7.4 Variance Investigation, Causes, and Management by Exception

7.4 Variance Investigation, Causes, and Management by Exception

Key Concept: Calculating a variance is merely identifying a symptom; effective management accounting requires diagnosing the operational disease. Organizations apply Management by Exception (MBE) to filter out random background fluctuations and focus managerial resources on significant, controllable deviations.

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Root Causes of Common Cost and Revenue Variances

When a variance is reported, management must determine whether the underlying cause is controllable (within the operational authority of the department manager) or uncontrollable (driven by external market forces, natural disruptions, or faulty initial standard setting).

1. Direct Material Variances

2. Direct Labour Variances

3. Overhead Variances

• Variable Overhead Expenditure: Tariff adjustments for gas/electricity, supplier price changes for cutting fluids and lubricants, unexpected maintenance service rate increases.
• Fixed Overhead Expenditure: Factory rent increases upon lease renewal, local municipal business rate revaluations, executive salary awards, unbudgeted building insurance premiums.

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Interrelated and Offsetting Variances: The Systems View

Variances also cannot be evaluated in isolation. A decision made in one functional department frequently ripples through the organization, creating offsetting variances in other departments.

The 'Cheap Material' Trap: A Classic Interrelationship

Suppose the purchasing manager decides to buy low-grade steel from an unvetted overseas supplier at a 15% discount:

1. Material Price Variance is Favourable: Purchasing appears to have saved £10,000 against standard.
2. Material Usage Variance is Adverse: The metal is brittle; stamping presses crack 20% of the sheets, generating £14,000 in excess scrap.
3. Labour Efficiency Variance is Adverse: Assembly workers spend hours unjamming dies, smoothing burrs, and reworking flawed parts, costing £8,000 in unproductive hours.
4. Customer Quality Suffers: Defective components slip into finished goods, leading to warranty claims and lost customer goodwill.

Managerial Conclusion: What appeared to be a £10,000 'favourable' purchasing triumph resulted in a net operational loss of £12,000 on the factory floor (£10,000 F - £14,000 A - £8,000 A = -£12,000 Net Adverse). If the purchasing manager is appraised in isolation on their favourable price variance, the business incentivizes behaviour that destroys corporate profit!

Other Interrelated Scenarios

• Using Higher-Grade Craftsmen: A foreman assigns master craftsmen to routine assembly tasks. This produces an Adverse Labour Rate Variance (higher hourly pay), but generates a Favourable Labour Efficiency Variance (completed in half the time) and a Favourable Material Usage Variance (zero cutting waste).
• Express Freight: Paying for emergency air freight creates an Adverse Material Price / Carriage Variance, but avoids an impending assembly line shutdown that would have generated catastrophic Adverse Labour Idle Time and Overhead Variances.

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Management by Exception (MBE)

In a commercial enterprise producing hundreds of products across multiple operational departments, thousands of individual variance figures are generated every month. Investigating every single discrepancy—no matter how minor—is physically impossible and commercially irrational.

Definition: Management by Exception (MBE) is a management control system where senior executives concentrate their attention, time, and corrective action solely on significant deviations from planned performance, allowing operational areas that conform to budget to proceed without managerial interference.

Operational Rationale for MBE

1. Executive Time Optimization: Senior managers have limited time; MBE focuses cognitive bandwidth on critical operational failures.
2. Cost-Benefit Balance: Investigating a variance incurs administrative costs (clerical audits, engineering reviews, management meetings). If a variance is only £30, spending £250 in management time to investigate it makes no commercial sense.
3. Worker Empowerment: Demanding an explanation for every trivial 50p fluctuation demotivates operational supervisors. MBE provides supervisors with operational autonomy within normal tolerance bounds.

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Setting Materiality Thresholds for Investigation

To implement Management by Exception effectively, organizations establish formal materiality rules determining which variances must be investigated.

1. Quantitative Criteria

Organizations define objective mathematical boundary rules:

• Monetary Threshold: Investigate any variance exceeding a fixed absolute amount (e.g. any variance $> £1,000$).
• Percentage Threshold: Investigate any variance exceeding a proportion of the flexed budget line (e.g. any variance $> 5\%$ or $10\%$ of standard cost).
• Combined Rule (Most Robust): Investigate any variance that exceeds both an absolute amount and a percentage (e.g. $> £500$ and $> 5\%$), or any variance exceeding a large ceiling (e.g. $> £5,000$) regardless of percentage.
• Statistical Process Control: Plotting variances on a control chart; an investigation is triggered only if the variance falls outside upper and lower statistical tolerance limits (typically $\pm 2$ standard deviations from the mean).

2. Qualitative Criteria Overriding Numbers

Quantitative rules alone are insufficient. Management must investigate certain variances even if their current monetary value is below the quantitative threshold:

• Persistent Adverse Trends: A small variance that recurs in the same adverse direction month after month (e.g. material usage creeping up by 1.2% each month) indicates systemic decay, gradual machine wear, or pilferage that will compound if ignored.
• Safety and Regulatory Compliance: Discrepancies in safety inspections, chemical emission filtration, or certified component specifications must be investigated immediately regardless of financial impact.
• Critical Bottlenecks: A minor £100 variance occurring at the factory's principal constraint can shut down the entire production line.
• Controllability: A large variance driven by an uncontrollable global commodity surge may require standard revision rather than on-site investigation, whereas a small controllable waste on the shop floor warrants immediate supervisory action.

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Presentation and Formatting of Variance Reports

Variance reports must present financial and operational data in a clear, standardized format that facilitates rapid executive decision-making. Standard reporting guidelines include:

• Timeliness: Reports must be delivered promptly after the close of the period; ancient variances cannot be corrected.
• Exception Highlighting: Using visual markers (e.g. 'Investigate', bold text, or amber/red flags) to draw immediate attention to exceptions.
• Narrative Commentary: Numbers must be accompanied by concise operational explanations from line managers, outlining the root cause, controllability, and agreed corrective action.

Departmental Variance Exception Report Example

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Reporting Significant Variances: Causes, Effects and the Right Manager

The PCTN specification (learning outcome 3.2) asks you to do four things with a variance report: identify significant variances according to the organisation's policy, analyse their potential causes, analyse their potential effects, and report to the relevant manager. PCTN works with total variances. The price/usage and rate/efficiency headings in the cause tables above are simply a convenient way to organise the possible reasons behind a total materials or labour variance.

Worked Example: Pennine Pies Ltd

The March variances for Pennine Pies Ltd are calculated in Section 7.3. The company's policy is to report any variance of 5% of budget or more to the manager responsible.

Possible causes and effects to include in the report:

Who is the relevant manager? Send each variance to the person who controls that cost or income:

A favourable variance can be just as significant as an adverse one. The £6,000 favourable sales variance is reported because it meets the 5% threshold, and management needs to know whether the extra demand will continue.

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Common Exam Traps in Variance Reporting and MBE

• Trap 1: Assuming Favourable Variances Never Need Investigation. A large favourable variance is not necessarily good news. A favourable labour rate variance might reflect hiring undertrained workers, and a favourable material price variance might mean buying defective scrap. Both demand investigation.
• Trap 2: Ignoring Cross-Functional Linkages. Blaming the assembly foreman for adverse labour efficiency when the purchasing department bought shoddy, substandard components.
• Trap 3: Investigating Every Discrepancy. In exam scenario questions, recommending the investigation of trivial variances demonstrates a failure to understand the fundamental cost-benefit rationale of Management by Exception.