Exploring Variable Overhead Variances

A good manager will want to explore the nature of variances relating to variable overhead. It is not sufficient to simply conclude that more or less was spent than intended. As with direct material and direct labor, it is possible that the prices paid for underlying components deviated from expectations (a variable overhead spending variance). On the other hand, it is possible that the company's productive efficiency drove the variances (a variable overhead efficiency variance). Thus, the Total Variable Overhead Variance can be divided into a Variable Overhead Spending Variance and a Variable Overhead Efficiency Variance.

Before looking closer at these variances, it is first necessary to recall that overhead is usually applied based on a predetermined rate, such as $x per direct labor hour (you may find it helpful to review this concept from Part 3 of the Managerial and Cost Accounting book. This means that the amount debited to work in process is driven by the overhead application approach. This will become clearer with the following illustration.

All illustrations of Variable Overhead Variances

Let's return to the illustration for Blue Rail. Variable factory overhead for August consisted primarily of indirect materials (welding rods, grinding disks, paint, etc.), indirect labor (inspector time, shop foreman, etc.), and other items. Extensive budgeting and analysis had been performed, and it was estimated that variable factory overhead should be applied at $10 per direct labor hour. During August, $105,000 was actually spent on variable factory overhead items. The standard cost for August's production was as follows:

The total variable overhead variance is unfavorable $3,000 ($102,000-$105,000). This may lead to the conclusion that performance is about on track. But, a closer look reveals that overhead spending was quite favorable, while overhead efficiency was not so good. Remember that 12,500 hours were actually worked. Since variable overhead is consumed at the presumed rate of $10 per hour, this means that $125,000 of variable overhead (actual hours x standard rate) was attributable to the output achieved. Comparing this figure ($125,000) to the standard cost ($102,000) reveals an unfavorable variable overhead efficiency variance of $23,000. However, this inefficiency was significantly offset by the $20,000 favorable variable overhead spending variance ($105,000 vs. $125,000). The following diagram may prove useful in helping you sort out the variable overhead variances:

Journal Entry for Variable Overhead Variances

The following journal entry can be used to apply variable factory overhead to production and record the related variances:

Careful Interpretation of Variable Overhead Variances

Material and labor variances are more easily interpreted than variable overhead variances. The variable overhead efficiency variance can be somewhat confusing because it may reflect efficiencies or inefficiencies experienced with the base used to apply overhead, rather than overhead itself. For Blue Rail, remember that the total number of hours was "run up" beyond plan because of inexperienced labor. A good manager will want to keenly evaluate the cause and meaning of variable overhead variances. In fact, the variances are likely only the point of beginning for a proper evaluation. Remember that variable overhead is made up of many components. For Blue Rail, it is conceivable that the inexperienced welders used more welding rods, and the welds were likely sloppier requiring more grinding to smooth out the joints. Further, it is likely that inspectors had to spend more time checking work to make sure that the welds were strong. While the overall variance calculations would provide signals about these issues, a manager would actually need to drill down into each individual cost component (perhaps calculating variances for each budgeted line item rather than just on an overall basis) to truly find areas for business improvement.

How important is control of overhead? A study of self-made 50-year old millionaires revealed very little correlation between wealth and income, and a strong correlation between wealth and life-long savings patterns. Although the study is related to individuals, the message rings equally true for business. Careful control of spending is essential to long-term value building. Businesses vary considerably in their attitudes and discipline as it relates to control of overhead. Some businesses are rather cavalier about controlling things like light/electricity usage, control over low cost parts, efficiency in shipping methods, etc. Others are rather fanatical about maintaining absolute and stringent controls. For instance, one controller of a manufacturing plant was frustrated with the number of screws that were dropped and left to be swept away at the end of each business day. These were seemingly insignificant to the employees. In frustration, the controller scattered a box of nickels onto the factory floor - by the end of the day none remained for the janitorial staff to sweep away. A subsequent memo was issued reminding everyone that screws cost 5$ each. The rather obvious point was to draw a comparison between the nickels that everyone was eager to recover and the screws for which there was little concern. To build a successful business, a good manager will keep a keen eye on all overhead items, and control them with vigor. The variable overhead variances are macro indicators of success in accomplishing this goal.