Difficulty: Intermediate. Prerequisites: cost behaviour (Doc 1), cost allocation basics (Doc 2).
Variance analysis decomposes the gap between budgeted and actual profit into volume effects and spending effects, then further into price and efficiency components. The key insight: always compare actual results against a flexible budget (what you would have expected to spend at the actual volume), not the original static budget. Performance measurement systems, including balanced scorecards and incentive pay, shape behaviour, for better and sometimes for worse.
Static (original) budget
The budget prepared before the period begins, based on planned volume. It does not adjust when actual volume differs from plan.
Flexible budget
A budget recalculated at actual volume, using the same standard prices and standard quantities per unit as the original budget. In simple terms, it answers: what should we have spent to produce the units we actually made?
Total variance
The difference between actual results and the static budget. Equals the sum of the sales volume variance and the flexible budget variance.
Sales volume variance (SVV)
Flexible budget minus static budget. Captures the profit impact of selling a different number of units than planned. Driven by volume, not by spending.
Flexible budget variance (FBV)
Actual results minus flexible budget. Captures the spending impact: did we spend more or less than expected for the volume we actually achieved?
Price (rate) variance
The portion of a flexible budget variance caused by paying a different price per unit of input than the standard. Formula: actual quantity x (actual price - standard price).
Efficiency (usage / quantity) variance
The portion of a flexible budget variance caused by using a different quantity of input than the standard allows for the actual output. Formula: standard price x (actual quantity - standard quantity).
Standard price (SP)
The budgeted or expected price per unit of an input (materials, labour).
Standard quantity (SQ)
The budgeted or expected quantity of input allowed for the actual number of units produced.
Favourable (F) variance
Actual spending is less than the budget, or actual revenue is more. Not always good: buying cheaper materials that increase waste creates a favourable price variance but an unfavourable usage variance.
Unfavourable (U) variance
Actual spending exceeds the budget, or actual revenue falls short.
Balanced scorecard
A performance evaluation framework that measures financial results alongside nonfinancial dimensions such as customer satisfaction, internal processes, and learning/growth.
Controllability principle
Employees should be evaluated only on factors they can influence. Performance metrics that include uncontrollable factors impose risk and reduce the effectiveness of incentives.
Multi-task problem
When an employee is responsible for multiple objectives (quantity and quality), incentivising one dimension may lead to neglect of the others.
Piece-rate pay
Compensation based on the number of units produced or tasks completed, rather than hours worked.
Waltham Motors Division budgeted 18,000 units but produced and sold only 14,000 (after losing a major customer). The static budget showed a $91,200 profit; the actual result was a $7,200 loss.
The plant accountant's performance report compared actual costs against the static budget (18,000 units) and showed almost all manufacturing variances as favourable. This is misleading: of course you spend less in total when you produce 22% fewer units. The report flatters performance by comparing actual spending at 14,000 units against a budget set for 18,000.
The fix: introduce a flexible budget at 14,000 units. Recalculate what variable costs should have been at the actual volume (using the same per-unit standards). Fixed costs stay the same. Now compare actual spending against this flexible benchmark.
With the flexible budget:
Sales show a $14,000 favourable variance (actual price $49/unit vs budgeted $48/unit)
Most variable manufacturing costs are now unfavourable: direct material $1,400 U, direct labour $22,000 U, idle time $3,000 U, cleanup $1,600 U
Total variable manufacturing FBV: $27,556 U
Total FBV on contribution margin: $19,156 U
The favourable sales price variance is swamped by unfavourable spending variances. The "rosy picture" from the static comparison was fallacious.
The flexible budget variance for each input can be decomposed into a price variance and an efficiency (usage) variance.
Direct material analysis:
Standard price (SP) = $6.00 per unit of material
Actual price (AP) = $6.00 x (1 - 5% discount) = $5.70
Standard quantity (SQ) for 14,000 units = $84,000 / $6 = 14,000 units of material
Actual quantity (AQ) = $85,400 / $5.70 = 14,982 units
Price variance = (SP - AP) x AQ = ($6.00 - $5.70) x 14,982 = $4,495 F
Usage variance = (AQ - SQ) x SP = (14,982 - 14,000) x $6.00 = $5,895 U
The material price fell (favourable), but more material was used than expected (unfavourable). Possible explanations: the cheaper material was lower quality, requiring more to be used; or material usage control was poor.
Direct labour analysis:
SP = $16/2 hours = $8.00 per half-hour
SQ = $224,000 / $8 = 28,000 half-hours
AP = $8.20
AQ = $246,000 / $8.20 = 30,000 half-hours
Price variance = (AP - SP) x AQ = ($8.20 - $8.00) x 30,000 = $6,000 U
Usage variance = (AQ - SQ) x SP = (30,000 - 28,000) x $8.00 = $16,000 U
Labour cost more per hour and more hours were used. Possible explanations: short labour supply forcing higher wages; workers shirking to avoid layoffs during a volume decline.
Breakeven check: budgeted CM per unit = $351,200 / 18,000 = $19.51. Breakeven volume = $260,000 / $19.51 = 13,326 units. Actual volume of 14,000 is above breakeven, so the division should have been profitable if per-unit costs had stayed normal. The loss was caused by spending inefficiency, not volume.
Atlanta schools implemented a performance measurement system under Superintendent Beverly Hall. Teachers and principals were evaluated on student test scores (AYP and CRCT). Good performance earned bonuses and recognition; poor performance led to dismissals and mandatory interventions.
The increased pressure led to widespread cheating: teachers and administrators altered students' answer sheets. The performance measurement system created incentives so strong that they overwhelmed ethical boundaries.
Lessons on controls:
Performance measurement systems create both desired and undesired behaviours
Internal controls are needed: formalise and communicate core values; create and communicate boundaries specifying off-limits activities
Linking compensation to a single metric (test scores) is dangerous when the metric can be gamed
The same dynamic applies in business: linking CEO pay to earnings or share price can incentivise earnings manipulation and fraud
Safelite replaces automobile windshields. The company suffered from low productivity (workers averaged 2.5 installations per 8-hour day despite each job taking about 1 hour) and high turnover.
The proposed solution: switch from hourly wages to piece-rate pay (payment per windshield installed), with a guaranteed minimum wage.
Challenges with piece-rate pay:
Controllability: outside factors affect output (weather, dispatcher errors, parts availability). Imperfect measurement imposes risk on workers and weakens the incentive.
Teamwork: dispatchers assign jobs. If dispatchers are inefficient, installers are penalised for someone else's fault.
Multi-task problem: installers are responsible for both quantity and quality. Rewarding quantity can reduce quality. Fix: require installers to repair faulty installations at no additional pay; offer bonuses for quality.
High turnover: not necessarily bad if it means low-productivity workers leave and high-productivity workers stay. Piece-rate pay attracts workers who believe they will be highly productive and who are less risk-averse.
The guarantee rate debate: initially, installers received their previous hourly wage as a floor for 12 weeks, then it dropped by 30%. Pros: puts teeth into the incentive faster, pushes out low-productivity workers, lowers costs. Cons: low-paid workers living paycheck to paycheck find the risk threatening and may leave. Ultimately, the company kept a piece rate without the guarantee reduction.
Results: the Performance Pay Plan increased productivity partly through motivation (existing workers worked harder) and partly through selection (better workers joined, weaker ones left).
Citibank implemented a balanced scorecard evaluating branch managers across six dimensions: financial, strategy implementation, customer satisfaction, control, people, and standards.
The dilemma: James McGaran delivered excellent financial results ("above par" on all financial metrics) but scored "below par" on customer satisfaction. Under the new system, this meant he could not receive his full 30% bonus.
Arguments for rating him "below par" overall: follows the new system's guidelines, reinforces that customer satisfaction matters, communicates strategy.
Arguments for "par": the customer satisfaction survey may not accurately measure his branch's performance (his customer base is unusually demanding), too much weight on one metric may be distortionary.
Arguments for "above par": rewards his financial results, the old system would have given him a bonus, flexibility prevents demotivation.
Actual outcome: McGaran received an "above par" overall rating but kept "below par" in customer satisfaction, with a 25% bonus instead of 30%.
Overall lesson: linking employee pay to nonfinancial performance measures communicates strategy and motivates specific actions. Nonfinancial measures can be leading indicators of future financial performance. But measurement quality matters, and overly rigid systems can create perverse incentives.
\text{Total Variance} = \text{Sales Volume Variance} + \text{Flexible Budget Variance}\text{Sales Volume Variance (SVV)} = \text{Flexible Budget} - \text{Static Budget}\text{Flexible Budget Variance (FBV)} = \text{Actual} - \text{Flexible Budget}\text{Price Variance} = AQ \times (AP - SP)\text{Efficiency Variance} = SP \times (AQ - SQ)Where AQ = actual quantity of input used, AP = actual price per unit of input, SP = standard price, SQ = standard quantity allowed for actual output.
Students often compare actual costs against the static budget and conclude that spending was "under control" because total costs fell. This is wrong whenever volume also fell. The flexible budget is the correct benchmark.
Students sometimes treat all favourable variances as good news. A favourable materials price variance (buying cheaper inputs) can cause an unfavourable usage variance (more waste from lower quality). Always look at price and usage together.
Students confuse the sales volume variance with the flexible budget variance. SVV is about selling more or fewer units than planned. FBV is about spending more or less per unit than the standard allows.
Students sometimes assume that a balanced scorecard should weight all dimensions equally. It should not. The weights reflect the organisation's strategy and what it believes drives long-run value.
Be able to construct a flexible budget from a static budget and actual volume. This is the single most testable skill in variance analysis.
Know the decomposition: total variance = SVV + FBV, and FBV = price variance + efficiency variance for each input.
Price variance = AQ x (AP - SP). Efficiency variance = SP x (AQ - SQ). Memorise the formulas and which variable is held constant in each.
Waltham Motors: the key takeaway is that the original performance report was misleading. Expect a question asking you to prepare or critique a performance report.
Know the arguments for and against nonfinancial performance measures (balanced scorecard): they communicate strategy and can be leading indicators, but they can also be gamed.
Safelite: understand the trade-offs of piece-rate pay (controllability, multi-task, selection vs motivation effects).
True or false: the flexible budget uses actual prices and actual quantities. (False: it uses standard prices and standard quantities per unit, applied to the actual number of units produced.)
Fill in the blank: price variance = AQ x (______ - ______). (AP - SP)
True or false: at Waltham Motors, the static budget comparison showed unfavourable variances for most variable costs. (False: it showed favourable variances, which was misleading.)
Fill in the blank: the multi-task problem at Safelite arises because rewarding ______ may reduce ______. (quantity, quality)
True or false: Citibank gave James McGaran "below par" overall because of his customer satisfaction score. (False: he received "above par" overall but "below par" in customer satisfaction, with a reduced bonus.)
Q: Waltham Motors budgeted direct materials at $108,000 for 18,000 units. Actual production was 14,000 units and actual material cost was $85,400. What is the flexible budget for direct materials?
A: Standard material cost per unit = $108,000 / 18,000 = $6.00. Flexible budget = 14,000 x $6.00 = $84,000.
Q: Using the data above, what is the flexible budget variance for direct materials?
A: FBV = Actual - Flexible Budget = $85,400 - $84,000 = $1,400 Unfavourable.
Q: At Waltham Motors, material was purchased at a 5% discount (AP = $5.70 vs SP = $6.00) and actual quantity used was 14,982 units. Decompose the FBV into price and usage variances.
A: Price variance = (SP - AP) x AQ = ($6.00 - $5.70) x 14,982 = $4,495 F. Usage variance = (AQ - SQ) x SP = (14,982 - 14,000) x $6.00 = $5,895 U. Net = $5,895 - $4,495 = $1,400 U, matching the FBV.
Q: Why did the Atlanta Schools' performance measurement system lead to cheating?
A: The system tied high-stakes consequences (bonuses, dismissals) to a single metric (test scores) without adequate controls or boundaries. Teachers and administrators faced extreme pressure to hit targets and chose to game the metric rather than improve genuine instruction.
Q: At Safelite, why might piece-rate pay increase productivity through selection as well as motivation?
A: Piece-rate pay attracts workers who believe they will be highly productive (they earn more under piece rate than under hourly wages). It also pushes out low-productivity workers, who earn less. Over time, the workforce composition shifts toward higher-productivity individuals, boosting average output independently of any motivational effect on existing workers.
Variance analysis is the diagnostic counterpart to cost behaviour and CVP (Doc 1): the flexible budget rests on the variable/fixed distinction. It also connects to cost allocation (Doc 2) because overhead variances depend on how costs are allocated. Performance measurement links to pricing and strategy (Doc 3): the incentive systems that shape behaviour also affect strategic decisions.
Related Terms / Search Tags
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