Standard Costing

"Fixed" manufacturing overhead costs remain the same in total even though the volume of production may increase by a modest amount. For example, the property tax on the manufacturing facility might be $50,000 per year and it arrives as one tax bill in December. The amount of the property tax bill was not dependent on the number of units produced or the number of machine hours that the plant operated. Other examples include the depreciation or rent on production facilities; salaries of production managers and supervisors; and professional memberships and training for personnel in the manufacturing area. Although the fixed manufacturing overhead costs present themselves as large monthly or annual expenses, they are, in reality, a small part of each product's cost.

DenimWorks has two fixed manufacturing overhead costs:

Rent for space per month including heat/air	$600
Rent for equipment per month	$100
Total Fixed Manufacturing Overhead per Month	$700

A small amount of these fixed manufacturing costs must be allocated to each apron produced. This is known as absorption costing and it explains why some accountants say that each product must "absorb" a portion of the fixed manufacturing overhead costs.

A simple way to assign or allocate the fixed costs is to base it on things such as direct labor hours, machine hours, or pounds of direct material. (Accountants realize that this is simplistic; they know that overhead costs are a result of—or are driven by—many different factors.) Nonetheless, we will assign the fixed manufacturing overhead costs to the aprons by using the same method we used for variable manufacturing overhead—by using direct labor hours.

Establishing a Predetermined Rate

Companies typically establish a standard fixed manufacturing overhead rate prior to the start of the year and then use that rate for the full year. Let's assume it is December 2006 and DenimWorks is developing the standard fixed manufacturing overhead rate to use in 2007. (As mentioned above, we will assign the fixed manufacturing overhead on the basis of direct labor hours.)

Step 1.	Project/estimate the fixed manufacturing overhead costs for the year 2007. We indicated above that DenimWorks' only fixed manufacturing overhead costs are rents of $700 per month (space and equipment) totaling to $8,400 for the year 2007.
Step 2.	Project/estimate the total number of standard direct labor hours that are needed to manufacture your products during 2007.

We can do that from the information given earlier (and repeated here):

	Large Apron	Small Apron	Total
Time required to cut and sew - the standard	0.3 hr. (18 min.)	0.2 hr. (12 min.)
Planned production for the year 2007	5,000 aprons	3,000 aprons
Total standard direct labor hours in the planned production for the year 2007	1,500	600	2,100

Step 3.

Compute the standard fixed manufacturing overhead rate to be used in 2006. = Expected fixed manufacturing overhead for 2007 ÷ Expected total standard direct labors hours (DLH) for 2007 = $8,400 ÷ 2,100 Standard DLH = $4 per Standard Direct Labor Hour

Fixed Manufacturing Overhead Budget Variance

The difference between the actual amount of fixed manufacturing overhead and the estimated amount (the amount budgeted when setting the overhead rate prior to the start of the year) is known as the fixed manufacturing overhead budget variance.

In our example, we budgeted the annual fixed manufacturing overhead at $8,400 (monthly rents of $700 x 12 months). If DenimWorks pays more than $8,400 for the year, there is an unfavorable budget variance; if the company pays less than $8,400 for the year, there is a favorable budget variance.

Fixed Manufacturing Overhead Volume Variance

Recall that the fixed manufacturing overhead (such as the large amount of rent paid at the start of every month) must be assigned to each apron produced. In other words, each apron must absorb a small portion of the fixed manufacturing overhead. At DenimWorks, the fixed manufacturing overhead is assigned to the good output by multiplying the standard rate by the standard hours of direct labor in each apron. Hopefully, by the end of the year there are enough good aprons produced to absorb all of the fixed manufacturing overhead.

The fixed manufacturing overhead volume variance compares the amount of fixed manufacturing overhead budgeted to the amount that was applied to (or absorbed by) the good output. If the amount applied is less than the amount budgeted, there is an unfavorable volume variance—there was not enough good output to absorb the budgeted amount of fixed manufacturing overhead. If the amount applied to the good output is greater than the budgeted amount of fixed manufacturing overhead, the fixed manufacturing overhead volume variance is favorable. In summary, if DenimWorks applies more than the amount budgeted, the volume variance is favorable; if it applies less than the amount budgeted, the volume variance is unfavorable.

Illustration of Fixed Manufacturing Overhead Variances for 2007

Let's assume that in 2007 DenimWorks manufactures (has actual good output of) 5,300 large aprons and 2,600 small aprons. Let's also assume that the actual fixed manufacturing overhead costs for the year are $8,700. As we calculated earlier, the standard fixed manufacturing overhead rate is $4 per standard direct labor hour.

We begin by determining the fixed manufacturing overhead applied to (or absorbed by) the good output produced in the year 2007:

	Large Aprons	Small Aprons	Total
Actual aprons manufactured	5,300	2,600
Standard hours of direct labor hours per apron manufactured	0.3 hr.	0.2 hr.
Total standard hours of direct labor in the good aprons manufactured	1,590 hr.	520 hr.	2,110 hr.
Standard cost per direct labor hour for fixed manufacturing overhead	$4	$4	$4
Standard cost of fixed manufacturing overhead in (applied to) the good output	$6,360	$2,080	$8,440

Our analysis looks like this:

Fixed Manufacturing Overhead Analysis for the Year 2007:

4. Actual fixed manufacturing overhead	5. Fixed manufacturing overhead budget variance Budgeted Amount - Actual Amount	2. Fixed manufacturing overhead budget for the year 2007	3. Fixed manufacturing overhead volume variance (1 - 2)	1. Debit Inventory-FG for the standard hours of direct labor that should be in the good output x the standard fixed manufacturing overhead rate
Actual Amount	Difference	Annual Budget	Difference	Std Hr x Std Rate
				2,110 std hr x $4
$8,700		$8,400		$8,440
	$300 Unfavorable		$40 Favorable

This analysis shows that the actual fixed manufacturing overhead costs are $8,700 and the fixed manufacturing overhead costs applied to the good output are $8,440. This unfavorable difference of $260 agrees to the sum of the two variances:

Fixed manufacturing overhead volume variance	$  40 Favorable
Fixed manufacturing overhead budget variance	$300 Unfavorable
Total Fixed Manufacturing Overhead Variance	$260 Unfavorable

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

Date	Account Name		Debit	Credit
During 2007	Fixed Mfg. O/H Incurred		8,700
		Accounts Payable		8,700

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

Date	Account Name		Debit	Credit
During 2007	Inventory-FG		8,440
		Fixed Mfg. O/H Applied		8,440

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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