Overhead Variances in Nonmanufacturing Settings

Learning Objective 8 Examine the use of overhead variances in nonmanufacturing settings

• analyze nonmanufacturing variable overhead costs for decision making and cost management; fixed overhead variances are especially important in service settings

Our Webb Company example examined variable and fixed manufacturing overhead costs. Managers can also use variance analysis to examine the overhead costs of the nonmanufacturing areas of the company. For example, when product distribution costs are high, as they are in the automobile, consumer durables, cement, and steel industries, standard costing can provide managers with reliable and timely information on variable distribution overhead spending variances and efficiency variances.

What about service-sector companies such as airlines, hospitals, hotels, and railroads? How can they benefit from variance analyses? The output measures these companies commonly use are passenger-miles flown, patient-days provided, room-days occupied, and ton-miles of freight hauled. Few costs can be traced to these outputs in a cost-effective way. Most of the costs are fixed overhead costs, such as the costs of equipment, buildings, and staff. Using capacity effectively is the key to profitability, and fixed overhead variances can help managers in this task. Retail businesses such as Kmart also have high-capacity–related fixed costs (lease and occupancy costs). In the case of Kmart, sales declines resulted in unused capacity and unfavorable fixed-cost variances. Kmart reduced its fixed costs by closing some of its stores, but it also had to file for Chapter 11 bankruptcy.

Consider the following data for United Airlines for selected years from the past 18 years. Available seat miles (ASMs) are the actual seats in an airplane multiplied by the distance the plane traveled.

When air travel declined after the events of September 11, 2001, United’s revenues fell. However, most of the company’s fixed costs—for its airport facilities, equipment, personnel, and so on—did not decrease. United had a large unfavorable production-volume variance because its capacity was underutilized. As column 1 of the table indicates, United responded by reducing its capacity substantially. Available seat miles (ASMs) declined from 175,493 million in 2000 to 136,566 million in 2003. Yet United was unable to fill even the planes it had kept, so its revenue per ASM declined (column 2) and its cost per ASM stayed roughly the same (column 3). United filed for Chapter 11 bankruptcy in December 2002 and began seeking government guarantees to obtain the loans it needed. Subsequently, strong demand for airline travel, as well as productivity improvements from more efficient use of resources and networks, led to increased traffic and higher average ticket prices. United’s disciplined approach to capacity and tight control over growth led to an increase of more than 20% in its revenue per ASM between 2003 and 2006. United came out of bankruptcy on February 1, 2006. Subsequently, however, the global recession and soaring jet fuel prices negatively impacted United’s performance, leading to losses and further reduction in capacity. In 2011, United acquired Continental Airlines, resulting in 85% growth in ASM between 2011 and 2015. The revenue benefits from a stronger economy and a plunge in fuel prices led United to even greater profitability per ASM through 2018.

Financial and Nonfinancial Performance Measures

The overhead variances discussed in this chapter are examples of financial performance measures. As the preceding examples illustrate, nonfinancial measures such as those related to capacity utilization and physical measures of input usage also provide useful information. The nonfinancial measures that managers of Webb would likely find helpful in planning and controlling its overhead costs include the following:

1. Quantity of actual indirect materials used per machine-hour, relative to the quantity of budgeted indirect materials used per machine-hour
2. Actual energy used per machine-hour, relative to the budgeted energy used per machine-hour
3. Actual machine-hours per jacket, relative to the budgeted machine-hours per jacket

These performance measures, like the financial variances discussed in this chapter and Chapter 7, alert managers to problems and are reported daily or hourly on the production floor. Overhead variances capture the financial effects of factors such as the three listed. An especially interesting example along these lines comes from Japan: Some Japanese companies have begun reining in their ${CO}_2$ emissions in part by doing a budgeted-to-actual variance analysis of the emissions. The goal is to make employees aware of the emissions and reduce them in advance of greenhouse-gas reduction plans being drawn up by the Japanese government.

Both financial and nonfinancial performance measures are used to evaluate the performance of managers. Exclusive reliance on either is always too simplistic because each gives a different perspective on performance. Nonfinancial measures (such as those described) provide feedback on individual aspects of a manager’s performance, whereas financial measures evaluate the overall effect of and tradeoffs among different nonfinancial performance measures. We discuss these issues further in Chapters 12, 19, and 23.