When undertaking any project, it is always essential to have a solid plan from the onset. However, it is almost impossible to stick to the plan to the core in most cases. It may become necessary to make adjustments as the project progresses, which necessitates identification of cost variance and finding ways to manage them.
The good news is that there are several ways to achieve this. This article takes a deeper look at the concepts of cost variance and cost performance index. We shall also break down the difference between these two and finally give you a few examples for a better understanding.
I hope you find this article insightful and helpful in understanding how to work with your project’s budget and deal with any variances that may occur in the actual expenditure away from the budget allocated for the project. You will also learn how to differentiate when the variances are good for the business and when you should watch out. Stick to the end to grasp how these two concepts can help save your project.
Cost Variance
Cost variance is also referred to as budget variance. This is the difference between what you had budgeted to spend on the project and what you actually spent. The purpose of having a cost variance is to allow you to oversee the project to know whether you are over or under budget. Cost variance could either be positive or negative.
A positive cost variance indicates that you are under budget, while a negative cost variance means that you have gone over the budget. Once you do your calculations and your cost variance comes to zero or thereabout, then it means you are managing the budget perfectly, and you are on track.
To calculate the cost variance, you will need to subtract the actual cost from the earned value. In this case, the earned value is the money gained from the completed work in the scheduled timeframe.
Cost Variance = Earned Value – Actual Value
It would be best to study and analyze the cost variance once you have your values. This will allow you to keep track of the progress of the project processes and the flow of the operations. It is worth mentioning that this may arise in a work project due to differences in labor rates and purchase price differences.
You should also note that cost variances can either be favorable or unfavorable. If, in the end, you find that the actual cost of expenditure is less than the estimated value, then it is favorable. On the other hand, it is unfavorable if the actual cost exceeds the estimated amount.
It would be best to keep in mind that having an unfavorable variance does not always mean that you are in hot soup. Sometimes, the excess spending over the estimated amount may be crucial and necessary to a company. For example, money spent on servicing and maintaining equipment and machine is significant as it extends the said equipment’s life.
Similarly, simply because the variance is favorable does not automatically mean that it is suitable for the company. For instance, spending very little on essential parts of a company, such as customer service or employee training, is not a good indicator.
Examples of Cost Variance
Example 1:
LBH has a project running for 8 months. The allocated budget for the project is 150,000 USD. After 4 months, 60,000 USD has been spent and 50% of the work is done. In this case the Cost Variance is:
CV= Earned Value- Actual Cost
Earned Value=50% of 150,000
=75,000
Actual cost= 60,000
CV= 75,000-60,000
=15,000 USD
Since this is a positive figure, it shows that the project is operating under budget.
Example 2:
Company XYZ has a project scheduled to be completed in 6 months. The allocated budget is 40,000 USD. After an evaluation on the 3rd month, 25,000 USD had been spent on the project, and 40% of the work was done. The Cost variance in this instance will be:
CV= Earned Value – Actual Cost
Earned Value= 40% of 40,000
=16,000
Actual cost= 25,000
CV= 16,000- 25,000
=-9,000 USD
Since the figure you derive here is negative, you are performing way over the budget and may need to evaluate your project’s cost-efficiency parameters.
Cost Performance Index
This is the indicator that you use to measure the financial performance and efficiency of your project. Using CPI, you can tell whether the project is going as planned in terms of schedule and whether you need to make any adjustments along the way. You can also use CPI to ensure that you operate within the allocated budget and ensure that you expend cost-effectively.
CPI is a critical tool used in Earned Value Management System to allow you to know how far behind or ahead of schedule you are. In summary, it measures the cost-effectiveness of the project. This is because, every amount spent, it reflects the work done and completed.
With CPI, you can determine how much task is over or under the allocated budget. However, it would be best if you kept in mind to have a reference point in time. To get the accurate value of the cost performance index of your project. You have to measure the Earned Value and the Actual Cost after every phase or task by task and sum it up afterward. As you move along with the project, you can adjust your CPI according to how the earned value and actual cost change as well.
A cost performance index is essential in project management as it measures costs and earned benefits over the various cycles of a project. This means that you can determine how much money is gained for every coin spent and know how well you are sticking to the allocated budget. The project team will also tell whether their project management skills are up to standard using CPI.
To calculate the cost performance index of a project, you need to divide the earned value by the actual cost. As mentioned before, to get the most accurate value, the earned value and actual cost should be measured on a task-to-task basis. It would be best to assign the data on the start and finish date of each task. This is what is referred to as the cost baseline. It offers some benchmarks that you can compare against.
After doing your calculations, if the ratio you get is higher than 1, you should not be worried as it means that you are performing below the budget. If you get 1, then you are right on budget, while a ratio of less than 1 indicates that you are way above the allocated budget.
This may seem like a simple and straightforward concept. However, it is essential to note that as the project progresses, it is natural to have the CPI fluctuate, thereby no cause for alarm. You need to understand why CPI varies and fluctuates over time to calculate the acceptable range.
There are certain aspects that are crucial to a project that may change over the course of the project. For instance, the weather may suddenly change, the project team may get fatigued, and equipment may also fail. This means that performance will not always be at 100%. These are just some of the reasons that cause the CPI to fluctuate.
Despite a fluctuating CPI, there is a CPI operating range that is considered an acceptable range. This range may differ depending on the project as each project is unique. To arrive at the operating range, you need to factor in the various unpredictable factors that may hinder and prove to be a challenge in undertaking the project.
As mentioned above, fluctuation is normal. However, when you get values outside the operating range, then it indicates that other factors other than inefficiency affect your project. You thoroughly and carefully need to scrutinize both underperforming and overperforming projects to ensure that no scope is being missed.
Example of Cost Performance Index
Example 1:
PowerHouse Ltd has a project that should be completed in 6 months. The company has allocated a budget of 50,000 USD. After three months, the project’s amount is 35,000 USD, but only 40% of the work is done. In this case, the CPI is;
Actual cost: 35,000 USD
Earned Value: 40% of 50,000
=20,000 USD
Cost Performance Index= EV/AC
20,000/35,000 =0.57
This translates to mean that for every 1 USD you spend on the project, you get 0.57 USD because the CPI is less than one. This shows that you are operating over budget, and you need to re-evaluate your cost-efficiency parameters to make them more favorable for you.
Example 2:
Water Front Company is assigned a project that should be completed in 12 months. The allocated budget for the project is 200, 000 USD. A review after 6 months shows that 80,000 USD has been spent on the project, and it is 70% done. The CPI in this case is;
Actual cost:80,000 USD
Earned Value= 70% of 200,000
=140,000
Cost Performance Index= EV/AC
140,000/80,000=1.75
In this case, for every 1 USD spent, Water Front earns 1.75 USD. This project is operating under the budget since the CPI is more than 1. Thereby, this is a positive indicator that cost-efficiency parameters are very favorable.
Key Differences between Cost Variance and Cost Performance Index
Both cost variance and cost performance index are essential to a business and come in handy in managing a budget. However, as discussed above, you can tell that they have a few differences, the main one being on the formula of derivation.
- Formula for derivation
To arrive at the cost variance, you need to subtract the actual cost from the earned value. This is, Cost Variance= Earned Value- Actual Cost. On the other hand, the cost performance index is derived by dividing the earned value by the actual cost. This is Cost Performance index= EV/AC.
- Actual cost v Ratio
For cost variance, you get the difference in amount. That is the actual money difference between the earned value and the actual cost. On the other hand, the cost performance index gives you a ratio to work with. This is because you will be dividing the earned value by the actual cost.
- Time for evaluation
The cost performance index is more effective in calculating the ratio after every task or phase of the project. This will give you more accurate figures and will enable you to track all progress of the project. For cost variance, you can do the calculations after all the work is complete. However, do not feel restricted as you can also calculate after every phase for better tracking of progress.
Conclusion
Having an allocated budget before the commencement of any project is always crucial. This is the estimated value to be spent on the project. However, sticking to the budget to the last penny normally proves challenging. For this reason, it is vital to have ways to tracking the project’s progress in comparison to the estimated spending.
Cost variance and cost performance index are significant concepts when it comes to tracking expenses and ensuring that you are on the right track with the budget. Both help you to know how far beyond or under the budget you are operating. Once you are equipped with such information, you can account for the differences in the estimated amount and the actual spending. However, it would be best if you kept in mind that being a little over the budget is not always wrong for the business. It could be due to necessary additions to the company. For instance, money for equipment maintenance is an essential expenditure.
Similarly, being under the budget may not always be a positive indicator, even though it may appear as saving money to normal eyes. Spending less on crucial services may be detrimental to the business in the long run. I hope that this article has been eye-opening and helped you grasp how you can use these two concepts to budget appropriately for your next project.
