Cost Variance: Definition, Formula & Analysis

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  • 0:00 Cost Variance Defined
  • 0:41 Material Variances and Formula
  • 2:37 Material Variances Analysis
  • 3:41 Labor Variances and Formula
  • 5:11 Labor Cost Variance Analysis
  • 5:44 Lesson Summary
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Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

Every business should be reviewing any differences between planned and actual costs. Those differences are called cost variances. This lesson will show you how to determine the source of different types of variances.

Cost Variance Defined

As an individual, you've probably set up a budget for your income and expenses. Businesses also have budgets and they are very important. They are so critical to operating a company that additional steps are taken to analyze the differences between the planned budget and what was actually spent. These differences are called cost variances.

Cost variances can come in two general categories: material and labor. Material cost variances can be further broken down into price and quantity variances. Labor variances consist of rate and hour (sometimes called efficiency) variances.

Material Variances and Formula

When purchasing materials used to produce products, a difference between the planned and actual cost may be a result of different prices paid, different quantities purchased, or a combination of both. In order to figure out where the differences occurred, we need to know four things: actual quantity, actual price, standard price and standard quantity.

For the purposes of this lesson, we will assume you are a manager reviewing the differences between planned and actual budgets and are given the following budget information:

  • Actual quantity (AQ) - 5,500
  • Actual price (AP) - $23
  • Standard price (SP) - $25
  • Standard quantity (SQ) - 5,000

Once we know these four pieces of information, we can use a formula to determine price and quantity variances. There are three steps to computing the total variance that will provide us with enough information to analyze the data.

Step 1. The price variance is determinde by using the formula:

(AQ x AP) - (AQ x SP)

(5,500 x 23) - (5,500 x 25)

126,500 - 137,500 = -$11,000

Step 2. The quantity variance is determined by the following formula:

(AQ x SP) - (SQ x SP)

(5,500 x 25) - (5,000 x 25)

137,500 - 125,000 = $12,500

Step 3. Both of these are added together to establish the total material variance.

-11,000 + 12,500 = $1,500

Material Variances Analysis

As we can see from looking at the planned and actual costs, it initially appears that the company over spent by $1,500, but without any details we cannot determine what the reason was or get the full picture as to whether this was truly a bad thing.

As we look further into the different variances, we notice that the price variance was $11,000 less than what was expected due to a $2 price discount from the standard price. When we look at the quantity variance, we notice that the company was able to purchase 500 more of the item. The reasons for this may have been to meet additional production demand or to take advantage of a price break for a particular quantity. The additional quantity caused a $12,500 increase over what it would have been at the standard price.

The information provided does not tell the entire story but gives the manager enough information as to where he/she would need to go and what questions to ask in order to understand all of the reasons for any difference between planned and actual budgets.

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