Cost variance analysis definition
/What is Cost Variance Analysis?
Cost variance analysis is a control system that is designed to detect and correct variances from expected levels. In essence, a standard or budgeted revenue or expense level is set in advance, and then compared to actual results. Any significant variances from expectations are then highlighted for review by management. The intent is to identify and correct any issues that are preventing a business from achieving its goals.
How to Conduct a Cost Variance Analysis
A cost variance analysis is comprised of the following steps:
Calculate the difference between an incurred cost and an expected cost. The expected cost is a budgeted or standard amount, which is usually based on historical experience and adjusted for current-period expectations.
Investigate the reasons for the difference. This involves a detailed analysis of the actual expense incurred, to determine the reasons behind the expenditure and why it varied from expectations.
Report this information to management. This is usually contained within a report that is issued to management as soon as possible after the variance was noted, so that meaningful corrective action can be taken.
Take corrective action to bring the incurred cost into closer alignment with the expected cost. Managers will typically ignore minor variances, giving them more time to delve into the reasons for major variances.
The most simple form of cost variance analysis is to subtract the budgeted or standard cost from the actual incurred cost, and reporting on the reasons for the difference. A more refined approach is to split this difference into two elements, which are:
Price variance. That portion of the variance caused by a difference between the actual and expected price of the goods or services acquired.
Volume variance. That portion of the variance caused by any change in the volume of goods or services ordered.
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Example of Cost Variance Analysis
A company has an unfavorable variance in its cost of goods sold of $40,000. A detailed cost variance analysis reveals that the company sold several hundred more units than it expected, and the cost of those additional units comprised $35,000 of the variance. This was hardly indicative of poor performance, since it implied that the company was selling more units. Only the remaining $5,000 of the unfavorable variance was due to unusually high prices, which could then be investigated in detail. Thus, it frequently makes sense to divide cost variance analysis into price and volume variances, thereby gaining better insights into the costs incurred.
Using Cost Variance Analysis in Budgeting
Cost variance analysis is a central tenet of budgeting, since it requires the involvement of financial analysts in all aspects of operations to see if a business is following its planned activities. However, cost variance analysis can also be too rigorous in forcing a business to adhere to a plan of operations that has become out of date, and does not allow it to instead shift funding to more relevant projects. Thus, from an ongoing strategic perspective, cost variance analysis may not be a good thing. Instead, several more relaxed variations on the concept are:
Conduct the analysis only when there appears to be a clear case of egregiously high costs being incurred
Conduct the analysis only in areas where costs are of a long-term nature and are not expected to change much (such as in administrative functions)
Conduct the analysis only for acquired businesses, in order to learn about their cost structures, and then terminate any additional analysis