## Variable Mfg Overhead: Standard Cost, Spending Variance, Efficiency Variance

"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 (such as needles and thread) that increase when production increases. 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:

### January 2016

Let's begin by determining the standard cost of variable manufacturing overhead for the good output that DenimWorks produces in January 2016:

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 2016:

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:

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.

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:

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

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:

### February 2016

Recall that in February 2016 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 2016:

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 2016:

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

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

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

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 2016 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".