Performance analysis and behavioural aspects

Performance analysis and behavioural aspects

1. Using variance analysis

1.1 Analysing past performance with variance analysis: Variance analysis compares actual performance with a budget or standard cost. Differences between actual results and the budget or standard are reported in monetary terms as variances, and variances can be used to reconcile budgeted profit and actual profit in an operating statement. For the exam, you also need to show an awareness of what variances tell us, and what control measures management should take when a variance is reported. Basic principles of variance reporting are that:

(a) The monetary value that is given to variances should be a reasonable indication of how much profit has been made or lost as a result of actual performance differing from the budget or standard.

(b) The managers responsible for variances (adverse or favourable) should be identified, and they should be expected to account for the variance and, where appropriate, indicate what corrective or control measures they are taking.

1.1.1 Responsibility for planning variances: It was explained in the previous chapter that planning variances arise when a budget or standard cost is revised. 'Errors' in the budget or standard cost are attributable to the managers (planners) who prepared the budget or standard cost. Variances arising because the budget or standard cost was inappropriate should not be attributed to operational management.

In many cases, revisions to a budget or standard cost are due to causes outside the control of the planners. An unexpected increase in the market price for materials, for example, is beyond the control of planners. Similarly, an unexpected collapse in market demand for an industry's products, resulting in an adverse sales volume planning variance, cannot usually be 'blamed' on planners.

Even so, planning variances, where they occur, should be identified separately. Operational managers should be held responsible only for variances that may be realistically attributable to differences between actual performance and a realistic budget or standard. In other words, operational managers should be held responsible for operational variances. Unless they were also involved in the budgeting or standard- setting process, operational managers are not responsible for planning variances.

1.1.2 Responsibility for operational variances: Responsibility for operational variances should be traced to the managers who are in a position of authority and control over operations where the variances occur. Operational management responsibility for variances depends on the organisation structure and the division of authority and responsibility between management.

For example, a material price variance is the difference between actual and standard purchase costs of materials. The operational manager responsible for this variance should be the manager who makes the decisions about buying materials. This may be the head of buying in one organisation, and the production manager in a different organisation.

You should be able to identify the managers responsible for operational variances. A general guide is given in the table below.

Variance	Responsibility
Sales price variance	Sales or marketing management
Sales volume variance	Normally sales or marketing management However, if sales are less than budget due to problems with production, the production manager is responsible
Material price variance	The manager responsible for purchasing materials
Material usage variance	Normally the production manager
Labour rate variance	The manager responsible for pay rates. This may be senior management or Human Resources management. However, the production manager will be responsible for any adverse rate variances caused by working overtime and paying employees a premium rate per hour
Labour efficiency variance	Normally the production manager
Idle time variance	This depends on the cause of the idle time. It may be caused by lack of sales orders (sales management responsibility), inefficient production management (production management responsibility) or delays in deliveries of key raw material (buying manager responsibility)

1.2 Using variance analysis to improve future performance: Variance analysis is not simply a method of analysing past performance. It should provide guidance for operational management about aspects of performance that need improving. Variances should be a guide to control action and improving future performance.

It is important to understand that a reported variance is a measurement that relates to historical performance. Control action affects the future, not the past. So, for example, if an adverse labour efficiency variance of $10,000 is reported one month, and the production manager takes measures to improve efficiency:

(a) The effect of the control measures should be to improve efficiency, but the value of the efficiency improvement in future months is unlikely to be $10,000. Control measures may result in savings of more or less than $10,000 per month, depending on how effective the measures are.

(b) The effect of control measures should have a reasonably long-term impact, so control measures may result in savings not just in the following control period but also for a reasonably long time into the future.

1.2.1 The significance of variances: Control action to improve future performance should only be taken when a variance seems significant. Some variances are inevitable, because it is most unlikely that actual results will be exactly the same as the budget or standard.

(a) Favourable as well as adverse variances should be investigated, with a view to taking control action if they seem significant. Control action to improve poor performance may seem an obvious requirement. However, control action to reinforce favourable performance should also be expected from management.

(b) Variances need not be investigated if they do not seem significant. For example, variances that are less than, say, 5% of the budget or standard cost amount may be disregarded, because they fall within an acceptable tolerance limit.

(c) Management may not use variances in a single reporting period as a guide to control action, since a variance in one month may be due to a once-only event. Instead of relying on variances reported in a single month, management may monitor cumulative variances over a period of time, and identify those that should be investigated on the basis of performance or trend over a number of months.

1.2.2 The cost of control action: Taking control measures to deal with the cause of a variance takes effort and costs money. Control measures should only be taken if it seems probable that the benefits arising from improved performance are sufficient to justify the cost of investigating the causes of the variance and taking control action. This is a reason why insignificant variances are not investigated.

1.2.3 Improving performance: An exam question may ask about the nature of control action that an operational manager may take to deal with the cause of an adverse variance and so improve performance. The appropriate control measures will obviously depend on the circumstances and the reasons why a variance occurred, so you may need to use common sense and judgement in dealing with any question on this topic. A few ideas are set out in the following table to give you an idea of the issues that may be considered.

Variance	Possible control action
Adverse sales volume variance	Consider reducing the sales price in order to increase sales demand, although this will result in an adverse sale price variance
Adverse material price variance	Search for a supplier who is prepared to offer a lower price Consider purchasing in bulk quantities in order to obtain large-order discounts
Adverse material usage variance Adverse labour efficiency variance	Consider providing training for the workforce, with the objective of improving labour efficiency and reducing wastage of materials

2. Behavioural implications: Used correctly, a budgetary control and variance reporting system can motivate managers and employees to improve performance, but it may also produce undesirable negative reactions.

The purpose of a budgetary control and variance reporting system is to assist management in planning and controlling the resources of their organisation, by providing appropriate control information. The information will only be valuable, however, if it is interpreted correctly and used purposefully by managers and employees.

The appropriate use of control information therefore depends not only on the content of the information itself but also on the behaviour of its recipients. This is because control in business is exercised by people. Their attitude to control information will colour their views on what they should do with it and a number of behavioural problems can arise.

(a) The managers who set the budget or standards are often not the managers who are then made responsible for achieving budget targets.

(b) The goals of the organisation as a whole, as expressed in a budget, may not coincide with the personal aspirations of individual managers.

(c) Control is applied at different stages by different people. A supervisor may receive weekly control reports, and act on them; their superior may receive monthly control reports, and decide to take different control action. Different managers can get in each other's way, and resent the interference from others.

2.1 Motivation: Motivation is what makes people behave in the way that they do. It comes from individual attitudes, or group attitudes. Individuals will be motivated by personal desires and interests. These may be in line with the objectives of the organisation, and some people 'live for their jobs'. Other individuals see their job as a chore, and their motivations will be unrelated to the objectives of the organisation they work for.

It is therefore vital that the goals of management and the employees harmonise with the goals of the organisation as a whole. This is known as goal congruence. Although obtaining goal congruence is essentially a behavioural problem, it is possible to design and run a budgetary control system which will go some way towards ensuring that goal congruence is achieved. Managers and employees must therefore be favourably disposed towards the budgetary control system so that it can operate efficiently.

The management accountant should therefore try to ensure that employees have positive attitudes towards setting budgets, implementing budgets (that is, putting the organisation's plans into practice) and feedback of results (control information).

2.2 Poor attitudes when setting budgets: Poor attitudes or hostile behaviour towards the budgetary control system can begin at the planning stage. If managers are involved in preparing a budget the following may happen.

(a) Managers may complain that they are too busy to spend much time on budgeting.

(b) They may build 'slack' into their expenditure estimates.

(c) They may argue that formalising a budget plan on paper is too restricting and that managers should be allowed flexibility in the decisions they take.

(d) They may set budgets for their budget centre and not co-ordinate their own plans with those of other budget centres.

(e) They may base future plans on past results, instead of using the opportunity for formalised planning to look at alternative options and new ideas.

On the other hand, managers may not be involved in the budgeting process. Organisational goals may not be communicated to them and they might have their budget decided for them by senior management or administrative decision. It is hard for people to be motivated to achieve targets set by someone else.

2.2.1 Poor attitudes when putting plans into action: Poor attitudes also arise when a budget is implemented.

(a) Managers may put in only just enough effort to achieve budget targets, without trying to beat targets.

(b) A formal budget may encourage rigidity and discourage flexibility.

(c) Short-term planning in a budget can draw attention away from the longer-term consequences of decisions.

(d) There may be minimal co-operation and communication between managers.

(e) Managers will often try to make sure that they spend up to their full budget allowance, and do not overspend, so that they will not be accused of having asked for too much spending allowance in the first place.

2.2.2 Poor attitudes and the use of control information: The attitude of managers towards the accounting control information they receive might reduce the information's effectiveness.

(a) Management accounting control reports could well be seen as having a relatively low priority in the list of management tasks. Managers may take the view that they have more pressing jobs on hand than looking at routine control reports.

(b) Managers may resent control information; they may see it as part of a system of trying to find fault with their work. This resentment is likely to be particularly strong when budgets or standards are imposed on managers without allowing them to participate in the budget-setting process.

(c) If budgets are seen as pressure devices to push managers into doing better, control reports will be resented.

(d) Managers may not understand the information in the control reports because they are unfamiliar with accounting terminology or principles.

(e) Managers may have a false sense of what their objectives should be. A production manager may consider it more important to maintain quality standards regardless of cost. They would then dismiss adverse expenditure variances as inevitable and unavoidable.

(f) If there are flaws in the system of recording actual costs, managers will dismiss control information as unreliable.

(g) Control information may be received weeks after the end of the period to which it relates, in which case managers may regard it as out of date and no longer useful.

(h) Managers may be held responsible for variances outside their control.

It is therefore obvious that management accountants and senior management should try to implement systems that are acceptable to budget holders and which produce positive effects.

2.2.3 Pay as a motivator: Many researchers agree that pay can be an important motivator, when there is a formal link between higher pay (or other rewards, such as promotion) and achieving budget targets. Individuals are likely to work harder to achieve budget if they know that they will be rewarded for their successful efforts. There are, however, problems with using pay as an incentive.

(a) A serious problem that can arise is that formal reward and performance evaluation systems can encourage dysfunctional behaviour. Many investigations have noted the tendency of managers to pad their budgets either in anticipation of cuts by superiors or to make the subsequent variances more favourable. Moreover, there are numerous examples of managers making decisions in response to performance indices, even though the decisions are contrary to the wider purposes of the organisation.

(b) The targets must be challenging but fair, otherwise individuals will become dissatisfied. Pay can be a demotivator as well as a motivator!

3. Setting the difficulty level for a budget: 'Aspirations' budgets can be used as targets to motivate higher levels of performance but a budget for planning and decision-making should be based on reasonable expectations.

The level of difficulty in a standard cost may range from very challenging to fairly undemanding: standard costs may be ideal, or many establish either a target or a currently attainable level of performance.

Budgets can motivate managers to achieve a high level of performance. But how difficult should budget targets or standard levels of efficiency be? And how might people react to targets of differing degrees of difficulty in achievement?

(a) There is likely to be a demotivating effect where an ideal standard of performance is set, because adverse efficiency variances will always be reported.

(b) A low standard of efficiency is also demotivating, because there is no sense of achievement in attaining the required standards. If the budgeted level of attainment is too 'loose', targets will be achieved easily, and there will be no impetus for employees to try harder to do better than this.

(c) A budgeted level of attainment could be the same as the level that has been achieved in the past. Arguably, this level will be too low. It might encourage budgetary slack.

Academics have argued that each individual has a personal 'aspiration level'. This is a level of performance, in a task with which individuals are familiar, which individuals undertake for themselves to reach.

Individual aspirations might be much higher or much lower than the organisation's aspirations, however. The solution might therefore be to have two budgets.

(a) A budget for planning and decision-making based on reasonable expectations

(b) A budget for motivational purposes, with more difficult targets of performance

These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively. Similarly, the level of difficulty in a standard cost may vary.

Type of standard
Ideal	A standard of performance that assumes the highest possible level of achievement. A desirable target, but not at all achievable at the moment. Reported variances will always be adverse. This can be demotivating for the managers responsible for performance.
Target	This is a standard cost that sets performance targets at a higher level than is currently being achieved. However, the targets are not unrealistic. Improvements in performance will be needed to turn adverse variances into favourable variances. The value of target standards depends on the strength of motivation of management to improve performance. An incentive scheme may be needed to persuade managers to 'buy in' to the target standard.
Currently attainable	This standard is based on levels of performance that are currently being achieved. They do not provide an incentive to improve performance, although they may encourage management to avoid a deterioration in performance.
Basic standard	This is an original standard that is unchanged over a long period of time. It is used to measure trends and changes in performance standards over time. It is not a useful type of standard for control purposes.

3.1 The effect of reported variances on staff action: Reported variances, if significant and adverse, should prompt managers into taking control action to improve performance. The success of a variance reporting system in achieving this objective will depend on several factors.

(a) The manager who is considered responsible for the variance should agree and accept that the cause of the variance is their responsibility. Variances should be reported to the appropriate manager.

(b) The manager should consider the reported variance to be 'fair'. Variances should be a realistic measure. This is a reason why it is advisable to separate planning variances from operational variances when a budget or standard needs revision. It is also a reason why variances reported using ideal standards may be demotivating.

(c) The manager should want to do something to deal with the causes of the variance. Incentives and motivation are important factors.

(d) Variance should be reported in a timely manner, as soon as reasonably practical. If a reported variance relates to events that occurred a long time ago, managers will be reluctant to investigate them 'now' because the variance will seem out of date.

(e) The manager must believe that the cause of the variance is something that they are in a position to control. If a manager considers the cause of a variance to be outside their sphere of authority, or to be due to a factor that they cannot do anything to change, they will not be motivated to look for control measures.

The control culture within the organisation may also affect the response of managers to variances. If there is a 'blame culture', managers will be blamed for adverse variances and accused of poor performance.

This is likely to provoke a defensive reaction, with the manager trying to justify what has gone wrong.

In contrast, if there is an 'improvement culture', variances are considered as useful indicators for control action and improving performance. Managers are not blamed for adverse variances, but encouraged to look for suitable control measures whenever significant adverse variances occur.

4. Participation in budgeting: A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget). Many writers refer to a third style, the negotiated budget.

4.1 Participation: It has been argued that participation in the budgeting process will improve motivation and so will improve the quality of budget decisions and the efforts of individuals to achieve their budget targets (although obviously this will depend on the personality of the individual, the nature of the task (narrowly defined or flexible) and the organisational culture).

There are basically two ways in which a budget can be set: from the top down (imposed budget) or from the bottom up (participatory budget).

4.2 Imposed style of budgeting (top-down budgeting): In this approach to budgeting, top management prepare a budget with little or no input from operating personnel which is then imposed on the employees who have to work to the budgeted figures.

The times when imposed budgets are effective are as follows.

• In newly formed organisations

• In very small businesses

• During periods of economic hardship

• When operational managers lack budgeting skills

• When the organisation's different units require precise co-ordination

There are, of course, advantages and disadvantages to this style of setting budgets.

Advantages

• Strategic plans are likely to be incorporated into planned activities.

• They enhance the co-ordination between the plans and objectives of divisions.

• They use senior management's awareness of total resource availability.

• They decrease the input from inexperienced or uninformed lower-level employees.

• They decrease the period of time taken to draw up the budgets.

Disadvantages

• There may be dissatisfaction, defensiveness and low morale among employees.

• The feeling of team spirit may disappear.

• The acceptance of organisational goals and objectives could be limited.

• The feeling of the budget as a punitive device could arise.

• Unachievable budgets for overseas divisions could result if consideration is not given to local operating and political environments.

• Lower-level management initiative may be stifled.

4.3 Participative style of budgeting (bottom-up budgeting): In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is achievable and the associated necessary resources.

Participative budgets may be effective in the following circumstances.

• In well-established organisations

• In very large businesses

• During periods of economic affluence

• When operational managers have strong budgeting skills

• When the organisation's different units act autonomously

The advantages of participative budgets are as follows.

• They are based on information from employees most familiar with the department.

• Knowledge spread among several levels of management is pulled together.

• Morale and motivation is improved: employees feel more involved and that their opinions matter to senior management.

• They increase operational managers' commitment to organisational objectives.

• In general they are more realistic.

• Co-ordination between units is improved.

• Specific resource requirements are included.

• Senior managers' overview is mixed with operational level details.

There are, on the other hand, a number of disadvantages of participative budgets.

• They consume more time.

• When individuals are involved in negotiating their budget targets, they may want to set targets that are easily attainable rather than targets that are challenging. In other words, an ability to negotiate targets may tempt managers to introduce budgetary slack into their targets.

• Individuals may not properly understand the strategic and budget objectives of the organisation, and they may argue for targets that are not in the best interests of the organisation as a whole.

• Changes implemented by senior management may cause dissatisfaction if they seem to ignore the opinions of employees who have been involved in negotiating targets.

• Budgets may be unachievable if managers are not sufficiently experienced or knowledgeable to contribute usefully.

• They can support 'empire building' by subordinates.

• An earlier start to the budgeting process will be required, compared with top-down budgeting and target setting.

4.4 Negotiated style of budgeting: At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation. In the imposed budget approach, operational managers will try to negotiate the budget targets which they consider to be unreasonable or unrealistic with senior managers.

Likewise, senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower-level managers. Final budgets are therefore most likely to lie between what top management would really like and what junior managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is of vital importance, determining whether the budget is an effective management tool or simply a clerical device.

5. Variances in a JIT or TQM environment: Standard costing and variance analysis may sometimes be inappropriate in a production environment based on Just in Time (JIT) methods or a Total Quality Management (TQM) approach.

The use of standard costs and variance analysis is based on certain assumptions about the way in which operations should be managed. In particular, variance analysis is based on the view that:

(a) All resources should be used as efficiently as possible.

(b) A standard cost is a performance target that operational managers should seek to achieve.

However, this approach to analysing performance is not always appropriate. Variances indicating adverse performance are sometimes inappropriate in a Just in Time (JIT) or Total Quality Management (TQM) environment.

5.1 Variances and a JIT environment: In a JIT manufacturing environment, production is managed on the principle that items should not be produced until they are required to meet sales orders. There should be no accumulation of inventories of work in progress and finished goods.

A JIT approach implies that if there are no sales orders, production resources should be kept idle. In addition, as explained in the earlier chapter on the theory of constraints, the volume of production should be restricted to the output capacity of the bottleneck resource, meaning that there will inevitably be idle capacity for all resources that are not the bottleneck resource.

(a) In JIT manufacturing, idle time should therefore be expected.

(b) In a system of standard costing, idle time is an adverse labour efficiency variance, and is undesirable.

If idle time variances are reported for a manufacturing operation that is based on JIT methods, the variances will encourage managers to use idle capacity in a productive way, by producing more and building up inventories. With increases in inventory, there will be a higher reported profit.

This is unacceptable in a JIT environment.

5.2 Variances and a TQM environment: Total Quality Management (TQM) is an approach to management that originated from different sources, and has a number of different aspects.

(a) One aspect of TQM is the view that work should be 'right first time'. Mistakes that result in wastage and reworking of faulty output should be avoided.

(b) Another aspect of TQM is similar to the JIT principle that items should be produced only when they are needed for the next stage in the production process, and finished goods should not be produced until they are needed for sales orders.

(c) A third aspect of TQM is the principle of continuous improvement or 'kaizen'. This is the view that the organisation should always look for small ways of improving performance standards and that improvements should be made continually. The ideal level of performance will never be reached, because further improvements will always be possible.

Each of these principles of TQM may be inconsistent with standard costing and variance analysis. The inconsistency between standard costing and the view that production resources should be kept idle until required has already been discussed in the context of JIT.

(a) The philosophy in TQM of 'right first time' may be inconsistent with a standard cost that includes an allowance for wastage. TQM is more consistent with environmental cost accounting (material flow cost accounting) than a costing system that allows for normal loss in the standard cost.

(b) The principle of 'kaizen' or continuous improvement is that a steady state of production will never be achieved, because further improvements will always be possible. A standard cost is based on an assumption of a desirable steady state; this view is inconsistent with the principle of continuous improvement.

5.2.1 Quality and quantity: Standard costing concentrates on quantity and ignores other factors contributing to effectiveness. In a total quality environment, however, quantity is not the main issue; quality is. Effectiveness in such an environment therefore centres on quality of output, and the cost of failing to achieve the required level of effectiveness is measured not in variances, but in terms of internal and external failure costs, neither of which would be identified by a traditional standard costing analysis.

Standard costing systems might measure, say, labour efficiency in terms of individual tasks and level of output. In a total quality environment, labour is more likely to be viewed as a number of multi-task teams who are responsible for the completion of a part of the production process. The effectiveness of such a team is more appropriately measured in terms of reworking required, returns from customers, defects identified in subsequent stages of production, and so on.

Traditional feedback control would seek to eliminate an adverse material price variance by requiring managers to source cheaper, possibly lower-quality supplies. This may run counter to the aim of maximising quality of output.

5.2.2 Can standard costing and TQM coexist?

Arguably, there is little point in running both a Total Quality Management programme and a standard costing system simultaneously.

(a) Predetermined standards are at odds with the philosophy of continual improvement inherent in a total quality management programme.

(b) Continual improvements are likely to alter methods of working, prices, quantities of inputs, and so on, whereas standard costing is most appropriate in a stable, standardised and repetitive environment.

(c) Material standard costs often incorporate a planned level of scrap. This is at odds with the TQM aim of zero defects and there is no motivation to 'get it right first time'.

(d) Attainable standards which make some allowance for wastage and inefficiencies are commonly set. The use of such standards conflicts with the elimination of waste which is such a vital ingredient in a TQM programme.

(e) Standard costing control systems make individual managers responsible for the variances relating to their part of the organisation's activities. A TQM programme, on the other hand, aims to make all personnel aware of, and responsible for, the importance of supplying the customer with a quality product.

6. Standard costs in a rapidly changing environment: The role of standards and variances in the rapidly changing modern business environment is open to question.

It can be argued that standard costs have limited relevance and value in the modern business world, where the environment is continually changing, and the life cycle of products can be very short.

Standard costs are appropriate for a 'steady state' production environment where the manufacturing system produces standard products, often in large quantities, using standard and repetitive production methods and processes.

In many industries today:

(a) Products are customised to the individual specifications of the customer. Although there may be a basic product, customers do not buy a standard product. Standard costing is more suitable for a mass production environment.

(b) In such countries as the UK, there are more service industries than manufacturing industries, and services are often non-standard in nature and the way they are delivered.

(c) Standard cost variances focus mainly on material cost and labour cost variances (and overhead variances may be a simple fixed cost expenditure variance). In many manufacturing companies, overhead costs are much more significant than labour costs. Variance reporting therefore fails to focus on the most important costs.

(d) Many of the variances in a standard costing system focus on the control of short-term variable costs. In most modern manufacturing environments, the majority of costs, including direct labour costs, tend to be fixed in the short run.

(e) In some industries, products have a very short life cycle. In these circumstances, it may not be worthwhile developing a standard cost for new products. Instead, costing techniques, such as life cycle costing and target costing, may be more appropriate for planning and control purposes.

(f) Variance reporting involves regular formal performance reports, typically every four weeks or month. Modern IT systems make it possible for operational managers to monitor performance much more frequently and 'on demand'. Variance reporting is not easily adapted to 'on demand' performance monitoring.

6.1 The role in modern business of standards and variances: However, a survey by Drury et al (1993) indicated the continued widespread use of standard costing systems. Although this survey is now somewhat out of date, the following points should be noted.

• Planning: Even in a TQM environment, budgets will still need to be quantified. For example, the planned level of prevention and appraisal costs needs to be determined. Standards, such as returns of a particular product should not exceed 1% of deliveries during a budget period, can be set.

• Control: Cost and mix changes from the plan will still be relevant in many processing situations.

• Decision-making: Existing standards can be used as the starting point in the construction of a cost for a new product.

• Performance measurement: If the product mix is relatively stable, performance measurement may be enhanced by the use of a system of planning and operational variances.

• Product pricing: Target costs may be compared with current standards, and the resulting 'cost gap' investigated with a view to reducing it or eliminating it using techniques such as value engineering.

• Improvement and change: Variance trends can be monitored over time.

• Accounting valuations: Although the operation of a JIT system in conjunction with backflush accounting will reduce the need for standard costs and variance analysis, standards may be used to value residual inventory and the transfers to cost of sales account.