Accounting: The Language of Business - Vol. 1 (Part 139)

You can’t be the accountant in your accounting firm.
Michael Gerber

 Performance Evaluation Using Variances from Standard Costs (Part F)

by

Charles Lamson

Fixed Factory Overhead Volume Variance

Using currently attainable standards, Western Rider Inc. set its budgeted normal capacity at 5,000 direct labor hours. This is the amount of expected capacity that management believes will be used under normal business conditions. You should note that this amount may be much less than the total available capacity if management believes demand will be low.

The fixed factory overhead volume variance is the difference between the budgeted fixed overhead at 100% of normal capacity and the standard fixed overhead for the actual production achieved during the period. The volume variance measures the use of fixed overhead resources. If the standard fixed overhead exceeds the budgeted overhead at 100% of normal capacity, the variance is favorable. Thus, the firm used its plant and equipment more than would be expected under normal operating conditions. If the standard fixed overhead is less than the budgeted overhead at 100% of normal capacity, the variance is unfavorable. Thus, the company used its plant and equipment less than would be expected under normal operating conditions.

The volume variance for Western Rider Inc. is shown in the following calculation:

Exhibit 6 illustrates the volume variance graphically. For Western Rider Inc., the budgeted fixed overhead is $12,000 at all levels. The standard fixed overhead at 5,000 hours is also $12,000. This is the point at which the standard fixed overhead line intersects the budgeted fixed cost line. For actual volume greater than 100% of normal capacity, the volume variance is favorable. For volume at less than 100% of normal volume, the volume variance is unfavorable. For Western Rider Inc., the volume variance is unfavorable because the actual production is 4,000 standard hours, or 80% of normal volume. The amount of the volume variance, $2,400, can be viewed as the cost of the unused capacity ($1,000).

EXHIBIT 6 Graph of Fixed Overhead Volume Variance

An unfavorable volume variance may be due to such factors as failure to maintain an even flow of work, machine breakdowns, repairs causing work stoppages, and failure to obtain enough sales orders to keep the factory operating at normal capacity. Management should determine the causes of the unfavorable variance and consider taking corrective action. A volume variance caused by an uneven flow of work, for example, can be remedied by changing operating procedures. Volume variances caused by lack of sales orders may be corrected through increased advertising or other sales effort.

Volume variances tend to encourage manufacturing managers to run the factory above the normal capacity. This is favorable when the additional production can be sold. However, if the additional production cannot be sold and must be stored as inventory, favorable volume variances may actually be harmful. For example, one paper company ran paper machines above normal volume in order to create favorable volume variances. Unfortunately, this created a six months' supply of finished goods inventory that had to be stored in public warehouses. The "savings" from the very favorable volume variances were exceeded by the additional inventory carrying costs. By creating incentives for manufacturing managers to overproduce, the volume variances produced goal conflicts as we described in a preceding post.

Reporting Factory Overhead Variances

The total factory overhead cost variance is the difference between the actual factory overhead and the total overhead applied to production. This calculation is as follows:

The factory overhead cost variance may be broken down by each variable factory overhead cost and fixed factory overhead cost element in a factory overhead cost variance report. Such a report, which is useful to management in controlling costs, is shown in Exhibit 7. The report indicates both the controllable variables (variables whose values are determined by the decision process and/or decision maker) and the volume variance (the difference between the actual quantity sold or consumed and the budgeted amount expected to be sold or consumed, multiplied by the standard price per unit).

EXHIBIT 7  Factory Overhead Cost Variance Report

Factory Overhead Variances and the Factory Overhead Account

At the end of the period, the factory overhead account normally has a balance. As we discussed in an earlier post, a debit balance in Factory Overhead is underapplied overhead, while a credit balance is overapplied overhead. This end of period balance, which represents the difference between actual overhead incurred and applied overhead, is also the total factory overhead variance for the period. A debit balance, underapplied overhead, represents an unfavorable total factory overhead variance, while a credit balance, overapplied overhead, is a favorable variance.

To illustrate, the factory overhead account for Western Rider Inc. For the month ending June 30, 2023, is shown below.

The $1,600 overapplied factory overhead is the favorable total factory cost variance shown in Exhibit 7. The variable factory overhead controllable variance and the volume variance can be computed using the factory overhead account and comparing it with the budget total overhead for the actual amount produced. As shown below the difference between the actual overhead incurred and the budgeted overhead is the controllable variables. The difference between the applied overhead and the budgeted overhead is the volume variance.

If the actual factory overhead exceeds (is less than) the budgeted factory overhead, the controllable variance is unfavorable (favorable). In contrast, if the applied factory overhead is less than (exceeds) the budgeted factory overhead, the volume variance is unfavorable (favorable). This is because, when the applied overhead is less than the budgeted overhead, the company has operated at less than normal capacity, and thus the volume variance is unfavorable.

It is also possible to break down many of the individual factory overhead cost variances into quantity and price variances, similar to direct materials and direct labor. For example, the indirect factory wages variance may include both time and rate variances. Likewise, the indirect materials variance may include both a quantity variance and a price variance.

*WARREN,REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 926-930*

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