The accounting treatment under over absorption of overheads

The accounting treatment of under or over absorption of overheads depends upon the extent of such under or over absorption and the circumstances under which it arises. The following are the main methods of disposal of under or over absorption of overheads.

Use of supplementary Rates

- if the amount of under or over absorption is considerable; the cost of job or process is adjusted by means of supplementary levy of the overhead. Supplementary rate is calculated by dividing the amount of under or over absorption by the actual base. Under absorption is set tight by the plus rate

while over absorption is adjusted by minus rate. The supplementary rates will defeat the purpose for which it is calculated. Supplementary rates is useless in those cases where in order to have a uniform charge of overhead thought out, the accounting period is fixed in order to avoid seasonal fluctuations in the overhead cost or level of activity. Correction of costs through supplementary rate is necessary when the management likes to maintain actual historical costs for future comparison. Its use is made when prices are fixed on cost plus basis. The amount of under or over absorption at the end of the accounting period is adjusted in work in progress, finished stock and cost of sale in proportion to direct labor hours or machine hours or the values of the balances in each of these accounts be the use of supplementary rate. Subsidiary records or individual items are not corrected. The amount so adjusted will be shown in the balance sheet as deductions from or additions to the work in progress and finished good stock. Under this method, the profit for the period will be reduce or increased by the amount adjusted to cost of sales and value of stock will increase or decrease by the amount adjusted to work in progress and finished good stock.

By writing off to costing Profit and Loss accounts

- If the amount of under or over absorption is small it may be written off to costing Profit and Loss account instead of calculating a supplementary rate by complicated procedure. Under absorption due to idle facilities should be written off in this manner whatever the amount may be. The amount of  under or over absorption at the end of accounting period is transferred to the Overhead Suspense Account which is ultimately transferred to the Costing Profit and Loss account or directly to Costing Profit and Loss Account. If some portion of under or Over absorption arises due to abnormal causes such as strikes, lock out etc., then such portion should be carried over to the next year

Absorption in the Accounts in Subsequent Years

- The amount of under or over absorption of overhead may be carried over as deferred charges of deferred credit to the next accounting period by transferring to a Suspense or Overhead Reserve Account. The use of this method is justified when normal business cycle is more than one year and in the case of new projects and schemes when the output is low in the initial stages of production and cannot bear the entire share of overhead. Under such circumstances, it is desirable that some portion of such cost be carried over to the next period to be absorbed in the production of subsequent years.