In cost accounting, the absorption of overheads is a critical process that ensures all indirect costs are allocated to products or services accurately. However, due to estimates and fluctuations in business operations, there are times when overheads are either under-absorbed or over-absorbed.
This topic explains under absorption and over absorption of overheads, their causes, effects, and methods of adjustment.
What Is Overhead Absorption?
Overhead absorption is the process of allocating indirect costs, such as rent, utilities, and administrative expenses, to different products or services. It ensures that total costs reflect both direct expenses (materials, labor) and indirect costs (factory rent, electricity).
Businesses use predetermined overhead rates to allocate these costs, often based on estimated figures rather than actual expenses. This estimation can lead to differences between absorbed overheads and actual overheads, resulting in under or over absorption.
What Is Under Absorption of Overheads?
Under absorption of overheads occurs when the actual overhead costs exceed the absorbed overheads. In other words, the company has not allocated enough overheads to its products, leading to an understatement of total costs.
Causes of Under Absorption
Several factors can lead to under absorption of overheads, including:
- Incorrect Estimation – If overhead rates are set too low, fewer costs will be absorbed.
- Unexpected Cost Increases – A rise in rent, electricity, or maintenance costs can cause actual expenses to surpass absorbed overheads.
- Lower Production Volume – If fewer units are produced than expected, the overheads per unit increase, resulting in under absorption.
- Inefficient Operations – Wastage, machine breakdowns, or idle time can lead to higher actual overheads than planned.
Effects of Under Absorption
- Understated Costs – Products appear cheaper than they actually are, affecting pricing decisions.
- Lower Profits – If overhead costs are higher than anticipated, net profits may decrease.
- Misleading Financial Statements – Reports may not reflect true expenses, leading to incorrect managerial decisions.
What Is Over Absorption of Overheads?
Over absorption of overheads occurs when the absorbed overheads exceed the actual overhead costs. In this case, a company allocates more indirect costs to its products than it actually incurs.
Causes of Over Absorption
- Overestimated Overhead Rate – Setting a high absorption rate can lead to excess allocation of costs.
- Lower Actual Expenses – If expenses like rent, utilities, or administrative costs decrease unexpectedly, absorbed overheads may be higher than actual overheads.
- Higher Production Output – Producing more units than expected spreads overheads over a larger base, reducing actual overheads per unit.
- Efficiency Improvements – Increased productivity or cost-saving measures can lower actual overhead costs.
Effects of Over Absorption
- Overstated Costs – Products seem more expensive than they actually are, potentially affecting sales.
- Higher Profits – If actual expenses are lower than absorbed costs, reported profits may be inflated.
- Distorted Financial Analysis – Incorrect allocation of costs may lead to poor business decisions.
Methods to Adjust Under and Over Absorption of Overheads
To ensure accurate financial reporting, companies must adjust under and over absorption. Here are common methods used to correct discrepancies:
1. Transfer to Profit and Loss Account
The simplest way to handle absorption differences is to transfer the excess or shortfall to the profit and loss account.
- Under Absorbed Overheads â Added to expenses in the P&L account
- Over Absorbed Overheads â Credited as income in the P&L account
2. Supplementary Rate Method
A supplementary overhead rate is applied to correct the difference.
- For Under Absorption: A supplementary charge is added to cost units.
- For Over Absorption: A credit adjustment is applied to reduce cost per unit.
3. Carry Forward to Next Period
If differences are small and expected to balance out over time, businesses may carry forward the under or over absorption to the next accounting period.
4. Recalculation of Overhead Rates
Companies can revise their predetermined overhead absorption rates to ensure future accuracy. This method prevents continuous under or over absorption in subsequent periods.
Example of Under and Over Absorption of Overheads
Let’s consider a manufacturing company that estimates total overheads of $100,000 and produces 10,000 units. The predetermined overhead rate is calculated as:
Scenario 1: Under Absorption
- Actual overhead cost: $120,000
- Absorbed overhead: 10 à 10,000 = $100,000
- Under absorption = $120,000 – $100,000 = $20,000
This $20,000 shortfall must be adjusted using one of the methods mentioned earlier.
Scenario 2: Over Absorption
- Actual overhead cost: $90,000
- Absorbed overhead: 10 à 10,000 = $100,000
- Over absorption = $100,000 – $90,000 = $10,000
In this case, the business overestimated overheads, leading to an excess allocation of $10,000.
How to Prevent Under and Over Absorption of Overheads
While some variations are inevitable, companies can take proactive steps to minimize discrepancies:
1. Improve Cost Estimation
Regularly review past data and trends to set more accurate overhead rates.
2. Monitor Production Levels
Track actual production and adjust absorption rates accordingly to prevent major differences.
3. Conduct Periodic Overhead Reviews
Evaluate overhead costs regularly to ensure alignment with estimated rates.
4. Enhance Operational Efficiency
Reducing idle time, improving productivity, and controlling costs help minimize deviations in overhead absorption.
5. Use Flexible Budgeting
A flexible budget adjusts overheads based on actual production levels, reducing absorption errors.
Under and over absorption of overheads occurs when there is a mismatch between actual overheads and the absorbed costs. Under absorption happens when actual costs exceed allocated overheads, while over absorption occurs when allocated overheads exceed actual costs.
Both situations impact financial reporting and business decision-making. By improving estimation accuracy, monitoring costs, and using effective adjustment methods, companies can ensure a fair and realistic allocation of overhead costs.
Understanding and managing overhead absorption is essential for businesses to maintain accurate pricing, profitability, and financial transparency.