Cost variance formula: Keeping projects on a budget

The cost variance formula is a project cost management tool that can help you keep projects under budget. “Cost variance” is the difference between the expected cost of the project (or the amount budgeted) and the actual cost of the project (or the amount spent). When this value is positive, it indicates that a project is under budget, while a negative variance indicates that a project costs more than what you budgeted.

When you’re managing a project, calculate cost variance periodically in order to determine whether your project is staying on or under budget. You can even calculate individual variances for different budget categories, like labor or supplies, in order to find areas that are most likely to push a project over budget.

In this post, we’ll explain what cost variance is and how you can apply the cost variance formula. We’ll also look at different individual cost variance formulas and how to calculate each.

What is cost variance?

Cost variance is the difference between the planned cost of a project and its actual cost after accounting for any extra expenses or unexpected savings. The formula for calculating cost variance is:

• Projected cost – actual cost = cost variance

A positive cost variance indicates that a project is coming in under budget, while a negative cost variance means that the project is over budget. If the cost variance is zero, it means that the actual cost of the project is equal to the expected cost of the project. 

Positive vs. negative cost variance

In a perfect world, the cost variance for a project would be zero, meaning budgeted cost and amount spent match exactly. In reality, it’s extremely rare for a project’s actual cost to perfectly match its initial budget. 

In general, aim for a positive or favorable variance, as this indicates that the project is on track and within budget. However, a negative or unfavorable variance does not necessarily mean that your project is in trouble. It could simply mean that the original budget was too optimistic and that you need to take action to ensure all costs stay under control. 

Simple cost variance example

It's easier to get a full understanding of cost variance when you're able to see it in practice. Let’s say you’re a small business owner who’s recently hired a graphic designer. The designer is responsible for creating marketing materials, website design, and other visual assets at a rate of $50/hour. If you expect the entire project to be finished in two months—or 1,200 work hours—you should budget $60,000 for this project. 

The project winds up taking about 10 weeks longer than you originally anticipated, and the graphic designer logged 1,600 hours in total. All in all, the project cost $80,000 in graphic design time.

To calculate the cost variance for the business's graphic design budget, you would subtract the actual cost ($80,000) from the budgeted (or projected) cost ($60,000) for a cost variance of -$20,000. When cost variance is negative, it means the project went over budget by that amount.

In our example above, you (the business owner) only calculated cost variance at the end of the project. Cost variance is more helpful when it can identify over-budget trends as they're happening so you have an opportunity to course-correct and put the project back on track financially. In order to do this, you need to factor in earned value.

What is earned value management?

Earned value, sometimes called planned value, represents the budgeted cost of work performed at a particular point in a project. Earned value management can help you check in on progress periodically and ensure your project is on track and on budget. 

Going back to the example above, let's say you checked in on the graphic design project when 25% of the work was done. At the 25% completion mark, your projected cost—the amount that you expected to have spent at this point—should be $15,000, or 25% of your total budget. 

But in this case, it took your designer 400 hours to get 25% of the project done. The actual cost of work performed at the 25% progress mark was $20,000 (or 400 hours of work at $50/hour).

Had you calculated cost variance at the 25% progress point—subtracting actual cost ($20,000) from projected cost or earned value ($15,000) for a cost variance of -$5,000—you would have learned early on that your project was running over budget and adjusted accordingly.

This process of performing a value analysis at regular intervals throughout a project to ensure that the earned value matches or exceeds the actual cost of a project is called earned value management. 

3 ways to calculate cost variance

There are three different methods of calculating variance in your cost accounting: 

• Cumulative cost variance method

• Period-by-period cost variance method

• Variance at completion method 

All three methods use the same formula, but they apply the calculation differently in order to determine different things.

Cumulative cost variance method

Cumulative cost variance is calculated by taking the difference between the actual cumulative cost of the project and the expected cumulative cost of the project. This method can be used to get an overview of how much a project has deviated from its original budget.

In our example above, we used the cumulative cost variance method to determine how much the cost of the whole project had deviated from the budget up to that point.

Period-by-period cost variance method

You can calculate period-by-period cost variance by taking the difference between the actual cost of the project and the expected cost of the project at a specific point in time or over a specific project phase. 

Let's say that you check in again on your graphic design project's progress at the halfway point. To calculate period-by-period cost variance, you would calculate the cost variance of the first quarter and second quarter of the project separately. 

The benefit of period-by-period cost variance is that it allows you to get a better picture of where budget fluctuations occur in the project schedule. If a project is on track at the halfway point but off track at the three-quarter mark, you not only know that something went wrong—you also know when it went wrong. With a narrower time frame, you can find and fix problems more easily. 

Variance at completion method

You can use the variance at completion method at any point throughout the project in order to predict how far over or under budget the project will be when it's completed, based on how much progress has been made thus far. You can calculate variance at completion by subtracting what you currently think the total project will cost (or forecasted cost) from what you originally thought the project would cost (the expected cost). 

When you evaluate your graphic design project at the 25% completion point and find that you'd already spent $20,000, your forecasted cost of the project at this point would be $80,000. By subtracting the forecasted cost from your original expected cost of $60,000, you can determine that the variance at completion, if the project continues at this pace, will be -$20,000.

The variance at completion method allows you to use current pacing information to predict how far the project will have deviated from its budget at completion.

5 types of cost variance

The three categories above describe three different ways to calculate cost variance. Here, we’ll go over the five types of cost variance that you can calculate.

Each of these formulas produces the cost variance for a different budget category, which allows project managers to drill down and determine where costs are coming in under or over budget and adjust accordingly.

Material cost variance

Projects that require direct materials will have a material cost variance, which calculates the difference between the amount budgeted for materials and the amount actually spent. 

Material costs can be found by multiplying the quantity of materials by the materials price. The actual cost of materials can differ from budgeted cost if either the quantity or the price of the materials changes.

If you calculate cost variance at the halfway point of the project and find that materials cost variance is trending higher than anticipated, you will need to adjust your project scope or find extra funds elsewhere that can cover excess material costs.

Labor variance

Labor cost variance is the difference between budgeted and actual costs for direct labor. Labor costs can deviate from the budget if the project requires more hours than anticipated, or if hourly wages increase. Our graphic design example above is a labor cost variance example.

If your company has a large positive labor cost variance—meaning more was budgeted for labor than is proving necessary—adjust the labor budget and redirect extra funds to other budget categories with negative cost variances. If labor cost variance is negative, this indicates that your team is under producing, or the project scope is greater than anticipated. Additional training or better quality control measures can help you bring labor costs down.

Sales variance

Sales variance differs from all of the other types of cost variance in that it has to do with costs comingin (revenue) rather than costs going out (expenses). Sales variance only comes into play in projects with a sales component—for example, our graphic design example would not have a sales variance, because nothing in that project is being sold. 

The calculation for sales variance is budgeted sales minus actual sales. This is the only type of variance on the list that is good when it is negative. If your budgeted (or expected) sales total was $1,000 and your actual sales total was $2,000, then your sales variance is -$1,000. When actual sales exceed budgeted sales, your variance will be negative—but your profits will be positive.

Variable overhead variance

Overhead costs are expenses associated with operating a business. Variable overhead costs are costs incurred during business operations that increase or decrease depending on how productive your business is. Shipping costs, warehouse energy costs, and machine maintenance are all examples of variable overhead costs.

To calculate the cost variance for variable overhead, you'll first need to find the "standard variable overhead rate per hour." This is the sum total of variable costs incurred in an hour of production. For example, if you pay $2 per unit shipped and produce 10 units per hour, your standard shipping rate per hour would be $20.

Variable overhead cost variance is the difference between the standard variable overhead during a period of time, and what the actual variable overhead turns out to be after any price changes or changes in hours worked are factored in.

Fixed overhead variance

Fixed overhead expenses remain the same no matter how much work is done. Rent, property taxes, and subscriptions are all examples of fixed overhead costs. The "fixed" in fixed overhead refers specifically to the type and quantity of overhead expenses—for example, you don't have to pay more rent the more you use your office space, but that doesn't mean that your landlord can't raise your rent.

The formula for fixed overhead variance is standard (or budgeted) overhead cost minus actual overhead cost. Both figures are overhead totals, so they encompass the total cost of all of your overhead expenses for a given period.

Let's say your company has just two fixed overhead costs: rent ($10,000/month) and business insurance ($500). Your standard overhead cost for a six month project would be $10,500/month, or $63,000. If your landlord raises your rent to $15,000/month halfway through the project, your actual fixed overhead cost will be higher—$10,500 for the first three months plus $15,500 for the remaining three months, or $78,000 total.

To calculate fixed overhead variance, subtract your actual fixed overhead from your standard fixed overhead for a final variance of -$15,000.

Use cost variance to keep project budgets on track

The first key to keeping a project's costs under control is to ensure that initial costs estimates are reasonably accurate. In order to do this, make sure you’re working closely with the project team to determine the necessary expenses for a project. Then, collaborate with other internal stakeholders in finance and accounting departments to accurately project future costs and prices for those expenses.