When analyzing overhead costs, it is essential to distinguish between variable overhead and fixed overhead. Total variable overhead costs vary in total in proportion to changes in activity whereas total fixed costs do not change within the relevant range. This distinction is important when constructing flexible budgets and when computing overhead variances.

A flexible budget shows what costs should be for various levels of activity. The flexible budget amount for a specific level of activity is determined differently depending on whether a cost is variable or fixed. If a cost is variable, the flexible budget amount is computed by multiplying the cost per unit of activity by the level of activity specified for the flexible budget. If a cost is fixed, the original total budgeted fixed cost is used as the flexible budget amount.

The two variances for variable overhead discussed in the chapter are the variable overhead spending and variable overhead efficiency variances. These variances were also covered in the previous chapter.

Two variances for fixed overhead are covered in the chapter. One—the budget variance—is quite simple; the other is considerably more complex. The budget variance is the difference between the actual total fixed overhead cost incurred and the total amount of fixed overhead cost that was originally budgeted. The volume variance is the difference between the amount of fixed overhead cost applied to inventory and the total amount of fixed overhead cost that was originally budgeted. The budget variance is a straightforward measure of the degree to which fixed overhead spending was under control. The volume variance is a consequence of treating a fixed cost as if it were variable and is more difficult to interpret meaningfully.

The sum of all four overhead variances equals the overhead overapplied or underapplied for the period. Unfavorable variances are equivalent to underapplied overhead and favorable variances are equivalent to overapplied overhead.

Prepare a flexible budget and explain the advantages of the flexible budget approach over the static budget approach.

Prepare a performance report for both variable and fixed overhead costs using the flexible budget approach.

Use a flexible budget to prepare a variable overhead performance report containing only a spending variance.

Use a flexible budget to prepare a variable overhead performance report containing both a spending and an efficiency variance.

Compute the predetermined overhead rate and apply overhead to products in a standard cost system.

Compute and interpret the fixed overhead budget and volume variances.