Overhead rates of absorption

Meaning and treatnment of under and over absorbed overheads

1. Overhead Rates… Dr. Shruti Ganpule

2. Actual Rate… Formula…. Actual o/h rate = Actual overheads incurred during the period Actual quantity produced during the period This rate can be calculated only after the accounting period is over. It causes delay in determination of cost. The actual volume of activity is affected by seasonal and cyclic factors. Actual rates do not provide any basis for cost control.

3. Pre Determined Rate…. Formula… Predetermined rate = Budgeted overheads for the period Budgeted Base for the period It facilitates computation of costs in advance. Quotations can be given in advance. It helps to prepare bills promptly. It is more helpful if budgetary control system is followed.

4. Blanket Rate… This is the single and general overhead rate applicable to the whole factory. Blanket or flat rate = Overhead cost for the entire factory Total Quantity of the base selected. It is applicable when only one product is manufactured in a factory on a large scale. It is also feasible where work performed by each department is almost similar.

5. Multiple Overhead Rates… Overhead Rate = Overhead costs of each department Corresponding Base These are applicable where production lines are varied. These are also applicable where different types of machinery is used. If the conditions of the factory are not uniform.

6. Under / Over Absorption of Overheads This situation arises when pre determined rates of overhead absorption are used. Under absorption: When the amount of overheads absorbed is less than the amount of overhead incurred. In this case cost is understated as actual cost overheads recovered are not fully recovered in in the cost of jobs, processes, etc.

7. Over Absorption of Overheads This situation arises when pre determined rates of overhead absorption are used. over absorption: When the amount of overheads absorbed is more than the amount of overhead incurred. In this case cost is overstated as actual cost of overheads recovered is more as compared to actual overheads.

8. Reasons of over absorption & under absorption Faulty estimation of overhead costs Overheads incurred are either more or less than overheads absorbed. Faulty estimation of quantity of output. Seasonal fluctuation in the amount of overhead in certain industries. Unforeseen changes in the production capacity. Unexpected changes in the method of production affecting changes in the amount of overhead. Non utilization of full capacity.

9. Difference between under and over absorption Under absorption the amount of overheads absorbed is less than the amount of overhead incurred . Cost is understated There is positive supplementary rate Under absorbed overheads are to be added. Over absorption the amount of overheads absorbed is more than the amount of overhead incurred . Cost is overstated. There is negative supplementary rate Over absorbed overheads are to be deducted.

10. Accounting treatment of disposal of under or over absorption Supplementary Rate method: It is used when amount of under or over absorbed overheads is quite large. Under or over absorbed overheads are due to normal reasons. Supplementary Rate = Amount of under / over absorbed overheads Actual Base In case of under absorption: The cost of sales, stock of finished goods and WIP are increased by applying positive supplementary rate. In case of over absorption : The cost of sales, stock of finished goods and WIP are decreased by applying negative supplementary rate.

11. Writing Off to Costing Profit & Loss a/c This method is usually used when… It is used when amount of under or over absorbed overheads is not large . Under or over absorbed overheads are due to abnormal reasons. The amount of under absorbed overheads is transferred to debit of costing profit and loss account. The amount of over absorbed overheads is transferred to credit of costing profit and loss account.

12. Carry over to next accounting Period Method.. It is used when the period of normal business cycle is more than one year and overhead rates are determined on a long term basis. In case of new projects, more output in the next period than that in the initial period is expected. The amount of under absorbed overheads is transferred to debit of overhead reserve or suspense account . The amount of over absorbed overheads is transferred to credit of overhead reserve or suspense account.