7.2 Overhead Variance Analysis

7.2 Overhead Variance Analysis

Indirect manufacturing costs—collectively designated as manufacturing overhead—represent factory expenditures that cannot be directly traced to individual product units in an economically feasible manner. Unlike direct materials and direct labour, overheads encompass heterogeneous expenses, ranging from machine lubrication and consumable tooling (variable overheads) to factory rent, equipment depreciation, and supervisory salaries (fixed overheads). Under standard absorption costing, predetermined overhead absorption rates (POAR) are calculated prior to the operating period to allocate these indirect costs to production units.

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Predetermined Overhead Absorption Rates & Absorption Dynamics

The Predetermined Overhead Absorption Rate is established during the annual planning process by dividing budgeted overhead expenditure by the budgeted level of activity (typically direct labour hours or machine hours):

$$\text{POAR} = \frac{\text{Budgeted Overhead Expenditure}}{\text{Budgeted Activity Base (Hours)}} = \text{POAR}_{\text{variable}} + \text{POAR}_{\text{fixed}}$$

During production, overhead is absorbed into work-in-progress inventory using standard hours permitted for actual output:

$$\text{Overhead Absorbed} = \text{Standard Hours Allowed for Actual Output (SH)} \times \text{POAR}$$

At the conclusion of the operating period, management reconciles overhead absorbed against actual overhead expenditures incurred. Any discrepancy represents under-absorption (actual cost exceeded absorbed overhead) or over-absorption (absorbed overhead exceeded actual cost):

$$\text{Over/(Under) Absorption} = \text{Overhead Absorbed} - \text{Actual Overhead Incurred}$$

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Variable Overhead Variances: Expenditure vs Efficiency

Variable overheads fluctuate in direct proportion to factory activity. Total variable overhead variance decomposes into two components:

Variable Overhead Expenditure (Spending) Variance

The Variable Overhead Expenditure Variance measures the difference between actual variable overhead costs incurred and budgeted variable overhead for the actual hours worked:

$$\text{VOH Expenditure Variance} = (SR_{\text{VOH}} - AR_{\text{VOH}}) \times AH = (AH \times \text{POAR}_{\text{VOH}}) - \text{Actual VOH}$$

Deviations stem from price movements in indirect supplies, utility tariff changes, or unexpected maintenance call-out fees.

Variable Overhead Efficiency Variance

Because variable overhead is absorbed on an activity-hour driver (such as direct labour hours), any labor inefficiency automatically inflates variable overhead consumption. The Variable Overhead Efficiency Variance evaluates this operational drag:

$$\text{VOH Efficiency Variance} = (SH - AH) \times \text{POAR}_{\text{VOH}}$$

If factory workers require more hours than standard to complete production, the enterprise incurs excess power, cooling, and consumable costs. When both use the same direct-labour-hour base and treatment of idle time, their signs coincide. A machine-hour overhead base need not track labour efficiency.

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Fixed Overhead Variances: Expenditure vs Volume Decomposition

Fixed manufacturing overhead is committed capacity expenditure that remains constant across relevant output ranges in the short term. However, under absorption costing, fixed overhead is treated as an inventoriable product cost via $\text{POAR}_{\text{fixed}}$. This introduces volume-related absorption variances that do not exist under marginal costing.

Fixed Overhead Expenditure (Budget) Variance

The Fixed Overhead Expenditure Variance is purely a spending deviation comparing original budgeted fixed overhead against actual fixed overhead incurred:

$$\text{FOH Expenditure Variance} = \text{Budgeted Fixed Overhead} - \text{Actual Fixed Overhead}$$

Crucially, because fixed costs do not vary with production, the budgeted fixed overhead is never flexed for changes in output volume.

Fixed Overhead Volume Variance

The Fixed Overhead Volume Variance quantifies the over- or under-absorption of fixed overhead resulting from producing at a volume different from the master budget baseline:

$$\text{FOH Volume Variance} = (SH_{\text{actual output}} - \text{Budgeted Hours}) \times \text{POAR}_{\text{fixed}} = \text{FOH Absorbed} - \text{Budgeted FOH}$$

When actual output exceeds budget ($SH > \text{Budgeted Hours}$), fixed overhead is over-absorbed (Favourable Volume Variance); producing below budget under-absorbs fixed capacity (Adverse Volume Variance).

Decomposing Volume Variance: Capacity vs Efficiency

To provide actionable operational insight, strategic management accounting unbundles the Fixed Overhead Volume Variance into two underlying economic drivers:

$$\text{FOH Volume Variance} = \text{FOH Capacity Variance} + \text{FOH Efficiency Variance}$$

                          Fixed Overhead Volume Variance
                                        |
            +---------------------------+---------------------------+
            |                                                       |
   FOH Capacity Variance                                   FOH Efficiency Variance
(AH - Budgeted Hours) x POAR_fixed                   (SH - AH) x POAR_fixed
Measures facility utilization hours                 Measures labor/machine productivity

1. Fixed Overhead Capacity Variance: Measures whether the production facility was kept operational for more or fewer total hours than budgeted:

$$\text{FOH Capacity Variance} = (AH - \text{Budgeted Hours}) \times \text{POAR}_{\text{fixed}}$$

A favorable capacity variance indicates overtime or extra shifts; an adverse variance reflects idle plant or lost working shifts. 2. Fixed Overhead Efficiency Variance: Measures whether the hours worked were utilized productively to generate output according to standard time allowances:

$$\text{FOH Efficiency Variance} = (SH - AH) \times \text{POAR}_{\text{fixed}}$$

This captures the fixed overhead absorbed (or lost) due to worker or machine efficiency.

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Comparative Overhead Frameworks: 2-Way, 3-Way & 4-Way

Management accounting textbooks and professional exam bodies structure overhead variance analysis across three distinct hierarchical frameworks:

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Corporate Application: Meridian Industrial Components

Meridian Industrial Components manufactures precision sub-assemblies. The standard overhead specifications for the current quarter were established as follows:

• Budgeted Production Volume: 10,000 units
• Standard Labour Hours: 3.0 DLH per completed unit
• Budgeted Activity Base: 10,000 × 3.0 = 30,000 DLH
• Budgeted Variable Overhead: $150,000 (POAR_VOH = $5.00 per DLH)
• Budgeted Fixed Overhead: $270,000 (POAR_FOH = $9.00 per DLH)
• Total POAR: $5.00 + $9.00 = $14.00 per DLH

Actual operating results for the quarter were recorded as follows:

• Actual Output: 9,600 units completed
• Actual Direct Labour Hours Worked ($AH$): 30,720 hours
• Actual Variable Overhead Incurred: $161,280 ($AR_{\text{VOH}} = \text{\textdollar}5.25$ per DLH)
• Actual Fixed Overhead Incurred: $280,000

Step-by-Step 4-Way Overhead Variance Analysis

1. Standard Hours Allowed for Actual Production ($SH$)

$$SH = 9,600\text{ units} \times 3.0\text{ DLH/unit} = 28,800\text{ standard hours}$$

2. Variable Overhead Variances

• VOH Expenditure Variance:

$$(AH \times \text{POAR}_{\text{VOH}}) - \text{Actual VOH} = (30,720 \times \text{\textdollar}5.00) - \text{\textdollar}161,280 = \text{\textdollar}153,600 - \text{\textdollar}161,280 = -\text{\textdollar}7,680\text{ (A)}$$

• VOH Efficiency Variance:

$$(SH - AH) \times \text{POAR}_{\text{VOH}} = (28,800 - 30,720) \times \text{\textdollar}5.00 = -1,920\text{ hrs} \times \text{\textdollar}5.00 = -\text{\textdollar}9,600\text{ (A)}$$

• Total Variable Overhead Variance: -$7,680 + (-$9,600) = -$17,280 (A).

3. Fixed Overhead Variances

• FOH Expenditure Variance:

$$\text{Budgeted Fixed Overhead} - \text{Actual Fixed Overhead} = \text{\textdollar}270,000 - \text{\textdollar}280,000 = -\text{\textdollar}10,000\text{ (A)}$$

• FOH Capacity Variance:

$$(AH - \text{Budgeted Hours}) \times \text{POAR}_{\text{fixed}} = (30,720 - 30,000) \times \text{\textdollar}9.00 = +720\text{ hrs} \times \text{\textdollar}9.00 = +\text{\textdollar}6,480\text{ (F)}$$

• FOH Efficiency Variance:

$$(SH - AH) \times \text{POAR}_{\text{fixed}} = (28,800 - 30,720) \times \text{\textdollar}9.00 = -1,920\text{ hrs} \times \text{\textdollar}9.00 = -\text{\textdollar}17,280\text{ (A)}$$

• FOH Volume Variance:

$$\text{Capacity} + \text{Efficiency} = +\text{\textdollar}6,480\text{ (F)} + (-\text{\textdollar}17,280\text{ (A)}) = -\text{\textdollar}10,800\text{ (A)}$$

Check: (SH - Budgeted Hours) × POAR_fixed = (28,800 - 30,000) × $9.00 = -1,200 hrs × $9.00 = -$10,800 (A).

Comprehensive Under-/Over-Absorption Reconciliation

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