The overheads are absorbed on the basis of predetermined overhead absorption rate according to the actual production of goods throughout the accounting period or specific period. Budgeted overheads and budgeted output are used to determine overhead rate. If budgeted overhead and budgeted output differ from actual overhead and actual output, three is a difference between predetermined overhead rate and actual overhead rate.
If the overheads absorbed are higher than the actual overheads incurred, it is called over absorption. If the overhead absorbed is lower than the actual overheads incurred during the accounting period, it is called under absorption.
Reasons for Over or Under absorption of overhead
The reasons for over or under absorption of overheads are as follows.
1. The actual hours worked is more or less than the budgeted hours.
2. The actual overhead costs are different from budgeted overheads.
3. Both actual overhead costs and actual activity level are different from the budgeted costs and level.
4. The method of overhead absorption may be wrong.
5. Unexpected expenses may be incurred during the accounting period.
6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.
7. Major changes like replacement of manual labour with machines. This leads to increase in capacity levels.
8. Seasonal fluctuations in the overhead expenses from period to period.
Treatment of Over or Under absorbed overhead
The over or under absorbed overheads are treated in the cost accounts in any one of the following ways.
1. Application of Supplementary Rates
The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. In case of over absorption, the over recovered amount will be adjusted by applying the supplementary rate and vice versa.
2. Adjustment to Cost of Sales
The over absorbed or under absorbed overheads is closed and transfers the same to the cost of sale account. This is done by the Cost Accountant at the end of every month or at the end of accounting period. If the transfer is made at the end of the accounting period, the over/under-absorbed overhead is carried forward from month to month treating it as deferred income if over applied and as deferred charges, if under applied.
3. Write off to Costing Profit and Loss Account
If the over or under absorbed overhead is small, and then it will be written off by transferring it to the costing profit and loss account. If so, the valuation of closing stock is over stated or under stated.
4. Adjusted to Gross Profit
The under or over absorbed overhead balances are closed by making the adjustment in gross profit.
5. Carry Forward to Subsequent Year
The under or over absorbed overhead may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account. This Overhead Suspense Account or Overhead Reserve Account will appear in the Balance Sheet.
The debit and credit balances representing under/over absorbed overhead showing in the asset side or liabilities side of the Balance Sheet. The basic idea is to off set the under absorbed overhead in one year with over absorbed overhead in another year. But, many accountants oppose this idea. The reason is that balances of under/over-absorbed overhead should not be carried forward from one year to another year. This method is otherwise called as use of reserve account.