The Fixed Overhead Budget Variance Formula

The illustration shows that materials costs are driven by prices and quantities, which in turn are driven by many other factors. Of course random variations in these factors are likely to cause a large percentage of the price fluctuations. Discuss the meaning, causes, tradeoffs and criticisms of direct labor rate and efficiency variances. Explain how direct labor costs are recorded and analyzed in a standard costing, including the required variance calculations and journal entries.

But remember, budgeted fixed costs are not flexible, thus a flexible budget calculation for fixed overhead is not appropriate. An estimating error occurs when a flexible budget based on the actual inputs of the allocation basis is used to separate the total variable overhead variance into two parts. When the estimates differ from the actual quantities consumed , an estimating error is included in the analysis.

Points B, C and D represent the three flexible budgets that all fall on the flexible budget line. The slope of the flexible budget line is the standard price . The fact that point A does not fall on the flexible budget line means that the actual price must be different from the standard price. Therefore, the vertical difference between points A and B represents the material price variance based on quantity purchased.

This problem may be the responsibility of the machine operator, or the maintenance department, or a combination of both production workers and maintenance workers. Quantities may also vary beyond acceptable limits because of material mix differences. In some situations, different materials can be substituted for each other as in the case of many liquid products (e.g., beverages, soups cleaning fluids).

To the extent that using more direct labor than expected causes variable overhead to increase the variable overhead efficiency variance shows the impact on overhead spending. The variance is unfavorable, as in this case, if standard fixed overhead costs are less than budgeted. Actual production was 800 hours below the average monthly denominator level. Therefore, the variance represents the cost of unused capacity and under-utilizing capacity is viewed as unfavorable. A continuation of the Expando Company example is used to illustrate the techniques and concepts.

Fixed Overhead Volume Variance Formula

The primary raw material is 40-foot long pieces of steel pipe. This pipe is custom cut and welded into rails like that shown in the accompanying picture. In addition, the final stages of production require grinding and sanding operations, along with a final coating of paint . A shortage in available indirect materials caused costs to increase unexpectedly.

As such, the total variable overhead variance can be split into a variable overhead spending variance and a variable overhead efficiency variance. As with direct materials and direct labor variances, all positive variances are unfavorable, and all negative variances are favorable. Note that there is no alternative calculation for the variable overhead spending variance because variable overhead costs are not purchased per direct labor hour. The analysis of fixed overhead costs also includes two variances, the fixed overhead spending variance and the production volume variance.

In accounting, we often have multiple terms that mean the same thing. For variances, “price”, “rate” and “spending” variances all refer to the price you pay- as opposed to the amount that you use. A) budgeted fixed overhead expenditures with budgeted fixed overhead costs.

Of course this is inconsistent with the JIT concepts of demand pull, quality at the source and cross functional cooperation. Using quantity purchased means comparing current period standard prices with current period actual prices. If the quantity used is the basis of the evaluation, then materials are charged into materials control at actual prices. This means that a cost flow assumption will determine what are retained earnings which actual prices are compared with the current period standard prices. In some cases prior period actual prices may be compared with current period standard prices. Determining the credit to materials control is also more difficult when several inventory layers exist, i.e., layers of materials that were purchased at different prices. The input side compares actual costs with target costs.

You’re supposed to use a specific amount of flour, for example. If you use more flour than the recipe calls for, you’ll have an unfavorable variance. Actual costs are higher than budgeted ($42,000 vs. $36,000). Because Online Accounting costs are higher than you planned, the variance is unfavorable. A favorable variance exists when actual costs are lower than planned. As mentioned earlier, the cause of one variance might influence another variance.

Variable Overhead Efficiency Variance Is The Difference Between Actual Hours Worked At Standard

Two flexible budgets are used to analyze direct labor costs, but one of them is the standard costs charged to work in process . The key is the flexible budget based on actual hours used because it is used to separate the total variance of $2,115 into two parts, i.e., the rate and efficiency variances. A graphic approach provides a different way to place emphasis on the flexible budgets and concepts involved. Point A represents the actual cost of material purchases.

These variations in the materials mix are influenced by the substitutability and availability of the various materials, as well as the skill and experience of the workers involved3. Although the mechanics of standard costing are adequately illustrated with T-accounts, journal entries and equations, the concepts are somewhat more illusive. Conceptually the variances represent an attempt to evaluate materials costs by isolating the effects of price and quantity differences. The flexible budget diagram in Exhibit 10-5 provides a more revealing way to emphasize these performance measurement concepts. The following pages include illustrations of how each type of manufacturing cost is recorded and analyzed using a complete standard cost method. Several types of illustrations are presented to help you see the concepts and techniques from different perspectives. First, a T-account approach is presented to provide a comprehensive view of the product costing and variance analysis involved.

If we used machine hours instead of direct labor hours as the overhead allocation basis, could we still calculate a variable overhead efficiency variance? The variable overhead efficiency variance represents an estimate of the quantity variance for indirect resources that is caused by efficient or inefficient use of the overhead allocation basis.

How Can We Improve Labour Efficiency?

The production volume variance is similar to the idle capacity variance introduced in Chapter 4. The production volume variance measures the variance caused by the difference between the denominator output level, i.e., capacity used to calculate the overhead rates, and the output level actually achieved. If unit data are available, it may also be calculated in the following manner. Although these traditional interpretations are intuitively appealing, the spending and efficiency variances are not precise measures and can be very misleading. This is because there are two invalid assumptions underlying the traditional analysis.

The differences between actual and standard costs are charged to variance accounts. This method is illustrated in the top section of Exhibit 10-1 where the materials, payroll and overhead accounts are aggregated into a summary account to simplify the illustration. The debits to WIP represent the standard costs allowed for all finished and retained earnings balance sheet partially finished units during the period. The credits to the materials, payroll and factory overhead accounts represent the cost of all work performed during the period. This method is said to be complete because all work performed during the period is represented and evaluated in the performance measurements, i.e., variance analysis.

• The flexible budget is the debit to the materials control account.
• If a Standard Costing System, the Flexible Budget Column in our table becomes the cost of the units that is transferred to Work In Process.
• The credit to the payroll account is $62,115 since the actual direct labor cost just flow though the account.
• Costs such as direct material and direct labor, on the other hand, vary directly with each unit of output.
• Therefore, the main causes of labor efficiency variances are labor productivity and labor mix.

The _______ manager is usually responsible for controlling the labor efficiency variance. Therefore, the raw materials quantity variance for the month is closest to 70 favorable. Because we used fewer labor hours than planned, the variance is favorable. To understand the reasons for a material variance, think about using a recipe for baking a cake.

Each approach provides a different view of the analysis to help you strengthen your understanding of the mechanics and concepts associated with standard cost systems. A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount expected to be sold or consumed, multiplied by the standard price per unit. This variance is used as a general measure of whether a business is generating the amount of unit volume for which it had planned. To calculate sales volume variance, subtract the budgeted quantity sold from the actual quantity sold and multiply by the standard selling price. For example, if a company expected to sell 20 widgets at $100 a piece but only sold 15, the variance is 5 multiplied by $100, or $500. As mentioned above, materials, labor, and variable overhead consist of price and quantity/efficiency variances. Fixed overhead, however, includes a volume variance and a budget variance.

How To Calculate Average Unit Of Production In Accounting

A good manager would want to take corrective action, but would be unaware of the problem based on an overall budget versus actual comparison. Because the actual hourly rate we paid was less than planned ($23 – $25), we have a favorable price variance.

Variable Overhead Efficiency Variance Calculation

Favorable price variances can also be obtained by receiving quantity discounts for purchasing large quantities. Of course, purchasing more material than needed conflicts with the logic of JIT that focuses on the total cost of purchasing, handling, storing and using materials, not just the purchase price. The entire price variance is calculated in Method 1, i.e., based on all materials purchased. In Method 2, the price variance is only calculated for the material used. However, obtaining the best price for materials is a purchasing function, not a responsibility of the production manager. Therefore, it is logical to calculate the price variance on the basis of the entire quantity purchased.

The validity of these interpretations depends on the strength of the relationships between the activity measure, or allocation basis, and the indirect resources. These interpretations are examined below after the graphic approach is presented. The total direct labor variance consists of the labor rate variance and the labor efficiency variance. The labor rate variance reveals the difference between the standard rate and the actual rate for the actual labor hours worked. The labor efficiency variance compares the standard hours of direct labor that should have been used compared to the actual hours worked to develop the actual output.

The difference between actual costs for direct labor and budgeted costs based on the standards. Discuss the behavioral problems associated with standard costs variance analysis and the potential conflict between this accounting control methodology and the lean enterprise concepts of JIT and TOC. Multiply the actual sales price by the number of units sold to find the total actual revenue. For example, if the company built 300 widgets and sold them at $85 each, multiply 300 by $85 to find the actual revenue equals $25,500.

Importance And Limitations Of Variable Overhead Spending Variance

This variance help management to assess the effect of entity profit as the result of differences between the target sales in the unit and actual sales at the end of the period. As such, you should evaluate any spending variance in light of the assumptions used to develop the underlying budget or expense standard. As with material variances, there are several ways to perform the intrinsic labor variance calculations. One can compute the values for the red, blue, and green balls.

Most firms want timely performance evaluations, and calculating the variance at the time that the materials are purchased accomplishes this. It is also possible that there may have been an unforeseeable event that caused material prices to change. A poor job performance by the the variable overhead efficiency variance compares the purchaser is another possible explanation. The Quantity Variance tells us that Ralph’s production supervisor used $400 less Direct Materials than Ralph expected. If the performance is likely to be repeated, then Ralph should consider revising its Standard Quantity per unit.