Treatment of Over and Under Absorption of Overheads

Overheads in Cost Accounting refer to the indirect expenses incurred in the production of goods and services. These costs include factory rent, electricity, depreciation, indirect labor, and administrative expenses. However, the estimated overheads may not always match the actual overheads incurred, leading to either over-absorption or under-absorption of overheads.

• Over-Absorption of Overheads: Occurs when the absorbed overheads exceed the actual overheads incurred. This means that the estimated overhead recovery rate was higher than necessary, resulting in an overcharged cost to production.

• Under-Absorption of Overheads: Occurs when the absorbed overheads are less than the actual overheads incurred. This indicates that the estimated overhead recovery rate was lower, leading to insufficient allocation of overhead costs.

To ensure accurate cost allocation, businesses must adopt appropriate methods to adjust for over-absorption and under-absorption. The following are the main treatments:

1. Use of Supplementary Rate

A supplementary rate is applied to adjust the difference between absorbed and actual overheads. It is calculated as:

Supplementary Rate = Over or Under Absorbed Overheads / Actual Base (e.g., Labour Hours, Machine Hours)​

• If overheads are Under-absorbed, an additional charge is made to cost accounts.

• If overheads are Over-absorbed, a credit adjustment is made to correct the excess allocation.

This method is useful when the discrepancy is significant and needs to be allocated fairly across different cost units.

2. Writing Off to Costing Profit and Loss Account

If the over-absorption or under-absorption of overheads is minor and does not significantly affect cost accuracy, the difference is written off directly to the Costing Profit and Loss Account.

• Over-absorbed overheads are credited to the Profit and Loss Account, increasing the profits.

• Under-absorbed overheads are debited to the Profit and Loss Account, reducing the profits.

This method is widely used when the variance is due to uncontrollable factors such as unexpected increases in costs.

3. Carrying Over to the Next Accounting Period

In cases where overhead absorption errors are expected to reverse in the next period, the difference can be carried forward.

• Over-absorbed overheads are deducted from the next period’s overhead absorption.

• Under-absorbed overheads are added to the next period’s overhead absorption.

This method is effective in industries where cost fluctuations occur due to seasonal variations. However, it can lead to inaccuracies if the difference is not adjusted properly in the next period.

4. Adjusting Overheads Through Budget Revision

If the discrepancy in overhead absorption occurs frequently, the company may revise its overhead budget or absorption rates.

• In case of Over-absorption, the predetermined overhead rate is reduced for future cost calculations.

• In case of Under-absorption, the overhead recovery rate is increased to prevent future discrepancies.

This method helps in improving cost estimation accuracy over time.

5. Apportionment to Cost Units

Another method of treating overhead absorption differences is by apportioning the under-absorbed or over-absorbed overheads to different cost units.

• Over-absorbed Overheads are adjusted by reducing the cost per unit.

• Under-absorbed Overheads are adjusted by increasing the cost per unit.

This method ensures that each unit bears its fair share of the overhead cost, improving product cost accuracy.

6. Use of Absorption Reserves

Some organizations maintain an absorption reserve to manage fluctuations in overhead absorption.

• If overheads are Over-absorbed, the excess amount is transferred to the absorption reserve.

• If overheads are Under-absorbed, funds from the reserve are used to balance the discrepancy.

This method ensures stability in cost reporting, especially for large-scale manufacturing firms.

7. Retrospective Adjustment in Pricing

If a company frequently experiences significant over-absorption or under-absorption of overheads, it may adjust its pricing strategy.

• In case of Under-absorption, future product prices may be increased to recover the cost.

• In case of Over-absorption, product prices may be reduced to reflect the corrected cost structure.

This method is used in industries where cost-plus pricing is common, such as construction and contract-based businesses.