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  Under or Over Absorption of Overheads

Introduction Under/Over Absorption of Overheads

We have observed in the absorption of overheads that via using any technique, a rate of absorption is calculated and then the overheads are charged to the products. The rate of absorption might be either previously determined or historical. The meaning of this is that there might be a previously determined rate that is based on budgeted overhead expenses and budgeted units of base. On the other hand the rate might be based on historical data that is actual overhead costs and actual units of the base. The major advantage of the historical rate is that there is no option of under/over absorption of overheads.

If predetermined rate is employed, there is every option of within or over absorption of overheads. The following demonstration will clarify the point.

Ø  Illustration: - A manufacturing company make use of direct material cost as the basis for absorption of overheads. The absorption rate is worked out as follows.

Budgeted Overheads - Rs. 50,000/ Budgeted Material Cost Rs. 1,00,000* 100 i.e. 50%

Nowadays if the actual overheads are Rs. 70,000 and the actual direct material cost is Rs. 1,20,000, the overheads absorbed will be Rs. 60,000 that is 50% of the direct material cost and there will be under absorption of Rs. 10,000 as the actual overheads acquired are Rs. 70,000. So it can be seen that there is an opportunity of over/under absorption of overheads if determined rates are employed for absorption. The cause for this is that there is all the time an option that budgeted expenses and actual expenses might not be exactly similar. There is bound to be a number of variations in the same. Despite this limitation, predetermined rate is extensively employed because it looks in the future and estimates the expenses when in case of historical rates; information is exists after the period is over. The meaning of that is there is a post mar team examination. Once the under/over absorption is noted, the following corrective steps are to be occupied to rectify similar.

  • Use of supplementary Rate: - The under/over absorption can be rectified through using the supplementary rate. This rate is calculated through dividing the under/over absorbed amount of overheads via the units of the base. The rate consequently arrived is known to be supplementary rate.
  • Carrying forward to future period: - If the amount of under/over absorption of overheads is small, it might be carried forward to the future period hoping that it will be cured in the future.

• Writing off to Profit and Loss A/c :- Amount of under/over absorption can be written off to Costing Profit and Loss Account and so not reflected in the total costs.

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