App 2 - Variance Investigation

APPENDIX 2 -VARIANCE INVESTIGATION
OVERVIEW
Objectives
To explain planning and operational variances.
To interpret and investigate variances.
VARIANCE INVESTIGATION
LIMITATIONS OF PLANNING AND OPPORTUNITY CAUSES OF

TRADITIONAL OPERATIONAL COST VARIANCES
VARIANCES VARIANCES VARIANCES
Interdependence Problems
Direct costs Calculations
Data manipulation Market volume
Fixed overheads and share
Causation Advantages and INVESTIGATION
disadvantages MODELS
Minimum size
Percentage rule
Statistical significance
Statistical control charts
Cost/benefit analysis
The Examiner has stated that
Candidates will not be asked to calculate variances in the paper 3.3 examination
Prior knowledge of variance analysis from previous papers is assumed.
Candidates may be given variances in the scenario and be required to interpret them
or use them for further analysis.
This section of the notes is therefore provided for reference purposes only.
 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1201

1 LIMITATIONS OF TRADITIONAL VARIANCE ANALYSIS
The limitations of standard costing mentioned in the previous session are relevant here.
In addition, traditional variance analysis has the following problems:
1.1 Interdependence of variances
A variance in one department may cause a variance in another.
Eg a favourable materials price variance may be achieved by buying substandard

materials.
This may cause an adverse usage variance.
If the analysis is not interpreted with care a company might hold the production
manager responsible for an adverse variance caused by a buyer.
1.2 Over-emphasis on direct costs
Traditional variance analysis concentrates on labour and materials variances.
However, in service businesses and in modern manufacturing environments, a large

proportion of costs may be overheads.
Traditional overhead variances eg fixed overhead expenditure, are unlikely to give

sufficiently detailed information for effective control.
1.3 Manipulation of data
In a budget constrained environment managers under stress may be tempted to

manipulate actual results. This may be a particular problem if performance
compared to budget is linked to rewards eg bonus, promotion.
Eg in a job costing system, the manager might try to hide overspends on a particular
job by transferring/dumping time to jobs under-budget.
This is dysfunctional behaviour and variance analysis becomes meaningless.
1.4 Fixed overhead volume variance
A favourable volume variance simply represents over-absorption of fixed overheads

due to actual output being above budget.
A belief that this “favourable” variance is of benefit to the business may lead to
stockbuilding.
Excessive stockholding will however incur costs and reduce profits.

1.5 Causation
Fails to distinguish variances caused by inaccurate standards from those caused by

operational factors.
Can be improved by calculating planning and operational variances.
2 PLANNING AND OPERATIONAL VARIANCES
2.1 Problems of traditional variance analysis
Traditional variance analysis compares:
Actual vs Expected
performance performance
If the actual environment differs from that which was anticipated then actual performance
should be compared with a standard which reflects the changed conditions (ex post standard).
Even if the environment has not changed, with hindsight (looking back) it might be realised
than an unrealistic standard was used eg ideal standard.
Actual performance should be compared with a realistic standard for control and appraisal
purposes – this variance is known as the Operating Variance. The difference between the ex
ante and ex post targets is known as the Planning Variance.
Planning variance – a classification of variances caused by ex ante budget allowances

being changed to an ex post basis.
Operational variance – a classification of variances in which non-standard

performance is defined as being that which differs from an ex post standard.

2.2 Calculations
Use the following table to separate out PLANNING and OPERATING variances.
PLANNING AND OPERATING VARIANCE TABLE
£
ORIGINAL FLEXED BUDGET
(EX ANTE) X PLANNING
VARIANCE
(UNCONTROLLABLE)
REVISED FLEXED BUDGET
(EX POST) X
OPERATING
VARIANCE
ACTUAL RESULT X (CONTROLLABLE)
Note – the examiner sometimes calls planning variances budget revision variances.
Example 1
Standard material cost/unit : 4 kgs at £2.50 = £10

Budgeted Output : 20,000 units
Actual Output : 22,000 units
Materials actually used : 86,000 kgs at £3
With hindsight a better standard would have been 3.75 kg per unit at £2.80 per kg.
Required:
(a) Calculate the traditional variances
(i) Price Variance

(ii) Usage Variance
(iii) Overall Material Variance (price + usage)
(b) Calculate planning and operating variances
(c) To gain a better assessment of performance we now analyse the operating

variance into Price and Usage.

Solution
(a) Traditional price and usage variances
(b) Planning and operating variances
£
Original flexed budget Planning variance
Revised flexed budget
Operating variance
Actual result
(c) Operating price and usage variances
£
Operating price variance
Operating usage variance
–––––
Total operating variance
–––––
This revised analysis still indicates inefficiency on the part of the buying department and that
there could be better use of materials.
Compare this with the traditional analysis which suggested a more serious inefficiency in
buying ie £43,000 adverse price variance, coupled with efficient use of materials.
The PLANNING VARIANCE can also be split into price and usage, but it is questionable
whether it provides useful information or not.

Example 2
Materials budget
3.4kg/unit
£2/kg
Actual
2,000 units produced
7,000kg purchased and used, costing £2.20 per kg.
Required:
(a) Calculate the traditional price and usage variance.
Solution
(a) Traditional variances
Traditional price variance =
kg
Traditional usage variance
2,000 units should use
Actual usage
–––––
=
–––––
Example 2 (Contd)
The purchasing manager is furious when he receives a variance report criticising him.
He produces evidence to suggest the average market price during the period was £2.30.
The production manager points out that the usage standard was an ideal standard and
totally unrealistic. He calculates the current standard as 3.6kg/unit.
Required:
(b) Calculate
(i) the planning variance

(ii) the operating price variance
(iii) the operating usage variance.

Solution
(b) Planning and operational variances

£
Operational
Actual result variance
£
Operational price variance
Kg
Operational usage variance
2,000 units should use
Actual usage
–––––
kg @
––––
––––
2.3 Market volume and market share variances
The traditional sales volume variance may have two elements:
the size of the market was different from expected – a change in the external
environment
the share of that market was different from budget. .

The sales volume variance can therefore by split:
Sales volume
variance
Sales volume Sales volume

planning variance operational variance
Caused by Caused by
external factors internal factors
Market volume Market share

variance variance
£
Budgeted profit/contribution for
original budgeted sales X
market volume
Budgeted profit/contribution for revised variance
budget sales X
(revised market volume X budget market share)
market share
Budgeted profit/contribution for variance
actual sales X

Example 3
Acme Ltd has a Sales Budget of 1,795 units at a unit contribution of £20.00. This is
based on the company maintaining a 5% market share. Total sales volume for the
industry was estimated to be 35,900 units.
Actual sales volumes were as follows.
ACME LTD 1,850 units

INDUSTRY 37,500 units
Required:
Calculate for ACME Ltd
(a) the traditional sales volume variance

(b) the market volume and market share variance
Solution
(a) Sales volume variance
(b) Planning and operating sales volume variances table
£
Budgeted contribution for Market volume
Original budgeted sales variance
Budgeted contribution for

Revised budgeted sales
Market share
Budgeted contribution for variance
Actual sales

2.4 Advantages and disadvantages
2.4.1 Advantages
Distinguishes between variances caused by bad planning or unavoidable factors, and

those due to operating factors.
Adverse operating variances indicate processes out of control which need correcting.
Planning variances can be used to update standards to current conditions.
Motivation may improve if managers know they will only be assessed on variances
under their control ie operational variances.
2.4.2 Disadvantages
Extra data requirements eg market volume.
More time consuming.
Managers may claim all adverse variances have external causes and all favourable
variances internal causes ie manipulation of revised standards for personal benefit.
3 OPPORTUNITY COST VARIANCES
Opportunity cost variance analysis attempts to associate variances with their direct cause.
A typical exam question requires a sub-analysis of the sales volume variance to show the
reasons for sales being different from budget.
Example 4
Holland Ltd manufactures clogs.
Standard contribution per units £10. Standard labour time is 3 hours per unit.
Budget production and sales was 1,000 units.
Actual production was 900 units.

Actual sales was 800 units.
Actual labour hours paid = 3,150 hours. Idle time = 500 hours.
Required:
Analyse the sales volume variance to show the gain or loss in contribution arising from
the following factors:
(a) capacity
(b) productivity
(c) idle time
(d) stock changes.

Solution
Sales volume variance =
(a) Capacity
Hours
Actual labour capacity
Budget capacity
–––––
–––––
Extras potential contribution =
(b) Productivity
Hours worked =
This should produce
Actual production =
Potential contribution gain =
(c) Idle time
Potential contribution lost =
(d) Stock changes
Lost contribution due to stock increase
Summary
£
Capacity increase
Productivity increase
Idle time
Stock increase
––––––
Sales volume variance
––––––

4 CAUSES OF VARIANCES
Measurement Inaccurate Random factors

errors standards (normal
fluctuations)
OPERATIONAL
FACTORS
Improve quality Calculate
of data planning
variances
Process is out
of control
Process is not
out of control
Should we
investigate?
No need for
investigation
Need an
investigation rule

5 VARIANCE INVESTIGATION MODELS
Statistical Minimum size

significance rule
% rule
VARIANCE
INVESTIGATION
MODELS
Statistical Management Cost/benefit

control judgement analysis
charts
Ideally, only investigate variances which are
operational
correctable
significant
benefits of investigation > costs of investigation.
5.1 Minimum size rule
Eg investigate all variances > £5,000.
An easy and widely used rule.
However, although £5,000 compared to a standard cost of £20,000 might indicate a problem,
£5,000 compared to £20m is probably insignificant.
5.2 Percentage rule
Investigate variances greater than a certain percentage of standard.
Easy and widely used.
However, it ignores the absolute size of variances.
Eg investigate variances more than 5% of budget. £6 variance on a £100 budget will be

investigated but £4,800 variance on a £100,000 budget will not be investigated.
Perhaps % rule should be combined will minimum size rule eg investigate if more than 5%
and more than £1,000.

5.3 Statistical significance rule
5.3.1 Steps
Observe process when operating normally.
Estimate mean and standard deviation of costs under normal operations (ie with
random fluctuations).
Assume costs are normally distributed eg an adverse variance more than 1.96
standard deviations (σ) above the mean (µ) has only a 2.5% chance of occurring due
to random fluctuations.
Set significance level ie acceptable probability of investigating random variances.
Calculate investigation limits.
Example 5
The expected standard cost is £800, but due to random factors actual cost may fluctuate
around the mean value with a standard deviation of £50. Costs fluctuate randomly
according to the normal distribution.
Management wish to set investigation limits so that there is only a 2.5% chance of
investigating a variance which has arisen simply due to random fluctuations.
Required:
Determine the investigation limits which management should set.
Solution

x−µ
Z=
σ
⇒ x = µ + zσ
The z-value for 1.25% is 2.24 (from normal distribution tables).
... Investigate costs in excess of
and below
5.4 Statistical control charts
The above information can be illustrated on a statistical control chart.
Warning limits and Action limits are set a given distance from the mean – typically 1 SD and
2 SD respectively.
Labour
related
costs
£900 Upper action limit

(2σ)
x Upper warning limit

£850
x (1σ)
x
x x
£800 STANDARD COST
JAN FEB MAR APR MAY
£750 Lower warning limit

(1σ)
£700 Lower action limit

(2σ)
Management can spot worrying trends in particular variances and so be proactive rather than
reactive.

5.5 Cost/benefit analysis
Identify:
costs of investigation (I)

costs of correction if process is out of control (C)
benefits of investigation (B)
probability that process is out of control (P).
Investigate if:
pB > I + pC
Note – process out of control = operational variance
should be corrected
– process not out of control = Variance caused by

random factor/planning
error/measurement error
Process does not need to

be corrected
Example 6
An £8,000 adverse variance will cost £1,500 to investigate and (if required) £4,000 to
correct. If the variance is not corrected, and the process remains out of control, losses
of £10,000 will occur.
Required:
(a) Should the process be investigated if there is a 0.4 chance it is out of control?
(b) At what level of probability would you be indifferent between investigating

and not investigating the variance?

Solution
Decision tree
£4,000
OUT OF CONTROL
0.4
0.6
£0
RANDOM
INVESTIGATE FACTOR
£1,500
DON’T INVESTIGATE
0.4 OUT OF CONTROL
£10,000
0.6
RANDOM
FACTOR
£0
(1) Expected cost of investigation =
Expected benefit of investigating =
Optimal decision is to investigate the variance.
(2) Let p = probability the process is out of control
Equating indifference with cost = benefit and re-arranging:
∴ pB =
=
=
p =

Example 7
Tudor’s management has the following data.
Cost to investigate whether a variance can be eliminated = £810.
Cost to correct a variance which can be eliminated = £300.
Probability that a variance can be eliminated = 0.30.
It has been estimated that the present value of the cost of not correcting a variance
which can be eliminated is 60% of the size of the variance.
Required:
Calculate the minimum size of variance that would justify investigation.
Solution
Let V = variance
pB > I + pC
FOCUS
You should now be able to
discuss the limitations of traditional variances
calculate and discuss the advantages and limitations of planning, operational and
opportunity cost variances
identify causes and explain the investigation of variances
explain and illustrate the use of investigation models including statistical control
charts and decision trees.

EXAMPLE SOLUTIONS
Solution 1 – Materials
(a) Traditional price and usage variances
Price variance (2.50 – 3.00) 86,000 = £43,000 Adv
Usage variance (22,000 × 4 – 86,000) £2.50 = £5,000 Fav
Total variance = £38,000 Adv
(b) Planning and operating variances
£
22,000 × 4 × £2.50 220,000 £11,000 Adv

22,000 × 3.75 × £2.8 231,000
Operating variance
Actual result £27,000 Adv
86,000 kg × £3 258,000
(c) Operating price and usage variances
£
Operating price variance
(2.80 – 3.00) 86,000 17,200 Adv
Operating usage variance

(22,000 × 3.75 – 86,000) £2.8 9,800 Adv
–––––
Total operating variance 27,000 Adv
–––––
Solution 2 – Materials
(a) Traditional variances
Traditional price variance = (2 – 2.20) × 7,000 = £(1,400) A
kg
Traditional usage variance
2,000 units should use (2,000 × 2.4) 6,800
Actual usage (7,000)
–––––
(200) kg @ £2
= £(400) A
–––––

(b) Planning and operational variances

£
2,000 × 3.4kg × £2 13,600 (2,960)

2,000 × 3.6 kg × £2.30 16,560
Operational
Actual result variance
(7,000 × 2.20) 15,400 1,160 F
Operational price variance = (2.30 – 2.20) × 7,000 = 700F
Kg
Operational usage variance
2,000 units should use (2,000 × 3.6) 7,200
Actual usage (7,000)
–––––
200 kg @ 2.30 £460 F
––––
£1,160 F
––––
Solution 3 – Sales
(a) Sales volume variance
(1,850 – 1,795) £20 = £1,100 Fav
(b) Planning and operating sales volume variances table
£
Budgeted contribution for Market volume
Original budgeted sales 35,900 variance
1,795 × £20 £1,600 Fav
Budgeted contribution for

Revised budgeted sales 37,500
0.05 × 37,500 × £20
Market share
Budgeted contribution for variance
Actual sales 37,000 £500 Adv
1,850 × £20

Solution 4 – Opportunity cost variances
Sales volume variance = (800 – 1,000) × 10 = £(2,000)A
(a) Capacity
Hours
Actual labour capacity 3,150
Budget capacity (1,000 × 3) (3,000)
–––––
150 hrs favourable
–––––
Extras potential contribution = 150 hours

× £10 = £500F
3 hours per unit
(b) Productivity
Hours worked = 3,150 – 500 = 2,650 hours.
2,650
This should produce = 883⅓ units
3
Actual production = 900 units
Potential contribution gain = (900 – 883⅓) × 10 = £167F
(c) Idle time
Potential contribution lost = 500

× 10 = £(1,667) A
3
(d) Stock changes
Lost contribution due to stock increase
= 100 units × £10 = £(1,000)A
Summary
£
Capacity increase 500
Productivity increase 167
Idle time (1,667)
Stock increase (1,000)
––––––
Sales volume variance (2,000) A
––––––

Solution 5 – Statistical significance
σ = 50
µ = 800
1.25% 1.25%
µ
800
x−µ
Z=
σ
⇒ x = µ + zσ
The z-value for 1.25% is 2.24 (from normal distribution tables).
... Investigate costs in excess of 800 + 2.24 × 50 = £912
and below 800 – 2.24 × 50 = £688
Solution 6 – Cost/benefit analysis
£4,000
OUT OF CONTROL
0.4
0.6
£0
RANDOM
INVESTIGATE FACTOR
£1,500
DON’T INVESTIGATE
0.4 OUT OF CONTROL
£10,000
0.6
RANDOM
FACTOR
£0

(1) Expected cost of investigation = £1,500 + (0.4 × £4,000) = £3,100
Expected benefit of investigating = 0.4 × £10,000 = £4,000
Optimal decision is to investigate the variance.
(2) Let P = probability the process is out of control
∴ pB = I + pC
10,000p = 1,500 + 4,000p
6,000p = 1,500
p = 0.25
Solution 7 – Minimum variance
Let V = variance
pB > I + pC
0.3 × 0.6 × V > 810 + (0.3 × 300)
0.18V > 900

V > 5,000


App 2 - Variance Investigation

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APPENDIX 2 -VARIANCE INVESTIGATION

To explain planning and operational variances.

To interpret and investigate variances.

LIMITATIONS OF PLANNING AND OPPORTUNITY CAUSES OF

The Examiner has stated that

Prior knowledge of variance analysis from previous papers is assumed.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1201

1 LIMITATIONS OF TRADITIONAL VARIANCE ANALYSIS

In addition, traditional variance analysis has the following problems:

1.1 Interdependence of variances

A variance in one department may cause a variance in another.

Eg a favourable materials price variance may be achieved by buying substandard

This may cause an adverse usage variance.

1.2 Over-emphasis on direct costs

Traditional variance analysis concentrates on labour and materials variances.

However, in service businesses and in modern manufacturing environments, a large

Traditional overhead variances eg fixed overhead expenditure, are unlikely to give

1.3 Manipulation of data

In a budget constrained environment managers under stress may be tempted to

This is dysfunctional behaviour and variance analysis becomes meaningless.

1.4 Fixed overhead volume variance

A favourable volume variance simply represents over-absorption of fixed overheads

Excessive stockholding will however incur costs and reduce profits.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1202

Fails to distinguish variances caused by inaccurate standards from those caused by

Can be improved by calculating planning and operational variances.

2 PLANNING AND OPERATIONAL VARIANCES

2.1 Problems of traditional variance analysis

Traditional variance analysis compares:

Planning variance – a classification of variances caused by ex ante budget allowances

Operational variance – a classification of variances in which non-standard

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1203

PLANNING AND OPERATING VARIANCE TABLE

Standard material cost/unit : 4 kgs at £2.50 = £10

(a) Calculate the traditional variances

(i) Price Variance

(b) Calculate planning and operating variances

(c) To gain a better assessment of performance we now analyse the operating

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1204

(a) Traditional price and usage variances

(b) Planning and operating variances

Revised flexed budget

(c) Operating price and usage variances

Operating usage variance

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1205

(a) Calculate the traditional price and usage variance.

(a) Traditional variances

Traditional price variance =

(i) the planning variance

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1206

(b) Planning and operational variances

Revised flexed budget

2.3 Market volume and market share variances

The traditional sales volume variance may have two elements:

the share of that market was different from budget. .

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1207

The sales volume variance can therefore by split:

Sales volume Sales volume

Market volume Market share

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 1208

Actual sales volumes were as follows.

ACME LTD 1,850 units

Calculate for ACME Ltd