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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.

In a Nutshell

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.

You will learn how to compute and analyze variances in this lesson.

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.

More on Responsibility Accounting

- 1What is Responsibility Accounting?
- 2Decentralized Organization
- 3Cost Variance Analysis
- 4Segment Margin Analysis and Segment Reporting
- 5Evaluating Investment Centers
- 6Transfer Pricing

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