8.4: Factory overhead variances

Factory overhead costs are also analyzed for variances from standards, but the process is a bit different than for direct materials or direct labor. The first step is to break out factory overhead costs into their fixed and variable components, as shown in the following factory overhead cost budget.

Factory Overhead Cost Budget

Number of units at normal production capacity	10,000
Variable costs:
\(\ \quad \quad\)Packing materials	$30,000
\(\ \quad \quad\)Direct labor	15,000
\(\ \quad \quad\)Variable utilities cost	5,000
\(\ \quad \quad\quad \quad\)Total variable costs	$50,000
Fixed costs:
\(\ \quad \quad\)Supervisor salary expense	$60,000
\(\ \quad \quad\)Depreciation expense	7,000
\(\ \quad \quad\)Machine rental expense	3,000
\(\ \quad \quad\quad \quad\)Total fixed costs	$70,000
Total budgeted costs	$120,000

This factory overhead cost budget starts with the number of units that could be produced at normal operating capacity, which in this case is 10,000 units. Assume each unit consumes one direct labor hour in production. Total variable factory overhead costs are $50,000, and total fixed factory overhead costs are $70,000. The following factory overhead rate may then be determined.

\(\ \text{Factory overhead rate }=\frac{\text { budgeted factory overhead at normal capacity }}{\text { normal capacity in direct labor hours }}=\frac{\$ 120,000}{10,000}=\$ 12 \text{ per direct labor hour}\)

The total factory overhead rate of $12 per direct labor hour may then be broken out into variable and fixed factory overhead rates, as follows.

\(\ \text{Variable factory overhead rate }=\frac{\text { budgeted variable factory overhead at normal capacity }}{\text { normal capacity in direct labor hours }}=\frac{\ $50,000}{10,000}=\$ 5 \text{ per direct labor hour}\)

\(\ \text{Fixed factory overhead rate }=\frac{\text { budgeted fixed factory overhead at normal capacity}}{\text { normal capacity in direct labor hours }}=\frac{\ $70,000}{10,000}=\$7 \text{ per direct labor hour}\)

The $5 fixed rate plus the $7 variable rate equals the $12 total factory overhead rate per direct labor hour.

Factory overhead variances can be separated into a controllable variance and a volume variance.

The variable factory overhead controllable variance is the difference between the actual variable overhead costs and the budgeted variable overhead for actual production. The following calculations are performed.

1.

Budgeted variable factory overhead

=

standard hours for actual units produced

x

variable factory overhead rate

If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours.

Budgeted variable factory overhead = 8,000 x $5 per direct labor hour = $40,000

2.

Variable factory overhead controllable variance

=

actual variable factory overhead

-

budgeted variable factory overhead

Assume actual variable overhead cost is $39,500

Variable factory overhead controllable variance = $39,500 - $40,000 = ($500), a favorable variance since actual is less than expected.

The variable factory overhead controllable variance indicates how well the company was able to adhere to the budget.

The fixed factory overhead volume variance is the difference between the budgeted fixed overhead at normal capacity and the standard fixed overhead for the actual units produced. The following calculations are performed.

Fixed factory overhead volume variance = (standard hours normal capacity – standard hours for actual units produced) x fixed factory overhead rate

If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours.

Fixed factory overhead volume variance = (10,000 – 8,000) x $7 per direct labor hour = $14,000

The 8,000 standard hours are less than the 10,000 available at normal capacity, so the fixed overhead was underutilized. This results in an unfavorable variance due to the missed opportunity to produce more units for the same fixed overhead.

If 11,000 units are produced (pushing beyond normal operational capacity) and each requires one direct labor hour, there would be 11,000 standard hours.

Fixed factory overhead volume variance = (10,000 – 11,000) x $7 per direct labor hour = ($7,000)

When standard hours exceed normal capacity, the fixed factory overhead costs are leveraged beyond normal production. A favorable fixed factory overhead volume variance results. Additional units were produced without any necessary increase in fixed costs.

An income statement that includes variances is very useful for managers to see how deviations from budgeted amounts impact gross profit and net income. These insights help in planning by addressing reasons for unfavorable variances and continuing with line items that are favorable.

In this example, assume the selling price per unit is $20 and 1,000 units are sold. The standard cost per unit of $113.60 calculated previously is used to determine cost of goods sold – at standard amount. Assume selling expenses are $18,300 and administrative expenses are $9,100.

Income Statement with Variances

Sales		$200,000
Cost of goods sold – at standard		113,600
Gross profits – at standard		$86,400
Variances from standard cost:
\(\ \quad \quad\)Direct materials quantity	($1,200)
\(\ \quad \quad\)Direct materials price	2,520
\(\ \quad \quad\)Direct labor time	1,000
\(\ \quad \quad\)Direct labor rate	(2,550)
\(\ \quad \quad\)Factory overhead controllable	(600)
\(\ \quad \quad\)Factory overhead volume	400
\(\ \quad \quad\quad \quad\)Net variance from standard cost – favorable		(430)
\(\ \quad \quad\quad \quad\)Gross profit		$86,830
Operating expenses:
\(\ \quad \quad\)Selling expenses	$18,300
\(\ \quad \quad\)Administrative expenses	9,100
\(\ \quad \quad\quad \quad\)Total operating expenses		27,400
Net income before income taxes		$59,430

The net variance from standard cost and the line items leading up to it build deviations from standard amounts right into the income statement. Managers can focus on discovering reasons for these differences to budget and operate more effectively in future periods.