Usually overheads are apportioned or allotted to cost units on an estimated basis. But it is quite natural that the overhead so estimated may be different from the amount of overhead actually incurred.
Hence the question of under or over absorption of overhead arises when there is a difference between the amount of overhead absorbed and the amount of overhead incurred.
Meaning of Under-absorption of overheads
Under-absorption of overheads means that the amount of overheads absorbed in the production is less than the amount of actual overheads-Incurred. For example if the overheads absorbed on a predetermined basis are Rs: 1, 00,000 and the actual overheads incurred are Rs. 1, 20,000, there is under-absorption to the extent of Rs.20, 000.
It represents under stating the costs as the overheads incurred are not fully recovered in the cost of jobs or processes, etc. Under-absorption is also termed as 'under recovery',
Meaning of over-absorption of overheads
Over-absorption of overheads means the excess of overheads absorbed over the actual amount of overheads incurred. In other words when the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates it would mean over-absorption of overheads. Usually over-absorption inflates the cost. Over- absorption is also formed as 'over recovery'.
For example the overheads recovered are Rs.3, 00,000 and the actual production overheads are Rs.2, 75,000 then there will be over-absorption of Rs.25, 000. (Rs.3, 00,000 - Rs.2, 75,000).
Reasons of under / Over-absorption of overheads
The under or over-absorption of overheads may arise due to any one or more of the following reasons:
(i) Wrong estimation of overhead expenses: The actual overhead expenses may be substantially less or more than the estimated amount.
(ii) Wrong estimation of work done: The amount of work done may greatly exceed or may be substantially less than the estimated work. For example if actual work is 8,000 working hours against estimated working hours of 10,000, then the expenses charged to job will be 20% less.
(iii) Error in using method of absorption: Sometimes the method of absorption may not be suitable. If the percentage of direct material method is used, fluctuation in prices of material may lead to under or over-absorption of overheads.
(iv) Seasonal fluctuation in overhead: Due to seasonal nature of work, overhead may fluctuate from one period to another period.
(v) Under or over utilisation of capacity: There may be under or over-absorption of overhead due to under or over utilisation of productive capacity.
(vi) Wrong estimation of output: When the actual output substantially differs from the anticipated output, it leads to under or over-absorption of overheads.
Treatment of under or over-absorption of overheads
The under or over-absorption of overheads may be disposed of by any one of the following three methods:
1st method: Writing off to costing profit and loss account
If the difference between actual overheads and absorbed overheads is small, it is simply transferred to costing profit and loss account.
If however this difference is large the reason should be investigated. When the cause is abnormal the amount of under / over-absorption should be treated as abnormal loss and transferred to costing profit and loss accent.
2nd method: Use of supplementary rate
Under this method, the difference of actual and estimated overheads is charged to three parts, i.e. cost of work-in-progress, cost of finished stock and cost of sales proportionately. This is usually done with the supplementary rate of overheads. The supplementary rate is computed by dividing under/over-absorbed overheads with the actual base.
Difference between actual and absorbed overheads
From the information given above show how do you adjust the difference among work-in-progress, finished stock and cost of sales by way of supplementary rate?
3rd Method: Carry forward to the next year
Sometimes it is recommended that the difference should be carried forward to the next year-with the expectation that in the next year the position will be corrected. But this results in rendering the costing data of both the years misleading. However this method is suitable only in case of new projects which will have more outputs in the next period than in the initial period.
In this method, the amount of under-absorbed overheads? Transferred to the debit of overhead reserve suspense account and the amount of over-absorbed overheads are transferred to its credit side.