A cost variance is the difference between an actual expenditure and the expected (or budgeted) expenditure. A cost variance can relate to virtually any kind of expense, ranging from elements of the cost of goods sold to selling or administrative expenses. This variance is most useful as a monitoring tool when a business is attempting to spend in accordance with the amounts stated in its budget.
The cost variance formula is usually comprised of two elements, which are:
- Volume variance. This is the difference in the actual versus expected unit volume of whatever is being measured, multiplied by the standard price per unit.
- Price variance. This is the difference between the actual versus expected price of whatever is being measured, multiplied by the standard number of units.
When you combine the volume variance and the price variance, the combined variance represents the total cost variance for whatever the expenditure may be.
The volume and price variances have different names, depending upon the type of expenditure being examined. For example, the volume and price variances for direct materials are:
Or, the volume and price variances for direct labor are:
Or, the volume and price variances for overhead are:
A cost variance is considered to be a favorable variance when the actual cost incurred is lower than expected. The variance is considered to be an unfavorable variance when the actual cost incurred is higher than expected.
For example, ABC International is calculating the cost variance for its usage of steel. It spent $80,000 during the past month on steel, and expected to spend $65,000. Thus, the total cost variance is $15,000. This cost variance is comprised of the following two elements:
- Material yield variance. ABC used an extra 70 tons of steel. At the standard cost per ton of $500, this results in an unfavorable purchase price variance of $35,000.
- Purchase price variance. The cost of the steel used was $460 per ton, versus an expected $500 per ton, and ABC used a total of 500 tons. This results in a favorable purchase price variance of $20,000.
Thus, the variances that comprise the cost variance indicate that ABC saved money on purchasing steel (possibly because it was substandard steel), and lost money on the use of the steel. These two variances, when combined, give management valuable information for where to go to conduct its investigation of the total cost variance.
Just because a cost variance exists does not mean that it should be tracked. In many cases, it takes more time to investigate and report on a variance than the benefits to be gained from this information. Accordingly, companies tend to focus on just a few cost variances in any reporting period.