Overhead Variance

Definition

Overhead variance is the difference between the actual overhead costs incurred and the overhead costs that were applied to products or services based on a predetermined rate. This variance is essential for assessing how well a company is managing its overhead costs and can indicate issues such as over- or under-application of overhead, which impacts overall profitability. Understanding overhead variance helps businesses in making strategic decisions regarding pricing, budgeting, and operational efficiency.

5 Must Know Facts For Your Next Test

1. Overhead variance can be broken down into two main components: the spending variance, which measures the difference between actual costs and expected costs, and the efficiency variance, which evaluates how effectively the overhead was applied based on actual activity levels.
2. A significant overhead variance can signal inefficiencies in production processes or changes in cost structures that need to be addressed to maintain profitability.
3. Monitoring overhead variance regularly enables companies to adjust their pricing strategies and improve budgeting accuracy for future periods.
4. Under-applied overhead occurs when the applied overhead is less than the actual overhead incurred, often indicating that production was higher than expected or costs increased unexpectedly.
5. Over-applied overhead happens when the applied overhead exceeds actual costs, suggesting that production was lower than planned or costs decreased unexpectedly.

Review Questions

• How does overhead variance help businesses evaluate their cost management strategies?
  • Overhead variance provides critical insights into how well a business is managing its indirect costs. By comparing actual overhead incurred to what was budgeted or applied, companies can identify areas where they are overspending or saving. This evaluation allows businesses to fine-tune their operational processes, improve cost control measures, and adjust pricing strategies to better align with financial goals.
• What are the implications of having a consistent under-applied overhead variance for a manufacturing company?
  • A consistent under-applied overhead variance indicates that a manufacturing company is regularly incurring higher actual overhead costs than what it has allocated based on its predetermined rates. This situation can lead to reduced profitability and may prompt management to investigate operational inefficiencies or rising costs. Additionally, it can signal a need for revising the predetermined overhead rate to better reflect current conditions and accurately predict future expenses.
• Evaluate the impact of both fixed and variable overhead on the calculation of overhead variances within a business context.
  • In evaluating overhead variances, understanding fixed and variable overhead is crucial. Fixed overhead remains constant regardless of production levels, meaning it can lead to over- or under-applied variances if production volume changes significantly. Variable overhead fluctuates directly with production levels, making its application more responsive but also more volatile. Analyzing these variances helps businesses identify not only overall performance but also specific areas where cost control is essential. This comprehensive understanding supports strategic decisions regarding resource allocation and operational improvements.

Related terms

Predetermined Overhead Rate: A rate calculated before the accounting period begins, used to allocate estimated overhead costs to products based on a specific activity level, like direct labor hours or machine hours.

Variance Analysis: The process of evaluating the differences between planned financial outcomes and actual financial outcomes to understand the causes of discrepancies.

Fixed and Variable Overhead: Fixed overhead refers to costs that do not change with production levels, while variable overhead fluctuates with production volume, impacting how variances are calculated.