How to Plan Variable Overhead Costs in Cost Accounting

In cost accounting, you plan variable overhead costs using a process similar to planning fixed overhead. Your goal is to plan overhead costs, compare your plan (budgeted) amounts to actual spending (real life), and review any variances. When you understand the variances, you may be able to make changes to reduce costs.

Consider variable overhead in planning in cost accounting

Think (try always to think, think, think) about variable overhead costs in the planning stage before you start writing checks. The idea is to avoid a knee-jerk decision that may result in false allocation of costs, causing you to spend more than necessary.

Any time you fail to plan or schedule, you may end up reacting to a situation when you should have implemented a plan. You run the risk of overspending; then you have to work twice as hard just to put out the fire. Poor allocation of overhead costs gives you gray hairs, and constant hassles shorten your life span.

There’s good news with variable overhead: It’s easier to spot and fix variable overhead overspending than fixed overhead overspending. By definition, variable overhead changes (being variable) with the level of activity, so if you think you’re overspending on variable overhead, you may be able to slow — or stop — the production process and investigate.

You’re less concerned with your required capacity when you plan variable overhead. You can start and stop production, which means that you can start and stop variable overhead spending. If for some reason you need to increase production by 10,000 units, you can add variable overhead as needed.

Figure budgeted costs and activity levels in cost accounting

Say you manage a business that produces tires for cars. You need to compute a cost allocation rate for your tire production. This rate explains how much variable overhead you’ve budgeted, based on some measurement of activity.

In planning, you determine that the cost pool for variable manufacturing overhead is repair and maintenance costs for the machinery. The annual budgeted cost is $36,000. Your cost allocation base is machine hours, the same basis as for fixed overhead. The total budgeted machine hours are 20,000.

Compute a cost allocation rate:

Budgeted cost allocation rate = cost ÷ machine hours
Budgeted cost allocation rate = $36,000 ÷ 20,000
Budgeted cost allocation rate = $1.80 per machine hour

The $1.80 per machine hour is also the flexible budget variable manufacturing overhead per machine hour. This says that you are planning to spend $1.80 on repair and maintenance for every hour the machine runs. A flexible budget applies actual production to budgeted costs and activity levels.

Keep in mind that the allocation base for fixed and variable overhead isn’t always the same. In this case, using machine hours for both types of overhead makes sense. That activity is driving both fixed overhead (utility cost, for example) and the variable overhead (repair and maintenance costs). The more the machines run, the more utility and maintenance costs you are likely to have.

Say the actual tire output for the period was 5,000 units (tires). You can now compute flexible budget machine hours per output. This is a new term that was not used for fixed overhead.

Flexible budget machine hours per output = machine hours ÷ units (output)
Flexible budget machine hours per output = 20,000 hours ÷ 5,000 units
Flexible budget machine hours per output = 4 hours

Each tire (unit) produced requires 4 hours of machine time. You use budgeted machine hours (from the cost allocation rate) and actual units produced.

Now pause for just a minute and consider the two previous formulas:

  • Budgeted cost allocation rate: Total cost divided by total machine hours

  • Flexible budget machine hours per output: Total machine hours divided by units produced

A cost allocation rate is always a total cost divided by some level of activity. In this case, it’s machine hours. Machine hours per output is calculated as a level of activity (machine hours) divided by units produced. Read the bullet points and this paragraph a second time, if you need to. It’s a difficult concept but an important one.

Adding in actual costs and activity levels in cost accounting

You need data from actual costs and activity levels to perform your variance analysis. Your actual variable overhead costs totaled $38,000. You used 18,000 hours of actual machine time.

Actual machine hours per output explains how many machine hours you used per actual unit produced:

Actual machine hours per output = actual machine hours ÷ actual units (output)
Actual machine hours per output = 18,000 ÷ 5,000
Actual machine hours per output = 3.6 hours

Earlier you noted a flexible budget of 4 hours per unit. The actual hours, 3.6, are less than you planned. Using fewer hours will generate a favorable variance. You used less than you budgeted.

You can calculate the cost for each machine hour by applying actual variable manufacturing overhead per machine hour:

Actual variable manufacturing overhead per machine hour = budgeted cost ÷ budgeted machine hours
Actual variable manufacturing overhead per machine hour = $38,000 ÷ 18,000
Actual variable manufacturing overhead per machine hour = $2.11 per machine hour
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