Over or Under absorption of Overhead:
When, under historical costing system, on the basis of actual figures, the ascertainment
of recovery rate is made, then the overhead which has been actually incurred becomes
equal to the overhead recovered. So in this case there is no chance that the overhead
will be over or under absorbed; but difference may arise between the overhead incurred & overhead
recovered or absorbed, when, on the basis of estimated or expected figures, recovery
rate is predetermined. Under-absorption of overhead arises, when the amount of overhead
that has been incurred exceeds the amount of overhead that has been absorbed. Whereas,
over-absorption of overhead arises when the amount of overhead that has been absorbed
exceeds the amount of overhead that has been incurred.
Because of any one or both of the below mentioned two reasons, the under or over-absorption
of overhead may arise:
(a) the actual overhead expenses is more or less than the estimates of overhead,
(b) the base of actual amount of the absorption (cost of material, wages, hours of
work etc., as the case may be) is different from the base of estimated absorption.
Treatment of Over or Under-absorbed Overhead in Cost Accounts:
In three different ways, the treatment of over or under-absorbed overhead may be done:
(a) to the next period’s account, the amount may be carried forward.
(b) to costing profit & loss account, the amount may be written off.
(c) to the production, a supplementary rate may be worked out & applied.
In cases where over a number of years, the normal business cycle extends, the first
method may be applied. Since this method ignores matching of cost, this could not be
popular in normal conditions. If however, such carry forward is justified by conditions,
under or over-absorbed overhead, so that the same can be carried forward to the next
period for the purpose of absorption, should be transferred to a reserve or suspense
account.
In cases, where the amount of over or under-absorption is insignificant, the second
should be applied, so that without disturbing the cost of production, to the profit & loss
account, this small amount is written off.
The third method can be applied in cases where owing to -(i) a serious error in the estimation of overhead, (ii) an error in the estimation of the base of the rate of recovery, (iii) a serious error while computing the recovery rate, (iv) a major change in the production method, (v) a substantial change in the activity level etc., the considerable amount of over or under-absorption is involved. Under this method, the adjustment of amount of over or under-absorbed overhead is done through supplementary rates to the work-in-progress values, finished goods which have not been sold & factory cost of sales (i.e. work completed & sold). These accounts are credited with supplementary rates, in case there is over-absorption & factory overhead account is debited. On the other hand, these accounts are debited with supplementary rates & factory overhead account is credited, in case there is under-absorption. On the basis of (a) each account’s cost of direct material or direct wages, (b) each account’s labour hours or machine hours, or (c) each account’s money value (work-in-progress, finished goods, factory cost of sales); the computation of the supplementary rate is done.
Illustration: For a cost centre, the budgeted working
condition conditions are as follows:
Normal working week 42
hours
Number of machines 28
On maintenance etc., normal weekly loss of hours 5
hours per machine
Estimated annual overhead $124320
Estimated direct wages rate $
1.50 per hour
No of weeks worked per year 48
In respect of a 4-week period, actual results are:
Overhead incurred $10200
Wages incurred $
7400
Machine hours produced 4200
Calculate (a) the overhead rate per machine hour; & (b) the amount of under or
over-absorption of both wages & overhead.
Solution: (a) Normal working hour’s p.a.
(No. of machine* hours per week * No of weeks p.a.)
(28*42*48) 56448
hours
Normal loss of hours on maintenance etc. p.a.: 28*5*48 6720 hours
Effective working hours p.a. 49728 hours
Machine hour rate = $ 124320/49728 = $ 2.50
(b) Overhead absorbed = 4200 hours @ $ 2.50 $
10500
Overhead incurred $ 10200
Over-absorption $ 300_
Wages absorbed = (28*42*4) hours @ $ 15 $
7056
Wages incurred $ 7400
Under-absorbed $ 344
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- Nature & Treatment of some items of Expenses in Cost Accounts- Part III
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