Managers often use variance analysis to evaluate the performance of their employees or business units. Suppose a purchasing manager for Starbucks has just negotiated a deal that results in a favorable price variance for direct materials. As our earlier discussion suggests, a favorable direct materials price variance needs further investigation before reaching conclusions about the purchasing manager’s performance. If the purchasing manager bargained effectively with suppliers, it would support a positive evaluation. If, however, (1) the purchasing manager secured a discount by placing larger orders, leading to higher inventory costs, or (2) accepted a bid from a low-priced supplier by sacrificing quality, it is not so clear. The gains from the favorable direct materials price variance could be offset by higher inventory storage costs or higher inspection costs and defect rates, resulting in an unfavorable direct materials efficiency variance (using more inputs than budgeted to produce a given level of output).
Bottom line: Managers should not automatically interpret a favorable variance as “good news” or assume it means their subordinates performed well.
Firms benefit from variance analysis because it highlights individual aspects of performance. However, if any single performance measure (for example, achieving a certain labor efficiency variance or a certain consumer rating) is overemphasized, managers will tend to make decisions that will cause the particular performance measure to look good. These actions may conflict with the company’s overall goals, inhibiting the goals from being achieved. This faulty perspective on performance usually arises when top management designs a performance evaluation and reward system that does not emphasize total company objectives or overall effectiveness, such as sales, market share, or overall profitability.