What methods adopted for overhead absorption

The method adopted for overhead absorption varies from industry to industry and from one

undertaking to another. Some firms use separate rates for each type after classifying the overhead expenses into several types. The choice of a most equitable method is very important as the method adopted, if unsuitable, will distort costs and will be useless for control and decision making purposes. Type of industry, nature of product and process of manufacture, organization setup, individual requirement and policy of management are the factors which affect the choice of an overhead rate. Besides these, a satisfactory overhead rate should be simple, easy to operate, practical, accurate, economic in application, fairly stable and related to time factor. It should be preferably department rates as compare to blanket rates, homogeneous cost unit and should lay stress on the main production element of the concern.

The main factor should be taken into consideration before formulating overhead rates or deciding upon the basis for applying overheads to product.

Equitable apportionment of overhead.- the overhead rate should be such that overhead should be equitable apportioned to the cost centres or cost units. The amount of overheads recovered should also be equivalent to the amount of overheads incurred.

Simple and easy to understand- the overhead rate should be simple to calculate and easy to understand. It should not require unnecessary or additional clerical work.

Relation with time factor.- overhead rate should have some relation to the time taken by various jobs for completion. Thus, if a job takes twice as much time as another job, the first job should be charged twice the amount charged to the second job. It is because of this reason that direct wages percentage rate is preferred over direct material cost percentage rate.

Separate rates for manual or machine work.- the work done by manual labor should be distinguished from work done by machine and different overhead rates should be applied for manual and machine work.

Different overhead rates for different departments.- different overhead rates should be ascertained for different departments where the nature of the work done by one department is different from the work done by other department or departments.

Causes of under or over absorption of overheads

Meaning the amount of overhead absorption in cost is the total amount of the overhead costs allocated to individual costs units by application of overhead rate. Overhead cost are fully recovered

from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overhead incurred. But when a predetermined rate is used on the basis of budgeted overhead and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses. If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and the total output or hours worked being less than estimates, the difference is known as under absorption. Under absorption of overhead thus means the amount by which the absorbed overheads falls short of the actual amount of overhead incurred. It represent understanding the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, process etc. on the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and the output or hours worked exceeding the estimates., it would mean over absorption of overheads and will be the costs. Over absorption of overhead thus means the excess of overheads absorbed over the actual amount of overhead incurred.

Causes of under or over absorption of overheads

Error in estimating overheads- the total overheads actually incurred for a department may be more or less than the amount estimated because of error in estimating this may due to deliberate decision in this regard of lack of proper control.

There may be some important changes in the work situation such as heavy overtime, introduction of another shift etc.

The actual hors worked may be more or less than hours anticipated

Work in progress might not have been charged with its share of overhead in cost accounts.

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The overhead expenses classification functional classification

Overhead expenses are classified with reference to major activity divisions of a concern; it is called functional classification of overhead. This classification is necessary for the segregation of the cost of each of the principal functional division of the concern and having separate method of accounting and control for the diverse nature of expenses in each division. The main groups forming the basis of the classification are :

• Manufacturing overhead
• Administration overhead
• Selling overhead
• Distribution overhead
• Research and development overhead

Manufacturing or works overhead is the indirect expenses of operating the manufacturing divisions of a concern and cover all indirect expenditure incurred by the undertaking from the receipt of order until its completion ready for dispatch either to the customer or to the finished Goods store. Administration overheads are indirect expenditure by nature and incurred in formulating the policy, directing the organization, controlling and managing the operation of an undertaking which is not related directly to a research, development, production selling activity of function. It consists of all expenses incurred in the direction, control and administration of an undertaking. Selling overheads is the cost of seeking to create and stimulate demand and of securing orders and comprises the cost of soliciting and recurring order for the articles or commodities dealt in and of efforts to find and retain customer. Distribution overhead is the expenditure incurred in the process which begins with making the packed product available for dispatch and ends with making the reconditioned return empty package. And research and development overhead is cost of searching for new and improve products, new applications of materials or product, and new applications and improved method.

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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.