Task 6 of the Financial Performance assessment covers variance analysis, and this is one of the tasks that we see our students have the most difficulty with.
A particular area which students commonly struggle with in this task stems from the calculation and interpretation of fixed overhead variances.
To further complicate the problem, these variances can be calculated either under a marginal costing system, where fixed overheads are not absorbed into units of production but are instead considered a period cost or an absorption costing system, where fixed overheads are absorbed into units of production.
Here we will focus on under/over absorption costing fixed overhead variances.
The Total Fixed Overhead Variance (Figure 1) under absorption costing is equal to the under or over-absorption of fixed overheads. To arrive at under or over-absorbed overheads for a period, absorbed overheads are compared with actual overheads.
If absorbed overheads are greater than the actual overhead cost then this leads to over-absorption of fixed overheads or a favourable total fixed overhead variance. The reason why this is a favourable variance is because overheads charged in the period to units of production, are greater than those actually incurred. This means that the expense in the Income Statement for fixed overheads needs to be reduced (which is good).
Fixed overhead variances
Under an absorption costing system, the reasons for the under or over-absorption of fixed overheads are explained by the fixed overhead variances. You will see in figure 1 that any under or over-absorption of fixed overheads is due to either an expenditure variance and/or a volume variance.
Total Fixed Overhead Variance = Under/Over absorption
The expenditure variance is simple to understand and calculate. It is calculated by comparing the budgeted fixed overhead cost and the actual fixed overhead cost. If we spent more on fixed overheads than budgeted than this leads to an adverse variance.
The volume variance looks at volume of activity and compares the number of units that were budgeted to be produced, with the actual number of units produced. On comparing these two figures we arrive at a variance in units. But all variances need to be quantified into monetary terms and this is done by multiplying the variance in units by the FOAR/unit (fixed overhead absorption rate per unit). If a greater number of units have been produced than budgeted, this then leads to a favourable volume variance. The reason for this is because it is beneficial if an organisation is able to produce a greater number of units at a given level of fixed cost.
Let’s look at example which should help to understand the points made.
|Standard data for period 6||
|Fixed overhead cost||£450,000|
|Actual data for period 6|
|Fixed overhead cost||£470.000|
Calculate the fixed overhead expenditure and volume variances.
In order to undertake the calculation of the volume variance, we will need to calculate the FOAR/unit to quantify the variance into pounds. This is calculated by using the formula for calculating a FOAR/unit of budgeted fixed overhead cost/budgeted production units (£450,000/9000) which gives us a FOAR of £50 per unit. In the exam, this figure will either be given directly or you will need to calculate in an earlier part of the question before you undertake the variance calculations.
|Fixed Overhead Expenditure Variance||
|Budgeted fixed overhead cost||£450,000|
|Actual fixed overhead cost||£470,000|
The variance is adverse because more has been spent than expected/budgeted.
|Fixed Overhead Volume Variance||
|X FOAR/unit (£450,000/9000 units)||´ £50|
These two sub-variances lead us to conclude that the Total Fixed Overhead Variance (sum of expenditure and volume) is equal to £70,000 (A) meaning that there has been under-absorption of £70,000 in the period. This can be proved as follows by comparing the absorbed and actual fixed overheads.
|Absorbed fixed overheads (8000 units x £50 FOAR/unit)||£400,000|
|Actual fixed overhead cost||£470,000|
In the example above, because fewer overheads have been absorbed than actually incurred, this leads to under-absorption of fixed overheads.
You will see from figure 1 that the volume variance can be further sub-divided into an efficiency variance and/or a capacity variance. This can be done when the FOAR can be calculated on an hourly basis but this will be considered in a later blog.
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