What is Under-absorption and Over-absorption of Overhead?
Where the absorption of overhead is made by a rate based on actual data, the overhead absorbed must be equal to the actual overhead incurred. But where a pre-determined rate is employed, there is generally a difference between the overhead absorbed and the overhead incurred. If the absorbed amount is less than the actual overhead, there is said to be under-absorption of overhead. For example, if during the month of March, 2019, overheads absorbed are $9,500 and the actual overheads are $10,000, there is an under-absorption of overheads to the extent of $500. In the case of under-absorption, the cost of production is deflated to the extent of amount under-absorbed.
On the other hand, if the absorbed amount is in excess of the actual overhead, there is said to be over-absorption of overhead. For the example, if during April, 2019, overheads absorbed are $10,800 and the actual overhead are $10,000, there is an over-absorption of overhead to the extent of $800. In the case of over-absorption, the cost of production is inflated to the extent of over-absorption.
Causes of Under-absorption and Over-absorption of Overhead
The main causes responsible for under-absorption and over-absorption of overhead are:
- Under-utilization of the production capacity.
- Seasonal fluctuations in production in case of seasonal factories.
- Errors in anticipating the overhead costs or the quantum or value of the base.
- Major change in the method of production.
- Change in the working capacity.
Treatment of under-absorbed and over-absorbed overhead
The under-absorbed and over-absorbed overhead costs may be disposed of in any of the following manners:
(1). Use of Supplementary Rate
Under this method, under-absorbed or over-absorbed overhead is apportioned to work-in-progress inventory, finished goods inventory and cost of sales by means of supplementary overhead rate. The amount of under-absorbed overhead is adjusted by adding it back to the cost of production by applying a positive supplementary rate while over-absorbed overhead is deducted through a negative supplementary rate. The supplementary rate is obtained by applying the following formula:
Supplementary Overhead Rate = (Overhead Incurred – Overhead Absorbed) / Quantum of Base
This method has the ultimate effect of charging actual overhead to the cost of production and thus the distinction between the recovery at pre-determined rates and at actual rates no longer exist. The use of this method is generally recommended in the following cases:
(i). When there is a serious error in anticipating or estimating the overhead cost or quantum or value of base and the extent of under-absorption or over-absorption is considerable.
(ii). When there is a major change in the method of production leading to a significant difference between the overhead incurred and the overhead absorbed.
(iii). When there is a change in the working capacity of the manufacturing concern disturbing the estimates of overhead and quantum of the base.
(iv). When contracts or work-orders are undertaken on a cost-plus basis.
(2). Carry Forward to the Next Year’s Accounts
Under this method, the amount of overhead remaining under-absorbed or over-absorbed at the end of the year is transferred to an Overhead Reserve of Suspense Account to be carried forward to the next year’s accounts for absorption. This method can be applied when the normal business cycle extends over more than one year and overhead rates are pre-determined on a long term basis. This method is not commonly used.
(3). Transfer to Costing Profit and Loss Account
Under this method, which is applied in case of unusual circumstances causing an abnormal increase or decrease in actual overhead costs, the amount of overhead under-absorbed or over-absorbed is transferred to the Costing Profit and Loss Account. If the predetermined overhead rate is applicable for a year, there will be no problem in transferring the differences between overhead absorbed and overhead incurred to Costing Profit and Loss Account but if the same is applicable to a shorter period, the work of comparison between actual and estimated overhead will have to be done at frequent intervals. The other main disadvantage of this method is that the stocks of work-in-progress and finished goods remain under- or over-valued and are carried forward at the same values to the next period.
The total overhead expenses of a factory are $4,50,608. Taking into account the normal working of the factory, overhead was recovered in production at $1.25 per hour. The actual hours worked were 2,93,104. How would you proceed to close the account of works assuming that besides 7,800 units produced of which 7,000 were sold, there were 200 equivalent units in work-in-progress. On investigation, it was found that 50 percent of the unabsorbed overhead was on account of increase in the cost of indirect material and indirect labour and the other 50 percent was due to factory inefficiency.
50% of unabsrobed overheads is due to increase in cost of indirect material and indirect labour. So, 50% of $84,228 i.e., $42,114 be recovered by a supplementary rate.
Total number of units produced or in work-in-progress = 7,800 + 200 = 8,000 units
Supplementary rate = 42,114 / 8,000 = $5.26425 per unit
So this amount of $42,114 be apportioned as follows:
The balance 50% difference caused due to factory inefficiency should be transferred to Costing Profit and Loss Account as it is an abnormal loss.