In this article, we will cover how to calculate the variable overhead rate variance. This includes the definition, important, formula, example, reasons for favorable and adverse as well as the limitation of variable overhead rate variance.
What is Variable Overhead Rate Variance?
The variable overhead rate variance is the difference between the actual and budgeted rates of spending on variable overhead. It is used to focus more on those overhead costs that change from expectations.
A favorable variance is the actual variable overhead expenses incurred per labor hour that were not as much as budgeted.
The variable overhead rate variance is a compilation of information from production expense as submitted by the production department and the proposed labor hours to be worked, as figured by the industrial engineering and staff of the production department based on historical and proposed efficiency and equipment capacity levels.
There are a number of possible reasons for a variable overhead rate variance. For example:
- The variable overhead category includes a large number of accounts, some of which may have been classified fallaciously and so do not appear as part of variable overhead (or vice versa).
- Some tasks that were used to be done in-house have now been shifted to a supplier, or vice versa.
- Suppliers have changed their rates or prices, which have not yet been reflected in the updated standards.
Importance of Variable Overhead Rate Variance Calculation
Variable overhead rate variance calculation has substantial importance owing to the following reasons;
- An decrease or increase in the minimum wage rate.
- An decrease or increase in the prices of indirect material due to a discount on bulk orders or inflation.
- It also assists in effective use of resources due to better planning.
- Overtime or bonus that is paid on extra work done by indirect labor i.e. security guards, factory supervisors, factory cleaners etc.
- The concept is used in planning and forecasting inaccuracies that arises due to accounting errors.
- An decrease or increase in depreciation expense.
- Variable overhead rate variance helps in foreshadowing the amount of labor and the wage rate that will be required for future needs.
- The variable overheads can be brought down to the minimum after distinguishing the reasons behind a variable overhead rate variance.
- Variance analysis of variable overheads assists a company to know the expenses that will be incurred in the future and that is to be incurred at a particular rate. These costs must be paid as soon as they are incurred or on the statement of financial position a current liability balance would increase. It is important for a company that it must increase its liquidity as per the expenses estimated.
How to Calculate Variable Overhead Rate Variance?
The variable overhead rate variance can be calculated by using the formula below:
Variable Overhead Rate Variance = Actual Manufacturing Variable Overheads Expenditure – (Actual Hours × Standard Variable Overhead Rate per Hour)
Or the simple formula for calculating this variance is:
Variable Overhead Rate Variance = (Actual Overhead Rate – Standard Overhead Rate) × Hours Worked in Actual
Where:
Actual hours are the number of labor hours or machine hours during a period.
Example and Analysis
ABC skylarks Ltd is a small production company which has specialization in the manufacturing of cricket bats. ABC skylarks Lt is presently making bats of two types:
M Maroon – a hand-crafted english willow bat designed for using in cricket played by cricket professionals
G Green – a machine-manufactured cheaper bat that is designed for using in casual cricket
Following is given a break-up of standard variable manufacturing overhead cost:
| M Maroon | G Green | |
| Number of Hours | 3 direct labor hours | 2 machine hour |
| Overheads: | ||
| Indirect Labor | $ 20 | $ 1 |
| Polish | $ 10 | $ 2 |
| Sandpaper | $ 2 | $ 1 |
| Glue | $ 2 | $ 1.5 |
| Machine lubricants | $ 1 | $ 1.5 |
| Electricity | $ 4 | $ 20 |
| Total | $ 39 (13 per direct labor hour) | $ 27 (13.5 per direct labor hour) |
Following information belongs to the actual data from the last month:
| Variable Manufacturing Overheads | $ 185,000 |
| Direct Labor Hours | 20,000 |
| Machine Hours | 10,000 |
Variable overhead rate variance shall be calculated as follows:
| M Maroon | G Green | Total $ | |
| Actual variable overhead expense | $ 185,000 | ||
| Less: | |||
| Actual hours | 20,000 | 10,000 | |
| Standard variable overhead rate | × 13 | × 13.5 | |
| Standard overhead expense | = 260,000 | = 135,000 | (395,000) |
| Variable overhead rate variance | 210,000 ADVERSE |
Favorable variable manufacturing overhead rate variance shows that an entity incurred alower expense than the budgeted cost.
Possible Causes for Favorable Variance
Below are the possible variance for the variable overhead rate variance:
- More effective cost control (e.g. optimizing electricity consumption by installing energy-efficient equipment).
- Planning error (e.g. Ignoring the learning curve effect which could have reasonably be expected to result in more effective use of indirect materials in the upcoming period).
- Economies of scale (e.g. increase in order size of material that is indirectly used in the process of production. This increased order size leads to bulk discounts on purchase).
- A decline in the general price level of indirect supplies.
An adverse variable manufacturing overhead rate variance indicates that the company incurred a higher cost than the budgeted expense.
Potential Causes for Adverse Variance
Below are the possible causes for adverse variance of variable overhead rate:
- Ineffective cost control (e.g. not optimizing the batch production quantities which leads to increased set up costs).
- A rise in the minimum wage rate that leads to a higher cost of indirect labor.
- A decline in the level of activity not fully cancelled by a decline in overheads (e.g. electricity consumption of machines during set up is usually the same even if a smaller batch of output is needed to be manufactured).
- Planning error (e.g. failing to consider an increase in unit rates of electricity applicable for the level of activity budgeted during a period).
Limitation of Variable Overhead Rate Variance
Though the concept of variable overhead rate variance plays a significant role in the costing and assists while making the budgets but it has limitations too which an organization cannot ignore.
- Variable production overheads by including those costs also that are not directly attributable to a specific unit of output unlike direct material and direct labor which changes directly with a change in the output. Variable overheads do however vary with any change that may occur in another variable. Conventional management accounting often explains blanket variables such as machine hours or labor hours which seldom provides a meaningful basis for controlling the cost. The use of costing base on activity to calculate overhead variances can importantly heighten the usefulness of such variances.
- A standard variable overhead rate which is calculated while finding variable overhead rate variance is extremely likely to be incorrect and fabricated at a large level since it is made up of various accounts. Also, there is a chance of human errors that can be happened while estimation of indirect labor/material rate, utility bills, consumables etc. A standard variable overhead rate in real is an average of a few correct and incorrect classifications of expenses.
- It is too toilsome to figure out the exact cause behind a variable overhead rate variance because one cannot put a finger on one specific overhead that was way more than the estimate.
- In an organization there are multiple departments, and the manager of each department uses his own judgment while making calculations. Judgments by too many departments are involved in the calculation of total variable overhead makes it prone to error.
- The concept of variable overhead variance can also not be applicable to the service sector as most of their service cost includes overheads instead of direct costs or production costs.
- Another major limitation is that it needs too much time to examine the variances which cause a time lag due to which corrective measures are taken too late to be effective to the cause.
Conclusion
When it comes to analyzing the cost behavior for factory variable overhead, it’s almost like direct material and direct labor and the variance analysis is similar. The main aim here is to consider the total actual variable overhead which is done by applying the standard amount to work in process and the difference to the appropriate variance accounts.
Professional managers should research about the nature of variances related to their variable overhead. It will not be enough to simply conclude that more or less was spent than proposed. It is possible that with direct labor and direct material, there are chances that the prices paid by the organization for underlying components diverted from the expectations. And on the other hand, it is also possible that the productive efficiency of a company drove the variances. Total variable overhead variance in actual is the sum of variable overhead rate variance and a variable overhead efficiency variance.
Variable overhead rate variance is basically the cost associated with operating a business that often alters with variations in operational activity as production output levels increase or decrease, variable overheads also change in direct proportion.
For a given level of production output for a product over a given period of time, the variable overhead rate variance is actually a difference in between what the variable production overheads were proposed to cost and how much they actually ended up.
Variable overhead rate variance is an important indicator when comparing different forms of accounting, management of inventory, outsourcing certain aspects of the business or even when trying to work with new suppliers.
