Variable Overhead and Efficiency Variances

Many costs within the manufacturing process are related to the quantity of units made but do not fall under the categories of direct material or direct labor. These costs get lumped together as overhead. Variable overhead refers to costs that rise or fall depending on how much or how little a business produces. For instance, if a furniture manufacturer is producing more sofas, then machines on the production line will have to be serviced more often, and shipping costs will increase.

In the furniture manufacturing business, when workers cut wood, they often cool the saws with water. This water has a cost per gallon. The amount is not fixed because 1,000 cut strokes would use more water than 10 cut strokes. Generally, the water will not have a meter that can measure the cost per unit manufactured. Therefore, this amount becomes variable overhead. The variable overhead rate is the rate that is computed by dividing total variable overhead cost by expected number of standard hours for producing the product.

The accountant calculates the variable overhead rate by taking the total variable overhead applied and dividing it by the number of units produced for the period. Assume that workers at a furniture manufacturer use a machine to mill wood. The machine uses 2,000 gallons of water every labor hour at $0.03 per gallon. Someone must also replace the oil after every 5,000 labor hours. The oil costs $1,200. The company used the machine for 150,000 hours. The standard usage is 145,000 hours.

First, find the rate for the water. Next, calculate the rate for the oil.
The accountant adds the two to find that the total actual variable overhead rate is $60.24 per hour. Using this rate, the accountant can calculate the variable overhead variance in the same way as the earlier variances. If the standard variable overhead rate is $62.00 per hour, then the variable overhead variance is:
Since the actual rate is lower than the standard, the variance is favorable. It is good for the company to have actual costs lower than standard costs.

Remember to perform the operations inside parentheses first, so subtract the standard rate from the actual rate before multiplying the result by the number of hours.

The accountant calculates the variable overhead efficiency variance. Since actual hours are greater than standard hours in this example, the variance is unfavorable. The accountant then calculates the total variable overhead variance.
This unfavorable variable overhead variance is not necessarily dangerous for the company. This example is only for the usage of one machine within the manufacturing process. The accountant might do the same analysis for every overhead pool or for all the overhead costs.

The term fixed overhead refers to costs that stay the same no matter how much or how little a business produces; examples include insurance and rent. In contrast, variable overhead means costs that increase or decrease depending on how much a business produces. Shipping costs and machine maintenance are examples of variable overhead.

Nearly all businesses have overhead costs. A variance is the difference between an expected cost or output and an actual cost or output. In the real world, variances happen all the time because of outside factors that affect a company, such as rising or falling costs for raw materials.

At their core, overhead costs and their variances are simply an extension of direct materials and direct labor costs. Using this logic, calculating variable overhead means picking up the information that the other two analytical categories are not monitoring. Because of this, the efficiency portion of the analysis can be interpreted as information about missing efficiency components in the manufacturing process. In other words, managers who keep track of overhead variances have a better understanding of how efficient the company's processes are.

Overhead variances have their own terminology.

The variable overhead efficiency variance is the difference between the actual and budgeted hours worked, which is then applied to the standard variable overhead rate per hour.

To understand variances, it is important to recognize the difference between direct labor and indirect labor. Direct labor is the wages and benefits paid to the workers who turn direct materials into a finished product. Assembly-line workers at a manufacturing plant are examples of direct labor. On the other hand, indirect labor is the wages and benefits paid to workers who support the manufacturing process but do not actually create the product or service. Quality-control supervisors are an example of indirect labor. Direct labor costs are usually easy to understand, but it can be difficult for managers to determine how much in indirect labor costs each unit requires.

The accountant then calculates the labor efficiency variance for indirect labor. Remember to perform the calculation inside the parentheses first.

The indirect labor rate variance is the difference between the standard cost and the actual cost paid for the actual number of hours.

If an accountant or manager finds an unfavorable indirect labor efficiency variance, then the actual overhead amount of work is greater than the standard or predicted amount. This may mean that supervisors needed to step in to perform some of the work. If that is true, then the workers may be undertrained, so the company should probably provide training programs. Or it could mean that the machinery is not performing as well as it should. If the machinery is not properly maintained, then it will use more variable costs, such as oil. This poor maintenance will raise costs and lower efficiency.

All of these variances are analytical tools that managers use in conjunction with one another. No single variance will give a manager all the answers. It is important to remember that benchmarking is a system and that each of the individual variances only gives the manager a glimpse at one piece of the system.