Variance Analysis Receives Criticism As Performance Measure

Variance Analysis Receives Some Criticism As A Performance Measure Wh

Variance analysis receives some criticism as a performance measure. What about other measures such as ROI and EVA? Do research on the Internet and show the reference for the information. Remember to respond to a colleague's posting also. Professor’s Note: Variance analysis compares actual performance to budgeted performance in the areas of material, labor, and overheads. If the results of a business unit show all positive variances, should the manager be rewarded for (excellent) performance? A simple counter argument can be – what if the manager had padded his business unit’s budget? In addition to searching the Internet for text related to this discussion, watch the following YouTube videos (click on the following links to access these videos) and post your comments. Video 1: Performance Management & Evaluation Video 2: Return on Investment - ROI Video 3: Economic Value Added - EVA

Paper For Above instruction

Introduction

Variance analysis is a widely used tool by organizations to measure performance by comparing actual financial performance to budgeted expectations. Despite its widespread use, it faces criticism for its potential limitations, such as encouraging managerial behavior aimed at manipulating budgets rather than genuine performance improvements. Alternative performance measures like Return on Investment (ROI) and Economic Value Added (EVA) have been proposed to address some of these shortcomings. This paper explores the criticisms of variance analysis, examines the advantages and disadvantages of ROI and EVA, and discusses whether positive variances necessarily indicate excellent performance, especially in the context of potential budget padding.

Criticism of Variance Analysis

Variance analysis, as outlined by Professor’s note, compares actual results to budgeted numbers across materials, labor, and overheads (Drury, 2018). While it provides valuable insights into deviations, it can also foster undesirable managerial incentives. For example, managers might "pad" budgets to ensure favorable variances, which can lead to inflated performance expectations and undermine the true assessment of efficiency (Kaplan & Norton, 1992). Moreover, variance analysis tends to focus on short-term financial metrics, disregarding broader strategic goals and qualitative factors such as customer satisfaction and employee morale (Anthony & Govindarajan, 2014).

Critics argue that reliance on variance analysis may lead to gaming the system—managers manipulating estimates, delaying expenses, or cutting crucial costs to meet targets artificially. Additionally, variance analysis doesn't adequately account for the context or external factors influencing performance, such as market fluctuations or economic downturns (Chenhall & Langfield-Smith, 2007). Therefore, while useful, variance analysis should be part of a broader performance management system rather than the sole measure.

Alternative Measures: ROI and EVA

Return on Investment (ROI) measures the efficiency of investments by comparing net income to invested assets (Brigham & Ehrhardt, 2016). Its strength lies in aligning managerial decisions with investment efficiency, encouraging managers to optimize the use of assets. However, ROI can be criticized for potentially discouraging investment in long-term projects since such investments might temporarily reduce ROI, thus penalizing managers for initiatives that have future benefits (Kaplan, 1984).

Economic Value Added (EVA), developed by Stern Stewart & Co., measures a company's true economic profit by deducting the cost of capital from net operating profit after taxes (Stewart, 1991). EVA emphasizes value creation beyond accounting profits, aligning managerial incentives with shareholder wealth. Its advantage is in promoting investment decisions that add real economic value and discouraging projects that do not surpass the cost of capital (Ballas & Vo, 2000). Yet, EVA's complexity and reliance on accurate cost of capital calculations pose challenges, particularly for smaller firms lacking sophisticated financial systems.

Compared to variance analysis, both ROI and EVA are forward-looking and reflect long-term value creation rather than short-term deviations. They tend to promote strategic decision-making and holistic performance evaluation rather than focusing solely on operational variances.

Should Managers Be Rewarded for Positive Variances?

When a business unit reports all positive variances, on the surface, it might seem that the manager has performed excellently. However, this assumption warrants scrutiny in light of potential budget padding. Managers might inflate their budgets initially, setting higher targets to make actual results appear favorable relative to the inflated goals (Drury, 2018). Consequently, positive variances might reflect budget manipulation rather than genuine operational efficiency.

Furthermore, a focus solely on favorable variance results might overlook underlying issues such as cost-cutting at the expense of quality or employee morale. Rewarding managers based solely on variance outcomes could inadvertently encourage short-termism and unethical behaviors (Anthony & Govindarajan, 2014). Therefore, performance evaluations should incorporate multiple measures—including ROI and EVA—and consider qualitative factors such as strategic alignment, customer satisfaction, and employee engagement.

A balanced appraisal approach reduces the risk of incentivizing inappropriate managerial behavior and better aligns rewards with sustainable organizational success.

Conclusion

Variance analysis remains a valuable component of performance management but is insufficient as a standalone measure due to its susceptibility to manipulation and short-term focus. Alternative metrics like ROI and EVA provide more comprehensive insights into value creation and long-term performance, aligning managerial incentives with organizational goals. While positive variances can suggest good performance, they should be interpreted cautiously, particularly considering potential budget padding or manipulation. A multidimensional approach combining variance analysis with ROI, EVA, and qualitative assessments offers a more reliable framework for evaluating managerial performance and fostering organizational sustainability.

References

• Anthony, R. N., & Govindarajan, V. (2014). Management Control Systems. McGraw-Hill Education.
• Ballas, A. A., & Vo, N. G. (2000). Managing capital investments using EVA. Journal of Applied Corporate Finance, 13(2), 34-45.
• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Chenhall, R. H., & Langfield-Smith, K. (2007). Multiple paradigms in management accounting research: The case of strategic cost management. Accounting, Organizations and Society, 32(7-8), 713-755.
• Kaplan, R. S. (1984). The Evolution of Management Accounting. The Accounting Review, 59(3), 390-409.
• Kaplan, R. S., & Norton, D. P. (1992). The Balanced Scorecard: Measures that Drive Performance. Harvard Business Review, 70(1), 71-79.
• Stewart, G. B. (1991). The Quest for Value: A Guide for Senior managers. HarperBusiness.
• Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
• Stewart, G. B. (1991). The Quest for Value: A Guide for Senior Managers. HarperBusiness.
• Chenhall, R. H., & Langfield-Smith, K. (2007). Multiple paradigms in management accounting research: The case of strategic cost management. Accounting, Organizations and Society, 32(7-8), 713-755.