Explain what is over/(under) absorption Of Overheads

November 16th, 2007 Comments off
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In earlier articles, we discussed about absorption costing, its advantages and disadvantages and its various methodologies.

This article discuss about the over or under absorption of overheads:-

Over or Under Absorbed in Absorption Costing

  • Note that as long as planned level of activity and the actual level of activity is not the same there is always an Over or Under Absorption situation
  • This is because overhead absorption rate is set at the start of the period based upon an expected level of productionand that during the period, the level of output andor overheads will be different from the planned overheads and or output.
  • OVER-absorption occurs when the total overhead recovered or absorbed is GREATER than the actual level of overheads for the period.
  • UNDER-absorption occurs when the total overheads recovered or absorbed is LESS than the actual overheads incurred in the period.
Illustration:
Company A recovers its overheads based upon direct labor hours. The planned overhead expenditure is $2,500 per month and the planned direct labor hours are 1,000 per month. The results for the first 3 months were as follows:

Month 1 Month 2 Month 3
Actual Overhead ($) 4,000 5,000 3,500
Direct labor hours 1,000 2,000 2,000

Required:

(a)compute the overheads recovered each month;

(b)compute the total overheads over/under-absorbed

Solution:

(a)The pre-determined overhead absorption rate:

= Budgeted overhead per month/Budgeted direct labors per month

=$2,500/1,000 hours=$2.50 per direct labor hour.

Month 1 Month 2 Month 3
Actual Overhead ($) 4,000 5,000 3,500
Direct labor hours (a) 1,000 2,000 2,000

Overhead Recovery per direct labor hour (b)

2.5 2.5 2.5

Overhead recovered or absorbed(a x b)

2,500 5,000 5,000

(b)The monthly over/under absorption of overheads is the difference between the overhead recovered or absorbed and the actual level of overhead for the period

Month 1 Month 2 Month 3

Actual Overhead

(a)

4,000 5,000 3,500

Overhead recovered

(b)

2,500 5,000 5,000
Over/(under) absorbed overhead(a)-(b) (1,500) 0 1,500

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Financial Accounting

 
 

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