What is Cost Variance?
The Cost Variance (CV) is a key performance indicator (KPI) in project management that measures the difference between the budgeted cost of work performed (BCWP) and the actual cost of work performed (ACWP).
The comparative analysis of the earned value (EV) attributable to the work completed thus far on a project relative to the planned spending is a method to recognize discrepancies between the budgeted and actual costs at a given point in time.
How Does Cost Variance Work in Project Management
In cost accounting, performing a cost variance analysis is a method to pinpoint the specific areas wherein the operating performance deviates from expectations, facilitating corrective actions.
The cost variance is the difference between the actual cost incurred and the planned or budgeted cost at a specific time.
By conducting cost variance analysis, a company can ensure its resource allocation strategies and budgeting practices are optimized (and any weak points are spotted and directly addressed).
In practice, the cost variance reflects the financial performance of a project currently in progress, offering practical insights to the program managers and project personnel to apply informed adjustments.
Ultimately, the overarching objective to tracking the cost variance is to ensure the optimal utilization of remaining resources.
The underlying factors that constitute a cost variance analysis—i.e. the core drivers—include suboptimal planning (“overestimation” or “underestimation”), external market fluctuations (or unanticipated economic conditions), and the emergence of supply chain or production issues that cause overhead costs and production costs to change.
By quantifying the cost variance, project managers can adjust accordingly as the project is underway to improve the odds of a positive outcome that creates economic utility on behalf of the company, without an unanticipated shortfall in the budget (i.e. exceed the budget).
Once the insights derived and coinciding alterations are applied, there should be a tangible improvement in the efficiency (or output) of the project, assuming the analysis was performed accurately.
How to Calculate Cost Variance
The cost variance matters in project management and cost accounting because the key performance indicator (KPI) provides analytical insights on the current state of a project.
The two components of the cost variance formula are each described in the following list:
- Earned Value (EV) ➝ The earned value represents the value of the work actually completed based on the budgeted cost, i.e. Budgeted Cost of Work Performed (BCWP)
- Actual Cost (AC) ➝ The actual spending incurred for the work performed to date, i.e. Actual Cost of Work Performed (ACWP).
The step-by-step process to calculate the cost variance is as follows:
- Step 1 ➝ Estimated Earned Value (EV) of Project
- Step 2 ➝ Calculate Actual Cost (AC) of Project
- Step 3 ➝ Subtract Actual Cost from Earned Value (EV)
Cost Variance Formula
The formula to calculate the cost variance deducts the actual cost (AC) from the earned value (EV).
In contrast, the cost variance formula can be determined using the following formula, where the budgeted cost of work performed (BCWP) is subtracted by the actual cost of work performed (ACWP).
The distinction between the two approaches is merely related to switching out the terminology, so the outcome should be of equivalent value under either method.
Cost Variance Percentage Formula
The cost variance of a project is a gross measure of performance not suited for comparability.
In order for the cost variance to be tracked across time and relative to comparable projects, the metric must be standardized by dividing by the earned value (EV), akin to a valuation multiple and profitability ratio.
What is a Good Cost Variance?
The classification of a cost variance as either “good” or “bad” is contingent on the variance between the actual costs and budgeted costs.
Since the cost variance is the ratio between the actual cost of work performed (ACWP) and budgeted cost of work performed (BCWP), a positive cost variance is the most favorable outcome.
On the other hand, a negative cost variance implies the necessity to implement changes, or else the project cost incurred will exceed the original budget (and thereby reduce the profitability of the project).
Broadly put, the guidelines to understand the cost variance in earned value management (EVM) can be placed into one of the following categories:
- Positive Cost Variance (“Under-Budget”) ➝ Project Costs < Planned Spending in Budget
- Negative Cost Variance (“Over-Budget”) ➝ Project Costs > Planned Spending in Budget
- Zero Cost Variance (“On-Budget”) ➝ Project Costs = Planned Spending in Budget
Therefore, a positive cost variance implies a more profitable project, in which the resources on hand are allocated efficiently by the project managers.
The fact that the project is currently ongoing, rather than concluded, causes the key performance indicator (KPI) to be more useful, since changes for improvement can be implemented in real-time and prior to completion.
Cost Performance Index (CPI) Formula
The cost performance index (CPI) is a closely monitored metric to track the efficiency of resource utilization on a given project.
The CPI is calculated by dividing the earned value (EV) by the actual cost (AC) of the project.
If the CPI is greater than one serves as an indicator of efficient resource allocation, while a CPI less than or equal to one indicates poor resource efficiency (and room for improvement).
Thus, the cost performance index (CPI) is a metric used for purposes of ensuring the allocation of resources for a project is conducted properly, with minimal waste.
If the CPI is a positive percentage, the project is “under budget” by that amount, while a negative percentage indicates the project is “over budget”.
Cost Variance Calculation Example
Suppose we’re tasked with calculating the cost variance of a project with a budgeted cost of work performed (BCWP) of $50,000 and an actual cost of work performed (ACWP) of $60,000.
Project Management (Budgeted vs. Actual Costs)
- Budgeted Cost of Work Performed (BCWP) = $50,000
- Actual Cost of Work Performed (ACWP) of $60,000
Starting off, the initial step is to calculate the cost variance by subtracting the actual cost from the earned value, which comes out to negative $10k.
- Cost Variance (CV) = $50,000 – $60,000 = ($10,000)
The intuition behind conducting a cost variance analysis is to compare the estimated value of the work completed (or “earned value”) relative to the actual cost incurred.
Therefore, the negative cost variance of $10k indicates that the project cost has exceeded the planned spending by $10k, signaling a budget overrun.
Given the cost variance, we’ll convert the metric into the cost variance percentage by dividing the cost variance by the earned value (and multiplying by 100).
The cost variance percentage is negative 20%, implying the project is over budget by 20% relative to the work completed.
- Cost Variance Percentage (%) = –$10,000 ÷ $50,000 = –20.0%
The cost variance percentage is the normalized variation of the cost variance metric, where the project spend can be described on a percentage basis (i.e. “over budget by 20%”).
In closing, the cost variance of our hypothetical project is negative $10k, and trending over the budget by 20% relative to the work completed, creating the necessity to improve areas of improvement to ensure the project spend remains aligned with the original budget.
