Importance and limitation of fixed overhead total variance

Fixed overhead total variance:

A variance is the difference between actual cost/revenue and budgeted cost/revenue. Fixed overhead total variance measures the difference between actual fixed overheads and absorbed fixed overheads.

Absorbed or applied overheads are defined as the fixed overheads that the company was able to recover.

They are calculated by applying the fixed overhead absorption rate to the actual output produced.

Fixed overhead absorption rate can be calculated as follows:

The formula to calculate fixed overhead total variance is:

FOH total variance = Actual fixed overheads – Applied fixed overheads

Where applied fixed overheads = FOAH  Actual output

Analysis:

A favorable fixed overhead total variance is when actual fixed overheads are less than the applied fixed overheads meaning the budgeted overheads are over recovered or over absorbed.

The positive difference between actual and applied overheads is booked as an income on the financial statements causing an increase in total profit.

An unfavorable or adverse fixed overhead total variance occurs due to incurring more actual overheads than what were expected.

This is when the overheads are under-absorbed or under-recovered. The negative difference is charged as an  expense on the financial statements causing a reduction in total profit earned by the company.

Importance of fixed overhead total variance:

  • The fixed overhead variance analysis is performed to identify the reasons behind the deviation in overheads to rectify any inefficiency in the production process. I’ll state some of such reasons below:
  • Machine breakdown during the year due to which company faced lower annual productivity hence, fewer applied overheads and higher actual overheads.
  • An unexpected investment cost in plant and machinery will cause an increase the total fixed overheads incurred by the company resulting in higher actual fixed overheads and lower applied overheads.
  • Inaccurate planning done by management.
  • Management fails to follow the master budget.
  • Unexpected need or requirement of more labor due to under-staffing causing fixed wages and salaries expense of indirect labor to rise.
  • This variance helps us recognize material or significant variances which may be potential problems for the future. Fixed overhead means it won’t vary with the output however if it still does there may be chances of a significant new expense incurred by the company.
  • It is less time consuming to do fixed overhead total variance analysis since all the costs are fixed annually and do not vary as per the output saving us calculation and computation time.
  • Fixed overhead total variance is less prone to error since fixed costs are the same each year unless a significant change is made in the production process.
See also  Importance and Limitation of Sales Quantity Variance

Limitations of fixed overhead total variance:

  • The total fixed overhead cost includes all the other small accounts of fixed expenses i.e. indirect labor and indirect material cost, depreciation, utility bills etc. A mistake in estimating any of the small account budgets will be carried forward to the total fixed overheads account causing a deviation in the overall fixed overhead cost.
  • Since we calculate the overall variance for the fixed overheads, identifying the small accounts due to which the variance has occurred is time consuming and requires a lot of work.
  • Since so much time is taken in analyzing the differences and reasons behind them, the analysis becomes irrelevant or less reliable in the future due to a time lag.
  • A lot of judgment is involved by the management. The budgets could be prepared extremely and inappropriately high just so the variance is significant in the future causing material increase in the profit to impress directors.
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