Under/over absorption - why does it happen

reddwarfreddwarf Experienced MentorPosts: 528Registered
Would anyone like to explain this in a succinct way for me please?

I went round in circles in my recent test answer!

Comments

  • Paul24Paul24 Experienced Mentor Posts: 578Registered
    OAR (Overhead absorption rate) is calculated by taking the budgeted fixed costs, and dividing it by the budgeted output to determine how much fixed cost should be 'absorbed' (allocated) to each single unit of output.

    During a production period, if for instance fixed overhead spend is actually more than budgeted, but say production outputs meet planned quantities, there will be an under absorption of overheads i,e not enough money has been 'absorbed' within the units produced.

    In order to account for this, an under absorption adjustment, being the difference between the actual costs incurred, and the absorbed amount would be charged to the income statement, as not enough 'cost' has gone through.

    If the fixed cost spend was actually less, then the amount absorbed in production is too high, and would therefore be adjusted in the income statement, having the opposite effect - taking cost out.
  • reddwarfreddwarf Experienced Mentor Posts: 528Registered
    Okay I know all of that (thank you it's put very well!) but the scenario was a machine breakdown resulting in fewer hours of machine time in the period and the OAR had used much higher number of hours. Resulting in under absorbtion, I thought the question was after the circumstances that would cause under or over absorbtion like not selling as much as predicted or budgets being off....
  • RacheyRachey Experienced Mentor Posts: 589Registered
    Paul24 wrote: »
    OAR (Overhead absorption rate) is calculated by taking the budgeted fixed costs, and dividing it by the budgeted output to determine how much fixed cost should be 'absorbed' (allocated) to each single unit of output.

    During a production period, if for instance fixed overhead spend is actually more than budgeted, but say production outputs meet planned quantities, there will be an under absorption of overheads i,e not enough money has been 'absorbed' within the units produced.

    In order to account for this, an under absorption adjustment, being the difference between the actual costs incurred, and the absorbed amount would be charged to the income statement, as not enough 'cost' has gone through.

    If the fixed cost spend was actually less, then the amount absorbed in production is too high, and would therefore be adjusted in the income statement, having the opposite effect - taking cost out.

    WAW!! Please be my tutor!!! Lol :001_smile:
  • Paul24Paul24 Experienced Mentor Posts: 578Registered
    reddwarf wrote: »
    Okay I know all of that (thank you it's put very well!) but the scenario was a machine breakdown resulting in fewer hours of machine time in the period and the OAR had used much higher number of hours. Resulting in under absorbtion, I thought the question was after the circumstances that would cause under or over absorbtion like not selling as much as predicted or budgets being off....

    Im sorry I dont understand what you are actually asking. Feel free to pm me if you want to explain further, or post again?
  • Dorset StudentDorset Student Feels At Home Posts: 31Registered
    Looks to me like the overhead absorbtion was based on machine hours instead of number of units. Therefore, if machine breaks down, it is used for less hours, so less of the costs can be absorbed than budgeted.

    Hope that helps, but I do hate this subject, so could be totally wrong!

    Tracy
  • Paul24Paul24 Experienced Mentor Posts: 578Registered
    Looks to me like the overhead absorbtion was based on machine hours instead of number of units. Therefore, if machine breaks down, it is used for less hours, so less of the costs can be absorbed than budgeted.

    Hope that helps, but I do hate this subject, so could be totally wrong!

    Tracy

    No that sounds right, I didnt pick up on the OP meaning that!
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Okay I know all of that (thank you it's put very well!) but the scenario was a machine breakdown resulting in fewer hours of machine time in the period and the OAR had used much higher number of hours. Resulting in under absorbtion, I thought the question was after the circumstances that would cause under or over absorbtion like not selling as much as predicted or budgets being off....

    I am not adding much to Tracey's post but hope this example helps

    If the budgeted overhead cost was £300,000 and the budgeted machine hours were 150,000 hrs then you'd be expected to absorb £2 per machine hour worked

    At the end of the period if 120,000 hours were worked then £240,000 would be absorbed.
    If the actual overhead cost incurred by (or attributed to) the cost centre was £280,000 then you'll have an under absorption of £40,000.

    As there was a machine breakdown, this meant that the department did not have as many machine hours worked as they'd budgeted.
    More significant though, the overhead costs were substantially fixed costs. Things such as depreciation of equipment, salaries of foremen and insurance. As such they did not fall as machine hours fell.
    Between the two, fewer hours to absorb the £2s and most of the costs unaffected by the machine hours worked, there was a gap of £40,000 underabsorbed overhead.
    Sandy
    [email protected]
    www.sandyhood.com
  • reddwarfreddwarf Experienced Mentor Posts: 528Registered
    Thanks everyone. But! I think our questions was after other situations (other real scenarios) eg. machine breakdown, where under or over absorbtion would result .....I am thinking things such fewer labour hours because of dispute that sort of thing...
  • Paul24Paul24 Experienced Mentor Posts: 578Registered
    reddwarf wrote: »
    Thanks everyone. But! I think our questions was after other situations (other real scenarios) eg. machine breakdown, where under or over absorbtion would result .....I am thinking things such fewer labour hours because of dispute that sort of thing...

    Yes, there are many things that could lead to differences resulting in an adjustment. Labour hour variances, efficiency variances, idle time, machine efficiency, material quality etc.....
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Under/Over absorption can occur for one of 3 general reasons:
    1. The budgeted OAR was unrealistic - perhaps based on the wrong information
    2. The actual hours worked were more or fewer than we'd expect say because of more machines (in the case of labour hour based rates this could lead to fewer labour hours being worked). Another reason could be a change in the mix of products being produced.
    3. Some other factor causing the actual cost of overheads to rise (or fall)

    Does your firm treat machine insurance as a production overhead, could the budget be based on a modificatrion of last year's, but actual has been changed after ringing round and getting a much better quote?
    Sandy
    [email protected]
    www.sandyhood.com
  • reddwarfreddwarf Experienced Mentor Posts: 528Registered
    Great Sandy, just what I was after.
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