## Fixed Mfg Overhead: Standard Cost, Budget Variance, Volume Variance

"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:

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 2015 and DenimWorks is developing the standard fixed manufacturing overhead rate to use in 2016. (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 2016.

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 2016.

Step 2.
Project/estimate the total number of standard direct labor hours that are needed to manufacture your products during 2016.

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

Step 3.
Compute the standard fixed manufacturing rate to be used in 2016.

Note:

One of the reasons a company develops a predetermined annual rate is so that the rate is uniform throughout the year, even though the number of units manufactured may fluctuate month by month. For example, if the company used monthly rates, the rate would be high in the months when few units are manufactured (monthly fixed costs of \$700 ÷ 100 units produced = \$7 per unit) and low when many units are produced (monthly fixed costs of \$700 ÷ 350 units = \$2 per unit).

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.

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 2016

Let's assume that in 2016 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 2016:

Our analysis looks like this:

Fixed Manufacturing Overhead Analysis for the Year 2016:

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:

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:

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

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