Study tips: Understanding fixed overhead variances

Explore over and under absorption of fixed overheads using variance analysis with our AAT tutor.

Tracking income and expenditure regularly as part of the process of monitoring and controlling budgets, is one of the primary purposes of standard costing

Flexing budgets and comparing the volume adjusted figures gives accurate variances, but requires a good understanding of how costs behave and can be a little confusing when it comes to fixed overhead variances.

Understanding fixed overhead variances requires us to build on our knowledge and understanding of calculating overhead absorption rates and determining over and under absorption, gained at the Advanced Diploma level. This means remembering that:

• fixed overheads can be absorbed into the cost of production on either a unit, machine hour or labour hour basis
• the overhead recovery/absorption rate is calculated in advance, based on estimates of the production levels and costs, and both production and non-production overheads
• when a budget is flexed, the fixed overheads figure is not flexed because fixed costs do not change with production volume
• however, actual fixed costs are often different to budgeted fixed costs, for reasons such as price changes.

A business that is seasonal and has fluctuating production levels might well need to monitor its overheads carefully.

Let’s say that we’re setting a budget to produce 10,000 units, with an estimated overhead cost of £17,500 in the quarter. At this point we’ll either have used a previously calculated standard absorption rate to estimate the overheads, or we’ll have estimated the costs and now must calculate the overhead absorption rate (OAR).

In this case, we can only calculate a rate per unit, which is £1.75 (£17,500 ÷ 10,000 units).

Therefore, £1.75 is added to the direct cost of each unit produced during the period, to ensure that by the end of the quarter £17,500 will have been recovered to pay the overhead costs, as long as the estimated production levels and costs are accurate.

Fast forwarding to the end of the quarter, let’s imagine that 12,500 units were actually produced. This means that £21,875 was recovered as the OAR would have been applied to all the units actually produced (12,500 units x £1.75).

Let’s say the actual cost of the overheads incurred in the period was £20,000. Therefore, the business has over-absorbed because £1,875 has been recovered in excess of the amount required to pay for the overheads. In effect, we have calculated the total fixed overhead variance, we just didn’t call it that at Advanced level.

The total fixed overhead variance is the difference between the amount that would be absorbed into the cost of the actual units produced, and the actual cost of the fixed overheads.

An adverse variance occurs when overheads have been under-absorbed, and a favourable variance means overheads are over-absorbed. So, we could have said that the fixed overhead variance is favourable by £1,875 instead of being over-absorbed.

Calculating sub-variances

This total variance can be further understood by calculating two sub-variances, the volume and expenditure variances.

The fixed overhead volume variance highlights how much of the total variance is caused by the increase or decrease in production levels, and the fixed overhead expenditure variance measures the difference between the budgeted cost and the actual cost.

We know that planned production was 10,000 units and actual production was 12,500 units, so an additional 2,500 units were made and an extra £4,375 recovered (2,500 units x £1.75). This is the volume variance and it’s favourable as more units were made than budgeted.

The expenditure variance is £2,500 adverse because the budgeted cost was £17,500 and the actual cost £20,000.

As long as they’re correctly calculated, the sub-variances reconcile with the total variance: £4,375 favourable less £2,500 adverse equals £1,875 favourable.

Whilst fixed costs do not vary with production levels, the over- or under-absorption of fixed overheads is directly linked to production levels.

If fewer units than planned are produced, then insufficient overheads may be recovered to cover the actual costs. This will directly impact an organisation’s overall performance and any under-absorbed overheads will be charged as a cost against profit in the accounts. Over-absorption, like in this example, will result in additional income.

Increased production can result in positive over-absorption, however, it can also be caused by inaccurate absorption rates being included in the standard cost which will result in unintentionally inflated sales prices.

In summary

It’s important to monitor all income and expenditure lines within a budget and understanding the reasons for the variances is essential to inform good decision making.