Fixed overheads are those costs such as rent on factory premises, which do not vary in response to the level of production output, in a standard costing accounting system fixed overhead costs are allocated to production on an agreed allocation basis.
To operate a standard costing system and allocate fixed overhead, the business must first decide on the basis of allocation. Various methods can be used to allocate the fixed overhead including for example, the number of direct labor hours used in production or the number of machine hours used. The method of allocation is more fully discussed in our applied overhead tutorial.
Calculating the Fixed Overhead Allocation Rate
Suppose a manufacturer allocates fixed overhead based on the number of labor hours used in the manufacture of an item. The manufacturer sets the standards at 0.50 labor hours per item produced, and budgets for 10,000 labor hours and fixed overhead of 13,000. The standard rate for allocating fixed overheads is based on the budget and is calculated as follows:
Standard fixed overhead allocation rate = Budgeted overhead / Budgeted labor hours Standard fixed overhead allocation rate = 13,000 / (10,000 x 0.50) Standard fixed overhead allocation rate = 2.60
Based on this budget, fixed overhead can now be allocated to production at the rate of 2.60 for every labor hour used. The amount allocated to production is referred to as the standard fixed overhead cost.
Fixed Overhead Variance
In a standard costing accounting system, the fixed overhead variance is the difference between the standard fixed overhead and the actual fixed overhead.
The two variances are discussed in more detail below.
Fixed Overhead Budget Variance
If the actual amount spent on fixed overhead is not the same as the amount budgeted for fixed overhead, then there will be a variance known as the fixed overhead budget variance.
The fixed overhead budget variance, sometimes referred to as the fixed overhead spending variance or fixed overhead expenditure variance, is one of the main standard costing variances, and is simply the difference between the budgeted fixed overhead and the actual fixed overhead of the business. The variance is calculated using the fixed overhead budget variance formula as follows:
Since the expenditure is considered to be under the control of management, the overhead budget variance is referred to as a controllable variance.
Fixed Overhead Budget Variance Example
Using the same example as above, the manufacturer allocates fixed overhead based on the number of labor hours used in the manufacture of an item. The manufacturer sets the standards at 0.50 labor hours per item produced, and budgets for 10,000 items to be produced and fixed overhead of 13,000, giving the standard fixed overhead allocation rate of 2.60 per labor hour, as calculated above. At the end of the period, the actual number of items produced is 9,200 and the actual fixed overhead is 11,000. The fixed overhead budget variance is given as follows:
Fixed overhead budget variance = Budgeted overhead - Actual overhead Fixed overhead budget variance = 13,000 - 11,000 Fixed overhead budget variance = 2,000
In this example, the fixed overhead budget variance is positive (favorable), as the actual fixed overhead (11,000) is lower than the budgeted fixed overhead (13,000), and therefore the business paid less for the fixed overhead than it expected to. This variance would be posted as a credit to the fixed overhead budget variance account.
Fixed Overhead Volume Variance
Standard fixed overhead costs are allocated to production based on the standard rate which is calculated using the budgeted production volume. If the actual production volume is not the same as the budgeted production volume then there will be a variance between the budgeted fixed overhead and the standard fixed overhead. This variance is known as the fixed overhead volume variance.
The fixed overhead volume variance is also one of the main standard costing variances, and is the difference between the standard fixed overhead allocated to production and the budgeted fixed overhead.
The variance is calculated using the fixed overhead volume variance formula as follows:
Fixed Overhead Volume Variance Example
Again, using the same example as above, the manufacturer allocates fixed overhead based on the number of labor hours used in the manufacture of an item. The manufacturer sets the standards at 0.50 labor hours per item produced, and budgets for 10,000 items to be produced and fixed overhead of 13,000, which gives the standard fixed overhead allocation rate of 2.60 per labor hour as calculated above. At the end of the period, the actual number of items produced is 9,200 and the actual fixed overhead is 11,000. The fixed overhead volume variance is given as follows:
Fixed overhead volume variance = Standard overhead - Budgeted overhead Fixed overhead volume variance = 9,200 x 0.50 x 2.60 - 13,000 Fixed overhead volume variance = 11,960 - 13,000 Fixed overhead volume variance = -1,040
In this example, as a result of the actual production volume (9,200 items) being below the budgeted production volume of 10,000 items, the fixed overhead volume variance is negative (unfavorable), as only 11,960 of the budgeted fixed overhead of 13,000 has been allocated to production. This variance would be posted as a debit to the fixed overhead volume variance account.
This is summarized in the table below:
Items | Labor/Item | Quantity | Rate | Cost | |
---|---|---|---|---|---|
Budgeted | 10,000 | 0.50 | 5,000 | 2.60 | 13,000 |
Standard allocated | 9,200 | 0.50 | 4,600 | 2.60 | 11,960 |
Actual | 9,200 | 11,000 | |||
Fixed overhead variance | 960 |
The overhead variance can be analyzed as follows:
Cost | |||
---|---|---|---|
Fixed overhead budget variance | 2,000 | ||
Fixed overhead volume variance | -1,040 | ||
Fixed overhead variance | 960 |
In this example, the fixed overhead budget variance is positive (2,000 favorable), and the fixed overhead volume variance is negative (-1,040 unfavorable), resulting in an overall positive overhead variance (960 favorable).
Fixed Overhead Variance Journal Entry
The standard costing journal entry to record the overhead variances and to post the standard and actual fixed overhead cost is as follows:
Account | Debit | Credit |
---|---|---|
Work in process inventory | 11,960 | |
Fixed overhead budget variance | 2,000 | |
Fixed overhead volume variance | 1,040 | |
Fixed overhead expense | 11,000 | |
Total | 13,000 | 13,000 |
Initially the actual fixed overhead expense (rent etc) would have been posted to the expense account with the usual entry of debit expense, credit accounts payable (not shown). The journal above now allocates some of this expense (11,000) to production, this is represented by the credit entry to the expense account.
In the standard costing system, the fixed overhead is posted at the standard cost of 11,960, represented by the debit to the work in process inventory account.
The difference between the two postings is the fixed overhead variance of 960, which is split, and posted to the fixed overhead budget variance account as a credit of 2,000, representing the favorable variance, and to the fixed overhead volume variance account as a debit of 1,040, representing an unfavorable variance.
Clearing the Fixed Overhead Variance Accounts
The financial statements of the business must ultimately show the actual costs incurred by the business, and at the end of an accounting period, having investigated the overhead variances using the variance report, the balance on the variance accounts need to be cleared using the rules discussed in our standard costing and variance analysis tutorial and are available for download in PDF format here. These rules can be summarized as follows:
- For small, insignificant overhead variances it is not worth the time and effort apportioning the balance, so it is simply transferred to the cost of goods sold account.
- Larger unfavorable variances (debit balances) which have resulted from errors and inefficiencies in the business, are also transferred to the cost of goods sold account, as apportioning them to an inventory account would incorrectly increase the value of the inventory.
- All other significant overhead variances (debit or credit balances) are split between inventory accounts and the cost of goods sold account in proportion to the amount of the standard variable overhead remaining on that account.
Variance Apportionment Example
In the example used above, the fixed overhead budget variance was favorable leaving a credit balance of 2,000 on the variance account, and the fixed overhead volume variance was unfavorable leaving a debit balance of 1,040 on the variance account. Assume for simplicity that these were the only fixed overhead variances for the year.
If the balances are considered insignificant in relation to the size of the business, then they can simply be transferred to the cost of goods sold account.
Account | Debit | Credit |
---|---|---|
Fixed overhead budget variance | 2,000 | |
Fixed overhead volume variance | 1,040 | |
Cost of goods sold | 960 | |
Total | 2,000 | 2,000 |
If however, the balances are considered to be significant in relation to the size of the business, then the overhead variances need to be analyzed between the inventory accounts (work in process, and finished goods) and the cost of goods sold account.
In this particular example, the unfavorable fixed overhead volume variance (-1,040) falls under the category of resulting from errors and inefficiencies and is charged to the cost of goods sold account. For the favorable fixed overhead budget variance (2,000), suppose for example, 30% of the standard fixed overhead remained in the work in process inventory, and 70% had been used in production and the items sold, then the fixed overhead budget variance account balance needs to be split as follows:
Account | Percentage | Amount |
---|---|---|
Work in process inventory | 30% | 600 |
Cost of goods sold | 70% | 1,400 |
Total | 100% | 2,000 |
And the bookkeeping journal to post the transaction to clear the overhead variance accounts would be as follows:
Account | Debit | Credit |
---|---|---|
Fixed overhead budget variance | 2,000 | |
Fixed overhead volume variance | 1,040 | |
Work in process inventory | 600 | |
Cost of goods sold account | 1,040 | 1,400 |
Total | 3,040 | 3,040 |
The credit balance on the fixed overhead budget variance account (2,000), has now been split between the work in process inventory account (600) and the cost of goods sold account (1,400) decreasing both accounts by the appropriate amount. The debit balance on the fixed overhead volume variance account (1,040) has been charged to the cost of goods sold account, and both variance account balances have been cleared.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.