Fixed Manufacturing Overhead: Standard Cost, Budget Variance, Volume Variance
Fixed manufacturing overhead costs remain the same in total even though the production volume increased by a modest amount. For example, the property tax on a large manufacturing facility might be $50,000 per year and it arrives as one tax bill in December. The amount of the property tax bill did not depend on the number of units produced or the number of machine hours that the plant operated. A few of the many examples of fixed manufacturing overhead costs include the depreciation or rent on production facilities; salaries of production managers and maintenance supervisors; and professional memberships and training for managers in the manufacturing area. Although the fixed manufacturing overhead costs present themselves as large monthly or annual expenses, they are part of each product's cost.
DenimWorks has two fixed manufacturing overhead costs:
A portion of these fixed manufacturing overhead 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 caused by many different factors. Nonetheless, we will assign the fixed manufacturing overhead costs to the aprons by using the 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 entire year. Let's assume it is December 2019 and DenimWorks is developing the standard fixed manufacturing overhead rate for use in 2020. As mentioned above, we will assign the fixed manufacturing overhead on the basis of direct labor hours.
Estimate the fixed manufacturing overhead costs for the year 2020.
We indicated above that the fixed manufacturing overhead costs are the rents of $700 per month, or $8,400 for the year 2020.
Estimate the total number of standard direct labor hours that are needed to manufacture your products during 2020.
We can estimate the direct labor hours from the information given earlier (and repeated here):
Compute the standard fixed manufacturing rate to be used in 2020.
One reason a company develops a predetermined annual rate is to have a uniform rate for all months. If the company used monthly rates, the rate would be high in the months when few units are produced (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).
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 costs (such as the large amount of rent paid at the start of every month) must be assigned to the aprons produced. In other words, each apron must absorb a small portion of the fixed manufacturing overhead costs. 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 will be enough good aprons produced to absorb all of the fixed manufacturing overhead costs.
The fixed manufacturing overhead volume variance is the difference between 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. This means 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.
Illustration of Fixed Manufacturing Overhead Variances for 2020
Let's assume that in 2020 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 2020. Recall that we apply the overhead costs to the aprons by using the standard amount of direct labor hours.
Our analysis looks like this:
Fixed Manufacturing Overhead Analysis for the Year 2020:
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:
The 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 how to report the balances in the variance accounts under the heading What To Do With Variance Amounts.