Question

Discuss the reason for using an absorption rate in determining the variable cost variances as well as using an applied fixed overhead in the fixed overhead volume variance.

Answer 1

1st part

Some costs are easy to associate with the product, these are direct costs like Direct Material and Direct Labour. Some costs are not easily associated with the product but they vary according to the production volume, these are variable overheads like wages for handling or shipping expenses.

Before quoting a price to the customer, we need to know the manufacturing cost of the product. Since variable overheads are not directly attributed to a product line, we must find a way so that we can dedicate variable overheads to a particular product.

Overhead absorption rates are our attempt at coming up with the best ‘guess’ of how much overhead should be given to a product. Generally these rates are based on machine hours or labour hours.

Variable cost variance is the difference between actual variable cost incurred and Budgeted or standard variable cost. So it is pertinent to calculate variable cost and for that we need a absorption rate to attribute variable overheads to the product.

2nd Part

The Fixed overhead volume variance is the difference between the amount of fixed overhead actually applied to produced goods based on production volume, and the amount that was budgeted to be applied to produced goods. These overheads are absorbed on the basis of allocation rate that management decides.