Analyzing the Variance Investigation Decision: The Effects of Outcomes, Mental Accounting, and Framing.

Abstract In evaluating the variance investigation decision made by a manager, information ex ante or ex post to the decision may have an impact. Although normative models generally consider only ex ante data, research on hindsight or outcome bias has shown that performance evaluations are often affected by decision outcomes. This outcome effect can be explained through the following cognitive links. First, the outcome of the investigation will have an impact on the perceived benefits of the investigation. Second, as posited by decision research on mental accounting, investigation expenditures matched with perceived benefits are framed as costs while those without perceived benefits are framed as losses. Third, evaluators with a cost frame provide higher performance ratings than those with a loss frame. A series of experiments with students and members of the Institute of Management Accountants demonstrates that managers making variance investigation decisions were evaluated more favorably when investigations revealed problems in the system. This is the well-known outcome effect. Further, the investigation outcome affected the perceived benefits from the investigation and, as predicted by mental accounting, expenditures with perceived benefits were framed as costs while those without perceived benefits were framed as losses. Finally, these frames affected performance evaluation as predicted. Thus, the outcome effect on performance evaluation can now be understood within a framework that includes the cognitive impact of mental accounting and framing. Surveys report that 85 percent of large U.S. manufacturing companies use standard costing systems (Cress and Pettijohn 1985; Gaumnitz and Kollaritsch 1988). Standard costing is particularly useful for managerial control purposes since variances from standards can be calculated for management use (Horngren and Foster 1987). At that point, managers must decide whether to collect more information regarding the performance reflected in the variances. Mathematical models have been formulated to analyze this variance investigation decision (e.g., see Kaplan 1969; Jacobs and Marshall 1984). Although these mathematical models provide normative or optimal prescriptions for the variance investigation decision, managers may not follow the recommendations of the models if their decisions are judged using criteria unrelated to the models (Magee 1976). Research on human information processing and decision making has shown that judgments are affected by outcomes (or hindsight) and mental accounting (a form of decision framing). If the managerial evaluations are affected by these phenomena, managerial actions will be effected by their potential impact. This study investigates the effects of outcomes and framing on the evaluations of managers responsible for the variance investigation decision. Specifically, it develops a cognitive mechanism for the impact of outcomes on such evaluations using prior results and ideas from judgment and decision making research. Although the impact of hindsight and outcomes has been demonstrated in prior work in accounting (Helleloid 1988; Brown and Solomon 1987), a satisfactory cognitive explanation for the effect remains elusive (but, see Brown and Solomon 1991). Thus, the contribution of the present study is in the development and testing of this cognitive mechanism.