Standard Cost Variances That Reward the Wrong Behavior
Atlas Components uses standard costing. Standard: 3 kg of alloy at $8/kg per unit and 0.5 labor hours at $22/hour. Budgeted production was 20,000 units. Actual production was 19,200 units; purchased and used 60,000 kg at $7.40/kg; labor was 9,800 hours at $23/hour. The purchasing manager earned a favorable material price variance by buying a lower-grade alloy. Scrap rose to 4.5% from a normal 1.5%, and rework added 600 labor hours. The plant manager is evaluated on total manufacturing cost variance; the purchasing manager is evaluated on purchase price variance. HR reports morale problems in the quality team.
1. Compute the material price and quantity variances and the labor rate and efficiency variances. Interpret them.
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Standard quantity allowed for actual output: 19,200 x 3 = 57,600 kg. Standard hours allowed: 19,200 x 0.5 = 9,600 hours.
Material price variance: ($7.40 - $8.00) x 60,000 = $36,000 favorable. Material quantity variance: (60,000 - 57,600) x $8 = $19,200 unfavorable. Net material variance: $16,800 favorable.
Labor rate variance: ($23 - $22) x 9,800 = $9,800 unfavorable. Labor efficiency variance: (9,800 - 9,600) x $22 = $4,400 unfavorable. Net labor variance: $14,200 unfavorable.
Overall net variance: $2,600 favorable. The plant manager appears slightly favorable, and the purchasing manager appears strongly favorable, even though the lower-grade alloy increased scrap and rework. The favorable price variance is partly offset by quantity and labor inefficiencies, but the scorecards hide the cause.
2. Explain why the variances mislead and recommend a performance-measurement fix.
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The purchasing manager is rewarded for a price variance that ignores quality. The lower-grade alloy saves $0.60 per kg but raises scrap from 1.5% to 4.5%: excess scrap is (4.5% - 1.5%) x 19,200 = about 576 units, plus 600 rework hours at $22 = $13,200. Those costs land on the plant manager, not the purchasing manager. The plant manager's total cost variance is only slightly favorable, so the organization looks fine while value is being destroyed.
Fixes:
- Evaluate purchasing on total cost of ownership, including scrap, rework, warranty, and downtime, not price variance alone.
- Charge quality-related excess costs back to the responsible function through a rework/scrap account.
- Add quality metrics such as first-pass yield and scrap rate to both scorecards.
- Use team-based incentives for joint cost and quality goals.
- Review standards after the fact so that a favorable variance does not simply reflect an outdated standard.
3. What should management and internal audit do about the quality and ethical implications?
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Management should investigate whether purchasing knowingly bought substandard material to hit a variance target, whether specifications allowed it, and whether quality objections were overridden. If so, this is a control and incentives failure, not merely an accounting variance. Internal audit should test the approval trail for the alloy purchase, compare specifications with accepted receipts, and verify that scrap and rework are recorded completely and in the correct period.
Actions: revise purchasing authority and specifications, require quality sign-off for material substitutions, adjust the standards and scorecards, and communicate that favorable variances achieved by shifting costs to another unit are not acceptable. HR should address the quality team's morale issue and ensure no retaliation for raising concerns. Follow up by monitoring scrap and rework trends for at least two quarters.