CHAPTER 17: Cost Variances for

Variable and Fixed Overhead

 
 
Chapter Contents:
-                      Cost variances for variable overhead
-                      Cost variances for fixed overhead
-                      The fixed overhead spending variance
-                      The fixed overhead volume variance
-                      Additional issues related to the volume variance
-                      Comprehensive example of fixed overhead variances
-                      Exercises and problems
 
 
Cost Variances for Variable Overhead:
The formulas for splitting the flexible budget variance for variable
overhead into a “price” variance and an “efficiency” variance are the
same as the formulas for direct materials and direct labor explained
in Chapter 7. The “price” variance for variable overhead is called
the variable overhead spending variance:
 
Spending variance = PV = AQ x (AP – SP)
 
Efficiency variance = EV = SP x (AQ – SQ)
 
Where AP is the actual overhead rate used to allocate variable
overhead, and SP is the budgeted overhead rate. The “Q’s” refer to
the quantity of the allocation base used to allocate variable
overhead, so that AQ is the actual quantity of the allocation base
used during the period, and SQ is the standard quantity of the
allocation base. The standard quantity of the allocation base is the
amount of the allocation base that should have been used (i.e.,
would have been budgeted) for the actual output units produced.
 
Given the use of the allocation base in these formulas for the cost
variances for variable overhead, the meaning of these variances
differs fundamentally from the interpretation of the variances for
direct materials and direct labor. Consider a company that allocates
electricity using direct labor as the allocation base. A negative
variable overhead efficiency variance does not necessarily mean that
the factory used more electricity than the flexible budget quantity of
kilowatt hours for the actual outputs produced. Rather, the negative
variance literally means that the factory used more direct labor than
the flexible budget quantity for direct labor. If there is a cause-and-
effect relationship between the allocation base and the variable
overhead cost category (i.e., if more direct labor hours implies more
electricity used), then the negative efficiency variance suggests that
more electricity was used than the flexible budget quantity, but the
efficiency variance does not measure kilowatts directly.
 
Similarly, a negative spending variance for variable overhead does
not necessarily mean that the cost per kilowatt-hour was higher than
budgeted. Rather, a negative spending variance for variable
overhead literally states that the actual overhead rate was higher
than the budgeted overhead rate, which could be due either to a
higher cost per kilowatt-hour, or more kilowatt hours used per unit
of the allocation base. Hence, what one might think should be
included in the efficiency variance (kilowatt hours required per
direct-labor-hour being higher or lower than budgeted) actually gets
included as part of the spending variance.

Cost Variances for Fixed Overhead:

Whereas the cost variances for direct materials, direct labor, and
variable overhead all use the same two formulas, the cost variances
for fixed overhead are different, and do not use these formulas at all.
 
Also, whereas cost variances for direct materials, direct labor, and
variable overhead can be calculated for individual products in a
multi-product factory, cost variances for fixed overhead can only be
calculated for the factory or facility as a whole. (More precisely,
fixed overhead cost variances can only be calculated for the
combined operations to which the resources represented by the fixed
costs apply.)
 
There are two fixed overhead cost variances: the spending variance
and the volume variance.
 
 
The Fixed Overhead Spending Variance:
The fixed overhead spending variance is the difference between
two lump sums:
 
Actual fixed overhead costs incurred - Budgeted fixed overhead
costs
 
The fixed overhead spending variance is also called the fixed
overhead price variance or the fixed overhead budget variance.
 
 
The Fixed Overhead Volume Variance:
The fixed overhead volume variance is also called the production
volume variance, because this variance is a function of production
volume. The volume variance attaches a dollar amount to the
difference between two production levels. The first production level
is the actual output for the period. The second production level is the
denominator-level concept in the budgeted fixed overhead rate,
expressed in units. As discussed in the previous chapter, there are
two common choices for this denominator:

(1)               budgeted production

(2)               factory capacity
 
The interpretation of the volume variance depends on which of these
two denominators are used, but in either case, the production
volume variance is the difference between budgeted fixed overhead
(a lump sum), and the amount of fixed overhead that would be
allocated to production under a standard costing system using this
fixed overhead rate.
 
The volume variance with budgeted production in the
denominator of the O/H rate:
First we use budgeted production to calculate the volume variance.
In this case:

             
 
volume
varianc =(
budgeted fixed overhead
budgeted production
x units produced
)- budgeted fixed
overhead
e
         
 
The term in parenthesis equals the amount of fixed overhead that
would be allocated to production under a standard costing system,
when budgeted production is the denominator-level concept.
 
 
Since
 
budgeted fixed overhead ÷ budgeted production =
budgeted overhead rate
 
the above expression for the volume variance is algebraically
equivalent to the following formula:

volume variance = (units produced - budgeted production) x budgeted overhead rate

This formula for the volume variance illustrates the statement

above; that the volume variance attaches a dollar amount to the
difference between two production levels. In this case, the two
production levels are actual production and budgeted production.
The interpretation of the volume variance, when budgeted
production is used in the denominator of the overhead rate, is the
following. When actual production is less than budgeted production,
the volume variance represents the fixed overhead costs that are not
allocated to product because actual production is below budget. In
this case, the volume variance is unfavorable. When actual
production is greater than budgeted production, then the volume
variance represents the additional fixed overhead costs that are
allocated to product because actual production exceeds budget. In
this case, the volume variance is favorable.
 
The intuition for when the volume variance is favorable and when it
is unfavorable is the following. If the company can produce more
units of output using the same fixed assets (i.e., the resources that
comprise fixed overhead), then assuming those additional units can
be sold, the company is more profitable. When fixed overhead is
allocated to production, this greater profitability is reflected in a
lower per-unit production cost, because the same amount of total
fixed overhead is spread over more units. On the other hand, if
fewer units are produced than planned, then the same fixed overhead
is spread over fewer units, the per-unit production cost is higher, and
the company is less profitable. This higher or lower profitability that
arises from changes in production levels is not an artifact of the
accounting system. Even if the company uses Variable Costing, and
expenses fixed overhead as a lump-sum period cost, when the
company makes and sells fewer units than planned using the same
fixed overhead resources, it really is less profitable than was
budgeted, and when the company makes and sells more units than
planned using the same fixed overhead resources, it really is more
profitable than was budgeted.
 
The volume variance with factory capacity in the denominator
of the O/H rate:
Next we use factory capacity to calculate the volume variance. In
this case:
 
             
 
volume
varianc = (
budgeted fixed overhead x units produced
factory capacity )- budgeted fixed
overhead
e
         
Since
 
budgeted fixed overhead ÷ factory capacity = budgeted
overhead rate
 
the above expression for the volume variance is algebraically
equivalent to the following formula:

volume variance = (units produced - factory capacity) x budgeted overhead rate

The interpretation of the volume variance, when factory capacity is

used in the denominator of the overhead rate, is the following.
Actual production is almost always below capacity. The volume
variance represents the fixed overhead costs that are not allocated to
product because actual production is below capacity. Hence the
volume variance represents the cost of idle capacity, and this
variance is typically unfavorable. For this reason, this volume
variance is sometimes called the idle capacity variance. In the
unlikely event that the factory produces above capacity (which can
occur if the concept of practical capacity is used, and actual down-
time for routine maintenance, etc., is less than expected), then the
volume variance represents the additional fixed overhead costs that
are allocated to product because actual production exceeds capacity.
In this case, the volume variance is favorable.

Additional Issues Related to the Volume Variance:

Under what circumstances would a company calculate the volume
variance using budgeted production as the denominator-level
concept, and under what circumstances would a company use
factory capacity as the denominator-level concept?
 
The use of budgeted production in the calculation of the volume
variance attaches a lump sum benefit or cost to actual production
levels that exceed or fall short of budgeted production levels. For
this reason, many companies consider this calculation of the volume
variance to be an important performance measure for the factory
manager and marketing managers responsible for making and
marketing the product.
 
The use of factory capacity in the calculation of the volume variance
provides an indication of how low the per-unit cost can go, if
demand equals or exceeds factory capacity. If senior management
would like product managers to make pricing and operating
decisions based on a long-term expectation that demand for the
product will equal or exceed factory capacity, even though current
or short-term demand is below capacity, calculating the per-unit cost
in this manner will encourage product managers to take this long-
run perspective. For example, consider the launch of a new product
line in a new factory. If fixed overhead is allocated based on
budgeted production, then product managers might feel pressured to
set sales prices that will cover full product costs at initially-low
production levels, but these sales prices might be too high to
generate sufficient initial consumer interest in the product for a
successful product launch.
 
Another reason to use factory capacity in the denominator of the
fixed overhead rate, and in the calculation of the volume variance, is
that doing so isolates the cost of idle capacity. Often, the decision to
build a factory that is larger than current demand warrants is a
strategic decision made at high levels within the organization. If the
fixed overhead associated with this factory is allocated based on
budgeted or actual production, the per-unit cost of every unit
manufactured includes a small portion of the cost of this strategic
decision, and the cost reports of factory managers and the product
profitability statements of product managers are negatively affected
by this unused capacity. Some companies prefer to isolate the cost
associated with this strategic decision, and to either show the cost of
idle capacity as separate line-items on the cost reports and profit
statements of the factory manager and product managers, or remove
this cost entirely from these performance reports, and report it only
at the corporate level.
 
Allocating fixed overhead using actual production can provide
managers short-run incentives to overproduce, because as
production increases, the per-unit cost decreases. Similarly,
calculating the volume variance using budgeted production in the
denominator of the overhead rate can provide managers short-run
incentives to overproduce, because as production exceeds budget,
the volume variance becomes increasingly favorable. For this
reason, some companies choose not to allocate fixed overhead at all.
However, the use of factory capacity in the denominator of the fixed
overhead rate accomplishes the same objective, because it isolates
the volume variance such that the performance reports of these
managers need not be affected by it.
 
We have assumed, throughout this section, that fixed overhead is
allocated based on units of output. However, we saw in the chapter
on activity-based costing that units of production is often a poor
choice of allocation base in a multi-product factory, and many
companies that use standard costing systems use allocation bases
that are more sophisticated, such as direct labor hours or direct
materials dollars. The question might arise, how does the use of a
different allocation base, such as direct labor hours, affect the
calculation of the volume variance? The answer is: Not at all.
Because of the way in which standard costing systems work, the
amount of fixed overhead that will be allocated to product does not
depend on the choice of allocation base.
 
For example, assume that a one-product company budgets two direct
labor hours to make each unit, and assume that if fixed overhead is
allocated based on output units, the budgeted fixed overhead rate is
$10 per unit. Then using direct labor hours as the allocation base,
the budgeted fixed overhead rate is $5 per direct labor hour. Because
of the mechanics of standard costing systems, no matter whether the
$10-per-unit rate is used, or the $5-per-direct-labor-hour rate is
used, $10 of fixed overhead will be allocated to every unit produced,
no matter how many direct labor hours are actually used per unit. (If
this fact is not obvious to you, refer back to Chapter 10 on standard
costing.) Therefore, for the purpose of calculating the volume
variance, we might as well use the easiest allocation base, which is
units-of-output.
 
It is important to recognize that even though most manufacturing
companies use a standard costing system, and even though the
calculation of the fixed overhead volume variance relies on the
concept of standard costing, companies can calculate the volume
variance even if they do not use a standard costing system. In this
case, the calculation is identical to the discussion above, but the
company will not be able to obtain the required information from
the cost accounting system itself, but rather, will need to make a
separate calculation.

Comprehensive Example of Fixed Overhead

Variances:
The Coachman Company makes pencils. The pencils are sold by the
box. Following is information about the company’s only factory:

  Budget Actual Capacity

Number of boxes 10,000 12,000 20,000

Direct labor hours 200 250  

Machine hours 500 650  

Fixed overhead $40,000 $42,000

The outputs here are boxes of pencils. The inputs are direct labor
hours and machine hours. First we calculate a fixed overhead rate
using actual amounts, and output units as the allocation base:
 
$42,000 ÷ 12,000 boxes = $3.50 per box.
 
Using this overhead rate, every box of pencils is costed at the
variable cost of production plus $3.50 in allocated fixed overhead.
 
Next: we calculate a fixed overhead rate using budgeted costs, and
budgeted output units as the denominator-level concept:
 
$40,000 ÷ 10,000 boxes = $4.00 per box.
 
Next: we calculate a fixed overhead rate using budgeted costs, and
factory capacity as the denominator-level concept (expressed in
terms of output units).
 
$40,000 ÷ 20,000 boxes = $2.00 per box.
 
The advantage of using capacity in the denominator is that this
denominator-level concept shows how low the fixed cost per unit
can go, and hence, how low the total cost per unit can go, as
production increases.

The fixed overhead spending variance is calculated as follows:

 
$42,000 actual - $40,000 budgeted = $2,000 unfavorable.
 
Next: we calculate the volume variance using capacity as the
denominator-level concept:
 
volume variance = ($2.00 per box x 12,000 boxes) - $40,000 =
$16,000 unfavorable
 
or equivalently:
 
volume variance = $2.00 per box x (12,000 boxes - 20,000 boxes) =
$16,000 unfavorable
 
If the company uses a standard costing system, the amount of
overallocated or underallocated fixed overhead is the difference
between actual fixed overhead incurred, and fixed overhead
allocated to product, calculated as follows:
 
actual fixed overhead - fixed overhead allocated
 
= $42,000 - ($2.00 per box x 12,000 boxes)
 
= $42,000 - $24,000 = $18,000 underallocated
 
This $18,000 of underallocated fixed overhead is equal to the sum of
the $2,000 unfavorable fixed overhead spending variance and the
$16,000 unfavorable volume variance.
 
Next: we calculate the volume variance using budgeted production
as the denominator-level concept:

volume variance = ($4.00 per box x 12,000 boxes) - $40,000 =

$8,000 favorable
 
or equivalently:
 
volume variance = $4.00 per box x (12,000 boxes - 10,000 boxes) =
$8,000 favorable
 
If the company uses a standard costing system, the amount of
overallocated or underallocated fixed overhead is the difference
between actual fixed overhead incurred, and fixed overhead
allocated to product, calculated as follows:
 
actual fixed overhead - fixed overhead allocated
 
= $42,000 - ($4.00 per box x 12,000 boxes)
 
= $42,000 - $48,000 = $6,000 overallocated
 
This $6,000 of overallocated fixed overhead is equal to the sum of
the $2,000 unfavorable fixed overhead spending variance (which did
not change when we changed the denominator-level concept from
capacity to budgeted production) and the $8,000 favorable volume
variance.
 
To illustrate that the choice of allocation base does not affect the
calculation of the volume variance, we recalculate the volume
variance assuming the company allocates overhead using machine
hours as the allocation base and budgeted production as the
denominator-level concept. The budgeted overhead rate is now
 
$40,000 ÷ 500 machine hours = $80 per machine hour.

Since the standard for machine time is one hour for every twenty
boxes (derived from the budget column in the box at the beginning
of the example), the standard costing system will allocate fixed
overhead as follows:
 
Budgeted overhead rate x (standard inputs allowed for
actual outputs achieved)
 
= $80 per machine hour x (12,000 boxes ÷ 20 boxes per
machine hour)
 
= $80 per machine hour x 600 machine hours = $48,000
 
And the volume variance is
 
 fixed overhead allocated to product - budgeted fixed
overhead
 
= $48,000 - $40,000 = $8,000 favorable, as before.