Under Absorption and Overabsorption of Overheads | Cost Accounting - B Com PDF Download

Under Absorption and Overabsorption of Overheads

If the actual rate method of absorption is employed, production fully covers overhead costs. However, when a predetermined rate is utilized, the actual expenses may diverge from the budgeted or charged overhead expenses. Underabsorption of overheads occurs when absorbed overheads are less than the overheads incurred. Conversely, overabsorption of overheads happens when the absorbed overhead amount exceeds the actual overheads incurred.

Causes of Under or Overabsorption of Overheads

The following are the cause of under or overabsorption of overheads: 

1. Incorrect estimation of overheads can result in either overabsorption or underabsorption of overheads.
2. The expected output might deviate from the actual output.
3. The anticipated hours may be greater or lesser than the actual hours worked.
4. Fluctuations in material prices or wage rates can render the basis for recovering factory overhead from production incorrect.
5. If overheads are not allocated proportionately to work-in-progress.
6. Expenditures not part of regular operations incurred due to unforeseen alterations in production methods.
7. Variations in overhead expenses due to seasonal fluctuations.

Accounting for Under and Overbsorption of Overhead

The disposal of under/overheads depends on the extent of such under/overabsorption and the circumstances index which it arise. The main methods of disposal of under/overabsorption of overheads are as follows:

Use of Supplementary Rates 
Supplementary rates are employed to make adjustments for the variance between absorbed and incurred overhead. This rate is derived by dividing under/overabsorbed overheads by the actual base.

Advantages 
The use of supplementary rates enables the absorption of actual overhead costs incurred during production. The correction of costs through supplementary rates is essential for maintaining data for comparison.

Disadvantages 
Determining these rates is only possible at the conclusion of the accounting period, and the process involves a considerable amount of clerical work.

Writing Off to Costing Profit and Loss Account

A minor amount of overabsorption or underabsorption can be charged to the costing profit and loss account. Underabsorption resulting from idle facilities should also be written off to the costing profit and loss account. When under or overabsorption stems from abnormal causes like strikes, lockouts, breakdowns, etc., such costs should be carried forward to the next year and factored into the rate determination for that period.

This approach distorts the value of stock because the over or underabsorption of overheads is not apportioned to the stock of work-in-progress and finished goods.

Absorption in the Accounts of Subsequent Years

The over or underabsorption of overheads can be deferred to the next accounting period by transferring it to a suspense or overhead reserve account. This approach is applicable in situations involving new projects or when the normal business period extends beyond one year. Critics argue that this method distorts costs for comparison purposes, as the over or underabsorbed costs are carried forward.

Accounting and Control of Manufacturing Expenses

Manufacturing overhead control account opened in the cost ledger is debited by indirect material, indirect labor and indirect expense incurred by passing the following journal entry:

The debit side of this account represents the total manufacturing expenses incurred. The recovery of such expenses is made by passing the following entry.

The balance in the manufacturing overhead control account represents the amount of under or overabsorption of overheads.

Control of manufacturing Overheads

• Nature of overheads 
• Budgeting of overheads 
• Comparison of actual and budgeted overheads 
• Actual amount per functional unit 
• Standard costing

To enhance control over manufacturing overheads, the organization can categorize manufacturing expenses into fixed, variable, and semi-variable costs. The management should focus on managing controllable costs that are likely to be incurred. Increasing production levels, or employing economies of scale, is one approach to reducing overhead costs.

To estimate the service requirements of each department, reference can be made to the budgeted output of each production department. It is essential to carefully identify the variability of each item when determining the budgeted amount.

Control over manufacturing overheads can be achieved by comparing actual and budgeted overheads. Additionally, comparing the actual amount per functional unit with the corresponding budgeted amount is a useful practice.

Furthermore, control measures can be implemented through the use of the standard costing method. This involves comparing actual overheads with standard overheads, analyzing any variations, and reporting findings to the management for appropriate action.