A cost variance is the difference between actual and budgeted costs, which companies use to determine the efficiency of their operations. Variances can be favorable or unfavorable, as in the company used less or more money than expected. Measuring cost variance is common under managerial accounting practices. Accountants compare expected and actual production costs to determine where inefficiencies exist in the manufacturing system. The common tools for these measurements are flexible budgets and standard costing.
A flexible budget is the first step of the cost variance process. Companies often review previous year's expenditures to determine the average amount spent on certain business operations. The company lists the annual capital needed to cover expenses for the upcoming year. Managers must stay within these dollar limits when running their respective operations. Budget reviews can be a monthly or annual process, depending on the company’s accounting and financial processes.
Each month, companies can review the flexible budget to compare planned expenses versus actual expenses. Accountants note where the company spent more or less money. A cost variance report then summarizes all differences for the month. Accountants can submit the report to executives and allow them to review the differences. To further strengthen the reporting process, accountants can create a report by all major departments or divisions in the business.
Standard costing is a cost variance tool specific to a company’s manufacturing process. Accountants review the budgeted costs for the manufacturing overhead and create a predetermined overhead rate. This rate divides the total budgeted manufacturing overhead costs by the expected production output for the year. Accountants then calculate this figure using the same formula for each month they produce products. The actual predetermined manufacturing overhead rate is then compared to the standard rate.
Differences in the manufacturing overhead rate require the accountants to clear the ledger for any differences. Accountants can post small differences between the two rates to the company’s cost of goods sold account. Large differences need to go against a company’s inventory account. After this entry, accountants prepare a cost variance report to determine if differences were favorable or unfavorable.
Unfavorable differences on a cost variance report are not always bad. A company may have spent more money on producing products, for example, because of increases in consumer demand. More money may have been necessary to purchase materials and labor to meet this demand. Analysis of the cost variance report against other business reports help companies explain variances.