Principles of Accounting, Volume 2: Managerial Accounting

# 8.4Compute and Evaluate Overhead Variances

Principles of Accounting, Volume 2: Managerial Accounting8.4 Compute and Evaluate Overhead Variances

Recall that the standard cost of a product includes not only materials and labor but also variable and fixed overhead. It is likely that the amounts determined for standard overhead costs will differ from what actually occurs. This will lead to overhead variances.

## Determination and Evaluation of Overhead Variance

In a standard cost system, overhead is applied to the goods based on a standard overhead rate. This is similar to the predetermined overhead rate used previously. The standard overhead rate is calculated by dividing budgeted overhead at a given level of production (known as normal capacity) by the level of activity required for that particular level of production.

Usually, the level of activity is either direct labor hours or direct labor cost, but it could be machine hours or units of production.

### Creation of Flexible Overhead Budget

To determine the overhead standard cost, companies prepare a flexible budget that gives estimated revenues and costs at varying levels of production. The standard overhead cost is usually expressed as the sum of its component parts, fixed and variable costs per unit. Note that at different levels of production, total fixed costs are the same, so the standard fixed cost per unit will change for each production level. However, the variable standard cost per unit is the same per unit for each level of production, but the total variable costs will change.

We continue to use Connie’s Candy Company to illustrate. Suppose Connie’s Candy budgets capacity of production at 100% and determines expected overhead at this capacity. Connie’s Candy also wants to understand what overhead cost outcomes will be at 90% capacity and 110% capacity. The following information is the flexible budget Connie’s Candy prepared to show expected overhead at each capacity level.

## Think It Through

The XYZ Firm is bidding on a contract for a new plane for the military. As the management team is going over the bid, they come to the conclusion it is too high on a per-plane basis, but they cannot find any costs they feel can be reduced. The information from the military states they will purchase between 50 and 100 planes, but will more likely purchase 50 planes rather than 100 planes. XYZ’s bid is based on 50 planes. The controller suggests that they base their bid on 100 planes. This would spread the fixed costs over more planes and reduce the bid price. The lower bid price will increase substantially the chances of XYZ winning the bid. Should XYZ Firm keep the bid at 50 planes or increase its bid to 100 planes? What are the pros and cons to keeping the bid at 50 or increasing to 100 planes?

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