A cost variance is the difference between the cost actually incurred and the budgeted or planned amount of cost that should have been incurred. Cost variances are most commonly tracked for expense line items, but can also be tracked at the job or project level, as long as there is a budget or standard against which it can be calculated. These variances form a standard part of many management reporting systems. Some cost variances are formalized into standard calculations. The following are examples of variances related to specific types of costs:
- Direct material price variance
- Fixed overhead spending variance
- Labor rate variance
- Purchase price variance
- Variable overhead spending variance
There is an unfavorable cost variance when the actual cost incurred is greater than the budgeted amount. There is a favorable cost variance when the actual cost incurred is lower than the budgeted amount. Whether a variance ends up being positive or negative is partially due to the care with which the original budget was assembled. If there is no reasonable foundation for a budgeted cost, then the resulting variance may be irrelevant from a management perspective.
Cost variances are usually tracked, investigated, and reported on by a cost accountant. This person determines the reason why a variance occurred and reports the results to management, possibly along with a recommendation for changing operations to reduce the size of the variance (if unfavorable) in the future.
It is not always useful to bury management with an analysis of every possible cost variance. Instead, the cost accountant should determine which variances are large enough to be worth their attention, or if there is some action to be taken to improve the situation. Thus, a cost variance report should only include a few items each month, preferably with recommended actions to be taken.
Not all unfavorable cost variances are bad. Spending more money in one area may create a favorable cost variance somewhere else. For example, it might be necessary to spend twice as much on preventive maintenance to avoid a much greater total expense associated with replacing fixed assets more frequently. Thus, it is sometimes better to review cost variances from the level of an entire department, facility, or product line, rather than at a more detailed level. This higher level of analysis gives managers room in which to allocate funds in a manner designed to improve total profits.