Do you know all of your costs of operation? You probably keep up with the direct cost of labor and direct materials costs, and you've heard about allocating fixed overhead. But what about your variable overhead costs? Are variable manufacturing overhead expenses included in your standard costs budgets? Are they being properly allocated to your unit product cost of production? If not, let's find out how to calculate and allocate variable overhead costs.
While the direct costs of labor and materials are usually easy to calculate based on production volumes, variable overhead costs are not so easy. Variable manufacturing costs vary roughly with changes in production volumes.
A few examples of variable overhead costs are:
- Utilities such as gas, electric and water to operate equipment
- Production supplies like glues and cleaning items
- Wages for materials handling, shipping and delivery
- Maintenance that uses oils, greases and small tools
Variable overhead expenses are usually allocated to unit production costs in two ways: the number of direct labor hours or the number of machine hours. The choice depends on whether the manufacturing process is labor-intensive or is more automated.
Let's take the example of the Hasty Hare Corporation. Hasty Hare uses a highly-automated manufacturing process to make sneakers for rabbits. We have the following variable manufacturing cost examples about their operations:
- Production volume per month - 2,000 pairs of sneakers
- Machine hours used - 160 hours/month (40 hours/week for 4 weeks)
- Direct labor cost per pair - $25
- Materials cost per pair - $45
- Fixed overhead expenses - $20,000
- Selling price - $155
- Variable overhead costs based on production volume 2,000 pairs:
- Electricity - $8,000
- Gas - $3,000
- Water - $1,200
- Production supplies - $3,000
- Warehouse labor - $8,000
- Maintenance - $4,000
- Total variable overhead costs - $27,200
The calculation for the total production cost of a pair of sneakers is:
- Variable overhead cost per pair - $13.60 ($27,200 divided by 2,000 pairs)
- Variable overhead cost per machine hour - $170 ($27,200 divided by 160 hours)
- The total cost of production for a pair of sneakers becomes:
- Direct labor - $25
- Direct materials - $45
- Variable overhead costs - $13.60
- Fixed overhead - $10 ($20,000 divided by 2,000 pairs)
- Total production cost per pair - $93.60
With a selling price of $155 and a total production cost of $93.60, the gross profit becomes $61.40 per pair, or a gross margin of 40% ($61.40 divided by $155).
A variable overhead spending variance is the difference the actual costs and what it should have cost based on the activity level. Variances can be either favorable or unfavorable.
Favorable variances can include:
- Economies of scale gained from spreading overhead costs over a larger production volume.
- A decrease in costs of indirect supplies.
- Increased efficiency gained from installation of better performing equipment.
Unfavorable variances can be the result of:
- An increase in wage rates of indirect labor.
- An increase in utility costs per unit when declines in production volume are not offset by resetting of machines to smaller batches.
A variable overhead efficiency variance formula calculates the difference between the standard number of manufacturing hours expected to produce a unit and the actual number of hours that it took.
Favorable efficiency variances, taking fewer manufacturing hours, can come from:
- Using raw materials that are easier to handle and reduce hours it takes to make a unit.
- Employing better-skilled labor that leads to improvements in productivity.
- Installing more efficient equipment.
Unfavorable efficiency variances, taking more manufacturing hours than budgeted, could be the result of:
- Using cheaper materials that are hard to work with and take more time.
- Employing lower-skilled labor at a cheaper wage but are inefficient and take longer to produce a unit.
- A decline in production output because of wear and tear on equipment.
Just calculating the cost of direct labor and materials is not the end of the story when determining the actual cost of production. All variable overhead costs must be included and allocated across the production volume.