Under Absorption and Over Absorption of Overheads

Under Absorption and Over Absorption of Overheads

• Overheads = Indirect Cost: Overhead is indirect expenses which is not directly identify with production unit or object or activity. like factory overhead, office overhead, selling overhead etc. Overhead is required to charge at predetermined rate to the product.
• Predetermined Rate: Predetermine rate is overhead recovery rate calculated before production started on the basis of estimated overhead and estimated base like unit, hours, percentage, proportion etc.
• Actual Rate: This is historical overhead recovery rate. It is based on actual overhead incurred and actual base (like machine hours, labour hours, unit etc.) 
• Supplementary Rate: The rate at which under absorb (recovered) overhead charged to the cost.
• Under absorption(recovery): If recovered overhead is less than the actual overhead incurred the difference is known as under absorption of overhead.
• Over absorption (recovery): If recovered overhead is more than the actual overhead incurred the difference is known as Over absorption of overhead.
• Charging of Under and over absorption of overhead: 
• Under absorption due to increase in cost of unavoidable reasons charged to cost.
• Under absorption due to inefficiency or carelessness or wrong estimation or some avoidable reasons would be charge to Costing profit and loss account.

Example:1

Manufacturing Overheads incurred	1,70,000
Less: Manufacturing Overhead recovered	1,50,000
Under absorption of Overhead	20,000

Supplementary Overhead recovery Rate:

Cost of sales	3,36,000	480000                                 20,000	336000x4.16666% = 14,000
Finished Goods	96,000	100                                          ?	96,000x4.16666% =  4,000
Work in Process	48,000	4.166666666666666%	48,000x4.16666% = 2,000
	4,80,000

 New cost:

Cost of sales	3,36,000	+	14,000	3,50,000
Finished Goods	96,000	+	4,000	1,00,000
Work in Process	48,000	+	2,000	50,000
	4,80,000			5,00,000

Decrease in profit = -14000 + 4000 + 2000 = - 8000  

Example: 2

Manufacturing Overheads incurred	41,50,000
Less: Manufacturing Overhead recovered150000 x 25	37,50,000
Under absorption of Overhead	4,00,000

Overhead under absorbed charged to profit and loss account. 4,00,000 x 60% = 2,40,000

Overhead under absorbed recovered by supplementary rate.   4,00,000 x 40% = 1,60,000

Supplementary Overhead recovery Rate Rs.1,60,000/40,000 units = Rs. 4 per unit

Overhead charged to Cost of sales = 30,000 x 4 = 1,20,000

Overhead charged to Closing stock = 10,000 x 4 = 40,000

Example: 5

Calculation of estimated effective Hours:

Standard Hours (10 x 42 x 52)	21,840
Less: Annual Leave (10 x 42 x 2)	840
Less Other Leave (10 x 42 x 1)	420
Less: Cleaning Hours (10 x 2 x 49)	980
Less: Illness and absenteeism	1,100
	18,500

Overhead Absorption Rate:  Overheads/Effective Hours

   

13875/18,500 = Rs.0.75 per hour

Calculation of Actual Hours:

Standard Hours (10 x 42 x 52)	21,840
Add: Overtime	800
Less: Annual Leave (10 x 42 x 2)	840
Less Other Leave (10 x 42 x 1)	420
Less: Cleaning Hours (10 x 2 x 49)	1,000
Less: Illness and absenteeism	1,300
Less: Machine break down	200
	18,880

Overhead Recovered: = 18,880 x 0.75 = Rs. 14,160

Actual Overhead Rs.14,500

Under absorption of overhead = 14,500 – 14,160 = Rs.340