technical
understanding the causes of variances
relevant to CAT Scheme Paper 7 and
Professional Scheme Paper 1.2
cause and effect
Standard costing is a control technique which compares standard
costs and revenues with actual results to obtain variances which are
used to stimulate improved performance.
In order to stimulate improved performance, we need to understand
the potential causes of variances. In general, variances have four causes.
These are outlined below.
Inappropriate standard
If a standard is set at a level that does not reflect current conditions,
then variances will be recorded even if the organisation is operating at
the required level of efficiency. For example, if price standards have not
been updated for inflation, an expenditure variance calculated against
out-of-date price standards will result in an adverse variance – even when
the organisation is purchasing efficiently. This type of variance is often
dismissed in management meetings as ‘budget error’.
Inaccurate recording of actual costs and revenues
An organisation may be operating efficiently, but if costs are recorded
inaccurately then variances may result. For example, if workers complete
timesheets inaccurately some departments will be overcharged with
labour hours and others undercharged. This will lead to adverse and
favourable labour efficiency variances, even if the departments are
operating at the standard level of efficiency.
Random events
Variances can sometimes be caused by random events which, by their
very nature, are unlikely to occur again. For example, a freak accident may
damage raw material stocks and cause adverse material usage variances.
Operating efficiency
If the three causes above can be eliminated, then the variance must
be due to operating efficiency. Improving operating efficiency is the key
58 student accountant May 2006
to stimulating improved performance. Table 1 on page 60 gives some
examples of causes of operating efficiency variances, both adverse and
favourable.
In a traditional standard costing system, the variances recorded
are likely to be caused by a combination of inappropriate standards,
inaccurate recording of actual costs, random events, and operating
efficiency. To stimulate improvements management accountants need
to isolate the variances caused by operating efficiency. These are
potentially controllable variances and management action can lead to
improved organisational performance in these areas.
Operating efficiency variances can be identified by a process of
elimination. If standards are set at the correct level, if actual data are
correctly recorded and random events are noted, then what remains must
be due to operating inefficiency.
Variances caused by random events can often be identified by
talking to departmental managers (‘Has anything unusual happened this
week?’). Emphasising the need for accurate record-keeping can help
eliminate variances caused by poor recording of actual data. The effect
of inappropriate standards can be eliminated by the recalculation of
variances based upon revised standards. This involves using hindsight to
update standards for known, uncontrollable changes in circumstances.
Example 1 demonstrates this approach. Note that in the Paper 7
examination, candidates would not be required to calculate the split of
the variance into its controllable and uncontrollable elements (as in this
example), but might be required to explain why it is done.
EXAMPLE 1
The direct labour standard for a product is three hours of labour per unit
at a standard cost of £10 per hour. During a particular period, 2,000
units of product were manufactured using 6,500 hours of labour at an
actual average cost of £12 per hour. The usual calculation would result in
the following labour rate variance:
technical

Actual hours at the actual rate: variance. When judging the success of the price increase, it is necessary
6,500 hours x £12.00 = £78,000 to consider the two variances jointly. For example, a favourable sales
Labour rate variance >£13,000 Adv price variance of £10,000 would be unacceptable if it resulted in an
Actual hours at the standard rate: adverse sales volume variance of £20,000.
6,500 hours x £10.00 = £65,000
CONCLUSION
However, assume that (with hindsight) we discover that, due to wage The calculation of variances is not an end in itself. The main use
inflation, a more realistic standard for the period should have been of variances is to stimulate improved performance. Management
£11.50 per hour. The variance can then be recalculated as: accountants need to understand the potential causes of variances in order
to identify the variances that managers can control.
Actual hours at the actual rate: 6,500 hours x £12.00 = £78,000
Possible controllable labour rate variance >£3,250 Adv Steve Jay is examiner for CAT Paper 7
Actual hours at the revised standard rate:
6,500 hours x £11.50 = £74,750 TABLE 1: CAUSES OF OPERATING EFFICIENCY VARIANCES
Uncontrollable labour rate variance >£9,750 Adv
Actual hours at the original standard rate: Variance Favourable Adverse
6,500 hours x £10.00 = £65,000

With hindsight, it can be seen that of the £13,000 total rate variance, Material price Bulk buy discount Failing to shop
£9,750 is due to an increase in market wage rates that was beyond the around
control of managers. The remaining £3,250 could possibly be controlled
by managers, depending upon their level of control over wage rates, Material usage Careful usage Poor quality material
overtime working, and labour deployment. Holding managers responsible
for the uncontrollable element of the variance is contrary to the principles Labour rate Using less skilled Unscheduled
of responsibility accounting, which state that managers should only be labour overtime working
held accountable for items they can control. Violating these principles
would be bad for motivation and cost control. Labour efficiency Good motivation Using less skilled
labour
INTERRELATIONSHIPS BETWEEN VARIANCES
Finally, when operating variances have been identified it is important to Labour idle time Not applicable Machine breakdown
consider any potential interrelationships. Appreciating the relationship
between variances can reveal causes not apparent from individual Variable overhead Careful use of Poor negotiation
variances. Favourable variances in one area often cause adverse expenditure electricity etc with suppliers
variances in another, and it is important to consider the sum of the
interrelated variances before drawing any conclusions. Examples of these Variable overhead See labour efficiency See labour efficiency
interrelationships are described in Scenarios 1 and 2. efficiency

Scenario 1 Fixed overhead Good cost Some variable

A favourable material price variance – caused by buying lower grade expenditure management overheads mis
material – could result in an adverse usage variance due to more wastage. classified as fixed
This, in turn, could result in an adverse labour efficiency variance, caused
by the poorer quality material being harder to work with. This could also Fixed overhead See labour efficiency See labour efficiency
lead to adverse variable overhead efficiency, fixed overhead efficiency, efficiency
and favourable fixed overhead capacity variances. An adverse labour rate
variance could also occur if overtime had to be paid to accommodate the Fixed overhead Overtime working Low production due
extra labour hours. In evaluating the decision to buy lower grade material, capacity due to high demand to lack of orders
all the above variances would need to be considered.
Sales price Price increases due to Price cuts to
Scenario 2 improved quality increase sales
A sales price increase that caused a favourable sales price variance could
lead to a decrease in sales volume, resulting in an adverse sales volume Sales volume Price cutting Poor product quality

60 student accountant May 2006