Variable Overhead Variance

The variable overhead variance is a measure of the difference between the standard variable overhead costs and the actual variable overhead costs incurred for a given period. Furthermore in a standard costing accounting system, variable overhead has two main variances, the variable overhead rate variance and the variable overhead efficiency variance.

Variable overheads are those costs which vary in response to the level of production output but which cannot be attributed to individual units of production. For example, an item might be manufactured by equipment which cuts and shapes a sheet of plastic. The sheet of plastic can be attributed to the individual units of production and is a direct material cost, however, the electricity used to power the equipment, and the depreciation on the equipment, varies with the level of production but cannot be attributed to an individual unit of production, such costs are referred to as variable overhead which is allocated to the units of production on an agreed basis.

To operate a standard costing system and allocate variable overhead, the business must first decide on the basis of allocation. Various methods can be used to allocate the variable overhead including for example, the number of direct labor hours used in production or the number of machine hours used. Additionally the method of allocation is more fully discussed in our applied overhead tutorial.

Variable Overhead Rate Variance

The variable overhead rate variance, sometimes referred to as the variable overhead spending variance, is one of the main standard costing variances. The variance results from the difference between the standard cost and the actual cost of variable overhead used by a business.

The variance is calculated using the variable overhead rate variance formula. This formula takes the difference between the standard variable overhead rate and the actual variable overhead rate, and multiplies this by the actual quantity of units of variable overhead used.

Variable Overhead Rate Variance Example

To illustrate suppose a manufacturer allocates variable overhead based on the number of labor hours used in the production of an item. In this case the manufacturer has set the standard variable overhead rate at 5.00 per direct labor hour, and the standard quantity of labor needed per item manufactured at 0.50 hours. Additionally on a production run of 500 items they find they have used 230 hours of labor, and the actual variable overhead cost is 1,100

Variable overhead rate variance = (Standard rate - Actual rate) x Actual quantity
Variable overhead rate variance = (5.00 - 1,100 / 230) x 230
Variable overhead rate variance = (5.00 - 4.783) x 230
Variable overhead rate variance = 50

In this example, the variable overhead rate variance is positive (favorable), as the actual variable overhead rate (4.783) is lower than the standard rate (5.00), and therefore the business paid less for the variable overhead than it expected to. This variance would be posted as a credit to the variable overhead rate variance account.

Variable Overhead Efficiency Variance

The variable overhead efficiency variance, sometimes referred to as the variable overhead quantity variance, is also one of the main standard costing variances, and results from the difference between the standard quantity and the actual quantity of variable overhead allocated by a business during production.

The variance is calculated using the variable overhead efficiency variance formula. This formula takes the difference between the standard quantity and the actual quantity of variable overhead allocated, and multiplies this by the standard variable overhead rate.

Variable Overhead Efficiency Variance Example

To illustrate using the same example as above, the manufacturer allocates variable overhead based on the number of labor hours used in the manufacture of an item. In this case the manufacturer has set the standard variable overhead rate at 5.00 per direct labor hour, and the standard quantity of labor needed per item manufactured at 0.50 hours. Additionally on a production run of 500 items they find they have used 230 hours of labor, and the actual variable overhead cost is 1,100

Variable overhead efficiency variance = (Standard quantity - Actual quantity) x Standard rate
Variable overhead efficiency variance = (500 x 0.50 - 230) x 5.00
Variable overhead efficiency variance = (250 - 230) x 5.00
Variable overhead efficiency variance = 100

In this example, the variable overhead efficiency variance is positive (favorable), as the actual quantity of labor hours used (230) is lower than the standard quantity of labor hours (250), and therefore the business allocated less variable overhead than it expected to. Consequently this variance would be posted as a credit to the variable overhead efficiency variance account.

Additionally this is summarized in the table below:

Furthermore the variable overhead variance can be analyzed as follows:

In this example, the variable overhead rate variance is positive (50 favorable), and the variable overhead efficiency variance is also positive (100 favorable), resulting in an overall positive variable overhead variance (150 favorable).

Variable Overhead Variance Journal Entry

The standard costing journal entry to record the variable overhead variances and to post the standard and actual variable overhead cost is as follows:

Initially the actual variable overhead expense (electricity etc) would have been posted to the expense account with the usual entry of debit expense, credit accounts payable (not shown). Subsequently the journal above, allocates some of this expense (1,100) to production, this is represented by the credit entry to the expense account.

In the standard costing system, the variable overhead is posted at the standard cost of 1,250 represented by the debit to the work in process inventory account.

The difference between the two postings is the variable overhead variance of 150, which is split, and posted to the variable overhead rate variance account as a credit of 50, representing the favorable variance, and to the variable overhead efficiency variance account as a credit of 100, also representing a favorable variance.

Clearing the Variable 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. Consequently having investigated the variable 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. Additionally the rules are available for download in PDF format here. These rules can be summarized as follows:

1. For small, insignificant variable 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.
2. 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.
3. Finally all other significant variable 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 variable overhead rate variance was favorable leaving a credit balance of 50 on the variance account, and the variable overhead efficiency variance was also favorable leaving a credit balance of 100 on the variance account. Assume for simplicity that these were the only variable overhead variances for the year.

If the balances are insignificant in relation to the size of the business, then we can simply transfer them the cost of goods sold account.

If however, the balances are significant in relation to the size of the business, then we need to analyze the variable overhead variances between the inventory accounts (work in process, and finished goods) and the cost of goods sold account.

To illustrate, suppose for example, 30% of the standard variable overhead remained in the work in process inventory, and 70% had been used in production and the items sold. In this case the variable overhead variance account balances are split as follows:

Allocation Journal Entry

Additionally the bookkeeping journal to post the transaction to clear the variable overhead variance accounts would be as follows:

Accordingly the credit balance on the variable overhead rate variance account (50), and the credit balance on the variable overhead efficiency variance account (100) have now been split between the work in process inventory account (45) and the cost of goods sold account (105). This journal decreases both the inventory and COGS accounts by the appropriate amount and clears the variance account balances.

Conclusion

In conclusion, the variable overhead variance is an important tool for measuring and controlling indirect costs, and is used to evaluate the efficiency of overhead spending. Consequently by analyzing the variance, management can identify areas for improvement and take steps to reduce the cost of variable overhead, thereby increasing profitability and competitiveness.