Overhead Variances and Reconciling Budgeted Profit to Actual Profit

At the end of a month a management accountant in a tyre factory has the cost variances for materials and labour, and now has to deal with overheads. The variable overhead is easy: it behaves like labour, because it is driven by hours.

The fixed overhead is odd: it does not change with output, yet the product cost includes a share of it, so the difference between what the factory absorbed and what it spent has to be explained. Then, the managing director asks for a single page that explains why profit was ₦1.4 million below budget. This page is the operating statement.

This topic covers the variable overhead variances (expenditure and efficiency); the fixed overhead variances under absorption costing (total, expenditure, volume, and the split of volume into capacity and efficiency); the sales variances in the statement; the three resource utilisation ratios (efficiency, capacity and production volume); and the operating statement under both standard absorption costing and standard marginal costing, so that the budgeted profit is reconciled with the actual profit.

It builds on the earlier topic on planning and operational variances for materials and labour. The next topic covers the behavioural effects of variances: motivation, JIT and TQM.

Overhead variances

Variable production overhead

The total variable overhead variance is the standard variable overhead cost of the actual output less the actual variable overhead, split into two parts, just as for labour.

• Expenditure variance. Variable overhead is incurred during hours actively worked, not during idle time, so it is based on actual hours worked: (actual hours worked × standard rate per hour) − actual variable overhead cost. It resembles a price variance. Causes: price rises in power or consumables; savings not achieved.
• Efficiency variance. In hours it is the same as the labour efficiency variance (standard hours for the actual output − actual hours worked), valued at the standard variable overhead rate per hour. Causes are the same as for labour efficiency: methods, morale, incentives, the experience of the labour force.

Fixed production overhead (absorption costing)

Under standard absorption costing each unit is charged with a standard fixed overhead cost, found as budgeted fixed overhead ÷ budgeted activity (a rate per hour, or per unit). The fixed overhead variances therefore differ from the variable ones.

• Total fixed overhead variance = fixed overhead absorbed (actual units × standard fixed overhead per unit) − actual fixed overhead incurred. This is the over-absorption (favourable) or under-absorption (adverse).
• Expenditure variance = budgeted fixed overhead − actual fixed overhead. Adverse if more was spent than budgeted. It can also be found for administration and selling overheads. Causes: poor control or poor budgeting; an unplanned rise in rent or rates.
• Volume variance = (actual units produced − budgeted units) × standard fixed overhead per unit. It arises because production differs from the budgeted volume used to set the absorption rate. It can be analysed further into two parts.
• Efficiency variance (fixed overhead) = (standard hours for actual output − actual hours worked) × the standard fixed overhead rate per hour. It is the labour efficiency variance in hours, again.
• Capacity variance = (actual hours worked − budgeted hours) × the standard fixed overhead rate per hour. Favourable if more hours were worked than budgeted. Causes: strikes, breakdowns or a shortage of orders (adverse); extra shifts (favourable).

Expenditure + volume = total; efficiency + capacity = volume. Interrelationship: higher efficiency means fewer hours are needed for the budgeted output, so a favourable efficiency variance may cause an adverse capacity variance, and the reverse.

Sales variances in the statement

Sales price variance and sales volume variance (at standard profit per unit in absorption costing, at standard contribution per unit in marginal costing) were described in an earlier topic; they join the cost variances in the statement.

Resource utilisation ratios

These ratios express the volume variance in terms of hours and are linked to the fixed overhead variances:

• Efficiency ratio = standard hours for the actual output ÷ actual hours worked (100% if output takes exactly the expected time; above 100% if faster).
• Capacity ratio = actual hours worked ÷ budgeted hours (or hours available for work). Idle hours are excluded from hours worked.
• Production volume (activity) ratio = standard hours for the actual output ÷ budgeted hours.
• Efficiency ratio × capacity ratio = production volume ratio.

The operating statement

An operating statement reconciles the budgeted profit with the actual profit by listing all the variances. Senior management use it to see the effect of each variance on profitability and to assess how well junior managers controlled costs and achieved sales.

Standard absorption costing

1. Start with budgeted profit (budgeted sales × standard profit per unit).
2. Add or deduct the sales variances (price, then volume at standard profit). The sub-total is actual sales revenue minus the standard production cost of the units sold.
3. List the cost variances, favourable and adverse in separate columns: material price and usage; labour rate, efficiency and idle time; variable overhead expenditure and efficiency; fixed overhead expenditure, efficiency and capacity (the volume variance in two parts).
4. Total the cost variances and deduct (or add) to give actual profit.

Standard marginal costing

Units and stock are valued at standard variable production cost, so budgeted profit differs from that under absorption costing. All the variable cost variances and the sales price variance are the same. The differences:

• the sales volume variance is valued at standard contribution per unit, not profit
• there is no fixed overhead volume variance, because fixed overhead is not absorbed
• only the expenditure variance is shown

The statement starts with budgeted contribution, adjusts for sales variances and variable cost variances to actual contribution, then deducts actual fixed overhead (budgeted fixed overhead plus the adverse expenditure variance) to give actual profit. With no change in stock the two methods give the same actual profit.

Layouts for overhead variances and the operating statement

1. Variable overhead: actual hours worked × SR v actual cost (expenditure); (SH − AH worked) × SR (efficiency).
2. Fixed overhead: budget v actual (expenditure); absorbed v budget (volume); AH v budgeted hours (capacity); SH v AH (efficiency).
3. Ratios: SH ÷ AH; AH ÷ budgeted hours; SH ÷ budgeted hours.
4. Statement: budget; sales variances; cost variances; actual; verify against the actual figures.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Sales.
   Price: 4,600 × 3,500 = 16,100,000 against 15,870,000, ₦230,000 A.
   Volume (absorption): (4,600 − 5,000) × 800 = ₦320,000 A.
2. Materials.
   Price: 14,000 × 200 = 2,800,000 against 2,870,000, ₦70,000 A.
   Usage: standard 13,800 kg, used 14,000; 200 A × 200 = ₦40,000 A.
3. Labour.
   Rate: 9,400 × 500 = 4,700,000 against 4,794,000, ₦94,000 A.
   Efficiency: standard hours 9,200; worked 9,400; 200 A × 500 = ₦100,000 A.
4. Variable overhead.
   Expenditure: 9,400 × 150 = 1,410,000 against 1,457,000, ₦47,000 A.
   Efficiency: 200 A × 150 = ₦30,000 A.
5. Fixed overhead.
   Absorbed 4,600 × 800 = 3,680,000; actual 4,150,000; total ₦470,000 A.
   Expenditure 4,000,000 − 4,150,000 = ₦150,000 A.
   Volume (4,600 − 5,000) × 800 = ₦320,000 A.
   Efficiency 200 A × 400 = ₦80,000 A.
   Capacity (9,400 − 10,000) = 600 A × 400 = ₦240,000 A.
   Check 80,000 + 240,000 = 320,000
   150,000 + 320,000 = 470,000.
6. Ratios.
   Efficiency 9,200 ÷ 9,400 = 97.87%
   capacity 9,400 ÷ 10,000 = 94.0%
   production volume 9,200 ÷ 10,000 = 92.0%
   97.87% × 94% = 92.0%.
7. Operating statement (absorption), ₦000.
   Budgeted profit 5,000 × 800 = 4,000.
   Sales price (230) A; sales volume (320) A; sub-total 3,450.
   Cost variances (A): material price 70, usage 40; labour rate 94, efficiency 100; variable overhead expenditure 47, efficiency 30; fixed overhead expenditure 150, efficiency 80, capacity 240; total 851 A.
   Actual profit 2,599.
8. Verification.
   Revenue 15,870 − materials 2,870 − labour 4,794 − variable overhead 1,457 − fixed overhead 4,150 = 2,599.
9. Marginal costing, ₦000.
   Budgeted contribution 5,000 × 1,600 = 8,000.
   Sales price (230); sales volume 400 × 1,600 = (640); sub-total 7,130.
   Variable cost variances (A): 70 + 40 + 94 + 100 + 47 + 30 = 381; actual contribution 6,749.
   Fixed overhead: budgeted 4,000 plus expenditure variance 150 = actual 4,150.
   Actual profit 2,599, the same.

Expect variants: a statement with opening and closing stock (production and sales differ), idle time shown, partial data from which to derive missing variances, and requirements to explain the variances and ratios to management.

Factors to consider before investigating a variance

Investigation costs management time, so not every variance should be investigated.

Consider: the size of the variance (materiality, often as a percentage of the standard); whether it is adverse or favourable (adverse ones usually get more attention because they cut profit, but a large favourable one may signal a loose standard or falling quality); the probability that the cause is controllable; the cost and benefit of investigating (do not investigate unless the expected benefit exceeds the cost); the reliability and accuracy of the figures; possible interdependencies between variances (a favourable price and an adverse usage variance may have one cause); and the inherent variability of the item, since some costs normally fluctuate.

A common rule is to investigate when a variance exceeds both a set percentage and a set amount, or forms part of a trend.

Common mistakes

• Variable overhead expenditure on hours paid instead of hours worked.
• Fixed overhead volume on units but valued at a rate per hour, or the reverse. Match the base.
• Using profit for volume in marginal costing and contribution in absorption costing.
• Showing a fixed overhead volume variance in a marginal statement.
• Not verifying the actual profit from the actual figures.
• Wrong signs in the statement. Adverse variances reduce profit.

Quick revision

• VOH: expenditure on hours worked; efficiency = labour efficiency hours × VOH rate.
• FOH: expenditure = budget − actual; volume = (actual − budgeted units) × rate per unit; volume = efficiency + capacity.
• Ratios: efficiency × capacity = production volume.
• Statement: budget → sales → cost → actual; marginal uses contribution and has no FOH volume variance.

How the marks are earned

• Each variance with base and sign.
• Statement that reconciles to actual profit.
• Explanation of causes and links.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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