Spending variance

What Is Spending Variance?

Spending variance is a key concept within Cost accounting and Variance analysis, representing the difference between the actual amount incurred for an expense and the expected, or Standard costs, for that same expense³⁴, ³⁵. Also sometimes known as rate variance (for labor) or purchase price variance (for materials), spending variance helps organizations evaluate how efficiently they are procuring resources or managing specific cost categories. A favorable spending variance occurs when the actual cost is less than the standard or budgeted amount, while an unfavorable spending variance indicates that the actual cost exceeded the expected amount³³. It is a critical component of assessing financial performance and informing Cost control efforts.

History and Origin

The concept of spending variance, as part of broader variance analysis, has roots in the evolution of management accounting and the development of Standard costs. The need to understand deviations from planned expenditures became crucial as businesses grew in complexity, moving beyond simple financial record-keeping to more sophisticated systems for internal control and performance evaluation³¹, ³².

Standard costing, which forms the basis for calculating spending variance, gained significant traction in the early 20th century, notably championed by mass production pioneers like the Ford Motor Company, which adopted Frederick Taylor's ideas of scientific management. This era saw standard costing and variance analysis hailed as innovations in production control, taught widely in business schools as a method to manage production efficiencies and costs³⁰. While the specific term "spending variance" became formalized over time, the underlying principle of comparing actual expenditures to a predetermined benchmark for control purposes has been fundamental to managerial practice for decades²⁹. Management accounting, encompassing tools like spending variance, has continuously evolved to provide insights for informed decision-making in increasingly dynamic business environments²⁷, ²⁸.

Key Takeaways

Spending variance measures the difference between what was actually paid for an input and what should have been paid, given the actual quantity used.
It is a core component of Variance analysis within Cost accounting.
A favorable spending variance means actual costs were lower than expected, while an unfavorable variance means they were higher.
Analyzing spending variance helps managers identify issues related to purchasing efficiency or unexpected price changes for resources.
It serves as a tool for Cost control and Performance measurement.

Formula and Calculation

The formula for spending variance generally compares the actual price paid for an input to its Standard costs, multiplied by the actual quantity of the input used. This applies whether the input is Direct materials, Direct labor, or variable Overhead.

The generalized formula is:

$\text{Spending Variance} = (\text{Actual Price} - \text{Standard Price}) \times \text{Actual Quantity}$

Where:

(\text{Actual Price}) (AP) = The actual unit cost paid for the input (e.g., price per pound of material, hourly wage for labor).
(\text{Standard Price}) (SP) = The predetermined, expected unit cost for the input.
(\text{Actual Quantity}) (AQ) = The actual amount of the input used or purchased.

For example, if calculating the direct materials spending variance, the "Actual Quantity" would be the actual quantity of materials purchased or used, and the "Price" refers to the unit price of those materials²⁶.

Interpreting the Spending Variance

Interpreting spending variance involves understanding whether the deviation from the Budgeting or standard is favorable or unfavorable, and then investigating the root causes²⁵.

Favorable Spending Variance: This occurs when the actual price paid for an input is less than the standard price. For instance, if a company negotiated a better deal with a supplier or benefited from bulk discounts, it would result in a favorable spending variance for Direct materials. While generally positive, it warrants investigation to understand if the lower cost reflects sustainable savings or, for example, a compromise on quality.
Unfavorable Spending Variance: This arises when the actual price paid exceeds the standard price. Reasons could include unexpected price increases, purchasing smaller quantities at higher per-unit costs, or inefficient purchasing practices. An unfavorable variance signals that inputs are costing more than planned, potentially impacting Profitability.

Managers use the principle of Management by exception to focus on significant variances, both favorable and unfavorable, to identify areas requiring attention and to implement corrective Cost control measures²⁴. It's crucial to evaluate any spending variance within the context of the assumptions used to develop the underlying expense standard or budget²³.

Hypothetical Example

Consider "Evergreen Furniture," a company that manufactures wooden chairs. They have a Standard costs set for the wood used in each chair.

Scenario:

Standard Price (SP) of wood: $10 per square foot.
Standard Quantity (SQ) of wood per chair: 5 square feet.
Actual Quantity (AQ) of wood purchased and used this month: 1,000 square feet.
Actual Price (AP) paid for wood this month: $10.50 per square foot.

Evergreen Furniture produced 200 chairs this month (200 chairs * 5 sq ft/chair = 1,000 sq ft, matching AQ).

Calculation of Spending Variance for Direct Materials:
Using the formula:
$\text{Spending Variance} = (\text{Actual Price} - \text{Standard Price}) \times \text{Actual Quantity}$
$\text{Spending Variance} = (\$10.50 - \$10.00) \times 1,000 \text{ sq ft}$
$\text{Spending Variance} = (\$0.50) \times 1,000 \text{ sq ft}$
$\text{Spending Variance} = \$500$

In this example, Evergreen Furniture has an unfavorable spending variance of $500 for direct materials. This means they spent $500 more on wood than anticipated for the actual quantity purchased and used, solely due to paying a higher price per square foot than the standard. Management would then investigate why the Actual costs were higher, perhaps due to a new supplier, rush orders, or market price fluctuations. This analysis helps them refine their Budgeting and purchasing strategies.

Practical Applications

Spending variance plays a vital role across various aspects of business operations and financial management, particularly within Performance measurement and strategic planning.

Budgetary Control: Organizations regularly compare their actual expenditures to their Flexible budget using spending variances. This allows managers to identify deviations from planned spending and take corrective action, enhancing overall Cost control ²². For instance, if the spending variance for utilities (an Overhead cost) is consistently unfavorable, it prompts an investigation into energy consumption habits or supplier contracts²¹.
Purchasing Efficiency: For Direct materials, spending variance (often called purchase price variance) highlights whether the purchasing department is procuring materials at favorable or unfavorable prices compared to established standards. This provides crucial feedback on negotiation effectiveness and supplier selection²⁰.
Labor Rate Analysis: When applied to Direct labor, spending variance (also known as labor rate variance) indicates if the average wage rate paid to employees deviates from the standard rate. This could be due to changes in wage agreements, use of higher-skilled (and thus higher-paid) labor, or overtime pay¹⁹.
Variable Overhead Management: For variable overhead costs, the spending variance helps assess whether the actual variable overhead rate differs from the standard rate. This is useful for monitoring the cost of indirect materials, indirect labor, and other variable production support costs¹⁸.
Informing Future Decisions: Analysis of spending variances contributes to better Forecasting and Budgeting for future periods, enabling companies to adjust their Standard costs to reflect current market realities or operational changes¹⁶, ¹⁷. The Institute of Management Accountants (IMA) highlights that management accounting, which includes variance analysis, is crucial for decision-making and driving organizational success¹⁴, ¹⁵.

Limitations and Criticisms

While spending variance is a valuable Performance measurement tool, it is not without limitations and criticisms. A primary concern is that a singular focus on spending variance can sometimes lead to suboptimal decisions if not viewed holistically¹³.

Interdependence with Other Variances: Spending variance provides insight into price deviations, but it doesn't tell the whole story. For instance, a favorable Direct materials spending variance (due to buying cheaper materials) might lead to an unfavorable Efficiency variance if the cheaper materials are of lower quality and result in more waste or increased Direct labor time¹². A complete Variance analysis requires examining all related variances to gain a comprehensive understanding of performance.
Standard Setting Accuracy: The effectiveness of spending variance analysis hinges on the accuracy and relevance of the Standard costs. If standards are outdated, unrealistic, or not regularly updated, the resulting variances may not provide meaningful insights for Cost control ¹¹. Critics argue that standards might be too aggressive or fail to account for real-world purchasing conditions, leading to misleading unfavorable variances¹⁰.
Focus on Short-Term Costs: Over-reliance on spending variance can encourage managers to prioritize short-term cost reductions (e.g., buying the cheapest available inputs) which might negatively impact quality, delivery times, or long-term supplier relationships⁹.
Difficulty in Assigning Responsibility: Sometimes, an unfavorable spending variance may be beyond the control of the purchasing manager, such as a sudden, industry-wide price increase. Attributing responsibility solely based on the variance can be unfair and demotivating⁸.
Time Lag: Variance reports are often generated after the fact, creating a time lag between the occurrence of the variance and its analysis. This can hinder timely corrective actions, as events may not be fresh in the minds of those responsible⁷.

Despite these criticisms, financial professionals often use spending variance as a starting point for deeper investigation, recognizing that it provides a critical symptom, not necessarily the root cause⁶.

Spending Variance vs. Efficiency Variance

While both spending variance and Efficiency variance are integral components of Variance analysis in Cost accounting, they measure distinct aspects of cost deviations from Standard costs. The confusion often arises because both contribute to the overall difference between Actual costs and standard costs for a given input.

Spending Variance focuses on the price paid for a unit of input. It evaluates whether the actual cost per unit of material, labor, or Overhead deviates from the standard cost per unit, multiplied by the actual quantity of input used. Essentially, it answers: "Did we pay more or less than expected for each unit of input we acquired?" A purchasing manager's effectiveness might be reflected here.

Efficiency Variance, on the other hand, focuses on the quantity of input used. It assesses whether the actual quantity of material or labor consumed to produce a certain output deviates from the standard quantity that should have been used for that same output, multiplied by the standard price of the input. It addresses the question: "Did we use more or less input (e.g., raw materials, labor hours) than expected to produce the actual output?" This variance often reflects operational effectiveness and production processes.

For example, for Direct materials, a spending variance would tell you if you paid too much for the wood, while an Efficiency variance would tell you if you used too much wood to make a chair. Both are crucial for comprehensive Cost control.

FAQs

Q1: What does it mean if a spending variance is favorable?

A favorable spending variance means that the actual cost incurred for a particular expense or input was less than the Standard costs or budgeted amount⁵. This could be due to effective negotiations, bulk discounts, or market prices being lower than anticipated.

Q2: How does spending variance relate to budgeting?

Spending variance is a direct result of comparing Actual costs to a Budgeting or standard. It helps managers understand where and why actual expenditures deviate from the financial plans set in the budget, thereby facilitating better [Cost control](https://diversification.com/term/cost control) and future financial planning³, ⁴.

Q3: Can a favorable spending variance ever be a bad thing?

While usually positive, a favorable spending variance can sometimes indicate underlying issues. For example, purchasing cheaper Direct materials might lead to a favorable spending variance, but if those materials are of lower quality, they could increase waste or require more Direct labor time, resulting in an unfavorable Efficiency variance or quality problems down the line. It's crucial to look beyond just the variance number and investigate the reasons.

Q4: Is spending variance only for manufacturing companies?

No, while spending variance is prominently used in manufacturing for Direct materials, Direct labor, and Overhead, it can be applied to any expense where a standard or budgeted amount exists². For example, a service company could analyze spending variances for administrative Fixed costs like rent or utilities, or for Variable costs like office supplies.

Q5: Who is typically responsible for a spending variance?

Responsibility for a spending variance often falls to the department or individual primarily accountable for the procurement or pricing of the input. For Direct materials, it's typically the purchasing department. For Direct labor, it might involve human resources or production managers who set wage rates or approve overtime. The concept of Management by exception guides managers to the areas needing attention¹.