Source: Cost Accounting textbook, Chapter 8 | The Ohio State University
Difficulty: Intermediate | Prerequisites: Familiarity with standard costing basics (Chapter 7), understanding of direct cost variances, and the distinction between variable and fixed costs.
Big picture: This chapter sits at the heart of managerial cost control. Once a company sets standard costs (covered in earlier chapters), it needs a way to evaluate whether overhead spending and efficiency are on track. Chapter 8 gives you the tools to do that: flexible budgets and variance analysis for both variable and fixed overhead. If you have been following direct materials and direct labour variances, think of this as the same logic applied to the messier, less visible cost pool of manufacturing overhead. Understanding these variances is essential for anyone who will interpret management accounting reports or sit a cost accounting exam.
Standard costing assigns costs to output using pre-set (budgeted) rates and quantities, then compares those to what was spent and used. For overhead, you split the analysis into variable overhead (where both spending and efficiency variances exist) and fixed overhead (where only a spending variance and a production-volume variance exist, never an efficiency variance). The whole point is to flag where costs drifted from the plan so managers can investigate.
Standard costing
A costing method that assigns costs to products using pre-determined (standard) prices and quantities rather than actual prices and quantities. Think of it as the budget translated into a per-unit rate: "each widget should cost this much to make."
Cost allocation base
The activity measure used to link an overhead cost pool to the products that cause it. Machine hours are the classic example. In simple terms, it is the thing you count to decide how much overhead each product should absorb.
Variable overhead spending variance
The difference between the actual variable overhead cost incurred and the amount that should have been spent for the actual quantity of the allocation base used. It isolates whether you paid more or less per unit of the cost driver than the budget assumed.
Variable overhead efficiency variance
The difference between the actual quantity of the allocation base used and the standard quantity allowed, multiplied by the budgeted variable overhead rate. It tells you whether you used the cost driver (e.g. machine hours) more or less efficiently than expected.
Fixed overhead spending variance (budget variance)
The difference between actual fixed overhead incurred and budgeted fixed overhead. Because fixed costs do not change with volume by definition, this variance captures only whether total fixed spending was above or below the lump-sum budget.
Fixed overhead production-volume variance
The difference between budgeted fixed overhead and the fixed overhead allocated to actual output. It arises because fixed overhead is spread over an expected volume, and actual production almost never matches that expectation exactly. In simple terms, it measures the cost of unused (or over-used) capacity.
Flexible budget
A budget that adjusts expected costs for the actual level of output or activity achieved. Unlike a static budget, it removes volume differences so you can compare like with like: what should costs have been at the volume we produced?
Budgeted overhead rate
The pre-determined rate used to allocate overhead to products, calculated as budgeted overhead costs divided by the budgeted quantity of the allocation base. This is the rate set before the period begins and used throughout it.
Direct costs are traced to output by multiplying the standard price (or rate) by the standard quantity of inputs allowed for the actual units produced.
Example: if the standard allows 2 kg of material per unit at £5/kg, and you produced 1,000 units, the standard direct material cost assigned is 2 × £5 × 1,000 = £10,000.
Overhead costs are allocated using the standard overhead rate multiplied by the standard quantity of the allocation base allowed for the actual output produced.
The allocation base is whatever activity measure best captures how overhead is consumed (commonly machine hours).
The key idea: everything is measured at standard. You do not use actual hours or actual rates when assigning costs under standard costing. Variances capture the difference between standard and actual.
Four steps, done before the period begins:
Choose the budget period. Typically a year, broken into months or quarters.
Select the cost allocation base. Pick the activity that best explains why variable overhead changes. Machine hours is the most common choice in manufacturing.
Identify the variable overhead cost items tied to that base. These include costs of energy, machine maintenance, engineering support, indirect materials, and indirect manufacturing labour.
Compute the budgeted variable overhead rate. Divide total budgeted variable overhead by the budgeted quantity of the allocation base.
Once the rate is set, it stays fixed for the budget period. Actual spending and actual usage of the allocation base will differ from plan, and those differences become the spending and efficiency variances.
The same four-step process applies:
Choose the budget period.
Select the cost allocation base for allocating fixed overhead to output (often the same base as variable overhead, but it need not be).
Identify the fixed overhead cost items linked to that base. These are costs that do not change with short-run production volume: depreciation, insurance, property taxes, salaried supervisors.
Compute the budgeted fixed overhead rate. Divide total budgeted fixed overhead by the budgeted (denominator-level) quantity of the allocation base.
The denominator-level choice matters enormously here. If you budget based on practical capacity, you get one rate; if you budget based on expected output, you get another. This choice directly affects the size of the production-volume variance.
This is one of the most important points in the chapter.
Fixed overhead costs, by definition, do not change when you use more or fewer machine hours. If a factory uses 5% more machine hours than standard, the electricity for lighting and the building's depreciation do not increase. So it makes no sense to calculate an "efficiency variance" for fixed overhead the way you do for variable overhead.
Fixed overhead has only two variances:
Spending variance: Did we spend more or less in total on fixed overhead than the budget?
Production-volume variance: Did we produce more or fewer units than the denominator level used to set the rate?
Variable overhead has two as well, but different ones:
Spending variance: Did we pay more or less per unit of the allocation base than budgeted?
Efficiency variance: Did we use more or fewer units of the allocation base than the standard allows for actual output?
Variable overhead spending variance
(Actual variable overhead rate × Actual allocation base quantity) – (Budgeted variable overhead rate × Actual allocation base quantity)
Or equivalently: (Actual VOH rate – Budgeted VOH rate) × Actual quantity of allocation base
Variable overhead efficiency variance
(Actual allocation base quantity – Standard allocation base quantity allowed) × Budgeted variable overhead rate
Fixed overhead spending variance
Actual fixed overhead incurred – Budgeted fixed overhead
Fixed overhead production-volume variance
Budgeted fixed overhead – Fixed overhead allocated to actual output
Where: Fixed overhead allocated = Budgeted fixed overhead rate × Standard quantity of allocation base allowed for actual output
Total overhead variance (for either variable or fixed)
Actual overhead incurred – Overhead allocated to actual output
Overhead variance analysis is how factory managers figure out why the month's costs were off budget. A plant manager who sees an unfavourable variable overhead efficiency variance knows the shop floor used more machine hours per unit than planned, which is a signal to look at equipment condition, operator training, or production scheduling. The production-volume variance matters for strategic decisions about capacity: a consistently large favourable production-volume variance might mean the company is paying for factory space it does not need.
"Fixed overhead has an efficiency variance." It does not. This is the single most common error in this chapter. Fixed costs do not rise or fall when you use more or fewer machine hours, so an efficiency variance is meaningless for them.
"A favourable production-volume variance means we saved money." Not necessarily. It means we produced more than the denominator level assumed. The total fixed cost did not change; we simply spread it over more units. The "savings" are an accounting artefact of the allocation rate, not a real cash difference.
"The spending variance and the budget variance are different things." For fixed overhead, the spending variance is often called the budget variance. They are the same calculation. Do not treat them as separate variances.
"Overhead rates use actual costs." Under standard costing, the overhead rate is set before the period using budgeted figures. Actual costs are compared to the standard after the fact. The rate itself is always budgeted.
⚠️ Exams almost always ask you to calculate all four variances (variable spending, variable efficiency, fixed spending, fixed production-volume) from a single data set. Practise the full four-variance layout until it is automatic.
⚠️ The "no efficiency variance for fixed overhead" rule is a perennial exam favourite. If a question asks you to compute it, the answer is that it does not exist.
⚠️ Be ready to interpret variances, not just calculate them. A question may describe a scenario and ask whether a variance is favourable or unfavourable, and what management action it suggests.
⚠️ The denominator-level choice (practical capacity vs. expected output vs. normal capacity) can change the fixed overhead rate and therefore the production-volume variance. Know how each choice affects the numbers.
True or false: Fixed overhead has both a spending variance and an efficiency variance. False. Fixed overhead has a spending variance and a production-volume variance. There is no efficiency variance for fixed overhead.
Fill in the blank: The variable overhead efficiency variance is calculated by taking the difference between ______ and ______, multiplied by the budgeted variable overhead rate. Actual allocation base quantity used and standard allocation base quantity allowed for actual output.
True or false: A favourable production-volume variance means the company produced more units than the denominator level. True. More output than the denominator means more overhead was allocated than was budgeted in total, creating a favourable variance.
True or false: Under standard costing, overhead is allocated using actual overhead rates. False. Standard costing uses budgeted (pre-determined) overhead rates.
Fill in the blank: The most common cost allocation base for variable manufacturing overhead is ______. Machine hours.
Q: A company budgeted variable overhead at £6 per machine hour and expected to use 10,000 machine hours. Actual variable overhead was £65,000 and actual machine hours were 10,500. Standard hours allowed for actual output were 10,200. Calculate the variable overhead spending variance.
A: Actual VOH = £65,000. Budgeted rate × Actual hours = £6 × 10,500 = £63,000. Spending variance = £65,000 – £63,000 = £2,000 unfavourable (spent more per machine hour than budgeted).
Q: Using the same data, calculate the variable overhead efficiency variance.
A: (Actual hours – Standard hours allowed) × Budgeted rate = (10,500 – 10,200) × £6 = £1,800 unfavourable (used 300 more machine hours than the standard allows).
Q: A company's budgeted fixed overhead is £120,000 for the year. The budgeted fixed overhead rate is £4 per machine hour based on a denominator of 30,000 hours. Actual fixed overhead was £125,000 and standard hours allowed for actual output were 28,000. What are the two fixed overhead variances?
A: Spending variance = £125,000 – £120,000 = £5,000 unfavourable. Production-volume variance = £120,000 – (£4 × 28,000) = £120,000 – £112,000 = £8,000 unfavourable (produced fewer units than the denominator level assumed).
Q: Why is there no efficiency variance for fixed overhead?
A: Fixed overhead costs do not change with the quantity of the allocation base used. Whether the factory runs 28,000 or 32,000 machine hours, depreciation and insurance stay the same. An efficiency variance measures the cost impact of using more or fewer units of the allocation base, which is zero for fixed costs.
Q: What is the difference between a static budget and a flexible budget for overhead analysis?
A: A static budget is set for one expected level of output and does not adjust. A flexible budget recalculates expected costs for the actual output achieved, so it isolates spending and efficiency differences from volume differences. Overhead variance analysis uses the flexible budget as its benchmark.
This material connects directly to Chapter 7 (direct cost variances). The logic is the same: set a standard, compare it to actual, and decompose the difference into price/spending and quantity/efficiency components. The overhead chapter simply adds the complication of allocated (indirect) costs and the production-volume variance unique to fixed overhead.
It also links to job costing and process costing (Chapters 4 and 5), where overhead is applied to products using pre-determined rates. The rates developed in this chapter are the ones used in those costing systems. Later chapters on activity-based costing refine the choice of allocation base by using multiple cost pools and drivers rather than a single machine-hours rate.
Tags: standard costing, overhead variance analysis, variable overhead spending variance, variable overhead efficiency variance, fixed overhead budget variance, fixed overhead production-volume variance, flexible budget, static budget, cost allocation base, machine hours, budgeted overhead rate, denominator level, practical capacity, normal capacity, overhead under-applied, overhead over-applied, manufacturing overhead, indirect costs, cost control, managerial accounting, cost accounting chapter 8