Over and Under Absorption of Overheads

As we have already discussed overheads may be absorbed either on the basis of predetermined rates or actual rates. The problem of under or over absorption arises when predetermined rates are used. Since there are seasonal differences, so the difference between the budgeted overhead and actual overhead incurred is bound to happen.

If the actual overhead is more than the overhead absorbed, then this excess is termed as under absorption as this portion remains uncharged to production.

On the other hand if the overhead absorbed is more than the actual overhead, this difference is called as ‘over absorption’ as the amount charged to production has not been incurred.

Under or over absorption of overheads may arise due to the following reasons: 1. The overhead absorption rate may have wrongly been computed. 2. The seasonal fluctuations in the overhead costs in some industries.

3. Unforeseen changes in the capacity of production. Unexpected change in the volume of output. Treatment of under or over absorption:

1. Use of Supplementary Rate – if the difference is considerable then supplementary rate is calculated. 2. Transfer to Costing Profit and Loss Account – if difference is due to abnormal reasons which are beyond the control of management, then such amount should be transferred to Costing Profit and Loss Account.

3. Transfer to Overhead Suspense Account- if the difference is seasonal (for which it is possible that by the end of the accounting period it will wipe out) then it should be transferred to overhead suspense or adjustment account.

Illustration – 7:

In X Ltd, overheads were recovered at a predetermined rate of Rs. 25 per machine hour. The total factory overheads incurred were Rs. 83 lakhs and machine hours actually worked were 3 lakh. 80000 units of a product were produced out of which 70000 were sold. It was found that 60% of the unabsorbed overheads were due to defective planning and the rest were attributable to increase in overhead cost.

How would unabsorbed overhead be treated in cost accounts. Solution:

Rs.

Actual factory overheads 83 lakhs

Less: Factory overheads recovered

Rs. 25×3 lakhs machine hours 75 lakhs

unabsorbed overhead 8 lakhs

Treatment:-

(i) 60% of 8 lakh i.e. Rs. 480000 should be transferred to costing profit and loss account. (ii) The balance of Rs. 320000 should be recovered from this year’s production for this

supplementary rate i.e. Rs. 4 (320000 ÷ 80000) is used , which is charged as follow –

(a) Cost of sales account 70000×4 = Rs. 280000

(b) Closing stock account 10000×4 = Rs. 40000

Activity C:

1 In X ltd., two products are made. For a particular period production costs are as under:

Product- X Product –Y

Material used (Rs.) 1200 400

Direct labour cost (Rs.) 1600 800

Overheads actual (Rs.) 900 450

Overheads are charged at a rate of 25% on prime cost. Is there any difference in actual and absorbed overhead?

8.6

Summary

Besides the indirect expenses in the factory, there are many expenses which have to be incurred for smooth running and functioning of business. The cost which relates to general administration of business is termed as administrative overheads. On the other hand, expenditure incurred to create and stimulate demand and secure orders is selling cost. The cost which begins with making the packed product available for dispatch and ends with making the returned packages available for reuse is distribution overheads.

After calculating the departmental overheads they are ultimately charged to or absorbed to cost units or different jobs passing through that centre. This is known as the allotment of overhead to cost unit or absorption. The purpose of cost apportionment is to charge expenses in an equitable proportion to the various departments; where as the purpose in overhead absorption is to distribute the total overheads of each manufacturing department in a given period, so that overhead cost per unit of each product can be arrived. Absorption rates are determined for the purpose of charging factory, office, selling and distribution overheads to various units. The chances of actual and absorbed overheads are same is rare. This difference is termed as ‘under or over absorption of overheads,’ which may be disposed off by using of supplementary rate or transferred to Costing P&L Account or can be carried to next year.

Key Terms

Administrative overheads - The cost of incurred on general administration of the business. Selling overheads - All expenses incurred in obtaining and retaining a customer. Distribution overheads - It includes all expenditure incurred from the time the product

is completed until it reaches its destination. Absorption - The allotment of overhead to cost units. Machine Hour Rate - The cost of running a machine for one hour.

Over absorption - If the amount absorbed is greater than the actual amount of overhead, this difference is over absorption.

Under absorption - If the amount absorbed is less than the actual amount of overhead incurred, this difference is termed as under absorption.

8.7

Self Assessment Questions

1. What is machine hour rate? Explain briefly the situations in which a machine hour rate may suitably be used in cost accounting.

2. Define administrative overheads and state briefly the treatment of such overheads in cost accounts.

3. Write a short note on “Documents for collection of overheads”.

4. Explain how under absorption and over absorption are treated in cost accounts.

5. How will you treat the following items in cost accounts of a manufacturing concern (i) carriage outward (ii) idle time (iii) packing charges (iv) Interest on capital.

6. If in an industry estimated cost is – direct material Rs. 20000, direct wages Rs. 30000 and factory overheads Rs. 5000. on this basis calculate the total cost of a particular product in which direct material cost Rs. 1000, direct wages Rs. 600 and direct expenses Rs. 400 if the factory overheads are charged on the basis of (a) direct material (b) direct labour and (c) prime cost.

(Answer- (a) Rs. 2250 (b) Rs. 2100 and (c) Rs. 2200)

7. Calculate machine hour rate for a machine from the following data-

Cost of machine Rs. 19200

Estimated scrap value Rs. 1200

Average repairs charges per month Rs. 150

Standing charges allocated to the machine per month Rs. 50

Effective working life of machine 10000 hours

Running hours per month 160 hours

Power used by machine -5 unit per hour @ 19 Paisa per unit (Answer – Machine hour rate Rs. 4.00)

8. A manufacturer has shown an amount of Rs. 32380 in his books as establishment which includes the following: Insurance: Rs. Office 460 Warehouse 620 Travelling expenses 1520 Directors Remuneration 2800 Office salaries 2260 Office lighting 140

Ware house repairs 1020

Ware house wages 3600

Agent’s commission 11500 Bad debts 340 Discount allowed 3940 Bank charges 200 Donations 300 Trade magazines 140

From the above information prepare a statement showing totals of : (a) administration overheads (b) selling overheads (c) distribution overheads (d) expenses you would disregard in estimating the cost.

9. Calculate the tender price of 3000 units if the details of actual cost of 2000 units are as follows: Material cost Rs. 4500, labour cost Rs. 2500, direct expenses Rs. 500, factory overheads Rs. 1000, office overheads Rs. 800 and selling and distribution overheads Rs. 400. The further details in this connection are as follows-

(a) An increase of 10% is expected in the cost of raw material and 5% in the cost of labour. (b) 70% of factory overheads are fixed.

(c) The ratio of fixed and variable expenses in administrative overhead is 6:4. (d) 50% of selling and distribution overheads is variable.

The management desires to charge 25% profit on the sales price. Ascertain the selling price. (Answer. Selling price of 3000 units Rs. 19630)

8.8

Reference Books

- Ghosh,P.K., ‘Cost Accounting’, National Publishing House, New Delhi.

- Maheshwari, Mittal, ‘Cost Accounting and Financial Management’, Shri Mahaveer Book Depot, Delhi.

- Ravi. M. Kishore, ‘Cost Accounting’, Taxmann Publication, New Delhi. - Jain, Narang, ‘Cost Accounting’, Kalyani Publication, New Delhi.

Unit - 9 : Activity Based Costing