CHAPTER 14:
PLANNING AND OPERATIONAL VARIANCES
1.
Overview
Objective: To explain when standards and budgets should be revised, the
calculations in such circumstances and the effect of using variance analysis on
the behaviour of managers and employees.
2. Revision of Budgets and Standards
A. Principles
At the end of a budget period, before comparing an organisa on's actual performance
against the budget, budgets may be revised to take account of environmental changes that
were not an cipated when the budget was prepared. The reason for such revision is that
because managers are judged on how they performed rela ve to the budget, it is unfair to
use a budget that turns out to be unrealis c.
The principles that should be applied when revising budgets are as follows:

If something occurred during the budget period that was outside the control of the
manager meant that the budget became unrealis c, the original budget should be
revised.

Management should not revise budgets to hide inefficiencies.

Senior management should approve only appropriate revisions.
3. Planning and Opera onal Variances
A. Problems of Tradi onal Variance Analysis
Tradi onal variance analysis compares:
Management should consider revising the standards for expected performance:

If the actual environment differs from what was an cipated when the original
standard was set; or

Even if the environment has not changed, the benefit of hindsight shows that an
unrealis c standard was used (e.g. ideal standard).
The factors to consider in deciding whether to revise a standard are essen ally the same as
whether to revise a budget (as above).
The variances calculated by comparing actual performance against the revised standard are
referred to as opera onal (or opera ng) variances. The calcula on of these is the same as
the method used to calculate tradi onal variances; the only difference is that a revised
standard is used.

The difference between the revised standard and the original standard is
the planning variance (or budget revision variance). These variances can relate to
any element of the standard product specifica on or to sales/produc on volumes.
Defini ons
Planning variance – arises when an original budget is revised with the benefit of hindsight
(i.e. ex-post meaning “a er the fact”).
Opera onal variance – arises when actual performance differs from a revised standard.
B. Planning Cost Variances
There are various methods of calcula ng planning variances. The following approach starts
with the tradi onal variance (e.g. a material price variance), which is then analysed into
planning and opera onal variances.
Exam advice
This is the preferred approach for the Performance Management exam.
(i)
Materials Price and Labour Rate
The approach to calcula ng the materials price and labour rate variances is the same, so
these two variances are dealt with together here.

For materials, the references to quan ty are to quan

For labour, the quan
es of materials;
es are labour hours.
Tradi onal Price/Rate Variance
$
Actual quan ty x Actual price
x
Actual quan ty x Standard price
x
Price variance
x
If the standard price is subsequently revised, the tradi onal variance can be analysed into
planning and opera onal variances as follows:
Planning Price Variance
This shows the effect of revising the standard cost by comparing the standard cost of actual
materials using the old and new standard cost:
$
Actual quan ty x Original standard price
x
Actual quan ty x Revised standard price
x
Planning price variance
x

This is adverse if the revised standard price is higher than the original standard price.
Opera onal Price Variance
The calcula on of the opera onal price variance is very similar to the calcula on of the
tradi onal price variance. The only difference is that the actual price is compared with
the revised standard instead of the original standard:
$
Actual quan ty x Actual price
x
Actual quan ty x Revised standard price
x
Opera onal price variance
x

(ii)
This is favourable if the actual price is less than the revised standard price.
Materials Usage and Labour Efficiency
The approach to calcula ng the materials usage and labour efficiency variances is the same,
so they are dealt with together here.
Tradi onal Usage/Efficiency Variance
Kg/Hours, etc
Actual quan ty used
x
Kg/Hours, etc
Standard quan ty for actual output
x
Difference
x
At standard price/rate per unit/hour
$x
Materials usage (labour efficiency) variance
$x
Planning Usage/Efficiency Variance
Kg/Hours, etc
Original standard quan ty for actual output
x
Revised standard quan ty for actual output
x
Difference
x
At original standard price/rate per unit/hour
$x
Materials usage/labour efficiency planning variance
$x

This is adverse if the revised standard quan ty is greater than the original standard
quan ty.
Opera onal Usage/Efficiency Variance
Kg/Hours,
etc
Actual quan ty used
x
Revised standard quan ty for actual output
x
Difference
x
Kg/Hours,
etc
At original standard price/rate per unit/hour
$x
Materials usage/labour efficiency opera onal
variance
$x
C. Learning Curve and Labour Variances
Where a learning curve applies, standard costs based on the cost of producing the first unit
of a product may quickly become out of date, meaning that the variances will become
meaningless.
To adjust for this, the “standard hours for actual produc on” in the labour efficiency
variance should take into account the learning curve (see Chapter 10).
D. Market Size and Market Share Variances
(i)
The Concept
A tradi onal sales volume variance may result from:

a market size variance, which arises because the size of the market was different
from expected due to a change in the external environment (e.g. economic growth);
or

a market share variance, which arises because the share of that market was different
from the budget (e.g. due to effec ve adver sing).
If the actual market size for a product is known, the sales volume variance can be analysed
as follows:
Sales managers can control the market share variance but cannot control the market volume
variance. Therefore, any bonus for the sales manager should be linked to the market share
variance.
(ii)
Market Size Variance
Units
Budgeted sales quan ty
x
Revised budgeted quan ty
(Actual market size × Budgeted market share)
x
Difference
x
× Standard contribu on/profit per unit
x
Market size variance
$x
Exam advice
If marginal cos ng is used, mul ply the differences by the standard contribu on per unit.
If absorp on cos ng is used, mul ply the differences by the standard profit per unit.
(iii)
Market Share Variance
Units
Actual sales quan ty
x
Revised budgeted quan ty
x
Difference
x
× Standard contribu on/profit per unit
x
Market share variance
$x
(iv)
Topic Explainer Video Market Size Variance and Market Share Variance
E. Advantages and Disadvantages
Advantages


Dis nguishes between
those variances caused
by bad planning or
unavoidable factors and
those resul ng from
opera ng factors.
Adverse opera ng
variances provide
feedback control on
processes which need
correc ng.

Planning variances can
be used to update
standards to current
condi ons.

Mo va on may
improve if managers
Disadvantages

Extra data requirements
(e.g. market size).

More me-consuming.

Managers may claim that
all adverse variances have
external causes and all
favourable variances have
internal causes (i.e.
manipula on of revised
standards).

Opera onal managers may
claim that all adverse
variances are due to poor
standard se ng at the
planning stage (but take
credit for all favourable
variances).
Advantages
Disadvantages
know they will only be
assessed on variances
under their control (i.e.
opera onal variances).
F. Manipula on
From the previous discussion, it should be apparent that budgets and standards prepared at
the start of the year may need revision at the end of the year if they are inappropriate
because of factors that occurred outside of the organisa on's control.
Managers who have not achieved their budgets/targets may try to hide adverse variances by
revising their budgets and standards. Therefore, to prevent manipula on, there must be
strict rules to ensure that budget revisions are only made when appropriate. Revisions
should only be permi ed when there is independent, verifiable evidence (e.g. a published
price index for a change in market price).
4. Behavioural Aspects of Standard Cos ng
A. Effect on Staff Mo va on and Ac on
Standard cos ng and variance analysis may be used as part of the performance evalua on of
managers and staff. Variance analysis will, therefore, have some effect on mo va on.

As for budgets, a challenging target can mo vate managers and staff to work harder,
compared with having no target.
However, there are many poten al problems related to the use of variance analysis:

If managers use variance informa on insensi vely, morale may suffer. Employees
(workforce and supervisors) should be congratulated on tasks well done, but
management by excep on tends to focus on what has gone wrong. Employees
berated or disciplined for adverse variances may a empt to conceal them or take
ac ons to ensure that the variances within their control are favourable, which may
not be in the company’s best interests. For example, a rush to increase produc vity
at the end of the budget period to avoid an unfavourable labour efficiency variance
may reduce the quality of output.

Accurate prepara on of standards can be difficult. For example, workers may operate
below their ability during standard-se ng runs to build “slack” into the standard.

Labour quan ty standards and efficiency variances make two assump ons that may
not hold true:
1. Output increases if workers speed up (i.e. the pace of produc on is dictated
by labour). However, the volume of output may be influenced more by the
processing speed of equipment.
2. Labour is a variable cost. However, the cost of a workforce may be fixed.
Undue emphasis on efficiency can result in an excessive build-up of work in
progress and finished goods inventories.
B. Variances and Performance Evalua on
This chapter and the three preceding chapters have men oned the use of variances to
evaluate performance. This sec on provides comprehensive guidance on this aspect of
variance analysis.
(i)
Iden fy the Cause of the Variance
Possible causes of tradi onal variances were discussed in Chapter 12, and Chapter 13 gave
reasons for materials mix and yield variances. In the real world (and in examina on
ques ons), there may be other causes. The first stage in using variances to evaluate
performance is to understand what caused them.
Having iden fied the cause of a par cular variance, it is worth iden fying whether other
variances were also affected. For example:

A favourable materials price variance may have been caused by buying cheaper
materials, but this may also have resulted in an adverse materials usage variance.

It would be meaningless therefore to say that the favourable price variance was
“good” and that the adverse usage variance was “bad”.
All variances caused by a common factor should be considered together. It may be
worthwhile to add the variances together (trea ng favourable variances as posi ve and
adverse variances as nega ve) to appreciate the total financial impact.
Exam advice
Variances that are related to a common factor should be evaluated together.
(ii)
Iden fy Who Is Responsible
It may be that variances are being used to assess the performance of a par cular manager
(e.g. a factory manager). Managers should only be judged on variances that are within their
control. Variances are usually the responsibility of the following departments and their
managers:

Materials price variance – the purchasing department. However, look for signs that
the purchasing department may have been put under pressure to buy from a
par cular supplier. Or, if the purchase was requisi oned at very short no ce, the
purchasing department may have been unable to obtain a favourable price that it
might have had otherwise.

Labour rate variances – this depends on who decides how much to pay par cular
workers. It could be the human resources department or the factory manager.

Labour efficiency variances are usually assumed to be the responsibility of the person
who supervises the workers – this could again be the factory manager. However,
these variances may also be related to the rate variance – a higher grade of labour
will generally lead to an adverse rate variance, but the labourers might work more
efficiently.

Material usage variances are also associated with a produc on manager. However,
variances may also have been caused by the purchase manager buying a quality of
material different from the standard.

Mix and yield variances are typically controlled by the produc on manager, who
supervises the produc on process. However, these may also be affected by the
quality of materials used, which could be the responsibility of the purchasing
manager.

Overhead variances will be the responsibility of the appropriate managers –
equipment maintenance expenditure, for example, would depend on the
maintenance manager.
(iii)
Consider Whether the Standard Was Fair
As previously explained, a standard should be revised if it becomes outdated or is otherwise
unreasonable (e.g. it was a poor es mate). Opera onal variances are generally a more
reliable indicator of performance than tradi onal variances.
(iv)
Non-financial Factors
Variances reflect only the financial view. Non-financial factors such as quality may be equally
important, but these factors are ignored by variances. This is a significant limita on of
variance analysis.
If variances are favourable, this means costs are being kept under control. However, if this is
at the expense of quality, the favourable variance may have some nega ve consequences.
(v)
Improving Future Performance
A er iden fying the causes of variances, appropriate ac on can be taken to ensure that
future performance improves. For example:

Including non-financial factors as well as variances in managers’ appraisal systems.

Regular review and upda ng of variances to reflect changes in the external
environment.

Using target cos ng to iden fy ways to reduce costs further.
C. Relevance of Variances in the Modern Environment of JIT and TQM
Many writers have argued that variance analysis is not relevant in the modern, rapidly
changing business world and that it can lead to dysfunc onal behaviour for these reasons:

Use of a standard cos ng system may lead to an overemphasis
on quan ta ve elements of performance. It is important that qualita ve
performance is not neglected (e.g. customer sa sfac on, employee morale,
innova on), par cularly in a total quality management environment.

Just-in- me (JIT) and flexible manufacturing systems aim to provide more tailored
produc on to meet customers’ needs. There may, therefore, be less standardisa on
of produc on, which makes comparison with a standard less meaningful.

JIT purchasing systems emphasise forging close, long-term rela ons with suppliers.
Under such a system, input costs will likely be known with certainty in advance, so
there will be no price variances.

Tradi onal standard se ng is based on a company’s own costs and procedures. This
may be too inward-looking where the company operates in a rapidly changing,
compe ve market.
A more modern approach is benchmarking, which also takes into account the prac ces of
other organisa ons in the industry (i.e. external informa on).
D. Behavioural Problems in Rapidly Changing Environments
The use of standard cos ng and variance analysis can have adverse effects on behaviour in a
rapidly changing environment.

Merely mee ng standards may be insufficient to ensure a company’s survival in a
compe ve environment. It may be necessary to focus on trends in variances which
aim for con nual improvement.

Standards provide an internal focus to management. In a rapidly changing
environment, an external focus would be more appropriate.

New products come online more frequently. There may be learning curves associated
with these. Standards which fail to reflect learning curves may not set an appropriate
target. They could be too easy, which would not challenge staff, or too difficult, which
would be demo va ng.
Syllabus Coverage
This chapter covers the following Learning Outcomes.
D. Budge ng and Control
6.
Planning and opera onal variances
1. Calculate a revised budget.
2. Iden fy and explain those factors that could and could not be allowed to revise an
original budget.
3. Calculate, iden fy the cause of and explain planning and opera onal variances for:
1. sales, including market size and market share;
2. materials;
3. labour, including the effect of the learning curve.
4. Explain and discuss the manipula on issues involved in revising budgets.
7.
Performance analysis
1. Analyse and evaluate past performance using the results of variance analysis.
2. Use variance analysis to assess how future performance of an organisa on or
business can be improved.
(d) Discuss the effect that variances have on staff mo va on and ac on.
(e) Describe the dysfunc onal nature of some variances in the modern environment of JIT
and TQM.
(f) Discuss the behavioural problems resul ng from using standard costs in rapidly changing
environments.
Summary and Quiz

Actual performance is compared with budgets at the end of each budget period.
Before performing this comparison, it may be appropriate to revise the budget if it
turns out to be unrealis c in retrospect or if factors outside the control of the
relevant manager occurred which make the original budget inappropriate.

Standards also may be revised before performing variance analysis:

o
Opera onal variances compare actual performance against a revised budget
or standard.
o
Planning variances compare the original standard with the revised standard
for actual output.
Tradi onal cost variances can be analysed into planning and opera onal as follows:
o
Price (rate) planning variance:
(Actual quan ty × Original standard price) − (Actual quan ty × Revised standard price)
o
Opera onal price (rate) variance:
(Actual quan ty × Actual price) − (Actual quan ty × Revised standard price)
o
Planning usage (efficiency) variance:
(Revised SQ for actual output − Original SQ for actual output) × Original standard price
o
Opera onal usage (efficiency) variance:
(Actual quan ty − Revised SQ for actual output) × Original standard price.

The sales volume variance can also be analysed into a market size (planning) variance
and a market share (opera onal) variance.

A revised budgeted sales quan ty is found by mul plying the budgeted market share
with the actual market size.

o
Market size variance is (Original budget quan ty − Revised standard quan ty)
x Standard contribu on/profit per unit.
o
Market share variance is (Revised standard quan ty − Actual sales quan ty) x
Standard contribu on/profit per unit.
The use of standard cos ng and variance analysis aims to improve opera onal
efficiency. Managers need to be aware of the poten al adverse effects of variance
analysis on behaviour.