What it means
A plan states what something should cost. Actual costs state what it did.
The difference is information about the plan, the execution or both, and cost variance is the name for it. The concept is the same in every setting; the calculation and the analysis differ by context.
In project management, cost variance is part of earned value analysis. A project has a budget for each element of work; as work is completed, its budgeted cost is "earned"; the earned value is compared with the actual cost of that work.
Cost variance = earned value minus actual cost. A project that has completed work budgeted at $400,000 and spent $460,000 doing it has a cost variance of minus $60,000: it is 15% over cost for the work done, regardless of whether it is ahead of or behind schedule (which is measured by schedule variance, earned value minus planned value).
The cost performance index (earned value divided by actual cost) expresses the same thing as a ratio, and projecting it forward gives an estimate of the cost at completion, which is the number the sponsor wants. In budgeting, cost variance is actual minus budget for each line of a cost centre or department, reported monthly.
The refinement is the flexed budget: where costs vary with activity, the budget is restated at the actual activity level before the variance is computed, so that a department that handled 20% more volume for 10% more cost shows a favourable variance rather than an adverse one. In standard costing, the variance is decomposed.
For materials, the difference between standard and actual cost splits into a price variance (paid more or less per unit than standard, on the quantity actually bought) and a usage variance (used more or fewer units than standard for the output achieved, at standard price). For labour, into a rate variance and an efficiency variance.
For variable overhead, into spending and efficiency; for fixed overhead, into spending (budget) and volume (capacity and efficiency). Each component points to a cause and a person: purchasing for price, production for usage and efficiency, HR or scheduling for rate, management for fixed overhead spending, sales or planning for volume.
Interpretation follows. Is the variance significant (above a threshold in amount or percentage)?
Is it a timing difference that will reverse, or permanent? Is its cause controllable by the manager to whom it is reported?
Is the standard or budget itself wrong (a persistent variance in one direction usually means the plan, not the performance, needs revision)? What action follows, and who owns it?
A variance report that answers these questions is a management tool; one that lists numbers is noise. Variances interact.
A favourable material price variance from buying cheaper material may cause an adverse usage variance from higher scrap and an adverse labour efficiency variance from rework; the purchasing manager's saving is the production manager's problem, and only the combined view shows whether the decision was good. Similarly, a favourable cost variance on a project achieved by cutting scope or quality is not a saving, and cost variance must be read with schedule, scope and quality measures.
In practice
Real-world examples.
Example
A construction project reports a cost variance of minus $1.2 million at 40% completion and revises its estimate at completion by $3 million.
Example
A hospital ward's staffing cost variance of $40,000 adverse is found to be $30,000 of agency premium for vacancies and $10,000 of extra hours for higher patient acuity.
Example
A manufacturer's monthly variance report shows a persistent favourable material usage variance, and investigation finds the standard was set with an excessive waste allowance.
Think of it
“Cost variance shows whether you're spending more or less than planned-budget performance.
Formula
Calculation
Project cost variance (CV) = Earned value (EV) minus Actual cost (AC); Cost performance index (CPI) = EV / AC; Estimate at completion (EAC) = Budget at completion / CPI (assuming the current performance continues)
Budget cost variance = Actual cost minus Budgeted cost (adverse if positive); Flexed: Actual minus Flexed budget
Material price variance = (Actual price minus Standard price) x Actual quantity purchased
Material usage variance = (Actual quantity used minus Standard quantity for actual output) x Standard price
Labour rate variance = (Actual rate minus Standard rate) x Actual hours
Labour efficiency variance = (Actual hours minus Standard hours for actual output) x Standard rate
Worked example 1, a project. A software implementation has a budget at completion of $2,000,000 over 12 months. At month 6: planned value (work scheduled to be done by now) $1,000,000; earned value (budgeted cost of work actually done) $850,000; actual cost $1,020,000.
- Cost variance = $850,000 minus $1,020,000 = minus $170,000 (adverse: the work done has cost 20% more than budgeted)
- Schedule variance = $850,000 minus $1,000,000 = minus $150,000 (behind schedule: 15% less work done than planned)
- CPI = $850,000 / $1,020,000 = 0.83
- EAC = $2,000,000 / 0.83 = $2,400,000: if the cost performance continues, the project will cost $400,000 more than budgeted
- Remaining work: $1,150,000 of budgeted value; at the current CPI it will cost $1,380,000; to finish on budget, the remaining work would need a CPI of $1,150,000 / $980,000 = 1.17, a 40% improvement on performance to date, which is implausible without a change in approach
- The sponsor's decision: accept the $2,400,000 forecast and secure the funding, or reduce scope by about $330,000 of budgeted value to finish within $2,000,000. The cost variance analysis also identifies the cause: the data migration workstream is at a CPI of 0.6 (unexpected data quality problems) while the rest of the project is at 0.95; the remedy is targeted at migration
Worked example 2, standard costing. A factory's standard for a product: 4 kg of material at $5 per kg ($20), 1.5 labour hours at $22 ($33). In a month it makes 3,000 units, buys and uses 12,800 kg at $4.80, and uses 4,800 hours at $22.60.
- Standard cost of actual output: material 12,000 kg x $5 = $60,000; labour 4,500 hours x $22 = $99,000; total $159,000
- Actual cost: material 12,800 x $4.80 = $61,440; labour 4,800 x $22.60 = $108,480; total $169,920
- Total cost variance: $10,920 adverse
- Material price variance = ($4.80 minus $5.00) x 12,800 = $2,560 favourable (purchasing found a cheaper supplier)
- Material usage variance = (12,800 minus 12,000) x $5 = $4,000 adverse (6.7% more material used: the cheaper material has more waste)
- Labour rate variance = ($22.60 minus $22.00) x 4,800 = $2,880 adverse (overtime premium)
- Labour efficiency variance = (4,800 minus 4,500) x $22 = $6,600 adverse (6.7% more hours: rework on the cheaper material)
- Check: $2,560 favourable minus $4,000 minus $2,880 minus $6,600 = $10,920 adverse. Agreed.
- Reading: the purchasing manager's favourable price variance of $2,560 caused adverse usage and efficiency variances of $10,600 and an overtime premium of $2,880. The cheaper material cost the company about $11,000 in the month. The report goes to both managers together, and the supplier change is reversed.
Worked example 3, a budget. A distribution depot's monthly budget for fuel is $48,000 for 60,000 kilometres. Actual: $56,000 for 66,000 kilometres. Variance against fixed budget: $8,000 adverse. Flexed budget at 66,000 km: $52,800. Variance against flexed budget: $3,200 adverse, which analysis attributes to a 6% fuel price rise ($3,170) with efficiency unchanged. The depot manager is asked to explain nothing; the fuel price is reported to the finance director for the forecast and to sales for the customer surcharge.Case study
Seen in the real world.
A capital project to build a new production facility had a budget of $45,000,000 and a monthly report that compared spend to date with the phased budget. For eleven months the report showed spend at or below the phased budget, and the steering committee was reassured. In month twelve the project manager reported that the facility was 55% complete and would cost $62,000,000.
The spend-versus-budget comparison had shown nothing because spend was below plan for the same reason work was: the project was late, and the work it had done had cost far more than budgeted. An earned value analysis, introduced by the finance director after the shock, showed that the cost performance index had been below 0.8 from month three; a cost variance report on that basis would have forecast a $56,000,000 outcome in month four, when there was still time to change the contractor's approach and the scope.
The project completed at $60,000,000, eight months late. The company's project governance now requires earned value reporting (planned value, earned value, actual cost, CPI, SPI and estimate at completion) monthly on every project over $2,000,000, and the finance director's note explained that comparing spend with budget had told the committee how much money had gone out and nothing about what it had bought.
Watch out
Common mistakes.
- Comparing spend with budget on a project without measuring the work done, which hides cost overruns behind schedule delays.
- Reporting cost variances against a fixed budget when activity has changed, which blames managers for volume and hides real efficiency changes.
- Reporting price and usage (or rate and efficiency) variances to different managers separately, so that a decision that helps one and hurts the other is never seen whole.
Questions
People also ask.
What is the difference between cost variance and schedule variance?
Cost variance compares the value of work done with what it cost (are we over or under cost). Schedule variance compares the value of work done with what was planned by now (are we ahead or behind). A project can be under cost and behind schedule, or the reverse.
What threshold should trigger investigation?
Commonly 5% to 10% of the line or a fixed amount, set so that the report captures the variances that matter. Persistent small variances in one direction also warrant investigation, since they usually indicate a wrong standard.
How is the estimate at completion calculated?
Most simply as the budget divided by the cost performance index, assuming current performance continues. More refined estimates apply the CPI only to remaining work, or combine CPI and SPI, or rebuild the estimate bottom-up.
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