6.00($1.50)19951990VarianceLinear Variance Example(Variance per Gallon)9Variance Analysis Thorough Bain analysis of the data allocated the reduced costs into three components.Linear Variances Example(Ice Cream Co.)10Variance AnalysisLinear Variances Example Management of Ice Cream Co.appears to have enjoyed increasing economies of scale,particularly relating to production costs,which have driven costs downwardOrit and Tom might want to focus in the future on gaining even greater leverage in managing production costs as production volume increases11Variance AnalysisAgenda What is variance analysis?Linear variance Ice Cream Co.Two component variance analysis Jesses BreweryVariance analysis with more than two components Boston VideoKey takeaways12Variance Analysis Situation:Jesses Brewery produces high-quality beers which it sells in casesIn the past year,Jesses Brewery has experienced 15%revenue growth.During the same time,sales volumes and prices have both increasedQuestion:Jesses Brewery would like to understand what percent of the revenue increase comes from the increase in sales volumes,and what percent from the increase in priceTwo Component Variance Example-Jesses Brewery(1 of 6)13Variance AnalysisTwo Component Variance Example-Jesses Brewery(2 of 6)Case Price:Cases Sold:$18.20$20.009.7MM10.2MMWhat percent of the$27MM increase in revenue is due tothe price increasing?the volume sold increasing?both the price and volume sold increasing?8this is covariance,where part of the variance is not easily attributable to a single variable14Variance Analysis Volume1998 Revenue$203.5MM1997 RevenuePrice Variance(Part of revenue change attributable to price)$18.20(1997)$20.00(1998)10.2MM(1998)9.7MM(1997)PriceVolume Variance(Part of revenue change attributable to volume)Covariance(part of revenue change attributable to change in both volume and price)The best way to approach variance analysis problems is to use the rectangle diagrams to intuitively understand how the changes in the two variables account for the change in the overall quantity.Two Component Variance Example-Jesses Brewery(3 of 6)15Variance Analysis Volume1998 Revenue(P2 x V2)1997 Revenue(P1 x V1)Price Variance(Part of revenue change attributable to price)P1(1997)P2(1998)V2(1998)V1(1997)PriceVolume Variance(Part of revenue change attributable to volume)Co-varianceStep 1:Volume Variance =(V2-V1)x P1Step 2:Price Variance =(P2-P1)x V1Step 3:Covariance =(V2-V1)x(P2-P1)Step 4:Allocate covariance to volume and price variance based on the proportion of the total for each variance-e.g.,if:volume variance=$2Mprice variance=$1Mcovariance=$.5Mthen 66.7%of$.5 is added to the volume and 33.3%is added to the price A four-step process leads to the solution.Two Component Variance Example-Jesses Brewery(4 of 6)16Variance Analysis Jesses Brewery1997VarianceDataPrice per case$18.20$1.8Number of cases sold(in MM)9.7.5Revenues(in$MM)$176.5$27.0Step 1:Price Variance$17.0Step 2:Volume Variance$9.1Step 3:Covariance$0.9Revenue variance excluding covariance$26.1Proportions for assigning covariancePriceVolumeAssignment of covarianceto Price Variance$0.6to Volume Variance$0.3Adjusted VariancesPrice VarianceVolume Variance(P1)(P2-P1)(V1)(V2-V1)$176.5 (P1 x V1)(193.5-176.5)(185.6-176.5)(P2-P1)x(V2-V1)(17.0+9.1)(0.9x65%)(0.9x35%)63%34%3%65%35%(17.0/27.0)(9.1/27.0)(0.9/27.0)(17.0/26.1)(9.1/26.1)$176.5 (P1 x V1)1998$20.0010.2$203.5(P2)(V2)$185.6 (V2 x P1)$193.5 (P2 x V1)$17.6$9.4(17.0+0.6)(9.1+0.3)Variance%Here is an example of an annotated spreadsheet to determine variance.Two Component Variance Example-Jesses Brewery(5 of 6)17Variance AnalysisPrice variance:Volume variance:Covariance:$17.0MM$9.1MM$0.9MMProportions are65%35%65%35%to price variance$0.6MMto volume variance$0.3MM+$17.0MM$17.6MMPrice$9.1MM$9.4MMVolumeTotal variances:(65%)(35%)If price and volume variances are calculated correctly,then we can take their proportions to allocate covariance.Two Component Variance Example-Jesses Brewery(6 of 6)18Variance AnalysisNegative Covariance 14.7 new(1998)9.7(1997)$18.20(1997)$17.00 new(1998)VolumePriceEven if one variable decreases,the formula applies the same way.The only difference is that price variance and covariance turn negative.Volume=(14.7-9.7)x$18.20Price=($17.00-$18.20)x 9.7=$91.0 MM-$11.6 MMCovariance=(14.7-9.7)x($17.00-$18.20)=-$6.0 MM$73.4 MMTotal VarianceIn some situations one variable may fall as the other rises.The formula for covariance does not change.19Variance AnalysisNegative Covariance In two variable problems,when one variable increases and one decreases(+-),we arrive at a negative covariance if the formulas are applied exactly as before(change only the variable whose variance we are calculating)This negative covariance(P2-P1)x(V2-V1)then needs assigning in proportion to the absolute values of the two variablesThis absolute value approach can be applied to multiple variables using the Excel spreadsheetThe example given is also intuitively correct(price falls,volume rises)To summarize,the methodology does not change in calculating negative covariance.20Variance AnalysisAgenda What is variance analysis?Linear variance Ice Cream Co.Two component variance analysis Jesses BreweryVariance analysis with more than two components Boston VideoKey takeaways21Variance AnalysisMore Than Two Component Variance Example Situation:Boston Video is a chain of video rental stores in the Northeast U.S.In addition to renting video movies and games,the stores sell a variety of movie-related items(popcorn,candy,film magazines).They also get money for late feesBain has been hired to help Boston Video segment its customer base and understand what drives the differences in spending patterns between segmentsQuestion:What variables impact revenue per customer?What is the overall variance by customer type?What are the breakdowns of that variance by customer type?What should Bain focus on improving?22Variance Analysis 11,411 customers74K transactions$441KCustomers were segmented into 3 groups.“A”customers represent only 20%of Bostons customer base but generate 50%of store transactions and 60%of revenue.A,B,&C Customers DataHow might you frame an analysis to understand a lot impacts revenues per customer?More Than Two Component Variance Example23Variance AnalysisRevenue Drivers Framework The differences in customer spending levels between segments can be identified and isolated into two broad categories.Revenue per CustomerNumber of TransactionsSell ThruRevenueRentalRevenueLateFees and OtherQuantityProductMixRevenue per TransactionMore Than Two Component Variance Example24Variance Analysis Number of TransactionsRevenue per TransactionThe following data was made available about customer habits.Customer SegmentationMore Than Two Component Variance Example 25Variance AnalysisRevenue Per Customer Per Month“A”customers spent on average 2.6x the average“B”customer and nearly 10 x the average“C”customer.$11.82$17.02Customer segment:More Than Two Component Variance Example2.76 x$6.891.29 x$5.380.45 x$4.4526Variance AnalysisDrivers of Variance How would you complete this slide showing the split between the two variance drivers?More Than Two Component Variance Example27Variance Analysis This spreadsheet details the calculations necessary to compute the variances and covariance for transactions and revenue per customer.Facts:TotalTrans/Rev/TotalCustomerRev/MnthMnthTransVarianceA19.01$2.766.88$B7.20$1.295.58$(11.82)$C 2.00$0.454.45$(17.02)$Variance from A to B(11.82)$%total:calculation:trans variance(10.14)$(1.47)6.88$74%(B trans-A trans)times A pricerev variance(3.60)$2.76(1.30)$26%+(B price-A price)times A transtotal variance before covar(13.73)$=Total Variance before Covariancecovariance1.92$(1.47)(1.30)$+(B trans-A trans)times(B price-A price)answer(11.82)$=Total VarianceAllocate covariance:1.92$100%trans1.42$74%74%to transactionrev0.50$26%26%to revTotal Delta Trans(8.72)$74%Regular trans variance plus allocation from covarianceTotal Delta Price(3.09)$26%Regular rev variance plus allocation from covariance(11.82)$100%=total varianceSample SpreadsheetMore Than Two Component Variance Example28Variance AnalysisSample Spreadsheet More Than Two Component Variance Example29Variance AnalysisNow suppose the client wants to further understand what drives revenue per transaction.How would you complete this slide showing the split between the three revenue per transaction variables?Customer segment:More Than Two Component Variance ExampleRevenue Per TransactionSources of VarianceVariance Analysis(Revenue per Transaction)30Variance AnalysisSample Spreadsheet This spreadsheet further allocates revenue per transaction variance into types of product purchased.More Than Two Component Variance Example31Variance AnalysisVariance analysis showed that the primary difference between customer segments was how often they came to the store.Over 70%of the variance between A customers and the others was explained by transaction frequency.Drivers of Variance 26%74%70%30%More Than Two Component Variance Example32Variance Analysis Revenue per transaction analysis was not very telling.Customer segment:Revenue per TransactionSources of VarianceVariance Analysis(Revenue per Transaction)33Variance AnalysisSummary What drives A customer behavior is the number of transactions they completeso,Bain needs to help improve the frequency of transactions of B and C customers(assuming that A customers continue to remain loyal and that a retention strategy is therefore not the most leveraged work)34Variance AnalysisAgenda What is variance analysis?Linear variance Ice Cream Co.Two component variance analysis Jesses BreweryVariance analysis with more than two components Boston VideoKey takeaways35Variance AnalysisKey Takeaways Variance analysis is a simple way of breaking down changes in a variable into their component parts,to yield business insightKnow how to set up a spreadsheet and variance analysis becomes straightforwardOften we only look at two components at a time The basic approach is to change only one variable at a time and observe the effect on the totalCovariance explains the amount of variance that is attributable to the change of both variances(as opposed to one)and is normally split between variables in proportion to their variancesVariance analysis can be used in many instances to understand changes in a business and to drive strategic and tactical decision-making.Key points to remember are:36Variance AnalysisSample Spreadsheet Variance from A to CTrans varianceRev varianceTotal variance beforecovarcovarianceAnswerAlliance covariance:TransRev$(17.02)$(15.98)$(6.73)$(22.66)$5.64$5.64$3.96$1.64$(17.02)100%70%30%Total Delta TransTotal Delta Price$(11.96)$(5.6)$(17.02)(2.31)2.76(2.31)$(2.44)$6.88$(2.44)%total:70%30%calculation:(C trans-A trans)times A price+(C price-A price)times A trans=Total Variance before Covariance+(C trans-A trans)times(C price-A price)=Total Variance70%to transaction30%to revRegular trans variance plus allocation from covarianceRegular rev variance plus allocation from covariance=total variance70%30%100%37Variance Analysis9、静夜四无邻，荒居旧业贫。3月-233月-23Thursday,March 16,202310、雨中黄叶树，灯下白头人。08:13:4408:13:4408:133/16/2023 8:13:44 AM11、以我独沈久，愧君相见频。3月-2308:13:4408:13Mar-2316-Mar-2312、故人江海别，几度隔山川。08:13:4408:13:4408:13Thursday,March 16,202313、乍见翻疑梦，相悲各问年。3月-233月-2308:13:4408:13:44March 16,202314、他乡生白发，旧国见青山。16 三月 20238:13:44 上午08:13:443月-2315、比不了得就不比，得不到的就不要。三月 238:13 上午3月-2308:13March 16,202316、行动出成果，工作出财富。2023/3/16 8:13:4408:13:4416 March 202317、做前，能够环视四周；做时，你只能或者最好沿着以脚为起点的射线向前。8:13:44 上午8:13 上午08:13:443月-239、没有失败，只有暂时停止成功！。3月-233月-23Thursday,March 16,202310、很多事情努力了未必有结果，但是不努力却什么改变也没有。08:13:4408:13:4408:133/16/2023 8:13:44 AM11、成功就是日复一日那一点点小小努力的积累。3月-2308:13:4408:13Mar-2316-Mar-2312、世间成事，不求其绝对圆满，留一份不足，可得无限完美。08:13:4408:13:4408:13Thursday,March 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