07.12.

2020 Standard Costs and Variance Analysis

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OVERHEAD VARIANCES
LEARNING OBJECTIVE2
Calculate and interpret variances for manufacturing overhead, and calculate the financial impact of operating at more or less than planned capacity.

The total variance for manufacturing overhead is the difference between the overhead applied to inventory at standard and actual overhead costs. The total overhead
variance can be separated into an overhead volume variance and a controllable overhead variance.1It is possible to decompose the difference between variable
overhead applied at standard and actual variable overhead into a variable overhead spending and a variable overhead efficiency variance. And the difference between
applied and actual fixed overhead can be decomposed into a fixed overhead budget variance and a fixed overhead volume variance. This “four-way analysis” of
overhead variances is covered in cost accounting textbooks. The formulas for the overhead variances are presented in Illustration 11-3 and are discussed next.

ILLUSTRATION 11-3 Manufacturing overhead variance formulas

Controllable Overhead Variance

The controllable overhead variance is the difference between the actual amount of overhead and the amount of overhead that would be included in a flexible budget for
the actual level of production. The variance is referred to as controllable because managers are expected to be able to control costs so that they are not substantially
different from the amount that would be included in the flexible budget:

Suppose the Vulcan Polymer Company expects $15,000 of fixed overhead and $20 of variable overhead per unit. In this case, the flexible budget for the actual level of
production (450 units) is . During the period, Vulcan Polymer incurs $23,000 of overhead. Thus, there is a $1,000 favorable
controllable overhead variance:

Again, the variance is labeled favorable because the actual amount of cost is less than the amount indicated in the flexible budget.

Detailed Analysis of the Controllable Overhead Variance

To gain insight into the causes of a controllable overhead variance, we can compare details of actual overhead cost to details of overhead costs in a flexible budget.
Assume that the details of the $23,000 of actual overhead are as follows:
Actual Overhead Costs
Fixed Overhead Costs
Rent $ 3,125
Supervisor salary 7,135
Depreciation 3,725
Other fixed    750
Total $14,735
Variable Overhead Costs
Power $ 4,725
Indirect materials 2,940
Machine maintenance    600
Total $ 8,265
Total actual overhead $23,000
.
Now suppose budgeted fixed overhead costs are as follows:
Rent $ 3,000
Supervisor salary 7,000
Depreciation 4,000
Other fixed   1,000
Total budget fixed costs$15,000
And suppose budgeted variable overhead costs per unit are:
Power $10
Indirect materials 6
Machine maintenance   4
Total budget fixed costs$20
Now let's prepare a flexible budget for overhead at the actual level of production (450 units):
Flexible Budget Overhead Costs
Fixed Overhead Costs
Rent $ 3,000

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07.12.2020 Standard Costs and Variance Analysis
Flexible Budget Overhead Costs
Supervisor salary 7,000
Depreciation 4,000
Other fixed   1,000
Total $15,000
Variable Overhead Costs
Power $ 4,500
Indirect materials 2,700
Machine maintenance   1,800
Total $ 9,000
Total flexible budget overhead $24,000
Now let's compare actual costs to the flexible budget. This analysis is in Illustration 11-4.
Actual Overhead CostsFlexible Budget Overhead Costs Variance
Fixed Overhead Costs
Rent $ 3,125 $ 3,000 $ 125unfavorable
Supervisor salary   7,135   7,000   135unfavorable
Depreciation   3,725   4,000  (275)favorable
Other fixed     750   1,000   (250)favorable
Total $14,735 $15,000 ($  265)favorable
Variable Overhead Costs
Power $ 4,725 $ 4,500 $ 225unfavorable
Indirect materials   2,940   2,700     240unfavorable
Machine maintenance     600   1,800 (1,200)favorable
Total $ 8,265 $ 9,000   (735)favorable
Totals $23,000 $24,000 ($1,000)favorable
ILLUSTRATION 11-4 Details of actual overhead versus overhead in the flexible budget
Again, we see that the controllable overhead variance is $1,000 favorable. However, we also have gained considerable insight into the cause of the variance. Note that
the largest single variance is the favorable $1,200 variance for machine maintenance. Although this variance is favorable, it would be important to investigate why it
occurred. It may be that the company is cutting back on needed maintenance to show good performance. Actually, this may be damaging in the long run.

Overhead Volume Variance

The overhead volume variance is equal to the difference between the amount of overhead included in the flexible budget and the amount of overhead applied to
production using the standard overhead rate:

Before calculating the volume variance, let's review the calculation of the standard overhead rate. Suppose that at the start of its accounting period, Vulcan Polymer
anticipates producing 500 of the 50-gallon drums of compound. Further, the company anticipates having $15,000 of fixed manufacturing overhead and variable
overhead equal to $20 per unit. In this case, total expected overhead is , and the overhead rate is $50 per unit (i.e.,
):
$25,000
    500units
$    50per unit
Note that the standard overhead rate in this example is expressed on a per unit basis. This is because Vulcan Polymer only produces a single product. When multiple
products are produced, the overhead rate should be based on labor hours, machine hours, or some other measure of activity that is common to the various products. Or
an activity-based costing system can be used with standard rates for each driver of overhead cost.

Computing the Overhead Volume Variance.

If Vulcan Polymer actually produces 450 units, $22,500 of standard overhead would be applied to production . However, the flexible budget amount for
450 units of production is $24,000. Thus, the overhead volume variance is $1,500 unfavorable:

Why is this variance labeled unfavorable? We turn to that question next.

Interpreting the Overhead Volume Variance.

Volume variances do not signal that overhead costs are in or out of control. That signal is provided by the controllable overhead variance, discussed earlier. An
overhead volume variance simply signals that the quantity of production was greater or less than anticipated when the standard overhead rate was developed. When
more units are produced than anticipated, the amount of overhead applied to inventory exceeds the flexible budget because the amount of fixed cost per unit is being
applied to more units than anticipated.
Consider the standard overhead rate of the Vulcan Polymer Company. The rate of $50 per unit is composed of $20 per unit of variable cost and $30 of fixed cost. The
$30 of fixed cost per unit results from dividing the expected amount of fixed cost ($15,000) by the anticipated production of 500 units:
STANDARD OVERHEAD RATE
Variable cost per unit $20
Fixed cost per unit ( expected units) 30
Total $50

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07.12.2020 Standard Costs and Variance Analysis
When this rate is applied to 450 units, a fixed cost of $13,500 is applied to inventory rather than the expected amount of fixed cost, which is $15,000. Thus, the amount
of fixed cost applied to inventory is $1,500 less than the amount of fixed cost in the flexible budget (which is not affected by the level of activity):
STANDARD COST APPLIED TO 450 UNITSFLEXIBLE BUDGET FOR 450 UNITSDIFFERENCE
Variable cost $ 9,000 $ 9,000
Fixed cost  13,500  15,000 $1,500
Total $22,500 $24,000 $1,500
If the company had anticipated that 450 units would be produced, the fixed cost per unit would have been $33.3333, and the standard overhead rate would have been
set at $53.3333:
STANDARD OVERHEAD RATE
Variable cost per unit $20.0000
Fixed cost per unit ( expected units) 33.3333
Total $53.3333
With a rate of $53.3333 per unit, $24,000 of overhead would have been applied to the 450 units produced, and the volume variance would be zero.
The usefulness of the volume variance is limited. It signals only that more or fewer units have been produced than planned when the standard overhead rate was set. If
more units are produced than were originally planned, the variance is labeled favorable because additional production often (but not always) reflects unexpectedly high
customer demand (a favorable outcome). If fewer units are produced, the variance is referred to as unfavorable.

Calculating the Financial Impact of Operating at More or Less than Planned Capacity

As just explained, the volume variance really doesn't measure the financial impact of operating at more or less than planned capacity. So you
are probably wondering how one would go about calculating the financial impact of producing more or fewer units than planned. To perform the calculation, we return
to a familiar concept: incremental analysis.
Recall that at the start of the accounting period, Vulcan Polymer anticipated producing 500 units. As it turned out, the company operated at less than planned capacity
and produced only 450 units. Let's assume that a unit (a 50-gallon drum of compound) sells for $5,000. How much profit does the company lose when a unit is not
produced and sold? The company obviously loses the selling price per unit, but it saves the variable cost per unit of production. Fixed costs are not saved since they are
not affected by production volume. In other words, the company loses the contribution margin per unit. The contribution margin of a 50-gallon drum is $920:
Selling price per unit $5,000
Less variable costs:
Material $4,000
Labor 60
Variable overhead 20  4,080
Contribution margin $  920
Since 50 units were not produced and sold, Vulcan Polymer lost $46,000 of profit:
Number of units not produced and sold 50
Contribution margin per unit × $   920
Financial effect of not producing and selling 50 units   $46,000
Similarly, if 50 units more than planned were produced and sold, the company would have gained $46,000 of incremental profit.

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