Standard Costing

"Manufacturing overhead costs" refer to any costs within a manufacturing facility other than direct material and direct labor. Manufacturing overhead includes such things as indirect labor, indirect materials (such as manufacturing supplies), utilities, quality control, material handling, and depreciation on the manufacturing equipment and facilities.

"Variable" manufacturing overhead costs will increase in total as output increases. An example is the cost of the electricity needed to operate the machines that cut and sew the denim. Another example is the cost of the manufacturing supplies that increase when production increases (such as needles and thread). In our example we assume that these variable manufacturing overhead costs fluctuate in response to the number of direct labor hours. Recall the original estimates made when DenimWorks was formed:

		Large Apron	Small Apron
Time required to cut and sew		0.3 hr. (18 min.)	0.2 hr. (12 min.)
Electricity and supplies used per hour of labor	$2

January 2007

Let's begin by determining the standard cost of variable manufacturing overhead for the good output that DenimWorks produces in January 2007:

	Large Aprons	Small Aprons	Total
Actual aprons manufactured	100	60
Standard hours of direct labor per apron manufactured	0.3 hr.	0.2 hr.
Total standard hours of direct labor in the good aprons manufactured	30 hr.	12 hr.	42 hr.
Standard cost of variable manufacturing overhead per direct labor hour	$2	$2	$2
Standard cost of variable manufacturing overhead in the good output	$60	$24	$84

Recall that there were 50 actual direct labor hours in January. Let's assume that the actual cost for the variable manufacturing overhead (electricity and manufacturing supplies) during January is $90.

Our analysis will look like this:

Variable Manufacturing Overhead Analysis for January 2007:

4. Actual variable manufacturing overhead used	5. Variable manufacturing overhead spending variance Act Hr x (Std Rate - Act Rate)	2. Actual hours of direct labor used x the standard variable manufacturing overhead rate	3. Variable manufacturing overhead efficiency variance (Std Hr - Act Hr) x Std Rate	1. Debit Inventory-FG for the standard hours of direct labor that should have been used in the good output x the standard variable manufacturing overhead rate
Act Hr x Act Rate	Difference	Act Hr x Std Rate	Difference	Std Hr x Std Rate
50 act hr x $1.80*	50 act hr x $0.20	50 act hr x $2	(8 hr) x $2	42 std hr x $2
$90		$100		$84
	$10 Favorable		$16 Unfavorable

*Actual cost of $90 divided by 50 actual hours.

Notice that for the good output produced in January, the actual cost of variable manufacturing overhead was $90 and the total standard cost of variable manufacturing overhead cost allowed for the good output was $84. This unfavorable difference of $6 agrees to the sum of the two variances:

Variable manufacturing overhead efficiency variance	$16 Unfavorable
Variable manufacturing overhead spending variance	$10 Favorable
Total Variable Manufacturing Overhead	$ 6 Unfavorable

Variable Manufacturing Overhead Efficiency Variance

As the above analysis shows, DenimWorks did not produce the good output efficiently—it used 50 actual direct labor hours instead of the 42 standard direct labor hours allowed.

The additional 8 hours no doubt caused the company to use additional electricity and supplies. Measured at the originally estimated rate of $2 per direct labor hour, this amounts to $16 (8 hours x $2). This is referred to as an unfavorable variable manufacturing overhead efficiency variance.

Variable Manufacturing Overhead Spending Variance

In the analysis above, item 2 shows that based on the 50 direct labor hours actually used, electricity and supplies could reasonably add up to $100 instead of the standard of $84. (If the good output took 8 actual direct labor hours more than the standard hours to cut and sew the denim, the company will likely have additional electricity and supplies costs since it is operating the machines for an additional 8 hours.) We find, however, that the actual cost of the electricity and supplies is $90, not $100. This $10 favorable variance indicates that the company did not spend the planned $2 per direct labor hour. (Perhaps electricity rates were lower than the rates anticipated when the standard costs were established.)

Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits are made to accounts such as Accounts Payable. For example:

Date	Account Name		Debit	Credit
Jan. 31, 2007	Var. Mfg. O/H Incurred		90
		Accounts Payable		90

Another entry records how these overheads are assigned to the product based on standard costs:

Date	Account Name		Debit	Credit
Jan. 31, 2007	Inventory-FG		84
		Var. Mfg. O/H Applied		84

As our analysis notes above and these entries illustrate, DenimWorks has an actual variable manufacturing overhead of $90, but only $84 (the standard amount) was applied to the products. The $6 difference is "explained" by the two variances:

Variable manufacturing overhead efficiency variance	$16 Unfavorable
Variable manufacturing overhead spending variance	$10 Favorable
Total Variable Manufacturing Overhead	$ 6 Unfavorable

February 2007

Recall that in February 2007 the company produced 200 large aprons and 100 small aprons. We use that good output to compute the standard cost of variable manufacturing overhead for February 2007:

	Large Aprons	Small Aprons	Total
Actual aprons manufactured	200	100
Standard hours of direct labor per good apron manufactured	0.3 hr.	0.2 hr.
Total standard hours of direct labor in the good aprons manufactured	60 hr.	20 hr.	80 hr.
Standard cost of variable manufacturing overhead per direct labor hour	$2	$2	$2
Standard cost of variable manufacturing overhead in the good output	$120	$40	$160

Given that there were 75 actual direct labor hours in February and assuming that the actual cost for the variable manufacturing overhead in February was $156, our analysis will look like this:

Variable Manufacturing Overhead Analysis for February 2007:

4. Actual variable manufacturing overhead used	5. Variable manufacturing overhead spending variance Act Hr x (Std Rate - Act Rate)	2. Actual hours of direct labor used x the standard variable manufacturing overhead rate	3. Variable manufacturing overhead efficiency variance (Std Hr - Act Hr) x Std Rate	1. Debit Inventory-FG for the standard hours of direct labor that should have been used in the good output x the standard variable manufacturing overhead rate
Act Hr Act Rate	Difference	Act Hr x Std Rate	Difference	Std Hr x Std Rate
75 act hr x $2.08*	75 hr x ($0.08)	75 act hr x $2	5 hr x $2	80 std hr x $2
$156		$150		$160
	$6 Unfavorable		$10 Favorable

*Actual cost of $156 divided by 75 actual hours.

The favorable difference between the actual cost of $156 and the standard cost of $160 agrees to the sum of the two variances:

Variable manufacturing overhead efficiency variance	$10 Favorable
Variable manufacturing overhead spending variance	$ 6 Unfavorable
Total Variable Manufacturing Overhead	$ 4 Favorable

Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits are made to accounts such as Accounts Payable. For example:

Date	Account Name		Debit	Credit
Feb. 28, 2007	Var. Mfg. O/H Incurred		156
		Accounts Payable		156

Another entry records how these overheads are assigned to the product:

Date	Account Name		Debit	Credit
Feb. 28, 2007	Inventory-FG		160
		Var. Mfg. O/H Applied		160

As our analysis notes above and as these entries illustrate, even though DenimWorks had actual variable manufacturing overhead of $156, the standard amount of $160 was applied to the products. For the month of February 2007 the company applied more variable manufacturing overhead to its products than it actually incurred.

We will discuss later how to report the balances in the variance accounts under the heading "What To Do With Variance Amounts".

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