Understanding Variable Overhead Costs
Variable overhead refers to those operating costs in a manufacturing or production environment that vary directly with the level of output. Unlike fixed overhead costs, which remain constant regardless of production levels, variable overhead costs fluctuate as a direct consequence of changes in business activity.
Examples of Variable Overhead
These costs might include:
- Production supplies: Materials needed that vary with production volume.
- Utilities: Costs of electricity and water needed to operate machinery, which increase with higher production levels.
- Labor costs: Wages paid to temporary or hourly employees who are hired based on production needs.
Variable Overhead and Pricing Strategy
For manufacturers, accurately forecasting and accounting for variable overhead is crucial in setting product prices that ensure profitability. This involves not only understanding the variable costs that accompany increased production but also how these costs impact the overall cost per unit.
Calculating Impact on Product Pricing
If, for example, increasing production lowers the material cost per unit due to bulk purchasing, it is essential to also consider whether the increase in utility and labor costs due to higher production levels will offset this savings. Effective management of variable overhead can lead to significant cost efficiencies and enhanced profit margins.
Cost Efficiency Through Improved Practices
Efficiencies in production can sometimes reduce the per-unit variable overhead as a company scales. Techniques such as lean manufacturing can optimize the use of resources and labor, reducing waste and thus the variable overhead associated with less efficient practices.
Strategic Management of Variable Overhead
Strategic decisions, such as choosing more efficient machinery, optimizing labor schedules, and negotiating better rates for bulk materials, are essential in managing variable overhead. Forecasting and responsive planning allow businesses to adjust quickly to changes in demand without disproportionately increasing costs.
Related Terms
- Fixed Overhead: Costs that do not vary with the level of production, such as rent and salaries of permanent staff.
- Breakeven Analysis: A calculation to determine at what point production covers all costs, including both fixed and variable overhead.
- Cost-Volume-Profit Analysis: Used to determine how changes in costs and volume affect a company’s operating profit.
Suggested Books for Further Study
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren - Provides in-depth coverage of cost dynamics, including variable and fixed costs.
- “The Lean Startup” by Eric Ries - Although focused on startups, this book offers valuable insights into managing costs and resources efficiently.
- “Management Accounting for Decision Makers” by Peter Atrill & Eddie McLaney - Focuses on how accounting and financial management support the decision-making process in business.
By understanding and strategically managing variable overhead, businesses can better align their production levels with market demand, optimizing profitability and performance in highly competitive markets.
