What Is Variable Overhead?
Variable overhead is the cost of operating a business, which fluctuates with manufacturing activity. As production output increases or decreases, variable overhead moves in tandem. Although overhead is typically a fixed cost, as in the case of administrative expenses, variable overhead is instead, tied to the production facility.
It's important for businesses to have a firm understanding of its variable overhead costs because product pricing needs to factor in both fixed and variable overhead. If variable overhead isn't calculated properly, and production increases, costs can get out of control and eat into profit margins.
- Variable overhead is the cost of operating a business, which fluctuates with manufacturing activity.
- As production output increases or decreases, variable overhead moves in tandem.
- Examples of variable overhead include production supplies, utilities for the equipment, wages for handling, and shipping of the product.
Understanding Variable Overhead Costs
For companies to operate continuously, they need to spend money on producing and selling their goods and services. The overall operation including the managers, sales staff, marketing staff for the production facilities as well as the corporate office, are known as overhead costs.
There are two types of overhead costs, fixed and variable. Typically, the overhead doesn't fluctuate with increases in production of a product—which is why it's considered a fixed cost. Examples of fixed costs include:
- Mortgage or rent for the buildings such as the corporate office
- Salaries for administrative staff, managers, and supervisors,
- Taxes and insurance
Variable overhead, as eluded to earlier, fluctuates with the number of units produced in a factory. As a result, variable overhead can be tougher to pin down and keep within the budget. Examples of variable overhead include:
- Production supplies
- Utilities for the equipment and facility
- Wages for handling and shipping of the product
- Raw materials
- Sales commissions for workers
Variable overhead costs can include workers that are tied to production if the staff is added due to an increase in output. Also, any extra hours paid for production increases would be a variable cost.
For example, the cost of utilities for the equipment—electric power, gas, and water—tend to fluctuate depending on production output, the rollout of new products, manufacturing cycles for existing products, and seasonal patterns. Additional factors that may be included in variable overhead expenses are materials, changes in the labor force, and maintenance of equipment.
The key difference between variable and fixed overhead costs is that if the production of goods stopped for a period, there would be no variable overhead, but there would be fixed overhead.
Variable Overhead and Pricing
Manufacturers must include variable overhead expenses to calculate the total cost of production at current levels, as well as the total overhead required to increase manufacturing output in the future. The calculations can then be applied to determine the minimum price levels for products to ensure profitability.
A manufacturing facility's monthly expense for electricity, for example, can vary greatly depending on production output. If shifts were added to meet product demand, the facility and equipment would undoubtedly use more electricity. As a result, the variable overhead expenses must be included in the calculation of the cost per unit to ensure accurate pricing.
Although increasing production usually increases the total cost of variable overhead, efficiencies can occur as more products are produced. Also, price discounts on larger orders of raw materials—due to the ramp-up in production—can lower the direct cost per unit.
A company that has production runs of 10,000 units and a cost per unit of $1, might see a decline in the direct cost to 75 cents if the manufacturing rate is increased to 30,000 units. If the manufacturer maintains selling prices at the existing level, the cost reduction of 25 cents per unit represents $2,500 in savings on each production run. In this example, as long as the total increase in the indirect costs such as utilities and supplemental labor is less than $2,500, the company can maintain its prices, increase sales, and expand its profit margin.
Example of Variable Overhead
Let's say, for example, a mobile phone manufacturer has total variable overhead costs of $20,000 when producing 10,000 phones per month. As a result, the variable cost per unit would be $2.0 ($20,000/10,000 units).
Let's say the company increases its sales of phones, and in the following month, the company must produce 15,000 phones. At $2 per unit, the total variable overhead costs increased to $30,000 for the month.