Blueprint Problem: Standard Costing: Overhead Variances

Four Variance Method of Computing Overhead Variances

Overhead is the third category of manufacturing costs (Direct materials and direct labor are the other two.) subject to standard costing. We start with the overall overhead variance. Overhead is typically applied based on some driver - such as direct labor hours. Recall from Chapter 4 that:

Applied overhead = Predetermined overhead rate actual direct labor hours

Overhead variance = Actual overhead - Applied overhead

But, what does this overhead variance mean? Why did it occur? Over (under) spending? Over (under) production? More or less efficient use of overhead? Because overhead is a compilation of many types of costs - some variable and some fixed - it is more difficult to separate into price and quantity. As a result, a number of different techniques for figuring overhead variances have been developed. The most widely used methods of separating the overall overhead variance into component variances are the four-variance, three-variance and two-variance methods. These will be discussed in turn in this Blueprint exercise.

The Four-Variance Method

In the four-variance method, overhead costs are separated into fixed and variable amounts. The variable amount is applied based on a unit-based cost driver such as direct labor hours. The fixed costs are itemized and summed into total fixed overhead.

Select the four variances with its appropriate definition.

Definition		Type of Variance
Occurs when budgeted unit production is different from actual unit production.		Fixed overhead volume variance
Compares actual variable overhead cost with the variable overhead rate times actual direct labor hours.		Variable overhead spending variance
Compares actual with standard direct labor hours and multiplies the difference times the variable overhead rate.		Variable overhead efficiency variance
Compares actual fixed overhead spending with budgeted fixed overhead spending.		Fixed overhead spending variance

Similar to the price variances for direct materials and direct labor, the variable overhead spending variance is the difference between total actual variable overhead and the variable overhead rate times actual direct labor hours worked.

Variable overhead spending variance = Actual variable overhead - (Variable overhead rate Actual DLH)

The variable overhead efficiency variance is linked to the efficient use of direct labor. To the extent that using more(less) direct labor than expected causes variable overhead to increase (decrease) the variable overhead efficiency variance shows the impact on overhead spending.

Variable overhead efficiency variance = (Variable overhead rate Actual DLH) - (Variable overhead rate Standard DLH)

Example: Adler Company budgeted the following amounts at the beginning of the year:

Units		150,000
Direct labor hours		15,000
Variable overhead		$30,000
Fixed overhead		$69,000

At the end of the year, Adler provided the following actual data:

Units		140,000
Direct labor hours		14,300
Variable overhead		$27,600
Fixed overhead		$70,000

Adler Company's variable overhead rate is $ per direct labor hour; fixed overhead rate is $ per direct labor hour; and total overhead rate is $ per direct labor hour.

The standard hours for actual production equal direct labor hours. Fill in the following table, being sure to select the appropriate direction for the variance (Favorable or Unfavorable). Enter all amounts as positive numbers.

	Actual		Applied		Variance
Variable overhead	$		$		$
Fixed overhead
Total overhead	$		$		$

Next, we can break down the total variable overhead variance into the spending and efficiency variances.

Variable overhead spending variance = $27,600 - ($2 14,300) = $27,600 - $28,600 = $1,000 Favorable

The variable overhead spending variance tells us that Adler spent $1,000 less than expected on variable overhead.

Variable overhead efficiency variance = ($2 14,300) - ($2 14,000) = $28,600 - $28,000 = $600 Unfavorable

The variable overhead efficiency variance shows the impact of working hours than standard for the actual production of 140,000 units. This resulted in $600 variable overhead than standard.

We can see that the sum of the variable overhead spending variance and the variable overhead efficiency variance does equal the total variable overhead variance ($1,000 Favorable + $600 Unfavorable = $400 Favorable)

The fixed overhead variances are the fixed overhead spending variance and the fixed overhead volume variance. The fixed overhead spending variance compares actual fixed overhead with budgeted fixed overhead. Remember, fixed overhead is fixed, it depend on the number of units produced or the number of direct labor hours worked.

Fixed overhead spending variance = Actual fixed overhead - Budgeted fixed overhead

Fixed overhead spending variance = $70,000 - $69,000 = $1,000 Unfavorable

Thus, $1,000 was spent on fixed overhead items than was budgeted.

The volume variance occurs when actual production does not equal budgeted production. This is because fixed overhead is applied to production using standard direct labor hours allowed for actual production. If more units are produced than planned, there will be more standard direct labor hours and more fixed overhead applied to production. On the other hand, if fewer units are produced than planned, then there are fewer units over which to spread the budgeted fixed overhead.

Fixed overhead volume variance = Budgeted fixed overhead - (Fixed overhead rate Standard hours)

Fixed overhead volume variance = $69,000 - ($4.60 14,000) = $69,000 - $64,400 = $4,600 Unfavorable

The overhead fixed overhead variance is $5,600 underapplied (or unfavorable). This is composed of the $1,000 Unfavorable fixed overhead spending variance and the $4,600 Unfavorable volume variance.

Suppose Adler Company had made 15,200 units. The volume variance would have been is $ .

Three-Variance Method of Computing Overhead Variances

The three-variance method collapses the variable and fixed overhead spending variances into a spending variance. It retains the efficiency and volume variances from the four-variance method.

Spending variance = Actual overhead - (Budgeted fixed overhead + (Actual direct labor hours Standard variable overhead rate))

Example: Adler Company budgeted the following amounts at the beginning of the year:

Units		150,000
Direct labor hours		15,000
Variable overhead		$30,000
Fixed overhead		$69,000

At the end of the year, Adler provided the following actual data:

Units		140,000
Direct labor hours		14,300
Variable overhead		$27,600
Fixed overhead		$70,000

Spending variance = ($27,600 + $70,000) - [$69,000 + (14,300 $2)] = 0

Note that the spending variance is the sum of the variable overhead spending variance and the fixed overhead spending variance. For Adler Company, the variable overhead spending variance is $1,000 Favorable and the fixed overhead spending variance is $1,000 Unfavorable, so the overall spending variance is indeed zero.

Efficiency variance = [Budgeted fixed overhead + (Actual direct labor hours Standard variable overhead rate)] - [Budgeted fixed overhead + (Standard direct labor hours Standard variable overhead rate)]

Efficiency variance = [$69,000 + (14,300 $2)] - [$69,000 + (14,000 $2)] = $600 Unfavorable

Notice that the efficiency variance computed under the three-variance method is the variable overhead efficiency variance.

Volume variance = [Budgeted fixed overhead + (Standard direct labor hours Standard variable overhead rate)] - (Standard direct labor hours Overhead rate)

Volume variance = $97,000 - 92,400 = $4,600 Unfavorable

Notice that the volume variance computed under the three-variance method is the fixed overhead volume variance.

Two-Variance Method of Computing Overhead Variances

The two-variance method of computing overhead variances collapses the four-variance method into a budget variance and a volume variance. The volume variance is the volume variance computed in the four-variance method. The budget variance, then, must be the sum of the variance overhead spending variance, the variable overhead efficiency variance, and the fixed overhead spending variance.

Budget variance = Actual overhead - [Budgeted fixed overhead + (Standard hours Variable overhead rate)]

Volume variance = Volume variance = [Budgeted fixed overhead + (Standard direct labor hours standard variable overhead rate)] - (Standard direct labor hours Overhead rate)

Example: Adler Company budgeted the following amounts at the beginning of the year:

Units		150,000
Direct labor hours		15,000
Variable overhead		$30,000
Fixed overhead		$69,000

At the end of the year, Adler provided the following actual data:

Units		140,000
Direct labor hours		14,300
Variable overhead		$27,600
Fixed overhead		$70,000

Budget variance = ($27,600 + $70,000) - [$69,000 + (14,000 $2)]= $600 Unfavorable

Notice that the budget variance does equal the sum of the two spending variances and the efficiency variance.

$600 Unfavorable = $1,000 Favorable + $1,000 Unfavorable + $600 Unfavorable

Volume variance = [$69,000 + (14,000 $2)] - (14,000 $6.60) = $4,600 Unfavorable