Accounting: The Language of Business - Vol. 1 (Part 138)

To get qualified accountants, it’s extremely difficult.

Craig Scott

 Performance Evaluation Using Variances from Standard Costs (Part E)

by

Charles Lamson

Factory Overhead Variances

Factory overhead costs are more difficult to manage than are direct labor and material costs. This is because the relationship between production volume and indirect costs is not easy to determine. For example, when production is increased, the direct materials will increase. But what about the engineering department overhead? The relationship between production volume and cost is less clear for the engineering department. Companies normally respond to this difficulty by separating factory overhead into variable and fixed costs. For example, manufacturing supplies are considered variable to production volume, whereas straight-line plant depreciation is considered fixed. In the following sections, we discuss the approaches used to budget and control factory overhead by separating overhead into fixed and variable components.

The Factory Overhead Flexible Budget

A flexible budget may be used to determine the impact of changing production on fixed and variable factory overhead cost. The standard overhead rate is determined by dividing the budgeted factory overhead costs by the standard amount of productive activity, such as direct labor hours. Exhibit 5 is a flexible factory overhead budget for Western Rider Inc.

EXHIBIT 5 Factory Overhead Cost Budget Indicating Standard Factory Overhead Rate

In Exhibit 5, the standard factory overhead cost rate is $6. It is determined by dividing the total budgeted cost of 100% of normal capacity by the standard hours required at 100% of normal capacity, or $30,000 / $5,000 = $6 per hour. This rate can be subdivided into $3.60 per hour for variable factory overhead ($18,000 / 5000 hours) and $2.40 per hour for fixed factory overhead ($12,000 / $5,000).

Variances from standard for factory overhead cost result from:

1. Actual variable factory overhead cost greater or less than budgeted variable factory overhead for actual production.

2. Actual production at a level above or below 100% of normal capacity.

The first factor results in the controllable variables for variable overhead costs. The second factor results in a volume variance for fixed overhead costs. We will discuss each of these variances next.

Variable Factory Overhead Controllable Variance

The variable factory overhead controllable variance is the difference between the actual variable overhead incurred and the budgeted variable overhead for actual production. The controllable variance measures the efficiency of using variable overhead resources. Thus, if the actual variable overhead is less than the budgeted variable overhead, the variance is unfavorable.

To illustrate, recall that Western Rider Inc. produced 5,000 pairs of XL jeans in June. Each pair requires 0.80 standard labor hour for production. As a result, Western Rider Inc. had 4,000 standard hours at actual production (5,000 jeans x 0.80 hour). This represents 80% of normal productive capacity (4,000 hours / 5,000 hours). The standard variable overhead at 4,000 hours worked, according to the budget in Exhibit 5, was $14,000 (4,000 direct labor hours * $3,600). The following actual factory overhead costs were incurred in June:

The controllable variance can be calculated as follows:

The variable factory overhead controllable variance indicates management's ability to keep the factory overhead costs within the budget limits. Since variable factory overhead costs are normally controllable at the department level, responsibility for controlling this variance usually rests with department supervisors. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 925-926*

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