Variable overheads are a large and substantial portion of any company’s overall operating costs, especially in the manufacturing industry. Variable overheads fluctuate with operational efficiency and make up a significant portion of overall variable cost.
Variations in projected overhead expenditures can have a substantial impact on contribution margins, especially if selling prices are low and competition is fierce. In this post, we’ll go through the variable overhead efficiency variance in depth.
What is the Variable Overhead Efficiency Variance?
The difference between actual and budgeted hours worked is the variable overhead efficiency variance, which is subsequently applied to the standard variable overhead rate per hour. It is caused by differences in productivity efficiency.
The number of work hours required to produce a particular amount of goods, for example, may range considerably from the standard or planned number of hours. Total variable overhead variance is made up of two components: variable overhead efficiency variation and variable overhead spending variance.
The variable overhead efficiency variance is a combination of production expense data submitted by the production line and forecasted labor hours to be worked. It is generally predicted by the industrial technology and manufacturing scheduling staff using historical and expected efficiency and equipment capacities.
Variable Overhead Efficiency Variance Formula
Assuming that the application base for variable overhead is direct labor hours, the formula for calculating variable overhead efficiency variance is:
Variable overhead efficiency variance = Standard overhead rate x (Actual hours – Standard hours)
In the preceding calculation, the standard direct labor hours permitted (SH) is determined by multiplying the standard direct labor hours per unit by the actual units produced. In this method, indirect labor expenditures such as shop foreman and security are included in the hourly rate.
The variable overhead efficiency variance is positive if real labor hours are fewer than the budgeted or standard amount. It is negative if actual labor hours are higher than the planned or standard amount.
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Variable overhead efficiency variance formula measures the efficiency of the production department in converting inputs to outputs, as the name implies. When standard hours exceed actual hours, variable overhead efficiency variance is positive. As a result, a positive number is beneficial, suggesting that the manufacturing process was completed effectively with little resource loss.
When real hours exceed the number of hours allowed by the standard, the variance is negative and unfavorable, suggesting that the manufacturing process was inefficient.
Consider a widget-making factory where the usual variable overhead rate for indirect labor expenses is expected to be $20 per hour. Assume that the average number of hours required to produce 1,000 widgets is 2,000. The reality, on the other hand, required 2,200 hours to make 1,000 widgets.
The unfavorable variable overhead efficiency variation in this example is (2,200 – 2,000) x $20 = $4,000; the variance is adverse since the firm took longer to create 1,000 widgets than planned. The difference would be favorable $2,000 if the business had taken 1,900 hours to create 1,000 widgets instead.
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Analysis and Interpretation
A favorable overhead (OH) rate variance showed that a product unit was produced in fewer hours than planned or budgeted. A favorable OH rate variance can be aided by skilled staff, modern machinery, and efficient workflow. An unfavorable OH variance implies inefficiencies in the manufacturing process. In addition, the inability to get raw materials or competent personnel may result in longer hours for proctors.
Causes of Favorable Overhead Variance include the following
- JIT-style production workflow.
- Employees that are highly competent and motivated.
- Streamlined processes and modern equipment.
- Budgeted standards that have been manipulated or are inaccurate.
Unfavorable Overhead Variance is caused by a variety of factors
- Budgeting errors or a lack of previous data
- Due to a lack of incentives, the workforce is less competent and demotivated.
- Due to out-of-date machinery, the process is inefficient.
- Key raw materials or input components aren’t available.
The marginal costing method considers variable overhead expenses that are directly related to variable overhead efficiency. Production managers utilize historical data to calculate standard or budgeted Overhead (OH) efficiency rates; however, a variety of additional factors might produce positive or negative variations.
A fraction of a change in variable overheads can result in a change in contribution margins in the marginal costing technique. To obtain positive variances, cost accountants employing the marginal costing approach may be more interested in establishing lower requirements, such as greater hour rates to finish manufacturing.
Advantages of Variable Overhead Efficiency Variance Calculation
The management benefits from variable overhead efficiency variation formula in a variety of ways:
- Along with overhead expenditure variance, it is a key component of total overhead variation.
- Aids in the identification and improvement of process inefficiencies.
- Motivates operations management and skilled personnel to attain a favorable variance as a consequence of their efforts.
- Assists management in determining the source of inefficiencies in operations by distinguishing between labor and overhead issues.
- It aids management in improving internal standards, particularly for companies adopting a TQM or JIT production approach.
Limitations of Variable Overhead Efficiency Variance Calculation
The variable overhead efficiency variance formula, like any other theoretical technique, has several drawbacks:
- Depending on a variety of other factors, such as labor variations, overhead rate variance can have both good and unfavorable effects.
- The findings of overhead rate variance should always be seen in combination with overhead expenditure variance to get the whole picture.
- The type of costing used has an impact on the findings of an OH rate variance analysis, for example, marginal costing interprets variation differently from Activity Based Costing.
Variable Overhead Efficiency Variance: Additional Considerations
- To get better outputs, an entity should understand variable overhead efficiency with the entire inputs utilization ratio, not simply the standard and real-time rate. They need also to examine other elements like labor hours, machine hours, and raw material for a clear analysis because variable overheads are an important component of the production and often fluctuate with the number of units produced.
- Variable Overhead rate and expenditure variances are connected in such a manner that a change in one can induce a change in the other. For example, commission or hourly labor may charge more for products than fixed-rate labor, resulting in negative variance in both expenditure and rate.
- Variable overheads, such as raw material or energy costs, rise when output rises; nevertheless, we must use the variable overhead rate variance to determine how effectively resources were used and whether or not the standard hour objectives were met.
- Management may be able to identify idle work hours that are producing a negative variation in both labor rates and variable overhead rates with diligent monitoring. If an organization rewards operational managers and skilled labor for positive variance, it may encourage them to improve procedures and reduce idle time.
- Raw material shortages, outdated machinery, and power outages are just a few of the uncontrolled elements that can create negative variation in variable overhead rate analysis.
Finally, if the variable overhead rate variance is understood in conjunction with the constant and variable overhead expenditure variances, it can be a significant component in estimating total overhead variances. The variable overhead variance formula may be a useful performance evaluation tool, particularly for companies that use the marginal costing method.
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However, management should ensure that realistic standards or budget benchmarks are established, with the operations managers and skilled workers in mind. Because the majority of variable overheads are linked to production changes, the overhead variance should follow a similar trend. An entity, on the other hand, can use the variable overhead rate and expenditure variations as a foundation for benchmarking in production processes, and it can use incentives to push its employees to achieve positive results.