Cost variance analysis is a control system that is designed to detect and correct variances from expected levels. It is comprised of the following steps:
- Calculate the difference between an incurred cost and an expected cost
- Investigate the reasons for the difference
- Report this information to management
- Take corrective action to bring the incurred cost into closer alignment with the expected cost
The most simple form of cost variance analysis is to subtract the budgeted or standard cost from the actual incurred cost, and reporting on the reasons for the difference. A more refined approach is to split this difference into two elements:
- Price variance. That portion of the variance caused by a difference between the actual and expected price of the goods or services acquired.
- Volume variance. That portion of the variance caused by any change in the volume of goods or services ordered.
For example, a company has an unfavorable variance in its cost of goods sold of $40,000. A detailed cost variance analysis reveals that the company sold several hundred more units than it expected, and the cost of those additional units comprised $35,000 of the variance. This was hardly indicative of poor performance, since it implied that the company was selling more units. Only the remaining $5,000 of the unfavorable variance was due to unusually high prices, which could then be investigated in detail.
Thus, it frequently makes sense to divide cost variance analysis into price and volume variances, thereby gaining better insights into the costs incurred.
Cost variance analysis is a central tenet of budgeting, since it requires the involvement of financial analysts in all aspects of operations to see if a business is following its planned activities. However, cost variance analysis can also be too rigorous in forcing a business to adhere to a plan of operations that has become out of date, and does not allow it to instead shift funding to more relevant projects. Thus, from an ongoing strategic perspective, cost variance analysis may not be a good thing. Instead, several more relaxed variations on the concept are:
- Conduct the analysis only when there appears to be a clear case of egregiously high costs being incurred
- Conduct the analysis only in areas where costs are of a long-term nature and are not expected to change much (such as in administrative functions)
- Conduct the analysis only for acquired businesses, in order to learn about their cost structures, and then terminate any additional analysis