Cost variance definition
/What is a Cost Variance?
A cost variance is the difference between the cost actually incurred and the budgeted or planned amount of cost that should have been incurred. Cost variances are most commonly tracked for expense line items, but can also be tracked at the job or project level, as long as there is a budget or standard against which it can be calculated. These variances form a standard part of many management reporting systems, and are especially common in project management. Some cost variances are formalized into standard calculations.
Examples of Cost Variances
The following are examples of variances related to specific types of costs:
Direct Material Price Variance
The direct material price variance is the difference between the actual price paid to acquire a direct materials item and its budgeted price, multiplied by the actual number of units acquired. This information is needed to monitor the costs incurred to produce goods. The formula follows:
(Actual price - Budgeted price) x Actual quantity = Direct material price variance
As an example of the direct material price variance, the purchasing staff of Grumbly Corporation estimates that the budgeted cost of a chromium component should be set at $10.00 per pound, which is based on an estimated purchasing volume of 50,000 pounds per year. During the year that follows, Grumbly only buys 25,000 pounds, which drives up the price to $12.50 per pound. This creates a direct material price variance of $2.50 per pound, and a variance of $62,500 for all of the 25,000 pounds that Grumbly purchases.
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Fixed Overhead Spending Variance
The fixed overhead spending variance is the difference between the actual fixed overhead expense incurred and the budgeted fixed overhead expense. To calculate the fixed overhead spending variance, subtract budgeted fixed overhead from actual fixed overhead. The formula for this variance is as follows:
Actual fixed overhead - Budgeted fixed overhead = Fixed overhead spending variance
Labor Rate Variance
The labor rate variance measures the difference between the actual and expected cost of labor. It is calculated as the difference between the actual labor rate paid and the standard rate, multiplied by the number of actual hours worked. The formula is:
(Actual rate - Standard rate) x Actual hours worked = Labor rate variance
Purchase Price Variance
The purchase price variance is the difference between the actual price paid to buy an item and its standard price, multiplied by the actual number of units purchased. The formula is:
(Actual price - Standard price) x Actual quantity = Purchase price variance
Variable Overhead Spending Variance
The variable overhead spending variance is the difference between the actual and budgeted rates of spending on variable overhead. The variance is used to focus attention on those overhead costs that vary from expectations. The formula is:
Actual hours worked x (Actual overhead rate - standard overhead rate)
= Variable overhead spending variance
Favorable and Unfavorable Variances
There is an unfavorable variance when the actual cost incurred is greater than the budgeted amount. There is a favorable variance when the actual cost incurred is lower than the budgeted amount. Whether a variance ends up being positive or negative is partially due to the care with which the original budget was assembled. If there is no reasonable foundation for a budgeted cost, then the resulting variance may be irrelevant from a management perspective.
Not all unfavorable variances are bad. Spending more money in one area may create a favorable variance somewhere else. For example, it might be necessary to spend twice as much on preventive maintenance to avoid a much greater total expense associated with replacing fixed assets more frequently. Thus, it is sometimes better to review cost variances from the level of an entire department, facility, or product line, rather than at a more detailed level. This higher level of analysis gives managers room in which to allocate funds in a manner designed to improve total profits.
Reporting of Cost Variances
Cost variances are usually tracked, investigated, and reported on by a cost accountant. This person determines the reason why a variance occurred and reports the results to management, possibly along with a recommendation for changing operations to reduce the size of the variance (if unfavorable) in the future.
It is not always useful to bury management with an analysis of every possible cost variance. Instead, the cost accountant should determine which variances are large enough to be worth their attention, or if there is some action to be taken to improve the situation. Thus, a cost variance report should only include a few items each month, preferably with recommended actions to be taken.