You are on page 1of 6

# 13-7-20

## MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

By Dennis Caplan PART 4: DETERMINING THE COST OF INVENTORY
CHAPTER 17: COST VARIANCES FOR VARIABLE AND FIXED OVERHEAD Chapter Contents:

## 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 6. 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 Qs 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.
classes.bus.oregonstate.edu/spring-07/ba422/Management Accounting Chapter 17.htm 1/6

13-7-20

## CHAPTER 17: COST VARIANCES FOR VARIABLE AND FIXED OVERHEAD

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 variance

=(

## budgeted fixed overhead budgeted production

units produced

)-

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
classes.bus.oregonstate.edu/spring-07/ba422/Management Accounting Chapter 17.htm 2/6

13-7-20

## CHAPTER 17: COST VARIANCES FOR VARIABLE AND FIXED OVERHEAD

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

)-

## (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 denominatorlevel concept, and under what circumstances would a company use factory capacity as the denominator-level concept?
classes.bus.oregonstate.edu/spring-07/ba422/Management Accounting Chapter 17.htm 3/6

13-7-20

4/6

13-7-20

## Comprehensive Example of Fixed Overhead Variances:

The Coachman Company makes pencils. The pencils are sold by the box. Following is information about the companys only factory: Budget 10,000 200 500 \$40,000 Actual 12,000 250 650 \$42,000 Capacity 20,000

5/6

13-7-20