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Principles of Accounting, Volume 2: Managerial Accounting

8.4 Compute and Evaluate Overhead Variances

Principles of Accounting, Volume 2: Managerial Accounting8.4 Compute and Evaluate Overhead Variances
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  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

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.

Standard Overhead Rate equals Budgeted Overhead Rate divided by Level of Activity.

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.

Percent of capacity: 90 percent, 100 percent, 110 percent respectively. Direct labor hours 1,800, 2,000, 2,200. Units of output 900, 1,000, 1,100. Variable overhead $3,600, 4,000, 4,400. Fixed overhead $6,000, 6,000, 6,000. Total overhead $9,600, 10,000, 10,400. Normal capacity equals 100 percent and overhead is applied based on direct labor hours. Standard Overhead Rate equals $10,000 divided by 2,000 equals $5 per direct labor hour.

Units of output at 100% is 1,000 candy boxes (units). The standard overhead rate is the total budgeted overhead of $10,000 divided by the level of activity (direct labor hours) of 2,000 hours. Notice that fixed overhead remains constant at each of the production levels, but variable overhead changes based on unit output. If Connie’s Candy only produced at 90% capacity, for example, they should expect total overhead to be $9,600 and a standard overhead rate of $5.33 (rounded). If Connie’s Candy produced 2,200 units, they should expect total overhead to be $10,400 and a standard overhead rate of $4.73 (rounded). In addition to the total standard overhead rate, Connie’s Candy will want to know the variable overhead rates at each activity level.

Using the flexible budget, we can determine the standard variable cost per unit at each level of production by taking the total expected variable overhead divided by the level of activity, which can still be direct labor hours or machine hours.

Variable Overhead Rate equals Budgeted Variable Overhead divided by Level of Activity.

Looking at Connie’s Candies, the following table shows the variable overhead rate at each of the production capacity levels.

Production Capacity Variable/Unit
90% $3,600/1,800 = $2
100% $4,000/2,000 = $2
110% $4,400/2,200 = $2

Sometimes these flexible budget figures and overhead rates differ from the actual results, which produces a variance.

Determination of Variable Overhead Variances

There are two components to variable overhead rates: the overhead application rate and the activity level against which that rate was applied. If we compare the actual variable overhead to the standard variable overhead, by analyzing the difference between actual overhead costs and the standard overhead for current production, it is difficult to determine if the variance is due to application rate differences or activity level differences. Thus, there are two variable overhead variances that will better provide these answers: the variable overhead rate variance and the variable overhead efficiency variance.

Determination of Variable Overhead Rate Variance

The variable overhead rate variance, also known as the spending variance, is the difference between the actual variable manufacturing overhead and the variable overhead that was expected given the number of hours worked. The variable overhead rate variance is calculated using this formula:

Variable Overhead Rate Variance equals (Actual Hours Worked times Actual Variable Overhead Rate per Hour) minus (Actual Hours Worked times Standard Variable Overhead Rate per Hour).

Factoring out actual hours worked, we can rewrite the formula as

Variable Overhead Rate Variance equals (Actual Variable Overhead Rate minus Standard Variable Overhead Rate) times Actual Hours Worked.

If the outcome is favorable (a negative outcome occurs in the calculation), this means the company spent less than what it had anticipated for variable overhead. If the outcome is unfavorable (a positive outcome occurs in the calculation), this means the company spent more than what it had anticipated for variable overhead.

Connie’s Candy Company wants to determine if its variable overhead spending was more or less than anticipated. Connie’s Candy had this data available in the flexible budget:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 4,000. Fixed overhead $6,000. Total overhead $10,000.

Connie’s Candy also had this actual output information:

Percent of capacity: 100 percent. Direct labor hours 2,500. Units of output 1,000. Variable overhead 7,000. Fixed overhead $6,000. Total overhead $13,000.

To determine the variable overhead rate variance, the standard variable overhead rate per hour and the actual variable overhead rate per hour must be determined. The standard variable overhead rate per hour is $2.00 ($4,000/2,000 hours), taken from the flexible budget at 100% capacity. The actual variable overhead rate is $2.80 ($7,000/2,500), taken from the actual results at 100% capacity. Therefore,

Variable Overhead Rate Variance=($2.80$2.00)×2,500=$2,000(Unfavorable)Variable Overhead Rate Variance=($2.80$2.00)×2,500=$2,000(Unfavorable)

This produces an unfavorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to make production changes.

Let us look at another example producing a favorable outcome. Connie’s Candy had this data available in the flexible budget:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 4,000. Fixed overhead $6,000. Total overhead $10,000.

Connie’s Candy also had this actual output information:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 3,500. Fixed overhead $6,000. Total overhead $9,500.

To determine the variable overhead rate variance, the standard variable overhead rate per hour and the actual variable overhead rate per hour must be determined. The standard variable overhead rate per hour is $2.00 ($4,000/2,000 hours), taken from the flexible budget at 100% capacity. The actual variable overhead rate is $1.75 ($3,500/2,000), taken from the actual results at 100% capacity. Therefore,

Variable Overhead Rate Variance=($1.75$2.00)×$2,000=–$500or$500(Favorable)Variable Overhead Rate Variance=($1.75$2.00)×$2,000=–$500or$500(Favorable)

This produces a favorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to better understand the variable overhead reduction.

Interpretation of the variable overhead rate variance is often difficult because the cost of one overhead item, such as indirect labor, could go up, but another overhead cost, such as indirect materials, could go down. Often, explanation of this variance will need clarification from the production supervisor. Another variable overhead variance to consider is the variable overhead efficiency variance.

Determination of Variable Overhead Efficiency Variance

The variable overhead efficiency variance, also known as the controllable variance, is driven by the difference between the actual hours worked and the standard hours expected for the units produced. This variance measures whether the allocation base was efficiently used. The variable overhead efficiency variance is calculated using this formula:

Variable Overhead Efficiency Variance equals Actual Hours Worked times Standard Variable Overhead Rate per Hour) minus (Standard Hours times Standard Variable Overhead rate per Hour).

Factoring out standard overhead rate, the formula can be written as

Variable Overhead Efficiency Variance equals Actual Labor Hours minus Standard Labor Hour) times Standard Overhead Rate.

If the outcome is favorable (a negative outcome occurs in the calculation), this means the company was more efficient than what it had anticipated for variable overhead. If the outcome is unfavorable (a positive outcome occurs in the calculation), this means the company was less efficient than what it had anticipated for variable overhead.

Connie’s Candy Company wants to determine if its variable overhead efficiency was more or less than anticipated. Connie’s Candy had the following data available in the flexible budget:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 4,000. Fixed overhead $6,000. Total overhead $10,000.

Connie’s Candy also had the following actual output information:

Percent of capacity: 100 percent. Direct labor hours 2,500. Units of output 1,000. Variable overhead 7,000. Fixed overhead $6,000. Total overhead $13,000.

To determine the variable overhead efficiency variance, the actual hours worked and the standard hours worked at the production capacity of 100% must be determined. Actual hours worked are 2,500, and standard hours are 2,000. The standard variable overhead rate per hour is $2.00 ($4,000/2,000 hours), taken from the flexible budget at 100% capacity. Therefore,

Variable Overhead Efficiency Variance=(2,5002,000)×$2.00=$1,000(Unfavorable)Variable Overhead Efficiency Variance=(2,5002,000)×$2.00=$1,000(Unfavorable)

This produces an unfavorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to make production changes.

Let us look at another example producing a favorable outcome. Connie’s Candy had the following data available in the flexible budget:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 4,000. Fixed overhead $6,000. Total overhead $10,000.

Connie’s Candy also had the following actual output information:

Percent of capacity: 100 percent. Direct labor hours 1,800. Units of output 1,000. Variable overhead 3,500. Fixed overhead $6,000. Total overhead $9,500.

To determine the variable overhead efficiency variance, the actual hours worked and the standard hours worked at the production capacity of 100% must be determined. Actual hours worked are 1,800, and standard hours are 2,000. The standard variable overhead rate per hour is $2.00 ($4,000/2,000 hours), taken from the flexible budget at 100% capacity. Therefore,

Variable Overhead Efficiency Variance=(1,8002,000)×$2.00=–$400or$400(Favorable)Variable Overhead Efficiency Variance=(1,8002,000)×$2.00=–$400or$400(Favorable)

This produces a favorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to better understand the variable overhead efficiency reduction.

The total variable overhead cost variance is also found by combining the variable overhead rate variance and the variable overhead efficiency variance. By showing the total variable overhead cost variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.

Figure 8.5 shows the connection between the variable overhead rate variance and variable overhead efficiency variance to total variable overhead cost variance.

There are three top row boxes. Two, Actual Hours (AH) times Actual Rate (AR) and Actual Hours (AH) times Standard Rate (SR) combine to point to a Second row box: Variable Overhead Rate Variance. Two top row boxes: Actual Hours (AH) times Standard Rate (SR) and Standard Hours (SH) times Standard Rate (SR) combine to point to Second row box: Variable Overhead Efficiency Variance. Notice the middle top row box is used for both of the variances. Second row boxes: Variable Overhead Rate Variance and Variable Overhead Efficiency Variance combine to point to bottom row box: Total Variable Overhead Cost Variance.
Figure 8.5 Variable Overheard Cost Variance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

For example, Connie’s Candy Company had the following data available in the flexible budget:

Percent of capacity: 100 percent. Direct labor hours 2,000. Units of output 1,000. Variable overhead 4,000. Fixed overhead $6,000. Total overhead $10,000.

Connie’s Candy also had the following actual output information:

Percent of capacity: 100 percent. Direct labor hours 1,800. Units of output 1,000. Variable overhead 3,500. Fixed overhead $6,000. Total overhead $9,500.

The variable overhead rate variance is calculated as (1,800 × $1.94) – (1,800 × $2.00) = –$108, or $108 (favorable). The variable overhead efficiency variance is calculated as (1,800 × $2.00) – (2,000 × $2.00) = –$400, or $400 (favorable).

The total variable overhead cost variance is computed as:

Total Variable Overhead Cost Variance=(–$108)+(–$400)=–$508or$508(Favorable)Total Variable Overhead Cost Variance=(–$108)+(–$400)=–$508or$508(Favorable)

In this case, two elements are contributing to the favorable outcome. Connie’s Candy used fewer direct labor hours and less variable overhead to produce 1,000 candy boxes (units).

The same calculation is shown as follows in diagram format.

There are three top row boxes. Two, Actual Hours (1,800) times Actual Rate ($1.94) and Actual Hours (1,800) times Standard Rate ($2.00) combine to point to a Second row box: Variable Overhead Rate Variance $108 Favorable. Two top row boxes: Actual Hours (1800) times Standard Rate ($2.00) and Standard Hours (2,000) times Standard Rate ($2.00) combine to point to Second row box: Variable Overhead Efficiency Variance $400 Favorable. Notice the middle top row box is used for both of the variances. Second row boxes: Variable Overhead Rate Variance $108 F and Variable Overhead Efficiency Variance $400 F combine to point to bottom row box: Total Variable Overhead Cost Variance $508 F.

As with the interpretations for the variable overhead rate and efficiency variances, the company would review the individual components contributing to the overall favorable outcome for the total variable overhead cost variance, before making any decisions about production in the future. Other variances companies consider are fixed factory overhead variances.

Fundamentals of Fixed Factory Overhead Variances

The fixed factory overhead variance represents the difference between the actual fixed overhead and the applied fixed overhead. There are two fixed overhead variances. One variance determines if too much or too little was spent on fixed overhead. The other variance computes whether or not actual production was above or below the expected production level.

Your Turn

Sweet and Fresh Shampoo Overhead

Biglow Company makes a hair shampoo called Sweet and Fresh. They have the following flexible budget data:

For 90 percent, 100 percent, and 110 percent, respectively: Direct labor hours 14,000, 16,000, 18,000; Units of output 10,000, 10,000, 10,000; Direct labor $525,000, $346,500, $378,000; Variable overhead $315,000, $346,000, $378,000; Fixed overhead $45,500, $45,500, $45,500; Total $953,500, $1,044,300, $1,135,100.

What is the standard variable overhead rate at 90%, 100%, and 110% capacity levels?

Solution

90% = $315,000/14,000 = $22.50, 100% = $346,000/16,000 = $21.63 (rounded), 110% = $378,000/18,000 = $21.00.

Think It Through

Purchasing Planes

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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