Introduction
Variable overheads account for an important and significant part of the total operating cost for any business, particularly in the manufacturing business. Variable overheads change with operating efficiency and contribute an integral part of total variable cost. The Marginal costing method accounts for the variable overheads to calculate the contribution margin. Variances in planned overhead expenses can affect the contribution margins significantly especially if the sale prices are small and competition is severe. In this article, we will cover in detail about the variable overhead efficiency variance.
Total Variable overhead variance consists of two parts
- Variable overhead efficiency variance or sometimes called variable overhead rate variance and
- Variable Overhead Expenditure variance
What is Variable Overhead Efficiency Variance?
Variable overhead rate or efficiency variance can be defined as:
“The difference in actual time taken to produce a unit of product and the budgeted or standard time allocated”
Change in Production time can cause variable overheads to fluctuate significantly in the production process. It also performs as an indicator of efficiency in the production process.
How to Calculate the Variable Overhead Efficiency Variance?
The calculation formula for the variable overhead rate variance is:
Variable Overhead efficiency variance = (Actual Hours taken × Standard rate) – (Standard Hours × Standard Rate)
Or Variable Overhead efficiency variance = (AH × SR) – (SH × SR)
Or simplified:
Variable Overhead efficiency variance = (Actual Hours taken – Standard Hours) × Standard Rate
Example Calculation of Variable Overhead Efficiency Variance
Example:
Suppose Blue Tech produces a product and we have the data for variable and fixed overheads as below.
Output= 2000 units machine hours per unit = 0.25 hours
Variable overhead cost = $7,000 fixed overhead cost = $ 5,000
If 2000 units were to be produced then total machine hours = 2000* 0.25 = 500 machine hours
Solution:
So the variable overhead rate per machine hour = 7000/500 = $ 14 per hour
And Fixed Variable overhead rate per machine hour = 5000/500 = $10 per hour
Suppose techno blue produced 1,900 actual units in the manufacturing time:
Total Machine Hours= 513 hours, variable OH costs = $ 7,550 fixed OH costs = $ 5,500
By standard hours of 0.25 hour per unit, the total machine hours to produce 1900 units should be:
Machine hours = 1900 × 0.25 = 475 hours.
So, we can calculate the Variable and fixed overhead Variances as below:
Variable Overhead rate variance = (AH – SH) × SR
Variable Overhead rate variance = (513 – 475) ×14 = $ 532 Adverse
Fixed Overhead rate variance = (513 – 475) × 10 = $ 380 Adverse
Total Overhead Variance = $ 912 Adverse
In simple terms, variable overhead variance showed adverse results as the production took more machine hours than the standard rate of 0.25 machine hours per unit. Conversely, we can say that standard machine hours per unit production were set lower that resulted in adverse variance. As in any case, we should consider the quantitative numbers from any ratio or variance analysis as a starting point only.
The management should analyze in-depth for the production causing more machine-hours than expected. The production manager and skilled labor may also argue that standard machine-hours were set wrongly, as in our case if we set the standard machine hours at 0.30 then the same output measures will show a favorable overhead variance. The Standard setting is one of the main hurdles in variance analyses, as the market benchmarks for industry leaders are often unavailable or cannot be implemented for a smaller scale business.
Interpretation and Analysis
A favorable overhead (OH) rate variance indicated fewer hours taken to produce a product unit than expected or budgeted time. Skilled labor, new machinery, and efficient workflow can all contribute towards a favorable OH rate variance. An unfavorable OH variance indicates inefficiencies in the production processes, unavailability of raw material or skilled labor may also cause longer hours for production.
Causes of Favorable Overhead Variance:
- Efficient production workflow as in a JIT approach
- Highly skilled and motivated staff
- Standardized operations and newer machinery
- Manipulated or incorrect budgeted standards
Causes of Unfavorable Overhead Variance:
- Incorrect budgeting or no historical data availability
- Lower skilled staff and demotivation due to lack of incentives
- Inefficient workflow due to outdated machinery
- Unavailability of key raw material or input components
The Marginal costing approach takes into account variable overhead costs that can directly be linked with variable overhead efficiency. Production managers prepare standard or budgeted Overhead (OH) efficiency rates using past data; however, many other factors may cause favorable or unfavorable variances. In the marginal costing approach, a fraction of change in variable overheads can result in a change in contribution margins. Cost accountants using marginal costing method may be more interested in setting up lower standards I.e. higher hour rates to complete production to achieve favorable variances.
Advantages of Calculating Variable Overhead Efficiency Variance
Overhead rate variance offers several advantages to the management:
- It is an integral part of total overhead variance along with OH expenditure variance
- Helps identify process inefficiencies and in continuous improvements
- Motivates operations’ managers and skilled labor to achieve result-oriented favorable variances
- Helps management decide for the inefficiencies in the operations to distinguish between labor and overhead deficiencies
- It helps management improve on internal standards setting, especially for the firms adapting a TQM or JIT approach in manufacturing
Limitation of Variable Overhead Efficiency Variance
As in any other theoretical approach, the OH efficiency variance analysis also has some limitations:
- Overhead rate variance may show faulty results both favorable and adverse depending on several other factors such as labor variances
- OH rate variance results should always be interpreted in conjunction with OH expenditure variance to see the full picture
- Selection of costing method approach affects results achieved with an overhead rate variance analysis e.g. marginal costing will interpret the variance differently than the Activity Based Costing method
Further Considerations of Variable Overhead Efficiency Variance
Variable overhead efficiency is not just a calculation of standard and actual time rate; an entity should interpret with the total inputs utilization ratio to achieve higher outputs. As the variable overheads are an integral part of the production and often change with the number of units produced, we should also consider other factors such as machine hours, labor hours, and raw material for a clear analysis.
Variable OH rate and expenditure variances are linked in a way that change in one variance may cause a changes in the other, e.g. labor working on commission or hourly basis may charge more for products than with fixed rate labor that can cause adverse variance for both expenditure and rate.
Variable overheads increase with production increase such as raw material or energy expenses; however, we must use the variable overhead rate variance to analyze how efficiently the resources have been utilized, how the standard hour targets were achieved or not.
With careful monitoring, the management may be able to find out idle work hours causing adverse variance to both labor rate and variable overhead rates. If an entity provide incentive to the operational managers and skilled labor for favorable variance it may motivate them to improve on the processes and low idle hours. Unavailability of raw materials, old machinery, and disruptions in the power supply are some of the uncontrollable factors that can still cause adverse variance in variable overhead rate analysis.
Conclusion
In conclusion, the variable overhead rate variance can be an important factor in determining the total overhead variances, provided it is interpreted in conjunction with fixed overhead and variable overhead expenditure variances. Variable overhead variance can be an important performance measurement tool especially for the firms using marginal costing approach.
However, the management should make sure to set the realistic standard or budget benchmarks taking into confidence the operations’ managers and the skilled labor. Most of the variable overheads correlate to the production changes, so the overhead variance should follow the same pattern. However, an entity can set the variable overhead rate and expenditure variances as basis for benchmarking in production processes and such entity can motivate its labor to achieve favorable results with incentives.
