What Are Under-Absorption & Over-Absorption of Overheads?

(2) Cost of operating different machines is computed and efficiency of different machines is compared. (3) The rate is not affected by wage rates, different kinds of incentive systems, etc. (2) No consideration is given for fixed and variable cost. (2) When there is little variation in wage rates payable to different categories of employees.

  • The prime cost, comprising direct materials, direct labor, and direct expenses, is significant in every type of organization.
  • If automatic and semi-automatic machines are used in the manufacturing process, machine hour rate is applied in the case of overhead absorption.
  • The overhead absorbed in a period will be found out by multiplying overhead rate by total number of units produced for the period.
  • They are usually calculated and assigned to a product at a predetermined rate.
  • Thus, the absorption of overheads is the function of apportioning overhead costs to individual units, jobs, production lots, processes, work-orders, or such other convenient cost units.

In January, Higgins only produced 45,000 widgets, so it allocated just $90,000. Also, the actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Higgins experienced $8,000 of underabsorbed overhead. In audit working papers February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. Also, the actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed overhead.

Hourly rate methods for calculating absorbed overhead

Most companies use the hourly method of calculating overhead absorption as it produces the most accurate results. It is because most companies and their cost centres incur costs that are period costs and relate to time. While some companies use total units produced as a basis to calculate the overhead absorption rate, there are many other bases they can use as well.

It is a process of distribution of overheads allotted to a particular department or cost centre over the units produced. The absorption of overhead is done by applying overhead absorption rates. The overheads allocated or apportioned over different cost centres or cost units are again absorbed into unit cost on some equitable basis.

The machine hour rate may be calculated for a specific machine or group of machines. (5) When labour is not the major cost of production this method of absorption will not be suitable. (1) Fluctuations in material prices may affect the overhead absorbed. Overhead may be stable but absorption rate may not be appropriate as the basis is not suitable, when the raw material prices fluctuate. (ii) Nowadays, in every economy, material prices fluctuate substantially.

What are the different methods of absorption of factory overhead?

Direct costs are directly traceable to a specific product, cost centre or project. Direct costs are variable as they depend on the level of activity of the company. When a company uses standard costing, it derives a standard amount of overhead cost that should be incurred in an accounting period, and applies it to cost objects (usually produced goods). If the actual amount of overhead turns out to be different from the standard amount of overhead, then the overhead is said to be either under absorbed or over absorbed.

Under absorption of overhead example

This method is usually applied in cases where labor is the main factor in production. It is also applied when the quality, skill, and gender of employees do not differ significantly. This is one of the oldest methods of cost absorption and it is widely regarded as one of the best. Ideally, the quantity and cost of materials in each product are uniform, and processing is also uniform.

Sales Price Method:

(d) This method is better than percentage of direct material cost, since labour rates fluctuate less frequently than the rate of materials. Machine hour rate is calculated by dividing the factory overhead by machine hours. Under this method the overhead is divided by the aggregate of direct material and direct labour cost of the department. (3) Expensive materials may result in less overhead expenses than cheap materials. Thus, overhead cost has nothing to do with direct material cost of a product. Higgins Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget.

With time, the overhead allocation rate for the production of a product should be adjusted so it matches the actual amount of overhead it incurs. This means that eventually the amount of overabsorbed and underabsorbed overhead should balance each other out. Only actual hours run on production i.e., 1800 hours is taken into consideration for computation of machine hour rate, treating hours spent for setting and adjusting as non-productive. Machine hour rate will be able to account for varying lengths of time taken by products or jobs as they are worked on by the various machines in the department.

What is your current financial priority?

With Debitoor invoicing software, you can keep track of the expenses you incur during your production process. ‘Absorbed overhead’ refers to manufacturing overhead that’s been applied to a manufactured product or other cost object. (b) Work out the rate for quoting to the outside party for utilizing the idle capacity in the machine shop assuming a profit of 20% above variable cost.

(5) The total of standing charges per hour and machine expenses per hour is the ordinary machine hour rate. (1) Each machine or group of machines are treated as a cost centre to identify the overhead cost. (2) The time factor is not taken into account in this method which is very important for absorbing overhead cost. Overhead absorption is the name given to the process of absorbing the overhead of a business into the cost of its products. The process allows the total product cost to be used by the business in making decisions about pricing, profitability and inventory valuations.

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