The cost variance analysis is the most common performance evaluation tool when evaluating a cost center. A cost center is a subunit of an organization that has control over costs but not revenues and investments. Examples of cost centers are production department, maintenance department, finance and accounting, etc.
First, let's take a look at a simple total cost variance. Total cost variance is equal to the difference between actual costs and budgeted costs.
If actual costs are higher than budgeted costs, the there is an unfavorable variance. If actual costs are less than budgeted costs, such variance is favorable.
All variances, whether favorable or unfavorable, must be investigated.
Total cost variance = Actual costs - Budgeted costs
The total cost variance may be split into price variance and quantity variance.
Total cost variance = Price variance + Quantity variance
Price variance refers to the variance resulting from the difference in the purchase price per unit of the input. It results from changes in the price per unit of direct materials and labor (and factory overhead) rates. Price variance can be computed as:
Price variance = Actual quantity x (Actual price - Standard price)
If actual price is higher than standard price, there is an unfavorable variance. Otherwise, the variance is favorable.
Quantity variance refers to the variance resulting from the difference in the actual quantity used and budgeted quantity as per standards. Quantity variance is computed as:
Quantity variance = Standard price x (Actual quantity - Standard quantity)
If the actual quantity used is higher than standard quantity, the variance is unfavorable.
ABC Company uses blue widgets in producing its product. Based on its monthly budget, one unit of its final product requires 5 blue widgets. A blue widget normally costs $2.00.
The company produced 5,000 units of its product last month. The company used 26,000 blue widgets and paid $1.80 for each widget.
Cost Variance Analysis:
If the cost of producing a unit of the final product is $10 (5 widgets @ $2 each), the budgeted cost in producing 5,000 units is $50,000. The company used 26,000 widgets at a cost of $1.80 each. The actual cost is equal to $46,800. Hence, there is a favorable materials cost variance of $3,200.
This $3,200 favorable variance can be split into: (a) the portion brought about by difference in the price of the widgets (price variance), and (b) the portion brought about by the difference in quantity used (quantity variance).
a. Price variance
|Price Variance||=||AQ x (AP - SP)|
|=||26,000 x ($1.80 - $2.00)|
|Price Variance||=||$5,200 favorable|
b. Quantity variance
|Quantity Variance||=||SP x (AQ - SQ)|
|=||$2.00 x (26,000 - 25,000)|
|Quantity variance||=||$2,000 unfavorable|
Note: When using cost variance analysis in evaluating a cost center, the manager should be evaluated based only on costs he or she was able to control (controllable costs). Non-controllable costs such as depreciation, allocated repairs and maintenance costs, allocated administrative costs, and others not under his or her influence should be separated.
Variance analysis of costs is performed by comparing actual costs and budgeted costs. With sufficient data, the variance may be split into price variance and quantity variance.
In production departments, variance analysis may be done for different cost components, i.e. direct materials, direct labor, and factory overhead.