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This was how I was going to do it when I thought about using the variant. However, none of my players wanted to do it, and after playing in the session for a while, I realized that it's probably better to use the simple setup.I would say that for dwarves using the variant encumbrance, weight still counts, but the penalty is reduced by 10 feet:
encumbered, no penalty
heavily encumbered, speed drops by 10 feet.
I really like the idea of the variant encumbrance, but I find the implementation is just too restrictive. I do like the thought of there being a mechanic that encouraged not letting strength be a dump stat, however. In most cases, wizards and sorcerers won't come up against the limit. But because there's no straightforward way of reducing weight for small-sized armour, I find that halflings and gnomes regularly end up encumbered, regardless of build.
I don't mind that tendency, but it shouldn't be inevitable. It's not that I as a player want to be keeping track of weight throughout, but I do like the incentive not to overload one's characters.
Why can't you just reduce weight for small-sized armour?
Also, I don't see any penalties to the carrying capacity of small creatures. There's a penalty for tiny creatures, and a bonus for large creatures, but small and medium are treated as pretty much interchangeable. The little guys seem to be able to carry a greater percentage of their body weight than the big guys.