Absorption, over absorption and under absorption of overheads

07/04/2020 1 By indiafreenotes

According to CIMA, absorption of overhead means “the process of absorbing all overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”. In other words, apportion of overhead means the process of apportionment of overhead to cost centre.

In order to find out the total cost per unit, each unit of production is charged with its respective share of overhead. So, absorption of overhead is the charge made on each job for recording indirect cost. After careful consideration of all relevant factors a suitable basis is to be selected, e.g., direct labour hours, machine hours, direct wages, production units, etc.

The absorption rate is, thus, obtained by dividing the total departmental overhead by the basis which is applied to various production units for calculating cost of each unit of production, the so-called calculated rate is multiplied to the base unit of each product.

Over Absorption

The amount of overhead absorption in costs is the total amount of the overhead costs allotted to individual cost units by application of overhead rate. Overhead costs are fully recovered from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overheads incurred. But when a predetermined rate is used on the basis of budgeted overheads and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses.

If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and/or the output or hours worked being less than the estimates, the difference is known as under-absorption. Under-absorption of overheads thus means the amount by which the absorbed overheads fall short of the actual amount of overheads incurred. It represents understating the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, processes etc.

On the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and/or the output or hours worked exceeding the estimates, it would mean over-absorption of overheads and will inflate the costs. Over-absorption of overheads thus means the excess of overheads absorbed over the actual amount of overheads incurred.

Suppose actual production overheads are Rs 3,38,000 and overheads recovered are Rs 3,24,480, then there will be under-absorption of Rs 13,520 (i.e. Rs 3,38,000 – 7 3,24,480). Suppose in the above case the overheads recovered are Rs 3, 48,000, then there will be over-absorption of Rs 10,000 (i.e. Rs 3, 48,000 – Rs 3, 38,000).

Causes of Under or Over-Absorption of Overheads:

Under or over-absorption of overheads may arise due to any of the following reasons:

(i) Error in estimating overheads:

The total overheads actually incurred for a department may be more or less than the amount estimated because of error in estimating. This may be due to deliberate decision in this regard or lack of proper control.

(ii) Error in estimating of proper volume:

The actual volume of output may be more or less than the output anticipated because of error in estimating the level of production.

(iii) The actual hours worked may be more or less than hours anticipated.

(iv) The basis upon which the factory overheads are recovered from production may no longer be correct on account of changes in the prices of material or wages rates.

(v) Work-in-progress might not have been charged with its share of overhead in cost accounts.

(vi) Major unanticipated changes in method of production might have occurred due to which an expense of a non-recurring nature might have been incurred during the year.

(vii) Seasonal fluctuations in the overhead expenses from period to period. Overhead rate is calculated by averaging the peaks and troughs. This results in under-absorption of overheads if the rate is calculated with reference to full capacity and under-absorption of overhead cost represents the overheads pertaining to the unutilized capacity.

(viii) There may be some important changes in the work situation such as heavy overtime, introduction of another shift, substitution of manual labour by equipment etc.

Accounting of Under and Over-Absorbed Overheads:

The accounting treatment of under or over-absorption of overheads depends upon the extent of such under or over-absorption and the circumstances under which it arises. Following are the main methods of disposal of under or over-absorption of overheads.

(i) Use of Supplementary Rates:

If the amount of under or over-absorption is considerable; the cost of job or process is adjusted by means of supplementary levy of the overhead. Supplementary rate is calculated by dividing the amount of under or over-absorption by the actual base. Under-absorption is set right by the plus rate while over-absorption is adjusted by minus rate. The supplementary rate may also be calculated as a percentage of the amount absorbed.

Correction of overheads costs by a supplementary rate is nothing but recovering the overhead by actual rates. All the shortcomings of actual rate method will make the supplementary rate as unnecessary and add to the clerical expenses. When the overhead rate is linked with maximum attainable or normal capacity but other than actual capacity, then calculation of supplementary rate will defeat the purpose (i.e. to reveal the idle capacity) for which it is calculated.

Supplementary rate is useless in those cases where in order to have a uniform charge of overhead throughout, the accounting period is fixed in order to avoid seasonal fluctuations in the overhead cost or level of activity.

Correction of costs through supplementary rate is necessary when the management likes to maintain actual historical costs for future comparison. Its use is made when prices are fixed on cost plus basis.

The amount of under or over-absorption at the end of the accounting period is adjusted in work-in-progress, finished stock and cost of sales in proportion to direct labour hours or machine hours or the values of the balances in each of these accounts by the use of supplementary rate. Subsidiary records or individual items are not corrected. The amounts so adjusted will be shown in the Balance Sheet as deductions from or additions to the work-in-progress and finished goods stock.

Under this method, the profit for the period will be reduced or increased by the amount adjusted to cost of sales and value of stock will increase or decrease by the amount adjusted to work-in- progress and finished goods stock. The latter will affect the profit of the subsequent period.

(ii) By Writing Off to Costing Profit and Loss Account:

If the amount of under or over- absorption is small it may be written off to Costing Profit and Loss Account instead of calculating a supplementary rate by complicated procedure. Under-absorption due to idle facilities should be written off in this manner whatever the amount may be.

The amount of under or over-absorption at the end of accounting period is transferred to the Overhead Suspense Account which is ultimately transferred to the Costing Profit and Loss Account or directly to Costing Profit and Loss Account. If some portion of under or over-absorption arises due to abnormal causes such as strikes, lock-outs, major breakdown etc., then such portion should be carried over to the next year and is taken into account while fixing the rate for that period.

The main defect of this method is that it will distort the value of stock as the amount of under or over-absorption of overheads is directly transferred to Costing Profit and Loss Account and not allocated to the stock of work-in-progress and finished goods. The value of such stock will either be under or over-stated in the next accounting period. Under-absorption will reduce the profit of the concern by the same figure for the period.

(iii) Absorption in the Accounts in Subsequent Years:

The amount of under or over- absorption of overheads may be carried over as deferred charge or deferred credit to the next accounting period by transferring to a Suspense or Overhead Reserve Account. The use of this method is justified when the normal business cycle is more than one year and in the case of new projects and schemes when the output is low in the initial stages of production and cannot bear the entire share of overheads.

Under such circumstances, it is desirable that some portion of such cost be carried over to the next period to be absorbed in the production of subsequent years. One criticism which is generally levied against this method is that cost should be absorbed in the period in which it is incurred and utilised and should not be carried over to the next period for the purpose of absorption as it will distort the costs for the purpose of comparison.

General Principles for Items of Overhead Expenditure:

Following general principles should be kept in view while considering whether an item of expenditure is to be treated as overhead:

  1. Overhead comprises of indirect costs, i.e. the costs which cannot be directly charged or allocated to any particular job, process or product. Thus, the relationship of the items of expenditure to product, job etc., must be seen.
  2. Direct costs are not to be treated as overheads. But in certain cases even direct expenses may be treated as overheads; for example, when the cost of a particular item like screws, nuts, bolts etc. though incurred for a particular job or product is so small that it is not convenient to charge them as direct costs, is to be apportioned as overheads over the jobs or products.
  3. Overheads may be attached to a cost centre in accordance with the principles of benefit and I or responsibilities. The benefit principle implies that if a cost centre occupies a proportion of a larger unit of space for which standing charges such as rent and rates are exactly ascertainable, it should be charged with a due proportion of such costs. The responsibility principle implies that as the departmental head has no control over the amount of rent and rates paid, these being fixed by decisions of others, his department should not bear any allocation of them.
  4. All expenditures of capital nature should be excluded from costs and shall not be treated as overheads.
  5. All expenditures which do not relate to cost, such as penal rates of interest on loans, donations, subscriptions, income-tax etc., are excluded from costs and shall not be treated as overheads.
  6. While it is not convenient to charge items of direct costs to individual jobs, processes or products, it is advisable to allocate or apportion these costs as overhead. For example, electricity charges can be treated as direct costs if electric consumption metres are installed for separate machines or departments but when this is not so, the total electricity bill may be allocated and apportioned over various jobs, products or processes in the form of overheads.
  7. All indirect expenses of such nature for which cash has been paid or liability contracted or a loss in capital value sustained should be treated as overheads. An example of the first type would be telephone bills or electricity charges paid by the factory and an example of the third type would be depreciation of fixed assets in the factory or the office.