Overhead spending variance

What Is Overhead Spending Variance?

Overhead spending variance is a key concept in management accounting that measures the difference between the actual overhead costs incurred and the standard (or budgeted) overhead costs that should have been incurred for a given level of activity. It is a crucial component of variance analysis, providing insights into how efficiently an organization controls its indirect costs. This variance helps identify whether a company has spent more or less than expected on its general operating expenses, which include both fixed overhead and variable overhead. By analyzing this metric, businesses can pinpoint areas of overspending or cost savings, facilitating better cost control and operational adjustments.

History and Origin

The foundational principles of modern cost accounting, including variance analysis, began to formalize around the turn of the 20th century, driven by the needs of increasingly complex industrial enterprises. Early developments focused on establishing "standard costs" as benchmarks against which actual costs could be compared. G. Charter Harrison is often credited with designing one of the earliest complete standard costing systems in the early 1910s. Notably, in 1911, Harrison published the first set of equations specifically for the analysis of cost variances, laying critical groundwork for techniques like overhead spending variance analysis that became widely adopted in subsequent decades.⁹ This period saw the emergence of management accounting practices aimed at enhancing efficiency and control within manufacturing firms, moving beyond simple historical cost tracking to more analytical approaches for planning and control.⁸

Key Takeaways

• Definition: Overhead spending variance quantifies the difference between actual overhead expenses and the budgeted overhead for the actual level of activity.
• Purpose: It helps management understand whether actual spending on overhead items was higher (unfavorable) or lower (favorable) than anticipated.
• Components: This variance considers both fixed and variable overhead costs, often analyzed at the aggregate level for spending.
• Actionable Insights: Significant variances prompt further investigation into the causes, enabling corrective actions or adjustments to future budgeting.
• Performance Monitoring: It is a vital tool for performance measurement, highlighting management's effectiveness in controlling non-production costs.

Formula and Calculation

The overhead spending variance is calculated by comparing the actual overhead costs incurred to the budgeted overhead costs for the actual hours worked (or other activity base).

The formula for overhead spending variance can be broken down as:

To calculate the budgeted overhead costs, a flexible budget approach is often used, which adjusts the static budget to the actual activity level achieved. Therefore, the formula can be expanded for variable and fixed components:

Where:

• Actual Overhead Costs: The total actual amount spent on overhead (both variable and fixed components).
• Budgeted Overhead Costs: The amount of overhead that should have been spent according to the budget, adjusted for the actual level of activity.
• Standard Variable Overhead Rate: The predetermined rate at which variable overhead is expected to be incurred per unit of activity (e.g., per direct labor hour, per machine hour).
• Actual Activity Hours: The actual number of hours (or other activity base) worked.
• Budgeted Fixed Overhead: The total fixed overhead costs planned for the period, which typically remains constant regardless of activity level within a relevant range.

Interpreting the Overhead Spending Variance

Interpreting the overhead spending variance involves determining whether the variance is favorable or unfavorable and then investigating the underlying reasons. A favorable overhead spending variance occurs when the actual overhead costs are less than the budgeted overhead costs for the actual level of activity. This indicates that the company spent less than anticipated on overhead, which could be due to effective cost management, unexpected price reductions for overhead items, or lower-than-expected utility usage.

Conversely, an unfavorable overhead spending variance arises when actual overhead costs exceed the budgeted overhead costs. This suggests that the company spent more than planned on its overhead, possibly due to increases in utility rates, higher repair and maintenance expenses, or less effective cost control measures. Management uses this variance as a signal to delve deeper into the specific line items contributing to the deviation. For example, a large unfavorable variance might prompt an investigation into energy consumption or equipment maintenance schedules to improve cost control and enhance future performance measurement.

Hypothetical Example

Consider "Alpha Manufacturing Inc.," which produces widgets. For the month of July, Alpha Manufacturing had the following standard costing and actual figures related to its overhead:

• Budgeted Fixed Overhead: $10,000
• Standard Variable Overhead Rate: $2.00 per direct labor hour
• Budgeted Direct Labor Hours: 5,000 hours
• Actual Direct Labor Hours Worked: 5,200 hours
• Actual Fixed Overhead: $10,500
• Actual Variable Overhead: $10,800

To calculate the overhead spending variance:

1. Calculate Budgeted Variable Overhead for Actual Hours:
   Standard Variable Overhead Rate (\times) Actual Activity Hours = $2.00/hour (\times) 5,200 hours = $10,400

2. Calculate Total Budgeted Overhead for Actual Hours:
   Budgeted Variable Overhead (at actual hours) + Budgeted Fixed Overhead = $10,400 + $10,000 = $20,400

3. Calculate Total Actual Overhead:
   Actual Variable Overhead + Actual Fixed Overhead = $10,800 + $10,500 = $21,300

4. Calculate Overhead Spending Variance:
   Actual Overhead Costs - Budgeted Overhead Costs = $21,300 - $20,400 = $900

In this hypothetical example, Alpha Manufacturing Inc. has an unfavorable overhead spending variance of $900. This means the company spent $900 more on overhead than it should have, given its actual production activity. This unfavorable variance prompts management to investigate the causes, such as higher utility bills or unexpected repair costs, to understand where the additional actual costs were incurred and take appropriate corrective action.

Practical Applications

Overhead spending variance is a vital tool for internal decision-making within organizations, helping management improve efficiency and profitability. In manufacturing, it helps assess how effectively factory managers control costs like utilities, indirect labor, and depreciation. For example, if a division has a consistently unfavorable overhead spending variance, it may signal issues with maintenance practices or energy consumption that require attention.⁷

Beyond manufacturing, service-based companies also utilize this variance to manage expenses like office rent, administrative salaries, and technology costs. It provides insights into deviations from planned spending, allowing for timely interventions. The Institute of Management Accountants (IMA) highlights that management accountants leverage skills in preparing cost reports and performing variance analysis to provide expertise in financial reporting and control, supporting an organization's strategic objectives.⁶ By regularly analyzing overhead spending variance as part of a comprehensive variance analysis process, businesses can refine their budgeting and forecasting, optimize resource allocation, and enhance overall cost control⁵.

Limitations and Criticisms

While overhead spending variance provides valuable insights, it also has limitations and faces criticisms. One common critique is that it relies on historical data and predetermined standards, which may not always reflect dynamic operational environments. If standards are not regularly updated or accurately set, the resulting variances can be misleading.⁴ For instance, if unexpected market changes cause a sudden increase in utility costs, an unfavorable overhead spending variance might simply reflect external conditions rather than internal inefficiency.

Another criticism is that a strong focus on variance analysis can sometimes lead to dysfunctional behavior. Managers might engage in short-term cost-cutting measures that harm long-term quality or strategic goals simply to achieve a favorable variance.³ Additionally, in highly automated or complex production environments, attributing specific spending variances to individual responsibility centers can be challenging. The effectiveness of variance analysis, including overhead spending variance, heavily depends on the accuracy and reliability of the underlying data.² Companies may face challenges in effectively implementing and leveraging variance analysis if there is resistance to data-driven decision-making, a lack of communication between departments, or siloed information systems.¹

Overhead Spending Variance vs. Overhead Efficiency Variance

Overhead spending variance and overhead efficiency variance are two distinct components of overhead variance analysis, each providing different insights into how efficiently and effectively a company manages its overhead costs. While both aim to compare actual results to budgeted figures, they focus on different aspects of overhead performance.

Overhead Spending Variance primarily focuses on the price paid for overhead items and the overall control of overhead expenditures. It answers the question: "Did we spend more or less than planned on overhead, considering the actual activity level?" This variance isolates the impact of changes in the cost per unit of overhead resources (e.g., utility rates, indirect material prices) or discretionary spending decisions on overall overhead costs.

Overhead Efficiency Variance, in contrast, focuses on the efficiency with which the underlying activity base (e.g., direct labor hours, machine hours) was utilized relative to what was expected for the actual output achieved. It answers the question: "Were we efficient in using the resources that drive our variable overhead costs, given the actual production output?" This variance specifically measures the impact of actual activity hours differing from the standard hours allowed for the actual output. For example, if workers took more direct labor hours than standard to produce a batch of goods, it would result in an unfavorable overhead efficiency variance for variable overhead, regardless of the cost of those hours.

In essence, the spending variance looks at what was paid, while the efficiency variance looks at how effectively the resources were used in relation to output. Both are crucial for a comprehensive understanding of overhead performance, as one can have a favorable spending variance (due to lower costs) but an unfavorable efficiency variance (due to wasted effort or resources), or vice versa.

FAQs

What does a favorable overhead spending variance indicate?

A favorable overhead spending variance means that the actual costs incurred for overhead were less than the budgeted amount for the actual level of activity. This suggests effective cost control, lower-than-expected prices for overhead items, or efficient management of resources.

What causes an unfavorable overhead spending variance?

An unfavorable overhead spending variance typically results from actual overhead expenses exceeding the budgeted amount. Common causes include increases in the price of utilities, higher-than-anticipated repair and maintenance costs, unexpected increases in indirect material prices, or poor control over discretionary spending on overhead items.

How is overhead spending variance different from other cost variances?

Overhead spending variance specifically isolates the difference between actual and budgeted overhead expenditures. Other cost variances, like direct material price variance or direct labor rate variance, focus on the cost deviations of direct costs (materials and labor, respectively). Separately, overhead efficiency variance focuses on the usage of the activity base for variable overhead, not the cost itself.

Why is overhead spending variance important for a business?

Overhead spending variance is crucial for performance measurement and cost control. By highlighting deviations from planned spending, it enables management to investigate root causes, take corrective actions, refine future budgeting, and make informed decisions to improve profitability and operational efficiency.