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Variance Analysis - Fixed Overhead Variances

by Dr Philip E Dunn

Various definitions and terminology appear in texts in management accounting on the subject of the preparation and interpretation of fixed overhead variances; but the fixed overhead variance and the sub-analysis of this variance in standard absorption costing is shown as:

(1) Fixed Overhead Variance
                   / \                   
(1.1) Fixed Overhead
Expenditure Variance
(1.2) Fixed Overhead
Volume Variance
  / \
Fixed Overhead
Capacity Variance
Fixed Overhead
Efficiency Variance

The variances have been defined as:
(1) Fixed Overhead Variance
The difference between the fixed overhead recovered in the activity achieved and the actual fixed overhead incurred. It represents either an under or over-recovery of fixed cost.
(1.1) Fixed Overhead Expenditure Variance
The difference between the budgeted and actual fixed cost for the period.
(1.2) Fixed Overhead Volume Variance
That part of the fixed overhead variance which is due to the difference between the budgeted and actual level of activity and its effect on the overhead recovered.
(1.3) Fixed Overhead Capacity Variance
That part of the volume variance which is due to the difference between the budget or planned capacity in standard hours and the actual capacity expressed as hours worked, and its effect on overhead recovered.
(1.4) Fixed Overhead Efficiency Variance
That part of the volume variance which is due to the efficiency of labour.

Before illustrating fully the preparation and analysis of the fixed overhead variance, I wish to focus on the key control ratios. They form an essential part of any variance analysis report to cost centre management and are an aid to interpreting and analysing the fixed overhead variance.

These ratios include:

  • Productivity – efficiency;
  • Utilisation – capacity;
  • Production Volume – activity.

These ratios use the concept of the standard hour, which allows management to express budgeted and actual levels of activity in terms of the standard hour.

The ratios are expressed as:

  • Efficiency
    Standard hours produced x 100/1
    Actual hours worked
  • Capacity
    Actual hours worked x 100/1
    Budget, standard hours
  • Activity
    Standard hours produced x 100/1
    Budget, standard hours

The efficiency ratio is a measure of the effectiveness of the workforce, capacity a measure of utilisation and activity a measure of production volume.

I wish to use the model of ‘the control ratios’ to illustrate fully the application and analysis of the fixed overhead variance and the link with these measures.

The case study which follows focuses on these concepts.

Case study
Cuecraft manufactures snooker cues and the budget and actual data for the quarter January–March 2001 was:
  January February March Total
Production and sales in units standard hours/ unit 4 2000 2500 3000 7500
Actual production and sales in units 2300 2600 3100 8000
Actual hours worked 9430 10140 12555 32125
Budgeted fixed overhead for quarter £84,000
Actual fixed overhead incurred £84,350

Firstly, I wish to consider the control ratios for the period:
Production and sales units budgeted 7500
Standard hours/unit 4
Budget standard hours 30000
Actual production and sales in units 8000
Standard hours produced 32000
Actual hours worked 32125

Efficiency Ratio
32000 x 100
32125        1
= 99.6%

Capacity Ratio
32125 x 100
30000       1
= 107.1%

Activity Ratio
32000 x 100
30000      1
= 106.7%

We can clearly see that production volume is favourable and is approximately 7 per cent greater than planned. As the efficiency is only marginally adverse, the additional volume has been achieved by management allowing more hours to be worked to meet the increased demand.

In order to prepare and present the fixed overhead variance and its full analysis, a fixed overhead recovery rate needs to be calculated for the period (FORR).

Budget fixed overhead
Budget standard hours

£84,000 = £2.80 per standard hour

If fixed costs remain in line with budget, and the volume planned is achieved, the fixed costs will be fully recovered.

1 Fixed Overhead Variance
Fixed overhead recovered in the period less the fixed overhead incurred.

32,000 standard hours x £2.80 89,600
Actual incurred 84,350

This is favourable variance and represents an over-recovery of fixed overhead during the period.

1.1 Fixed Overhead Expenditure Variance
Budget fixed overhead less actual incurred. £84,000 – £84,350 = £(350). This adverse variance indicates a marginal overspend on fixed costs for the period.

1.2 Fixed Overhead Volume Variance
(Budget standard hours – standard hours produced) FORR
(30,000 – 32,000) £2.80 = £5,600 F.

As the level of production volume is favourable, i.e. the level of activity is up, then an over-recovery results. There is a direct link here with the activity ratio, which was 106.7 per cent for the period. Volume = activity.

The favourable volume variance is highlighted by a favourable activity ratio. Full recovery of fixed overhead being planned on an activity of 7,500 units or 30,000 standard hours.

1.3 Fixed Overhead Efficiency Variance
As we have a marginally adverse efficiency ratio, then there will be an adverse fixed overhead efficiency variance.

(Standard hours produced – actual hours worked) FORR
(32,000 – 32,125) £2.80 = (350)

This represents an under-recovery due to the inefficiency of the workforce.

1.4 Fixed Overhead Capacity Variance
As the management increased the hours available in the period, as shown by the capacity ratio at 107.1 per cent, it is obvious that a favourable variance will be highlighted here.

(Budget standard hours – actual hours worked) FORR
(30,000 – 32,125) £2.80 = £5,950 F

Summary of variances

Fixed overhead variance £5,250F
Fixed overhead expenditure variance (350)
Fixed overhead volume variance £5,600F

NB: The volume variance comprises fixed overhead efficiency variance of (350) and fixed overhead capacity variance of £5,950 F.

This illustrates that under or over-recovery of fixed overhead in the short run is influenced by either expenditure and/or volume. The level of activity is directly affected by the efficiency of the workforce or by management providing the capacity, or a combination of both.