Underabsorbed Overhead: Meaning and Impact on Business Finances

Underabsorbed overhead is a critical concept in cost accounting, with significant implications for a business’s financial health. It occurs when the actual manufacturing overhead costs exceed the overhead costs allocated or applied to goods produced within a specific accounting period. This disparity can arise due to various factors, such as unexpected variations in overhead costs, differences in the basis used for overhead application, seasonal fluctuations, or allocation errors.

The repercussions of underabsorbed overhead can be far-reaching. Increased costs, distorted profits, and incorrect inventory valuations are some of the financial implications that businesses may face. Addressing underabsorbed overhead requires accounting adjustments, such as allocating the underabsorbed overhead to cost of goods sold or inventory.

Key Takeaways:

• Underabsorbed overhead occurs when actual manufacturing overhead costs exceed the allocated or applied costs.
• It can lead to increased costs, distorted profits, and incorrect inventory valuations.
• Accounting adjustments, such as allocating the underabsorbed overhead, are required to address this issue.
• Factors contributing to underabsorption include unexpected variations, different overhead application bases, seasonal fluctuations, and allocation errors.
• Businesses can mitigate the impact of underabsorbed overhead through appropriate accounting methods and adjustments.

Causes of Underabsorption and Overabsorption of Overheads

Underabsorption and overabsorption of overheads can occur due to various factors that affect the allocation and absorption of costs in a business. Understanding these causes is crucial for effective cost management and financial planning. The main factors contributing to underabsorption and overabsorption are:

1. Production Capacity: Underabsorption and overabsorption can occur when a business operates below or above its normal production capacity. If the actual production is lower than the capacity, overhead costs may be underabsorbed as fewer units bear the overhead. Conversely, if the actual production exceeds the capacity, overhead costs may be overabsorbed as the allocation is based on a higher capacity.
2. Seasonal Fluctuations: Businesses that experience seasonal variations in production may face underabsorption or overabsorption of overheads. During peak seasons, production levels may be higher than the anticipated levels used for overhead allocation, leading to overabsorption. Conversely, during lean seasons, production levels may fall below expectations, resulting in underabsorption.
3. Prediction Errors: Inaccurate estimation of overhead costs or the base used for overhead allocation can lead to underabsorption or overabsorption. If the predicted overhead costs or base are significantly different from the actual amounts, the absorbed overhead may not accurately match the actual overhead incurred.
4. Changes in Production Methods: When there are substantial changes in production methods, such as the introduction of new technology or machinery, the allocation of overhead costs may be affected. If the new production methods result in changes in the utilization of resources or the nature of overhead costs, underabsorption or overabsorption may occur.
5. Changes in Working Capacity: Any significant changes in the working capacity of a business, such as downsizing or expansion, can impact the absorption of overhead costs. If the capacity changes are not properly accounted for in the allocation process, underabsorption or overabsorption may arise.

It is important for businesses to identify and address the causes of underabsorption and overabsorption to ensure accurate cost allocation and financial reporting. By understanding these factors, businesses can make informed decisions and take appropriate measures to mitigate the impact of underabsorbed or overabsorbed overhead on their finances.

How to Deal with Underabsorbed and Overabsorbed Overheads

When a business encounters underabsorbed or overabsorbed overheads, there are various methods that can be employed to address this issue. The choice of method depends on the extent of underabsorption or overabsorption and the specific circumstances of the business. Some of the commonly used methods include:

1. Supplementary Rate: One approach is to use a supplementary rate to allocate the underabsorbed or overabsorbed overhead to different aspects of the business. This can involve allocating the underabsorbed or overabsorbed overhead to work-in-progress, finished goods inventory, and cost of sales. The supplementary rate helps to distribute the overhead costs in a more accurate and efficient manner.
2. Inventory Carry Forward: For businesses with long-term business cycles, another method is to carry forward the underabsorbed or overabsorbed overhead to the next year’s accounts. By carrying forward the underabsorbed or overabsorbed overhead, it can be absorbed in future periods when production levels may be more aligned with the estimated overhead costs. This method helps to smooth out any fluctuations in overhead absorption.
3. Transfer to Costing Profit and Loss Account: In cases where there is an abnormal increase or decrease in actual overhead costs, it may be appropriate to transfer the underabsorbed or overabsorbed overhead to the costing profit and loss account. This allows for a more accurate reflection of the impact of the overhead costs on the business’s profitability.
4. Adjustment Methods: Lastly, various adjustment methods can be employed to ensure the accurate allocation of underabsorbed or overabsorbed overhead. These methods involve adjusting the cost of goods sold or inventory to account for the difference between the actual overhead costs and the overhead absorbed. By making these adjustments, businesses can prevent misleading financial statements and ensure accurate reporting of the financial position.

It is important for businesses to carefully analyze the extent of underabsorption or overabsorption and consider the specific circumstances of the business before choosing a method to address the issue. Implementing the appropriate method will help ensure accurate cost accounting and maintain the financial health of the business.

Example of Underabsorption and Accounting Adjustments

To further understand the impact of underabsorption and the necessary accounting adjustments, let’s take a closer look at a hypothetical scenario involving a company called WidgetCo.

WidgetCo estimated their annual overhead costs to be $200,000, with a projected production of 100,000 widgets. This resulted in an overhead absorption rate of $2 per widget. However, the actual overhead costs turned out to be $220,000, while the actual production reached 95,000 widgets. As a result, WidgetCo experienced underabsorption of overhead by $30,000.

In order to rectify this situation, WidgetCo needs to make accounting adjustments. One approach is to allocate the underabsorbed overhead to the cost of goods sold (COGS) or the inventory based on a rational allocation method. By doing so, WidgetCo ensures accurate reporting of their financial statements and prevents any potential misleading information.

Accounting adjustments play a crucial role in reflecting the true financial position of a business. They help address any discrepancies caused by underabsorption or overabsorption of overhead, which can affect the inventory valuation, cost of goods sold, and ultimately the profitability of the company.