Under and over absorption of overhead costs is a significant concept in cost accounting that affects the accuracy of product costing and financial reporting. In this article, we will explore the definition and significance of under and over absorption and examine the factors that can lead to their occurrence. The information presented here is sourced from reputable materials such as aCOWtancy Textbook (https://www.acowtancy.com/textbook/acca-ma/material-labour-and-overheads/b1cvii-under-over-absorption/notes), Finance Strategists (https://www.financestrategists.com/accounting/cost-accounting/overhead-costing/under-and-over-absorption-of-overhead/), and LinkedIn (https://www.linkedin.com/advice/1/how-do-you-use-overhead-absorption-costing-support).
Factors Contributing to Under and Over Absorption
- Under-utilization of production capacity:
Under-utilization of production capacity occurs when the actual production falls below the planned or expected level. This can result in under-absorption of overhead costs since the overheads are spread over a lower volume of output. As a consequence, the cost per unit increases, affecting cost allocation and product pricing decisions. Under-utilization may arise due to factors such as low demand, machinery breakdown, or labor shortages.
- Seasonal fluctuations in production (for seasonal factories):
Seasonal factories experience variations in production levels throughout the year. During peak seasons, production is high, while it decreases during off-peak periods. These fluctuations pose challenges in accurately predicting overhead costs for each production period. As a result, under or over absorption of overheads can occur, leading to distortions in the cost of products manufactured during different seasons.
- Errors in predicting overhead costs or the quantity/value of the base:
Errors in forecasting overhead costs or inaccurately estimating the quantity or value of the base used for absorption calculations can result in under or over absorption. For example, if the base used is machine hours, an incorrect estimation of the total machine hours required for production can lead to inaccurate absorption of overhead costs. Such errors can have significant implications for the accuracy of cost allocation and financial reporting.
- Major changes in production methods:
When a company implements significant changes in its production methods, such as adopting new technology or altering the manufacturing process, the absorption of overhead costs may be affected. The existing predetermined overhead rates may no longer be appropriate, requiring adjustments to accurately allocate overheads based on the revised production methods.
- Major changes in working capacity:
Significant changes in working capacity, such as expansion or contraction of operations, can impact the absorption of overhead costs. If the changes are not adequately considered when determining the predetermined overhead rates, under or over absorption may occur. Strategies need to be implemented to address the resulting imbalances and ensure accurate cost allocation.
Methods for Treating Under and Over Absorbed Overheads
- Use of Supplementary Rate:
The supplementary rate method is employed to rectify the under or over absorption of overhead costs. It involves calculating a supplementary overhead rate based on the difference between the actual overhead incurred and the overhead absorbed using the predetermined rate. The formula for calculating the supplementary rate is:
Supplementary Rate = (Actual Overheads – Overheads Absorbed) / Actual Base
The supplementary rate is then used to adjust the cost per unit by multiplying it by the actual base to determine the revised overhead cost.
- Carry Forward to the Next Year’s Accounts:
In some cases, under or over absorbed overheads can be carried forward to the next accounting period. This method is particularly applicable in businesses with long-term cycles and predetermined overhead rates. The under or over absorbed amount is included as an adjustment in the next year’s overhead calculation, thereby reducing the impact on the current period’s financial statements.
- Transfer to Costing Profit and Loss Account:
Under exceptional circumstances, such as abnormal increases or decreases in actual overhead costs, the under or over absorbed overheads may be transferred to the costing profit and loss account. This approach allows for the recognition of these variances separately and ensures proper valuation of work-in-progress and finished goods.
Conclusion
Accurate absorption of overhead costs is crucial for reliable product costing, financial reporting, and decision-making. Under and over absorption can occur due to various factors, including under-utilization of production capacity, seasonal fluctuations, errors in predictions, changes in production methods, and working capacity. To address under or over absorption, methods such as the useof supplementary rates, carrying forward to the next year’s accounts, and transfer to the costing profit and loss account can be employed. These methods help correct the imbalances and ensure accurate cost allocation. It is essential for businesses to understand the factors contributing to under and over absorption and choose appropriate treatment methods to maintain financial accuracy.
Sources:
- aCOWtancy Textbook: https://www.acowtancy.com/textbook/acca-ma/material-labour-and-overheads/b1cvii-under-over-absorption/notes
- Finance Strategists: https://www.financestrategists.com/accounting/cost-accounting/overhead-costing/under-and-over-absorption-of-overhead/
- LinkedIn: https://www.linkedin.com/advice/1/how-do-you-use-overhead-absorption-costing-support
FAQs
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What is under and over absorption of overhead costs?
Under and over absorption of overhead costs refers to the situation where the actual overhead costs incurred by a business are either less than or greater than the amount allocated or absorbed into the cost of products or services.
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How is under-absorption of overhead costs calculated?
Under-absorption of overhead costs can be calculated by subtracting the total absorbed overheads from the actual overhead costs incurred. The resulting difference represents the under-absorbed amount.
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How is over-absorption of overhead costs calculated?
Over-absorption of overhead costs can be calculated by subtracting the actual overhead costs incurred from the total absorbed overheads. The resulting difference represents the over-absorbed amount.
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What factors contribute to under or over absorption of overhead costs?
Factors that contribute to under or over absorption of overhead costs include under-utilization of production capacity, seasonal fluctuations in production, errors in predicting overhead costs or the quantity/value of the base, major changes in production methods, and major changes in working capacity.
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How does under-utilization of production capacity affect the absorption of overhead costs?
Under-utilization of production capacity leads to under-absorption of overhead costs because the actual production volume is lower than the expected or planned level. As a result, the overhead costs are spread over a smaller output, increasing the cost per unit.
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What challenges arise from seasonal fluctuations in production regarding overhead absorption?
Seasonal fluctuations in production pose challenges in accurately predicting overhead costs for each production period. The variations in production levels during peak and off-peak seasons can result in under or over absorption of overheads, affecting the cost of products manufactured in different seasons.
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What are the implications of errors in predicting overhead costs or the quantity/value of the base?
Errors in predicting overhead costs or inaccurately estimating the quantity or value of the base used for absorption calculations can lead to under or over absorption. This can result in distorted cost allocation, affecting the accuracy of product costing and financial reporting.
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How are under or over absorbed overheads treated?
Under or over absorbed overheads can be treated through methods such as the use of supplementary rates, carrying forward to the next year’s accounts, or transferring to the costing profit and loss account. These methods help adjust the cost per unit, account for imbalances, and ensure accurate cost allocation.