Treatment of Over Absorption of Overheads
Over absorption of overheads occurs when the actual overhead costs incurred are less than the budgeted or estimated overhead costs. This can happen due to various reasons, such as changes in production volumes, improved efficiency in production processes, or lower actual costs for overhead items. Over absorption of overheads leads to a situation where the overheads allocated to products are higher than the actual overheads incurred.
To treat over absorption of overheads Steps:
Identify the amount of over absorption:
The first step is to determine the amount of over absorption by comparing the actual overheads incurred with the budgeted or estimated overheads. The formula for calculating over absorption is:
Over absorption = Budgeted or estimated overheads – Actual overheads
Allocate the over absorption:
The over absorption amount needs to be allocated to the different products or services that were produced during the period. The allocation can be done using any of the methods discussed earlier, such as allocation based on labor hours, machine hours, or any other appropriate allocation base.
Adjust the cost of goods sold:
The over absorption amount allocated to each product or service needs to be added to the actual overheads allocated to the product to arrive at the total overhead cost for each product. This total overhead cost is then added to the direct costs of production to determine the total cost of each product. The cost of goods sold (COGS) in the income statement needs to be adjusted to reflect the correct total cost of each product.
Adjust the cost of inventory:
If the over absorption amount is significant, it may also impact the value of inventory held by the business. In this case, the value of inventory needs to be adjusted to reflect the correct total cost of each product.
Investigate the reasons for over absorption:
Over absorption of overheads may indicate that the estimated or budgeted overheads were overstated or that the actual overheads were lower than expected due to improved efficiency or other factors. It is important to investigate the reasons for over absorption to ensure that the budgeted or estimated overheads are adjusted appropriately for future periods.
Treatment of Under Absorption of Overheads
Under absorption of overheads occurs when the actual overhead costs incurred are greater than the budgeted or estimated overhead costs. This can happen due to various reasons, such as unexpected increases in production volumes, inefficiencies in production processes, or higher actual costs for overhead items. Under absorption of overheads leads to a situation where the overheads allocated to products are lower than the actual overheads incurred.
To treat under absorption of overheads Steps
Identify the amount of under absorption:
The first step is to determine the amount of under absorption by comparing the actual overheads incurred with the budgeted or estimated overheads. The formula for calculating under absorption is:
Under absorption = Actual overheads – Budgeted or estimated overheads
Allocate the under absorption:
The under absorption amount needs to be allocated to the different products or services that were produced during the period. The allocation can be done using any of the methods discussed earlier, such as allocation based on labor hours, machine hours, or any other appropriate allocation base.
Adjust the cost of goods sold:
The under absorption amount allocated to each product or service needs to be added to the actual overheads allocated to the product to arrive at the total overhead cost for each product. This total overhead cost is then added to the direct costs of production to determine the total cost of each product. The cost of goods sold (COGS) in the income statement needs to be adjusted to reflect the correct total cost of each product.
Adjust the cost of inventory:
If the under absorption amount is significant, it may also impact the value of inventory held by the business. In this case, the value of inventory needs to be adjusted to reflect the correct total cost of each product.
Investigate the reasons for under absorption:
Under absorption of overheads may indicate that the estimated or budgeted overheads were understated or that the actual overheads were higher than expected due to inefficiencies or other factors. It is important to investigate the reasons for under absorption to ensure that the budgeted or estimated overheads are adjusted appropriately for future periods.