What it means
When managers look at an average, such as average monthly sales, they get only half the story. Variability describes the other half, which is how far the individual months tend to stray from that average.
The most common measures are the range, which is the gap between the highest and lowest result, and the standard deviation, which is a type of average distance from the mean. The coefficient of variation divides the standard deviation by the mean, giving a percentage that allows fair comparison between things of different sizes.
High variability makes planning harder. A business with steady sales can forecast cash needs closely, while one whose sales swing wildly must hold larger cash buffers, arrange more flexible borrowing and accept less predictable profit.
Investors treat variability as a measure of risk, and they usually expect a higher average return for accepting more of it. In investment analysis, the term volatility is often used for the variability of returns over time.
Not all variability is bad or avoidable. Some comes from seasonality, which is predictable, and some from random events, and a good analyst separates the two before deciding how to respond.
Variability can be reduced by diversifying across customers, products or investments, by smoothing contracts with fixed-price agreements, and by building reserves. The cost of doing so should be weighed against the benefit of more predictable results.
In budgeting, a finance team also builds low, expected and high scenarios so that management can see how far results might differ.
In practice
Real-world examples.
Example
A seaside cafe earns most of its profit in summer and loses money in winter. Its monthly profit swings from minus $8,000 to plus $30,000. The owner arranges an overdraft in advance to cover the lean months and times large purchases for the summer.
Example
An investor compares two funds that both averaged 7% a year over a decade. One never fell more than 4% in a year, while the other fell 25% in its worst year. The investor chooses the less variable fund because she needs the money in five years.
Example
A manufacturer's weekly output of parts varies between 4,000 and 6,000 units because of machine breakdowns. The operations manager investigates the causes. Reducing the variability allows the company to promise reliable delivery dates and to hold less safety stock.
Formula
Calculation
Standard deviation (population) = Square root of [ Sum of (each result - mean) squared / Number of results ]
Coefficient of variation = Standard deviation / Mean
Product A has quarterly sales of $90,000, $110,000, $90,000 and $110,000, so the mean is 400,000 / 4 = $100,000. Each result is $10,000 from the mean, so the squared deviations are all 100,000,000, and the standard deviation is the square root of 100,000,000, which is $10,000. The coefficient of variation is 10,000 / 100,000 = 10%. Product B has quarterly sales of $60,000, $140,000, $60,000 and $140,000, also with a mean of $100,000. Each result is $40,000 from the mean, so its standard deviation is $40,000 and its coefficient of variation is 40%. Both products average the same, but B is four times as variable.Case study
Seen in the real world.
This illustrative story involves a fictional company, Longmere Printing, which had two main customer groups. Schools placed steady orders worth about $50,000 a month, while event organisers placed large but irregular orders averaging $50,000 a month with swings between $5,000 and $120,000.
The finance director noticed that profit figures looked identical when averaged over the year, yet the company kept running short of cash. The variability of the event orders meant that in weak months, wages and rent still had to be paid.
The company set a target to move more revenue to annual contracts, built a cash reserve equal to two months of fixed costs, and agreed a standby credit line. The fictional example illustrates why averages alone can mislead.
Watch out
Common mistakes.
- Relying on averages without looking at the spread. Two sets of results with the same mean can carry very different risk.
- Treating all variability as risk to be eliminated. Some, like seasonality, is predictable and can be planned for.
- Comparing standard deviations of items of different sizes. Use the coefficient of variation to compare fairly.
Questions
People also ask.
What is the difference between variability and volatility?
Volatility is the term usually used for the variability of price or return over time, while variability is the general idea for any measure.
How can a business reduce variability?
Through diversification, longer fixed-price contracts, better forecasting and holding reserves.
Which measure of variability should I use?
The range is quick but affected by extremes, while standard deviation uses every data point and is standard for risk analysis.
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