What it means
A plan states what something should cost, and actual costs state what it did cost. 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, but the calculation and analysis differ by context. In project management, cost variance is part of earned value analysis: as work is completed, its budgeted cost is earned, and cost variance is earned value minus actual cost.
A project that has completed work budgeted at $400,000 and spent $460,000 has a cost variance of minus $60,000, which is 15% over cost for the work done. 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.
In budgeting, cost variance is actual minus budget for each line of a cost centre, reported monthly. The refinement is the flexed budget, where costs that vary with activity are restated at the actual activity level before the variance is computed.
A department that handled 20% more volume for 10% more cost then shows a favourable variance rather than an adverse one. In standard costing, the variance is decomposed.
For materials it splits into a price variance (paid more or less per unit than standard) and a usage variance (used more or fewer units than standard for the output achieved), and for labour into a rate variance and an efficiency variance. Variable overhead splits into spending and efficiency, and fixed overhead into spending and volume, and each component points to a cause and an owner, such as purchasing for price and production for usage.
Interpretation follows the numbers. Is the variance significant, is it a timing difference or permanent, can the manager control it, and is the standard itself wrong, since a persistent variance in one direction usually means the plan needs revision?
A variance report that answers these questions and names an owner is a management tool, whereas one that only lists numbers is noise. Variances also 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, so only the combined view shows whether the decision was good. A favourable project cost variance achieved by cutting scope or quality is not a saving, so cost variance should be read with schedule, scope and quality measures.
In practice
Real-world examples
Example 1
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 2
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 3
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
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 $1,000,000; earned value $850,000; actual cost $1,020,000.
- Cost variance = $850,000 minus $1,020,000 = minus $170,000 (adverse)
- Schedule variance = $850,000 minus $1,000,000 = minus $150,000 (behind schedule)
- CPI = $850,000 / $1,020,000 = 0.83
- EAC = $2,000,000 / 0.83 = about $2,400,000, so if performance continues the project will cost about $400,000 more than budgeted
- To finish on budget, the remaining $1,150,000 of work would have to be done for $980,000, a CPI of 1.17, which is a 40% improvement on performance to date and implausible without a change in approach
Worked example 2, standard costing. A product's standard is 4 kg of material at $5 per kg and 1.5 labour hours at $22. In a month the factory makes 3,000 units, uses 12,800 kg bought at $4.80, and works 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
- Material usage variance = (12,800 minus 12,000) x $5 = $4,000 adverse
- Labour rate variance = ($22.60 minus $22.00) x 4,800 = $2,880 adverse
- Labour efficiency variance = (4,800 minus 4,500) x $22 = $6,600 adverse
- Check: $4,000 + $2,880 + $6,600 minus $2,560 = $10,920 adverse
The purchasing saving of $2,560 was outweighed by $10,600 of extra usage and efficiency cost, probably because the cheaper material had more waste and caused rework, so the report goes to both managers together.Case study
Seen in the real world
This is a fictional, illustrative scenario. 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.