OVER ABSORPTION AND UNDER ABSORPTION OF OVERHEADS
Overhead expenses are usually applied to production on the basis of predetermined rates. The predetermined rates may represent estimated, actual or normal costs. If the actual expenses fall short of the amount applied, there is said to be an over-absorption of overheads, and, conversely, if the actual expenses exceed the amount applied to production, it is a case of under-absorption. Such over or under-absorption may also be termed as overhead variance, the amount of over-absorption being represented by the credit balance on the variance account, and, conversely, the amount of under- absorption by a debit balance.
CAUSES OF OVER ABSORPTION AND UNDER ABSORPTION OF OVERHEADS
- Error in estimating overhead expenses.
- Error in estimating the level of production, i.e. the base.
- Major unanticipated changes in the methods of production.
- Unforeseen changes in the production capacity.
- Seasonal fluctuations in the overhead expenses from period to period.
- Overhead rate may be applied to the Normal Capacity which may be less than the full operating
- capacity of the undertaking.
ACCOUNTING TREATMENT OF UNDER AND OVER-ABSORPTION
Three methods of accounting treatment of under absorption and over absorption are as follows:
1. Use of Supplementary Rates: the supplementary rate is adopted when the amount of under or over absorbed overheads is quite large, a supplementary rate may be found out. The cost of each job, order or process may be adjusted by applying this supplementary rate. The rate may be calculated as follows:
Supplementary Rate = Amount of over or under − Absorbed overheads/Actual Base
In case of under absorbed overheads the rate is considered as positive, while in case of overabsorption of overheads, it is termed as negative. In case of under-absorption the cost of the job or product is increased by adding it to overheads charged on the basis of a positive supplementary rate and in case of over-absorption the cost of the job or product is decreased by deducting the extra amount of overheads charged by applying a negative supplementary rate.
2. Carrying Over of Overheads: The amount of over or under absorption is carry forward to the next year. This method may be adopted in situation where the normal business cycle extends for more than one year. This method is not very prevalent in the industry.
3. Writing off to Costing Profit and Loss Account: In case the amount of under or overabsorbed overhead is very small it is not worthwhile to use supplementary may be written off to Costing Profit and Loss Account. If due to some abnormal factors, the amount of under or over absorbed is large it should be transferred to Profit and Loss Account.
REPORTING OF OVERHEAD COSTS
- Overheads shall be presented as separate cost heads like production, administration and marketing.
- Element wise and behavior wise details of the overheads shall be presented, if material.
- Any under-absorption or over-absorption of overheads shall be presented in the reconciliation statement.
The basis of assignment of overheads to the cost objects.
- Overheads incurred in foreign exchange.
- Overheads relating to resources received from or supplied to related parties
- Any Subsidy / Grant / Incentive or any amount of similar nature received / receivable reduced from overheads.
- Credits / recoveries relating to the overheads.
- Any abnormal cost not forming part of the overheads.
- Any unabsorbed overheads.