Definition: A cost variance is the difference between the actual expenses incurred and the standard expenses estimated at the beginning of a period. Management uses these variances are used to analyze and track the progress of production processes, budgets, and other operations.
What Does Cost Variance Mean?
Before a cost variance can be calculated, the standard cost must be established. This is the estimated expense that management anticipates incurring during the period. These costs usually include direct materials, direct labor, and factory overhead. When management has finishes setting their standard costs for the period, the production process can begin.
At the end of the accounting period, management analyzes the difference between the actual amount of expenses incurred and the standards that were set at the beginning. The difference between these two numbers is considered the cost variance. Variances can be favorable or unfavorable.
A favorable variance occurs when the actual costs incurred are less than the estimated costs. Similar to the budgeting process, unfavorable variances occur when the actual costs are higher than the estimated expenses.
After management has identified the favorable and unfavorable variances, they can break them down into their components. Each cost variance is made up of a quantity component and a price component. Each of these components in turn have an actual amount and standard amount associated with them just like the variance. Here are the cost variance equations.
Cost variance = Actual cost – Standard cost
Actual cost = Actual quantity x Actual price
Standard cost = Standard quantity x standard price
Management can use these formulas to analyze what happened during the accounting period and how to adjust the production process in the future. For instance, these formulas can be combined to find the price and quantity variance for the period. This way management can understand what caused the overall cost variance. Was it the change in quantities purchased, the change in price, or a combination of the two?