Cost Variance

Cost variance is the gap between the funds budgeted for a project and the amount actually spent finishing it. The term refers to the difference between the Budgeted Cost of Work Performed (BCWP) and the Actual Cost of Work Performed. It acts as a method of demonstrating the financial performance of a project, an expense line item, or any financial plan. Many different industries employ this variance in a number of ways, from reporting to predictions based on what they want to accomplish.

This variance is a standard tool utilized by project managers to monitor the gap between their actual and budgeted expenses. They employ this variance to improve the funds they allocate at different points during the project. Cost accountants employ the CV method to monitor, examine, and identify the causes of deviation. They usually present these reports to management, along with recommendations for future improvements to minimize or increase the level of the deviation.

The cost variance formula is:

CV = budgeted cost of work performed (BCWP) - actual cost of work performed (ACWP)

Or,

CV = earned value - actual cost

These variances can be of three types: negative, positive, or zero. When the actual exceeds the budget, and the project spends more than what it should, it is known as a negative variance. When the actual expense is within the budget and the project underspends, there is a positive variance. When the expenses match entirely with the budget, there is no or zero variance. Negative variations in expenses can reveal the degree to which a company is overspending and if it has sufficient funds on hand to pay for it. Positive variation in costs can indicate both successful and failed operations. However, a zero or no variation in cost is preferable.

There are two common reasons why the variance in costs fluctuates positively or negatively instead of resulting in zero. Overestimation or underestimation of a specific result may be a contributing factor to variations in cost. Another significant reason why this variance may fluctuate is due to external events that are outside of the organization's control, such as market changes.

There are several reasons why there may be unanticipated cost variations. Some of them have been discussed below:

• Direct labor expenses: Production delays, shifts in employment, and other internal variables might cause an unanticipated change in direct labor costs.
• Direct product expenses: These costs may vary erratically as a result of product damage, handling disruptions, industry shortages of materials, or higher shipping prices.
• Overhead expenses: Although they rarely fluctuate suddenly, expenses such as insurance coverage, salaries, rent, and taxes must be monitored during the project's lifespan.

Let us go through the following examples to understand this variance:

Example #1

Let us assume that Panache Builders, a construction company, took on a new project and estimated that the cost would be $100,000. However, after completion, the actual cost was estimated to be $150,000.

In this scenario, the earned value is $100,000, and the actual cost is $150,000. 

Using the cost variance formula, 

CV = earned value - actual cost

= $100,000 - $150,000

= - $50,000

This implies that the cost variance calculation value is negative, meaning that the project spent more funds than the budgeted amount.

Example #2

Trans Mountain Corp.'s request for a variance on a section of pipeline in British Columbia has been turned down by the Canada Energy Regulator. The organization has stated that this occurrence may cause a delay in the ongoing expansion project's construction and postpone the pipeline's launch date. The company requested approval to use a different diameter, wall thickness, and coating for a 2,300-metre stretch of pipeline than what it had been granted initially. However, from an initial estimate of $5.4 billion to the latest estimate of $30.9 billion, the project's expenses have increased dramatically during its progress. This is an example of cost variance.

The importance of this variance is as follows:

• Recognize trends in performance: The study of variance in costs can help compare actual and predicted results over time to help businesses find patterns in performance. It makes it easier for organizations to see where they are succeeding and where they still have potential for improvement. By recognizing these patterns, businesses can make educated choices and take the required action to enhance their financial performance.
• Enhance Budgeting Accuracy: Analyzing inconsistencies can help organizations increase the accuracy of their budgeting by highlighting the differences between expected and actual outcomes. Businesses can then enhance their budgeting technique and ensure that their financial projections are accurate.
• Track Business Performance: Using cost variance analysis, businesses can evaluate their financial performance and discover any areas of concern. Organizations can find problems or opportunities and take the appropriate steps to enhance their performance by examining the differences between their actual and expected results.
• Reduce Expenses: Businesses can better manage their expenses by identifying areas of overspending and underspending using variance analysis. By identifying these variations while taking the necessary measures, companies may strengthen their financial performance and lower expenses.
• Make Well-Informed Choices: Cost variance analysis provides businesses with the data they need to make sound choices. By analyzing gaps between predicted and actual outcomes, companies may recognize flaws or opportunities and implement the necessary changes to enhance their economic outcomes.