What Is Over Absorbed Overhead?
Over absorbed overhead occurs in cost accounting when the amount of overhead costs applied to products or services exceeds the actual overhead costs incurred during a specific period. This situation typically arises in companies that use a predetermined overhead rate to allocate indirect costs to production. When production activity or actual overhead differs from the estimates used to set the rate, a variance arises, leading to either over absorbed overhead or its opposite, under absorbed overhead. This concept is fundamental to cost accounting and managerial accounting, helping businesses understand the efficiency of their overhead allocation processes.
History and Origin
The concept of allocating overhead costs became increasingly important with the rise of industrialization and mass production. Initially, when direct labor was the dominant cost in manufacturing, traditional allocation methods often focused on labor hours or costs as the primary cost driver. However, as technology advanced and processes became more automated, overhead costs grew significantly in proportion to direct labor. This shift highlighted the need for more sophisticated allocation techniques. Despite criticisms regarding cost distortion, traditional methods of overhead allocation remain widely used, and are accepted by regulatory bodies like the Internal Revenue Service (IRS) and the Securities Exchange Commission (SEC) for external financial reporting in the United States.5
Key Takeaways
- Over absorbed overhead indicates that more overhead was applied to production than was actually incurred.
- It results from using a predetermined overhead rate that overestimates actual overhead or underestimates the actual activity level.
- This variance is typically closed out to the Cost of Goods Sold account at the end of an accounting period.
- Analyzing over absorbed overhead helps management assess the accuracy of their budgeting and cost estimation processes.
- It can suggest that a company’s production volume was higher than anticipated, or its actual indirect expenses were lower than expected.
Formula and Calculation
Over absorbed overhead is determined by comparing the applied overhead to the actual overhead.
The formula for calculating over absorbed overhead is:
Where:
- Applied Overhead is calculated by multiplying the predetermined overhead rate by the actual activity level (e.g., actual machine hours or direct labor hours).
- Actual Overhead represents the total indirect costs incurred during the period.
An over absorbed overhead occurs when the result of this calculation is a positive value. Conversely, a negative value would indicate under absorbed overhead. The predetermined overhead rate is a critical component, calculated at the beginning of the period based on estimated total overhead costs and estimated total activity.
Interpreting the Over Absorbed Overhead
A positive over absorbed overhead balance suggests that a company has allocated more indirect costs to its products or services than it actually spent. This can occur for several reasons. For example, if the estimated activity level used in the predetermined overhead rate was lower than the actual activity level achieved, more overhead would be applied per unit than intended. Similarly, if actual overhead costs were lower than budgeted, an over absorption would result. Understanding this variance is crucial for managers to evaluate the effectiveness of their cost control and cost allocation strategies. It can point to favorable conditions, such as higher-than-expected production efficiency or successful cost-cutting measures for indirect costs.
Hypothetical Example
Consider a small furniture manufacturing company, "WoodWorks Inc.," that produces custom wooden tables. WoodWorks uses machine hours to apply overhead to its products. At the beginning of the year, the company estimated its total overhead costs for the year to be $200,000 and estimated that it would use 10,000 machine hours.
Based on these estimates, the predetermined overhead rate is:
During the year, WoodWorks Inc. actually incurred $190,000 in actual overhead costs. However, due to an unexpected surge in demand, the company operated its machines for 11,000 actual machine hours.
Now, let's calculate the applied overhead:
Finally, we calculate the over absorbed overhead:
In this example, WoodWorks Inc. has $30,000 in over absorbed overhead. This indicates that the company applied $30,000 more in overhead costs to its products than it actually spent. This variance would need to be addressed at the end of the accounting period, typically by adjusting the Cost of Goods Sold account or other relevant financial statements.
Practical Applications
Over absorbed overhead plays a critical role in financial reporting and internal analysis, especially in manufacturing and service industries where indirect costs are significant. For tax purposes, businesses, including small businesses, must accurately account for costs associated with inventory, which includes direct costs and properly allocated overhead. The IRS provides guidance in publications like Publication 334, "Tax Guide for Small Business," on how businesses should handle inventories and costs for tax reporting. O4ver absorbed overhead implies that inventory values or the cost of services provided might be slightly overstated initially, requiring an adjustment.
Additionally, management uses insights from over absorbed overhead to refine future budgeting and pricing strategies. For instance, if U.S. manufacturing output, as tracked by the Federal Reserve's Industrial Production Index, is consistently higher than anticipated, and overhead costs are stable or declining, it could lead to systematic over absorption. T3his trend might indicate opportunities to re-evaluate pricing, invest in new equipment, or adjust production levels based on a more accurate understanding of cost behavior.
Limitations and Criticisms
While over absorbed overhead provides valuable information, its analysis has limitations. It is a symptom of a mismatch between estimated and actual costs or activity, rather than a direct cause. Critiques often center on the accuracy of the predetermined overhead rate itself. Traditional overhead allocation methods, which often rely on a single cost driver like direct labor hours, can lead to distorted product costs, especially in highly automated environments where direct costs are a smaller proportion of total costs.
2This distortion can result in some products being overcosted (contributing to over absorbed overhead for those specific products if not overall) and others undercosted, potentially leading to flawed pricing decisions or misinformed product profitability analysis. For example, if a company produces a mix of high-volume, simple products and low-volume, complex products, a single plant-wide overhead rate might unfairly burden the simple products with too much overhead, while complex products might not absorb enough. This issue led to the development of alternative methods, such as Activity-Based Costing (ABC), which uses multiple cost drivers to allocate overhead more precisely. T1hus, persistent or significant over absorbed overhead may signal that the underlying allocation method needs re-evaluation.
Over Absorbed Overhead vs. Under Absorbed Overhead
Over absorbed overhead and under absorbed overhead represent two sides of the same coin within cost accounting, both stemming from a variance between applied and actual overhead.
| Feature | Over Absorbed Overhead | Under Absorbed Overhead |
|---|---|---|
| Definition | Applied overhead is greater than actual overhead. | Applied overhead is less than actual overhead. |
| Result | Too much overhead was allocated to products. | Not enough overhead was allocated to products. |
| Implication for Profit | Potentially overstated profits on income statements before adjustment. | Potentially understated profits on income statements before adjustment. |
| Causes | Actual activity higher than estimated, or actual overhead costs lower than budgeted. | Actual activity lower than estimated, or actual overhead costs higher than budgeted. |
| Adjustment | Typically a credit (to Cost of Goods Sold or a variance account). | Typically a debit (to Cost of Goods Sold or a variance account). |
| Managerial Insight | Suggests efficient cost control or higher than anticipated production volume. | Indicates inefficient cost control or lower than anticipated production volume. |
The key confusion arises because both terms signify a discrepancy in the variance analysis of overhead. Over absorbed overhead means the company "took in" too much overhead, while under absorbed overhead means it didn't take in enough, relative to what was actually spent.
FAQs
What causes over absorbed overhead?
Over absorbed overhead typically occurs when a company's actual production activity (e.g., machine hours, labor hours) is higher than initially estimated, or when its actual total indirect costs turn out to be lower than budgeted. This leads to more overhead being applied to products than was actually incurred.
How is over absorbed overhead handled at the end of the accounting period?
At the end of an accounting period, over absorbed overhead is usually "closed out" or adjusted. For immaterial amounts, it is often debited to the Cost of Goods Sold account, effectively reducing it. For material amounts, it might be prorated among Cost of Goods Sold, Work-in-Process Inventory, and Finished Goods Inventory to more accurately reflect product costs.
Does over absorbed overhead mean the company is doing well?
Not necessarily. While it can suggest efficient cost control or higher-than-expected production, it primarily indicates an inaccuracy in the initial overhead estimation or budgeting process. It means that the company’s costs were lower than expected, or its production was higher, but it doesn't automatically imply optimal performance without further analysis of why the variance occurred.
Can over absorbed overhead lead to inaccurate product costing?
Yes, if significant, over absorbed overhead can lead to inaccurate product costing. When more overhead is applied than incurred, the per-unit cost of products can be overstated. This might lead to setting prices too high or misjudging product profitability, affecting strategic decisions.