The most critical task for any project manager is maintaining the project budget. When a project goes over or under the budget, project stakeholders become concerned due to cost variance.
It is because over-the-budget projects can affect the company’s profile as those projects require more money. In addition, if more funds are not available, the quality of the project can be compromised.
Similarly, projects under the estimated budget risk returning the money after the completion of the project. Thus, it can be a threat to future grants.
The project stakeholders can also question the quality of the project if the estimated budget is not spent. So, here regular cost variance analysis can help the project managers to determine and analyze the status of the project budget.
Furthermore, by determining the project budget status, PMs can adjust various things such as materials, resources, staffing, and even the project plan.
Due to the cost variance analysis, project managers can communicate efficiently with their stakeholders so that at the project completion, there are no surprises, particularly in terms of finances.
Therefore, it is essential for every project manager to perform a cost variance analysis. Therefore, it is a significant part of the certification exam of project manager professionalism (PMP).
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Cost Variance And The PMP Exam
The project management institute gives the exam of project manager professionalism (PMP). It is a standardized exam taken as a standard for project managers worldwide.
The institute provides formulas, concepts, and processes that project managers use to design, measure, and implement their projects industry-wise. Having PMP certification and credentials means that you are experienced enough to complete your projects correctly.
However, if we talk about the exam of PMP, it is challenging even for experienced project managers. So, it is not easy for inexperienced students to pass the test as it requires effort and time to pass the test.
In addition, it is also not easy for uncommitted professionals to pass the test. According to some experts’ estimates, only 30 to 50% of professionals can pass the test on the first attempt. There are 10 knowledge areas on which the exam of PPM certification tests the professionals. These areas are:
If we talk about the cost variance analysis of any project, it falls under the cost management project. But multiple knowledge areas work together to get the information for determining the cost variance of any project.
This article will tell you the cot variance component in project management. In addition, you will learn cost variance analysis in the different fields of manufacturing and accounting. In the last, we will explain standards and budgeting.
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What Is Cost Variance (CV)?
Cost variance is the difference between the budgeted cost and the actual cost. You can also consider the difference in cost you have planned to spend versus the actual cost you spent.
It is also known as the budget cost. Project managers can determine whether they are under or over budget from the cost variance formula.
If a project CV is positive, it shows that the project is under the budget, and if the CV is negative, it means that the project is over the budget. If the CV of the project is close to zero or zero, it means that your project is on budget.
In earned value management, value comes under money, and commodity refers to time and money spent. It is a project management technique that assembles time, scope, and costs to estimate a project. You can use many formulas to determine the cost variance of any project.
The general formula for CV is:
CV = EV – AC
CV= Cost variance
EV= Earned value
AC= Actual cost
For determining the earned value, you can use this formula:
EV= Work complete (%) x Budget
The actual cost is the amount of money you have spent on the project, and earned value is your earned by completing work in a specific time frame. Therefore, it is necessary to report these three factors together to better understand the magnitude of cost variance.
Project Cost Variance and Management
It is the process of planning and controlling the project budget for a business. Project cost management includes all the available processes in accounting for the incoming money and expenditures. It includes cost estimates, resource planning, cost control, and budget processes.
These all tasks are the duty of project managers, but they also involve the interaction of other processes. The common processes that you can involve in project cost management are:
In this process, the project manager defines the materials, time, equipment, and labor by using current standards and historical data of any comparable projects. After defining these things, one can calculate the possible cost.
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In cost estimation, project managers get information about the previous projects and use mathematical formulas to estimate costs. Then, as the project progresses, the manager can refine the estimates by defining the cost of each activity.
The project schedule and the cost estimate are combined to indicate the cost intervals and the total cost in this process.
The cost budget also indicates how the cost will arise and when it will set a baseline. If we talk about small projects, cost budgeting and cost estimation map overlap to appear like a single process.
In cost control, managers of the project measure the cost variance from the baseline and attempt to correct them. They make a continuous prediction of the cost based on any changes. They also explain why variances in the cost exist.
Cost Variance In Accounting
Cost accounting uses the same concepts as managers in project management use. But they work on the entirety of the companies, not just at the specific grant project.
Most of the time, there are numerous moving pieces and parts in the company that works company-wide, due to which they are more complicated.
The information and data of the cost accounting of any business are internal and specific to that company, and you cannot compare it with any other company or business. If the expected cost is more than the actual cost, we can say that the variance is favorable.
But if the expected cost is less than the actual cost, we can say that the variance is unfavorable. The procedure of variance analysis in accounting is the same as it is in project management. In accounting, you can examine the variance in various ways, such as:
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Direct Labor Costs
We compare the expected and actual labor and wages in the direct labor costs variance analysis. The numbers can be wrong due to poor scheduling where new workers are present in the higher positions. It can also be due to the difficulty in the product creation because of sub-standard materials.
Direct Product Costs
We compare the actual and expected material costs in the direct product costs variance analysis. It can be due to the damage to materials when you handle and store them inappropriately. It can also be due to the industry shortage, which results in higher shipping charges.
This variance refers to the determination of overhead costs such as taxes, rent, salaries, insurance and comparing the actual and expected costs. Although these costs do not exceed or decrease dramatically, they must be tracked over regular time intervals.
What Is Cost Variance In Manufacturing Accounting?
The manufacturing accounting cost variance is slightly different from the cost variance of traditional accounting. It is a common observation that manufacturing companies produce different things by converting raw materials into final products.
Here, the formulas are the same that determine the difference between the estimated and actual cost in terms of overhead, materials, and labor.
Furthermore, if we talk about the output of the manufacturing industry, it is tangible. Manufacturing systems have specified tangible production sites accountable inventory, and often they produce items before getting any order from the customer.
However, some accounting concepts do not apply to merchandise and service-oriented companies. For instance, some concepts of accounting that do not apply to some companies are:
Work in Process (WIP): It uses a separate balance sheet for the goods that have been completed and ready for sale and for those goods that are not yet completed.
Add Value: Defining costs based on the cost of labor and raw materials. The labor accounts for the service taken for the production of goods.
Incurred Manufacturing Expenses: It takes account of the actual labor cost and adds value.
The main cost variance in manufacturing occurs in production. The flow of the relationship between the differences in the cost variance and total production cost is represented in the following diagram:
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Cost Variance Analysis
The company management analyst or project manager who works on cost variance analysis checks the differences between actual and expected costs. First, let’s talk about the variance analysis cycle.
It begins with the analysis of the variance, asking questions, receiving the explanation of your questions, taking corrective measures, conducting the next period’s operation, and then preparing the report of standard cost performance.
Draft your questions that you want to ask based on variances that you find. For instance, if the efficiency variance for your manufacturing company shows positive results, you should ask the questions such as how your workers manufacture the products faster than predicted and whether it is possible in the future.
In this way, you can do other calculations such as labor variance and quality variance. The best way to report variance analysis after beginning a new cycle of operations. A general cost variance analysis cycle is as follows:
Price, Quantity, and Labor Cost Variance
You can use the cost variance analysis formula to calculate the standard cost variances. These are standard formulas across various industries and help calculate the major cost variances. The formulas for price variance and quantity variance are:
Price Variance = Actual Quantity (Actual Price – Standard Price)
Quantity Variance = Standard price (Actual Quantity – Standard Quantity)
The price variance shows all the purchased quantities, and the quantity variance shows only the used quantity.
In addition, quantity variance occurs due to the differences between the expected and the actual usage of machine time, materials, or square footage. Thus, these variances mainly depend on standard materials and indicate poor planning.
Furthermore, if you want to determine the standard labor cost variance, the formula is:
Labor Cost Variance = Standard Rate (Actual Hours – Standard Hours)
This variance can occur due to variation in staffing, poorly set standards, and alterations in benefits.
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Top 5 Frequently Asked Questions
How do you analyze cost variance?
You can analyze cost variance in the following ways:
1. Determine the difference between the actual cost and the expected cost.
2. Identify the reasons for the cost difference.
3. Send this information of difference to management.
4. Take corrective measures to bring the actual cost closer to the expected cost.
How do you interpret a variance?
Variance indicates how far a set of data can go or spread out. If a variance is zero, the data values are identical. And if the value of variance is not zero, it shows positive variance. A small value indicates that the values of data are close and are close to the mean value.
What are the 4 types of cost?
The four common types of costs are:
1. Direct cost
2. Indirect cost
3. Fixed cost
4. Variable cost
How do you do cost analysis in Excel?
The following ways can do a typical cost-benefit analysis in excel:
• Gather all the essential data.
• Calculate cost whether it is fixed, one-time, or variable.
• Determine the benefits.
• Compare costs with benefits over a specific period of time.
• Determine which option is best for the chosen time period.
Is low or high variance better?
Low variance means a lower return or a lower risk. Stocks of low variance are good for conservative investors with lower risk tolerance. In contrast, high variance stocks are good for aggressive investors who can tolerate high risks. Thus, variance is the measurement of risk potential in an investment.