Planning versus Operational Variances and the Decision to Investigate
Kaveri Industrial Valves prepared its annual budget for 12,000 valves. The material standard was set at 4.0 kg of imported alloy per valve at ₹150 a kg. Part-way through the year the government doubled the royalty on imported ore and the market price of the alloy moved to a level at which a revised standard of ₹160 a kg would have been set; at the same time the only available domestic substitute gives a lower yield, so a revised standard of 4.1 kg per valve would have been appropriate. Actual output was 11,200 valves, using 45,920 kg at an actual price of ₹155 a kg. Separately, the labour efficiency variance for the same period was ₹1,10,000 adverse; the standard deviation of this variance over the past three years is ₹65,000, an investigation would cost ₹42,000, and past records show that 55% of such variances have an assignable cause whose correction costs about ₹60,000 but saves ₹2,80,000 over the following year. The works manager wants the labour variance investigated; the CFO thinks variance analysis is a waste of time.
1. Split the material cost variance into planning and operational components, and check your answer against the conventional price and usage variances.
Read the worked answer
Actual cost = 45,920 × 155 = ₹71,17,600. Original standard cost = 11,200 × 4.0 × 150 = ₹67,20,000. Total variance = ₹3,97,600 adverse.
Planning variances (arising from the revision of the standard, measured at standard price and actual quantity):
- Price: (160 − 150) × 45,920 = ₹4,59,200 A
- Usage: (4.1 − 4.0) × 11,200 × 150 = 1,120 kg × 150 = ₹1,68,000 A
- Total planning = ₹6,27,200 A
Operational variances (measured against the revised standard):
- Price: (155 − 160) × 45,920 = ₹2,29,600 F
- Usage: revised standard quantity 4.1 × 11,200 = 45,920 kg; actual 45,920 kg, so nil
- Total operational = ₹2,29,600 F
Check: 6,27,200 A − 2,29,600 F = ₹3,97,600 A, agreeing with the total variance.
Conventional split for comparison: price (155 − 150) × 45,920 = ₹2,29,600 A; usage (45,920 − 44,800) × 150 = ₹1,68,000 A; total ₹3,97,600 A. The conventional statement shows two adverse variances that in substance are not the responsibility of either purchasing or production.
2. Interpret the two sets of variances for the board and explain how they should change the way performance is reported and rewarded.
Read the worked answer
What the traditional statement says: purchasing overspent by ₹2,29,600 and the works overspent on material by ₹1,68,000. Both look like controllable failures.
What actually happened: the external shock - the royalty increase and the loss of yield on the substitute ore - accounts for ₹6,27,200 of the total. Against the world as it was after the shock, purchasing bought ₹5 a kg below the revised market (₹2,29,600 favourable) and production used exactly the quantity the substitute material permits (nil usage variance). Both functions performed well; the business has a genuine cost increase.
Reporting implications.
- Show planning and operational variances as separate lines in the monthly pack; planning variances go to the board and to the commercial director, operational variances to the shop floor.
- Do not revise standards for temporary or reversible movements, and do not revise them silently mid-year; a documented revision with the reason protects the credibility of the standard.
- The ₹6,27,200 is a real cash cost, not a bookkeeping artefact. The response is commercial - a price increase, a raw-material clause in customer contracts, or a search for an alternative supplier - not a demand that the works recover it.
- Reward managers on operational variances only. Bonus based on the traditional variance would have punished two managers for a government decision, which is the fastest route to a standard-costing system being ignored.
3. Decide whether the labour efficiency variance should be investigated, showing your calculation, and comment on both managers' blanket positions.
Read the worked answer
Expected value of investigating:
- Expected saving if assignable: 0.55 × 2,80,000 = ₹1,54,000
- Less investigation cost: ₹42,000 (incurred whether or not a cause is found)
- Less expected correction cost: 0.55 × 60,000 = ₹33,000
- Net expected benefit = ₹79,000
Positive, so investigate.
How strong is the signal? 1,10,000 ÷ 65,000 = 1.69 standard deviations. If the process is in control, a deviation this large or larger would arise by chance roughly 9% of the time (two-tailed). The variance is therefore suggestive but not conclusive - which is precisely why the 45% no-cause branch belongs in the expected value rather than being assumed away.
On the two managers. The CFO's blanket dismissal is wrong: a variance with a positive expected investigation value is an asset being ignored, and the ₹79,000 is a recurring annual figure, not a one-off. The works manager's blanket demand is equally wrong: investigating every variance destroys value, since the ₹42,000 is spent whether or not a cause exists. The discipline is to screen variances by expected value and by position against control limits (typically 2σ warning, 3σ action), starting with the largest and those with a history of assignable causes; a variance found to be random should lead to a review of the standard, not to another investigation.