Introduction
In the realm of managerial accounting, the terms over absorption and under absorption of overheads play a crucial role in determining the efficiency of cost management in a business. These concepts relate to how indirect costs, such as utilities, rent, and administrative expenses, are allocated to products or services.
What is Over Absorption of Overheads?
Over absorption of overheads occurs when the overhead costs allocated to products or services exceed the actual overheads incurred over a specific period. This situation implies that more costs are assigned than what has genuinely been utilized.
Examples of Over Absorption
- Example 1: A manufacturing company estimates that it will incur $100,000 in overheads for the year and decides to allocate this amount based on the expected production of 10,000 units, leading to an overhead absorption rate of $10 per unit. However, if the actual overhead incurred turns out to be $80,000 while producing the projected units, the company has over absorbed $20,000.
- Example 2: An organization may project utility costs at $20,000 but by the end of the year, the actual costs are only $15,000. In this instance, if the costs are applied uniformly throughout the year based on production, any excess allocation compared to the actual incurred costs results in over absorption.
What is Under Absorption of Overheads?
Under absorption of overheads, conversely, happens when the overheads allocated to products or services fall short of the actual overheads incurred. This indicates a less favorable scenario where not enough costs have been charged to products or services relative to what was actually spent.
Examples of Under Absorption
- Example 1: Suppose the same manufacturing company estimated overheads would be $100,000 with a production of 10,000 units ($10 per unit). However, if the actual overhead is $120,000 while maintaining the same production, the company ends up with an under absorption of $20,000.
- Example 2: If a service-oriented firm anticipates a certain level of administrative costs at $30,000 but incurs $40,000 after a surge in operational demands, the result would be an under absorption of $10,000.
Case Studies
To illustrate these concepts further, let’s consider a couple of case studies:
- Case Study 1: ABC Manufacturing Inc.
In 2021, ABC Manufacturing projected $200,000 in overheads based on a production estimate of 20,000 units. By year’s end, actual overheads reached $150,000. The overhead absorption per unit was $10, leading to an over absorption of $50,000. This situation resulted in inflated profitability figures, misleading management decisions.
- Case Study 2: XYZ Services Ltd.
XYZ Services anticipated $80,000 in overhead costs but ultimately incurred $100,000 due to unforeseen consultancy expenses. Despite maintaining revenue, the company suffered from under absorption of $20,000, showing a poorer financial position than expected.
Consequences of Over and Under Absorption
Understanding over and under absorption is vital for accurate financial reporting and strategic decision-making. The implications can ripple through various aspects of a business:
- Impact on Profitability: Over absorption can inflate profits, while under absorption may depict losses.
- Management Decisions: These accounting discrepancies can mislead management in terms of resource allocation, costing strategies, and operational adjustments.
- Budgeting and Planning: Reliable overhead absorption rates are critical for accurate budgeting and forecasting.
Conclusion
To ultimately achieve a finely-tuned operational and financial strategy, businesses need to regularly evaluate their overhead absorption rates and adjust their approaches as necessary. By maintaining an awareness of both over and under absorption, companies can improve their cost management practices, leading to more precise financial insights and enhanced operational efficiencies.
