The Overhead Variance Is The Difference Between:

In manufacturing and cost accounting, understanding and managing costs is critical for profitability and efficiency; overhead variance, a key metric in cost accounting, provides insights into how well a company controls its overhead costs, which are indirect costs essential for production but not directly traceable to specific products or services. This variance highlights the difference between the actual overhead costs incurred and the budgeted or standard overhead costs, offering valuable information for cost control, budgeting, and performance evaluation.

What is Overhead Variance?

Overhead variance represents the difference between the actual overhead costs incurred during a production period and the standard or budgeted overhead costs for that period. Overhead costs include all indirect expenses required to run a manufacturing plant or production facility, such as utilities, rent, depreciation on equipment, and salaries of non-production staff.

Formula for Overhead Variance

The basic formula for calculating overhead variance is:

Overhead Variance = Actual Overhead Costs - Standard Overhead Costs

This variance can be further broken down into two main components:

• Spending Variance: Measures the difference between actual and budgeted overhead costs at the actual activity level.
• Efficiency Variance: Measures the difference between the actual activity level and the standard activity level applied to overhead costs.

Types of Overhead

Before diving deeper into the calculation and interpretation of overhead variance, it’s essential to understand the types of overhead costs:

• Fixed Overhead: Costs that remain constant regardless of the level of production, such as rent, insurance, and depreciation.
• Variable Overhead: Costs that change in proportion to the level of production, such as indirect materials, utilities, and hourly wages for maintenance staff.

Calculating Overhead Variance

To calculate the overhead variance, it is crucial to follow a step-by-step process. This includes determining the actual overhead costs, calculating the standard overhead costs, and then breaking down the total variance into spending and efficiency variances.

Step 1: Determine Actual Overhead Costs

Gather all actual overhead costs incurred during the period. This includes both fixed and variable overhead costs. Accurate record-keeping is essential for this step.

Step 2: Calculate Standard Overhead Costs

Standard overhead costs are determined based on a predetermined overhead rate (POHR) and the standard activity level. The POHR is calculated as:

Predetermined Overhead Rate (POHR) = Budgeted Overhead Costs / Budgeted Activity Level

The standard overhead costs are then calculated as:

Standard Overhead Costs = POHR x Actual Activity Level

Step 3: Calculate Total Overhead Variance

Using the formula mentioned earlier:

Total Overhead Variance = Actual Overhead Costs - Standard Overhead Costs

Step 4: Break Down into Spending and Efficiency Variances

• Spending Variance:

  • Measures how well the company managed to keep its actual overhead costs in line with what was budgeted for the actual level of activity.
  • Formula: Spending Variance = Actual Overhead Costs - (Budgeted Fixed Overhead + (Actual Activity Level x Standard Variable Overhead Rate))

• Efficiency Variance:

  • Reflects the difference between the actual activity level and the standard activity level in terms of overhead costs.
  • Formula: Efficiency Variance = (Actual Activity Level - Standard Activity Level) x Standard Variable Overhead Rate

Example Calculation

Let’s consider a manufacturing company, "TechPro Inc.," which produces electronic components. The company has the following data for the month of June:

• Budgeted Fixed Overhead: $50,000
• Budgeted Variable Overhead: $3 per unit
• Budgeted Activity Level: 10,000 units
• Actual Fixed Overhead: $52,000
• Actual Variable Overhead: $33,000
• Actual Production: 11,000 units
• Standard Activity Level: 10,500 units

1. Calculate Predetermined Overhead Rate (POHR)

First, calculate the total budgeted overhead:

Total Budgeted Overhead = Budgeted Fixed Overhead + (Budgeted Variable Overhead per unit x Budgeted Activity Level)

Total Budgeted Overhead = $50,000 + ($3 x 10,000)

Total Budgeted Overhead = $80,000

Now, calculate the POHR:

POHR = Total Budgeted Overhead / Budgeted Activity Level

POHR = $80,000 / 10,000 units

POHR = $8 per unit

2. Calculate Standard Overhead Costs

Standard Overhead Costs = POHR x Actual Activity Level

Standard Overhead Costs = $8 x 11,000 units

Standard Overhead Costs = $88,000

3. Calculate Total Actual Overhead Costs

Total Actual Overhead Costs = Actual Fixed Overhead + Actual Variable Overhead

Total Actual Overhead Costs = $52,000 + $33,000

Total Actual Overhead Costs = $85,000

4. Calculate Total Overhead Variance

Total Overhead Variance = Actual Overhead Costs - Standard Overhead Costs

Total Overhead Variance = $85,000 - $88,000

Total Overhead Variance = -$3,000

Since the variance is negative, it is considered a favorable variance, meaning the company spent less on overhead than expected.

5. Break Down into Spending and Efficiency Variances

• Spending Variance:

  • Spending Variance = Actual Overhead Costs - (Budgeted Fixed Overhead + (Actual Activity Level x Standard Variable Overhead Rate))
  • First, determine the standard variable overhead rate: $3 per unit
  • Spending Variance = $85,000 - ($50,000 + ($11,000 x $3))
  • Spending Variance = $85,000 - ($50,000 + $33,000)
  • Spending Variance = $85,000 - $83,000
  • Spending Variance = $2,000 (Unfavorable)

• Efficiency Variance:

  • Efficiency Variance = (Actual Activity Level - Standard Activity Level) x Standard Variable Overhead Rate
  • Efficiency Variance = (11,000 - 10,500) x $3
  • Efficiency Variance = 500 x $3
  • Efficiency Variance = $1,500 (Unfavorable)

Interpreting Overhead Variance

Interpreting overhead variance requires a thorough understanding of the factors that cause these variances. Both favorable and unfavorable variances need to be analyzed to identify underlying issues and opportunities for improvement.

Favorable Variance

A favorable variance (actual overhead costs are less than standard overhead costs) can indicate efficient cost management, better-than-expected productivity, or lower input prices. However, it is important to investigate the reasons behind a favorable variance to ensure it is sustainable and not due to cutting corners that may negatively impact quality or long-term performance.

Potential causes of a favorable variance:

• Efficient use of resources: Improved processes and reduced waste can lead to lower variable overhead costs.
• Lower input prices: Negotiating better deals with suppliers can reduce the cost of indirect materials and services.
• Effective cost control measures: Implementing cost-saving initiatives can result in lower fixed and variable overhead costs.

Unfavorable Variance

An unfavorable variance (actual overhead costs are more than standard overhead costs) suggests inefficiencies, higher input prices, or unexpected expenses. Addressing unfavorable variances is crucial for maintaining cost control and profitability.

Potential causes of an unfavorable variance:

• Inefficient processes: Wasteful practices, poor maintenance, and inadequate training can increase variable overhead costs.
• Higher input prices: Increased costs of materials, utilities, or labor can drive up overhead costs.
• Unexpected expenses: Unforeseen repairs, equipment breakdowns, or regulatory changes can lead to higher overhead costs.

Analyzing Spending and Efficiency Variances

In addition to the total overhead variance, analyzing the spending and efficiency variances provides deeper insights into cost performance.

Spending Variance Analysis

The spending variance focuses on the difference between the actual overhead costs and the budgeted overhead costs at the actual activity level. A significant spending variance indicates that the company is either overspending or underspending on overhead items compared to what was expected for the level of production achieved.

• Unfavorable Spending Variance: May be caused by higher prices for materials, inefficiencies in spending, or unexpected costs. Investigating the specific overhead items that contributed to the variance can help identify the root causes and implement corrective actions.
• Favorable Spending Variance: May be due to cost-saving measures, better negotiation with suppliers, or efficient use of resources. It is important to verify that the favorable variance is sustainable and not achieved at the expense of quality or long-term performance.

Efficiency Variance Analysis

The efficiency variance reflects the impact of the actual activity level differing from the standard activity level on overhead costs. It measures whether the company used its resources efficiently to achieve the actual level of production.

• Unfavorable Efficiency Variance: Occurs when the actual activity level is lower than the standard activity level. This indicates that the company did not utilize its resources effectively, resulting in higher overhead costs per unit. Possible causes include production bottlenecks, equipment downtime, or poor scheduling.
• Favorable Efficiency Variance: Occurs when the actual activity level is higher than the standard activity level. This suggests that the company utilized its resources more efficiently than expected, resulting in lower overhead costs per unit. This may be due to improved productivity, better utilization of equipment, or effective training programs.

Practical Implications and Uses

Understanding and analyzing overhead variance is essential for several practical purposes within a manufacturing or production environment.

Cost Control

Overhead variance analysis helps in identifying areas where costs are not being controlled effectively. By pinpointing the sources of unfavorable variances, managers can take corrective actions to reduce costs and improve efficiency.

Budgeting and Forecasting

Analyzing historical overhead variances can improve the accuracy of future budgets and forecasts. Understanding the factors that influence overhead costs enables more realistic and reliable budgeting.

Performance Evaluation

Overhead variance analysis can be used to evaluate the performance of departments or individuals responsible for cost control. It provides a quantitative measure of how well costs are being managed and can be used to incentivize better performance.

Decision Making

Information on overhead variances can inform various business decisions, such as pricing, production planning, and investment in new equipment or processes. Understanding the cost implications of different decisions is crucial for maximizing profitability.

Continuous Improvement

Regular analysis of overhead variances supports a culture of continuous improvement. By monitoring variances and identifying root causes, companies can implement ongoing improvements to processes and cost management practices.

Strategies for Managing Overhead Variance

Effective management of overhead variance requires a proactive approach that includes setting realistic standards, monitoring costs, and taking corrective actions when necessary.

Setting Realistic Standards

• Accurate Budgeting: Develop comprehensive and accurate budgets that reflect realistic expectations for overhead costs.
• Benchmarking: Compare overhead costs with industry benchmarks to identify areas for improvement.
• Regular Review: Periodically review and update standards to ensure they remain relevant and achievable.

Monitoring Costs

• Real-Time Tracking: Implement systems for tracking actual overhead costs in real-time.
• Variance Analysis Reports: Generate regular variance analysis reports that highlight significant deviations from standards.
• Key Performance Indicators (KPIs): Monitor KPIs related to overhead costs, such as overhead cost per unit, to identify trends and potential issues.

Taking Corrective Actions

• Root Cause Analysis: Investigate the root causes of significant variances to identify underlying issues.
• Process Improvement: Implement process improvements to eliminate waste, reduce inefficiencies, and lower overhead costs.
• Negotiate with Suppliers: Negotiate better deals with suppliers to reduce the cost of materials and services.
• Training and Development: Provide training and development programs to improve employee skills and productivity.
• Technology Investment: Invest in technology solutions that can automate processes, improve efficiency, and reduce overhead costs.

Common Pitfalls to Avoid

While analyzing overhead variance, it’s essential to avoid common pitfalls that can lead to incorrect interpretations and ineffective decision-making.

Over-reliance on Standard Costs

Relying solely on standard costs without considering actual conditions can lead to inaccurate variance analysis. Standard costs should be regularly updated to reflect changes in prices, technology, and processes.

Ignoring Favorable Variances

Focusing only on unfavorable variances and ignoring favorable variances can result in missed opportunities for improvement. Favorable variances should be investigated to identify best practices that can be replicated across the organization.

Lack of Detail

Analyzing total overhead variance without breaking it down into spending and efficiency variances provides limited insights. Detailed analysis is necessary to identify the specific factors driving the variances.

Failure to Take Corrective Action

Identifying variances without taking corrective actions is a waste of time and resources. It’s crucial to develop and implement strategies to address the root causes of significant variances.

Inadequate Communication

Failing to communicate variance analysis results to relevant stakeholders can hinder effective decision-making and cost control. Variance analysis reports should be shared with managers, supervisors, and employees responsible for cost control.

Conclusion

Overhead variance analysis is a critical tool for cost management in manufacturing and production environments. By understanding the difference between actual and standard overhead costs, companies can identify areas for improvement, control costs, and enhance profitability. Breaking down the total variance into spending and efficiency variances provides deeper insights into the factors driving cost performance. Effective management of overhead variance requires setting realistic standards, monitoring costs, taking corrective actions, and avoiding common pitfalls. By embracing these practices, companies can optimize their overhead costs and achieve sustainable competitive advantage.