Under absorbed overhead

What Is Under Absorbed Overhead?

Under absorbed overhead occurs when the actual overhead costs incurred by a business are greater than the overhead costs applied to products or services using a predetermined overhead rate. This situation is a key concept within cost accounting, a branch of accounting focused on recording, analyzing, and reporting a company's costs. When overhead is under absorbed, it indicates that a company has not allocated enough of its indirect costs to the units produced during a given period. This can happen for various reasons, such as lower-than-expected production volume, higher-than-anticipated fixed costs, or an inaccurate estimation of the overhead rate. Understanding under absorbed overhead is crucial for accurate product costing, financial reporting, and effective budgeting.

History and Origin

The concept of overhead allocation and, consequently, under- or over-absorption, evolved significantly with the rise of modern industrialization. Early forms of cost accounting primarily focused on easily traceable direct costs, such as raw materials and direct labor. However, as manufacturing processes grew more complex during the Industrial Revolution, businesses began incurring substantial indirect expenses, like factory rent, utilities, and depreciation of machinery. These overhead costs could not be directly linked to individual products but were essential for production.

The need to systematically account for these growing overheads led to the development of methods for their allocation. By the 19th century, industries such as textile mills and railroads started implementing rudimentary systems to ascertain overhead allocation and incorporate it into product costs. This historical shift laid the groundwork for modern absorption costing methods, where both variable and fixed manufacturing overheads are assigned to products, leading to the eventual identification of variances like under absorbed overhead.

Key Takeaways

• Under absorbed overhead results when applied overhead is less than actual overhead costs.
• It indicates that insufficient indirect manufacturing costs were charged to production.
• Common causes include lower production volume or higher actual overhead than budgeted.
• Under absorbed overhead typically leads to an increase in the cost of goods sold for the period.
• It highlights discrepancies between estimated and actual costs, signaling areas for managerial review.

Formula and Calculation

Under absorbed overhead is calculated by comparing the actual total overhead incurred with the total overhead applied to production.

The formula is:

$\text{Under Absorbed Overhead} = \text{Actual Total Overhead} - \text{Applied Total Overhead}$

Where:

• Actual Total Overhead: The sum of all manufacturing overhead costs incurred during the period.
• Applied Total Overhead: The amount of overhead allocated to products using a predetermined overhead rate multiplied by the actual activity level (e.g., actual machine hours, actual direct labor hours).

For example, if a company's predetermined overhead rate is ($10) per machine hour, and 1,000 machine hours were actually worked, the applied overhead would be ($10 \times 1,000 = $10,000). If the actual total overhead incurred was ($12,000), then the under absorbed overhead would be ($12,000 - $10,000 = $2,000).

Interpreting Under Absorbed Overhead

When a company experiences under absorbed overhead, it suggests that its production process was less efficient or more costly than anticipated. This variance can stem from two primary factors: a spending variance, where actual overhead costs were higher than budgeted, or an efficiency/volume variance, where the actual activity level (e.g., machine hours, labor hours) used as the allocation base was lower than the level used to set the predetermined overhead rate.

Managers often use variance analysis to delve into the reasons behind under absorbed overhead. A significant under absorption points to potential issues such as unforeseen increases in utility costs, maintenance expenses, or rent, or a downturn in production volume. From a reporting perspective, under absorbed overhead typically increases the cost of goods sold on the income statement, reducing reported profitability. For external reporting, particularly under generally accepted accounting principles (GAAP), the under absorbed amount is usually written off to the cost of goods sold or allocated proportionally across work-in-process, finished goods inventory, and cost of goods sold, depending on the materiality. This adjustment ensures that the financial statements accurately reflect the full cost of production.

Hypothetical Example

Consider "GadgetCo," a company that manufactures small electronic devices. GadgetCo uses a predetermined overhead rate based on direct labor hours to apply manufacturing overhead to its products.

At the beginning of the year, GadgetCo estimated:

• Total budgeted manufacturing overhead: $200,000
• Total budgeted direct labor hours: 10,000 hours
• Predetermined overhead rate: $200,000 / 10,000 hours = $20 per direct labor hour

During the year, GadgetCo’s actual results were:

• Actual total manufacturing overhead incurred: $215,000
• Actual direct labor hours worked: 9,500 hours

Now, let's calculate the applied overhead and then the under absorbed overhead:

1. Calculate Applied Overhead:
   Applied Overhead = Predetermined Overhead Rate (\times) Actual Direct Labor Hours
   Applied Overhead = $20/hour (\times) 9,500 hours = $190,000

2. Calculate Under Absorbed Overhead:
   Under Absorbed Overhead = Actual Total Overhead - Applied Total Overhead
   Under Absorbed Overhead = $215,000 - $190,000 = $25,000

In this example, GadgetCo has $25,000 of under absorbed overhead. This indicates that the company incurred $25,000 more in actual overhead costs than it allocated to the products manufactured during the period. This could be due to factors like unexpected utility increases, higher-than-budgeted maintenance costs, or a decline in production volume impacting the base for overhead allocation.

Practical Applications

Under absorbed overhead is a critical metric primarily in manufacturing environments, where significant variable costs and fixed costs are incurred in the production process. Companies employing absorption costing, which is required for external financial reporting under GAAP, will regularly calculate this variance. It is particularly relevant for businesses using job costing or process costing systems to track the costs of their products or services.

For managers, identifying under absorbed overhead serves as an important signal for cost control and operational efficiency. It prompts an investigation into why actual overhead spending exceeded expectations or why production volume, which determines the amount of overhead applied, fell short. In the context of the broader economy, industries like industrial manufacturing face ongoing cost pressures, making the accurate tracking and management of overhead variances essential for maintaining profitability and competitiveness. For example, if a manufacturing plant experiences a sudden dip in orders, the fixed overhead costs (like factory rent or depreciation) remain, but fewer units are produced over which to spread these costs, leading to under absorption.

Limitations and Criticisms

While necessary for external reporting, absorption costing and the resulting overhead absorption figures face several criticisms. One significant limitation is that under absorbed overhead can arise from factors unrelated to spending efficiency. For instance, if production volume is lower than anticipated, even with efficient cost management, the overhead may be under absorbed simply because fewer units were produced to absorb the overhead. This can make it challenging to discern whether the variance is due to poor cost control or insufficient sales/production activity.

Furthermore, the overhead allocation process itself can be arbitrary, especially for complex or shared indirect costs. As some research highlights, managers can be uncertain of their costs due to problems emanating from inaccurate cost allocations, suggesting that the primary issue of arbitrary cost allocations is maintained. T¹he choice of allocation base (e.g., machine hours, labor hours, direct labor costs) can significantly influence the amount of overhead applied, and an inappropriate base can lead to misleading under or over absorption figures, distorting product costs and profitability analysis. This can lead to incorrect pricing decisions or flawed performance evaluations.

Another criticism is that absorption costing can incentivize overproduction, particularly near the end of an accounting period. By producing more units, a company can absorb more fixed overhead into inventory, thereby decreasing the cost of goods sold and increasing reported net income in the short term. However, this can lead to excessive inventory levels, increasing holding costs and obsolescence risk, which may not be immediately apparent from the under absorbed overhead figure alone.

Under Absorbed Overhead vs. Over Absorbed Overhead

Under absorbed overhead and over absorbed overhead represent two sides of the same coin in absorption costing. The fundamental difference lies in the relationship between actual overhead costs and applied overhead costs.

Both variances provide valuable insights for standard costing and control, prompting management to investigate the underlying causes and adjust future budgeting and operational plans.

FAQs

Why does under absorbed overhead occur?

Under absorbed overhead occurs when the actual manufacturing overhead costs incurred during a period exceed the amount of overhead that was applied to products based on a predetermined overhead rate. This can happen if the actual production volume is lower than the volume initially estimated when setting the rate, or if the actual overhead expenses (like utilities, rent, or indirect labor) turn out to be higher than budgeted.

How is under absorbed overhead typically handled in accounting?

For financial reporting purposes, under absorbed overhead is usually treated as an expense. If the amount is immaterial (small), it is often directly added to the cost of goods sold for the period. If the amount is material (significant), it might be prorated, or allocated, across the work-in-process inventory, finished goods inventory, and cost of goods sold accounts to accurately reflect the true cost of inventory and products sold.

What are the implications of consistently having under absorbed overhead?

Consistently experiencing under absorbed overhead suggests that a company may be underestimating its production costs or operating at a lower efficiency than planned. This can lead to understated product costs, potentially resulting in unprofitable pricing decisions. It also indicates issues with budgeting and cost control, necessitating a review of overhead expenses, production forecasts, and the method used for overhead allocation and setting the predetermined rate.