In this article we will discuss about the over and under absorption of overheads.
By application of predetermined overhead absorption rates, overheads are absorbed into actual production throughout the accounting period. Because of the predetermined rates are based on expected overheads to be incurred and the estimated production, generally the overheads absorbed into the product cost do not agree with the actual overheads incurred for the period.
If the overheads absorbed are higher than the actual overheads incurred it is called ‘over absorption’. If the overheads absorbed are lower than the actual overheads incurred during the accounting period, it is called ‘under absorption’.
Reasons for Over or Under Recovery:
The reasons for over or under recovery of overheads are as follows:
(a) The actual hours worked may be more or less than the estimated hours.
(b) The actual overhead costs are different from budgeted overheads.
(c) Both actual overhead costs and actual activity level are different from the budgeted costs and levels.
(d) The absorption method used may not be correct.
(e) Extraordinary expenses might have been incurred during the accounting period.
(f) Major changes might have taken place for example replacement of manual labour with machines, replacement of general purpose machine with automatic high speed machine, increase in level of capacity etc.
(g) Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Under/Over Absorption of Overheads:
The methods used in treating the under or over absorbed overheads in Cost Accounts are given below:
Application of Supplementary Rates:
The under or over recovered overhead is adjusted by application of supplementary rates. This method is used to adjust the difference between overheads absorbed and overheads actually incurred by computing supplementary overhead rates.
Such rates may be either positive or negative. A positive rate is used to add the unabsorbed overheads to cost of production. A negative rate is used to correct the cost of production by deducting the amount of over absorbed overheads. The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base.
Write off to Costing Profit and Loss Account:
If the under or over absorbed overhead is small and negligible, then it will be written off by transferring it to the Costing Profit and Loss Account without using the supplementary rates. In case of under absorption of overheads arises due to factors like idle capacity, defective planning etc. it may also be transferred to Costing Profit and Loss Account.
Carry Forward to Subsequent Year:
Treating the under or over absorbed overheads as seasonal fluctuations, may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account.
This method is not considered desirable as it allows costs of one period to affect costs of another period, which renders the comparison of financial results difficult. This method may be used in the initial years of business since the operations will be low in the starting period.
Your company uses a historical cost system and applies overhead on the basis of ‘predetermined’ rates.
The following are the figure from the Trial Balance as at 31-3-2009: (Rs.)
Give two methods for the disposal of the unabsorbed overhead and show the profit implication of each method
Under this method the profit for the year will get reduced by Rs. 42,029 and the remaining amount i.e., Rs. 7,077 and Rs. 11,534 will be carried forward to next year in the form of work-in-progress and finished stock respectively.
Another method used in disposal of under absorbed overheads is write off Rs. 60,640 by charging it to Costing Profit and Loss Account.