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. For example, the number of labor hours taken to manufacture a certain amount of product may differ significantly from the standard or budgeted number of hours. Variable overhead efficiency variance is one of the two components of total variable overhead variance, the other being variable overhead spending variance. Figure 8.5 shows the connection between the variable overhead rate variance and variable overhead efficiency variance to total variable overhead cost variance.
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.
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Assume that the cost accounting staff of Company X has calculated that the company’s production staff works 10,000 hours per month. The company also incurs a cost of $100,000 per month as its variable overhead costs. The information given is largely based on historical and projected labor patterns.
- Variable overhead efficiency variance is one of the two components of total variable overhead variance, the other being variable overhead spending variance.
- Boulevard Blanks has decided to allocate overhead based on direct labor hours (DLH).
- Usually, the level of activity is either direct labor hours or direct labor cost, but it could be machine hours or units of production.
- By contrast, efficiency variance measures efficiency in the use of the factory (e.g., machine hours employed in costing overheads to the products).
Therefore, the company established a variable overhead rate of $10 per hour. Before we take a look at the variable overhead efficiency variance, let’s check your understanding of the cost variance. Variable overhead efficiency variance refers to the difference between the true time it takes to manufacture a product and the time budgeted for it, as well as the impact of that difference. By contrast, efficiency variance measures efficiency in the use of the factory (e.g., machine hours employed in costing overheads to the products).
Module 3: Standard Cost Systems
However, the variable standard cost per unit is the same per unit for each level of production, but the total variable costs will change. Although various complex computations can be made for overhead variances, we use a simple approach in this text. In this approach, known as the two-variance approach to variable overhead variances, we calculate only two variances—a variable overhead cost variance and a variable overhead efficiency variance. Budget or spending variance is the difference between the budget and the actual cost for the actual hours of operation. This variance can be compared to the price and quantity variance developed for direct materials and direct labor.
In addition to the total standard overhead rate, Connie’s Candy will want to know the variable overhead rates at each activity level. Other variances companies consider are fixed factory overhead variances. The hourly rate in this formula includes such indirect labor costs as shop foreman and security. If actual labor hours are less than the budgeted or standard amount, the variable overhead efficiency variance is favorable; if actual labor hours are more than the budgeted or standard amount, the variance is unfavorable. 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.
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. Boulevard Blanks has decided to allocate overhead based on direct labor hours (DLH). The standard variable OH rate per DLH is $0.80 (calculated previously), and the actual variable overhead for the month was $1,395 for 2,325 actual direct labor hours, giving an actual rate of $0.60. When a favorable variance is achieved, it implies that the actual hours worked during the given period were less than the budgeted hours. It results in applying the standard overhead rate across fewer hours, which means that the total expenses being incurred are reduced by a factor of the decrease in hours worked.
Understanding Variable Overhead Efficiency Variance
Before we go on to explore the variances related to fixed indirect costs (fixed manufacturing overhead), check your understanding of the variable overhead efficiency variance. Looking at Connie’s Candies, the following table shows the variable overhead rate at each of the production capacity levels. The productivity efficiency variance is the difference between the actual number of labor hours required to manufacture a certain number of a product and the budgeted or standard number of hours. The difference can be significant and needs to be monitored and managed. 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.
It does not necessarily mean that, in actual terms, the company incurred a lower overhead. It simply implies that an improvement was seen in the total allocation base used to apply overhead. The standard variable OH rate per DLH is $0.80 (see introduction page), and actual variable overhead for the month was $1,395 for 2,325 actual direct labor hours giving an actual rate of $0.60. A favorable variance means that the actual hours worked were less than the budgeted hours, resulting in the application of the standard overhead rate across fewer hours, resulting in less expense being incurred.
Variable Overhead Efficiency Variance Formulas and Examples
However, a favorable variance does not necessarily mean that a company has incurred less actual overhead, it simply means that there was an improvement in the allocation base that was used to apply overhead. The variance is negative because actual variable overhead costs were $1,395, but if the company had actually incurred the expected amount of variable overhead costs at $0.80 per unit, total VOH would have been $1,860. Theoretically, the reduction in cost is not due to employees using less material.
The variable overhead efficiency variance uses inputs provided by different departments within the organization. The production expense information is submitted by the production department of the enterprise. The estimated labor hours to meet output requirements are estimated by the staff responsible for industrial engineering and production scheduling. By using standard cost against both the actual and expected quantity, we get the variance in dollars that is attributed to quantity only. Variable overhead efficiency variance is one of the factors that impact the total variable overhead variance.
Often, explanation of this variance will need clarification from the production supervisor. Another variable overhead variance to consider is the variable overhead efficiency variance. It is entirely possible that an improperly-set standard number of labor hours can result in a variance that does not represent the actual performance of an entity. Consequently, investigation of the variable overhead efficiency variance should encompass a review of the validity of the underlying standard.