Product Costing Versus Cost Control for Variable and Fixed Overhead
There are two main purposes of any standard cost system in a manufacturing environment:
1. Product Costing to value inventory and COGS
2. Cost Control using some form of budget and standards.
The way these two purposes are accomplished differs for variable versus fixed mfg. overhead.
For Cost Control purposes, it is possible to determine a flexible budget using formula expressed
as a linear equation in which the slope is the variable cost per unit (or per direct labour hour). Graphically, this would appear as follows:
For Product Costing purposes, the variable overhead must be applied to the job using a standard variable overhead rate time the actual units. This gives us the variable overhead applied and
this application can likewise can be expressed as a linear function. In fact, both the linear function and the resulting graph will be identical to the function and graph used for Cost control purposes.
Hence both the Flexible budget line for variable overhead and the Variable Overhead Applied line will be identical in the case of variable overhead. Hence, on our variance diagrams, the std. x std amount on the far right of the diagram will be both the flexible budget and the variable
Fixed Mfg. Overhead is by definition a fixed cost that does not change with the level of activity. As a result, the Budgeted fixed overhead for control purposes would be shown graphically as follows:
However, when fixed overhead is applied to a product for Product Costing purposes, the fixed cost must be converted to a rate. This in effect, forces a lump sum fixed cost to be treated as if it were a variable cost.
When we calculate the fixed overhead rate, we must select a denominator volume as the divisor.
Fixed Overhead rate = _budgeted fixed overhead in $__
“denominator level” in units
The choice of denominator volume will directly affect the size of the fixed overhead rate. The higher the denominator level, the lower the fixed overhead rate. The denominator level is usually the expected master budget volume for the coming year (giving a relatively higher fixed MO rate) or some measure of plant capacity (giving a relatively lower MO rate).
Graphically, the Budgeted Fixed Overhead and the Applied Fixed Overhead appear as follows:
The only time the Fixed Overhead Budget and the Fixed Overhead Applied will be equal is if the business operates exactly at the denominator level. Either side of this level there is a gap between the two linear functions which we call a Volume Variance. The Volume Variance arises solely because you did not operate precisely at the denominator level.