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What is Under and Over Absorption of Overheads and Causes

Under and Over Absorption of Overheads
Under and Over Absorption of Overheads

Meaning of Under and Over Absorption of Overheads

Overhead expenses are usually applied to production on the basis of predetermined rate and the amount of expenses actually incurred will seldom the same. Some difference is inevitable.

If the actual expense exceed of the amount of predetermined rates, there is said to be an under absorption of overheads and conversely, if the actual expenses fall short of the amount of predetermined rates, it is a case of over absorption of overheads.

Such under or over absorption may also be termed as overhead variance.

Causes of Absorption Overheads

Under or over absorption may arise due to one or more of the following reasons:

(i) Faulty estimation of overheads.

(ii) Faulty estimation of the quantity of output.

(iii) Seasonal fluctuation in the amount of overhead in certain industries.

(iv) Unforeseen changes in the production capacity.

(v) Unexpected changes in the method of production affecting changes in the amount of overhead.

(vi) Non-utilization of normal capacity.

Whatever be the reason, under or over absorption is caused mainly due to wrong estimation either of the costs incurred or of the production over which they are to be absorbed.

ALSO READ- What is Allocation of Overheads ? Classification and Allocation Overheads

Accounting Treatment of Absorption of Overheads

The treatment will depend on the causes led to under or over absorption. The following are the main methods of disposal of under or over absorption of overheads:

(1) Transfer to cost profit & low account: Where the difference between actual and absorbed overhead is not large, the simple method is to write it off to the costing profit & loss account.

Under absorption due to abnormal facts like idle capacity, defective planning, etc., is also transferred to costing profit & loss account.

This method suffers from the shortcoming that stocks of work-in-progress and finished goods remain under or over valued and are carried over to the next accounting period at such varies.

(2) Application of supplementary rate: Where the amount of under or over absorption is considerable the cost of jobs or products is adjusted by means of a supplementary rate.

This rate is determined by dividing the amount of under or over absorption by the base that was adopted for absorption. The rate may be positive or negative. In form of formula:

Supplementary Rate = Amount of over or under absorbed overheads / Actual base

In the case of under absorption the overheads is adjusted by a plus rate since the amount is to be added whereas over absorption is adjusted by a minus rate since the amount is to be deducted.

Example: Pre-determined overhead rate=Rs. 5 machine per hour Actual machine hours = 1,500 Actual overhead Rs. 9,000

ALSO READ- What is Absorption of Selling and Distribution Overheads


Absorbed overhead = 1,500 hours x Rs. 5 per hour Rs. 7,500

Under absorption = Rs. 9,000-Rs. 7,500 = Rs. 1,500

Supplementary Rate = Amount of over under absorbed overheads / Actual base

                              = Rs. 1,500 / 1,500 Hrs.

                              = Rel.00 per hour 

This is a plus rate because it is for under absorbed overheads and will be used to add to the overhead already recovered.

The amount of under/over absorption at the end of 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 value of the balances in each of these accounts by use of supplementary rate.

Subsidiary records or individual items are not corrected the amount so adjusted will be shown in the balance sheet as deductions from the work-in-progress and finished stock.

(3) Carrying over of overhead: In this method. the balance of under/ over absorbed overheads at the end of the year is transferred to an overhead reserve or suspense account and is carried forward to the next year account for absorption. This method is preferably applied

(i) In case of seasonal factory the balance of a period (month or quarter or half year) may be carried forward to the next period on the presumption that it will be counter balanced at the end of the accounting year.

(ii) In case of business where output is affected by business cycles and overhead rate has been predetermined for a period of more than one year the balance of a year may be transferred to next year’s accounts and so on.

(iii) In case of new project, in the initial years the balance of one year may be transferred to the next year on the presumption that there will be more output in the next year which will absorbed more overheads.

This procedure is open to criticism on the ground that it is not logical carry over the overhead of one year to the subsequent years for absorption.

But this method can be usefully employed where normal business cycle extends over more than one year and overheads are determined on a long term basis.

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