Companies strive to control the costs related to projects. It is a crucial part of project management. One of the metrics often used to determine the reasonability of project costs is cost variance.
What is Cost Variance?
Cost variance is a critical metric in project management and accounting that assesses the financial performance of a project by comparing the budgeted or planned costs with the actual costs incurred. It provides insights into whether a project is adhering to its budget, identifying discrepancies that may require corrective actions. Interpreting cost variance helps project managers determine if a project is under or over budget.
The primary components of cost variance are the earned value (EV), which represents the budgeted amount for the work completed, and the actual cost (AC), which is the total expenditure recorded for accomplishing the objective. A positive cost variance indicates the project is under budget, while a negative cost variance shows it is over budget. A zero cost variance means the project is exactly on budget.
How to calculate Cost Variance?
As mentioned above, cost variance represents the differences between earned value and actual cost for a specific project. Therefore, companies must determine these two for the calculation. First, earned value refers to the budgeted amount for the actual work completed to date. It reflects the value of the work performed based on the project’s budget.
On the other hand, actual cost is the total expenditure incurred and recorded for the work performed during a specific period. It includes all costs, such as labour, materials, and overheads. Once companies determine these two, they can use the formula for cost variance as below.
Cost variance (CV)=Earned value (EV)– Actual cost (AC)
Interpreting the cost variance is also straightforward, as mentioned above. However, companies also consider other factors when determining whether a project is under or over budget. The cost variance formula above only shows the difference between the two figures.
Example
Blue Co. embarks on a construction project with a planned budget of $60,000 (earned, EV) to complete certain milestones. However, as the project progresses, the actual costs (actual cost, AC) incurred amount to $65,000. Blue Co. can calculate its cost variance as below.
Cost variance (CV) = Earned value (EV) – Actual cost (AC)
CV = $60,000 – $65,000
CV = -$5,000
This negative variance indicates that the actual costs have exceeded the budgeted amount by $5,000. Such a situation can arise due to factors such as unexpected material price increases, labour overruns, or scope changes during the project’s execution.
What are the causes of Cost Variance?
Cost variance can stem from various factors, often resulting in deviations from the planned or budgeted costs. One primary cause of cost variance is inaccurate estimation during project planning. If the initial budget doesn’t accurately reflect the actual costs of resources, materials, labour, and other expenses, it can lead to discrepancies between planned and actual expenditures.
Changes in project scope or requirements can also contribute significantly to cost variance. When the project scope expands beyond the original plan, additional resources and efforts are required, leading to higher costs than initially budgeted. Similarly, unexpected events or risks such as market fluctuations, regulatory changes, or disruptions in supply chains can impact project costs, causing deviations from the budgeted amounts.
Conclusion
Cost variance is a crucial metric in project management. It allows companies to calculate the difference between the earned value and the actual project cost. Companies can evaluate how a project fared against its budgeted amount by considering this difference. Several factors can cause a cost variance, such as inaccurate budgets, changes in project scope, and unexpected events.
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