Costs and Revenues - question?

Registered Posts: 41 Epic contributor 🐘
Hi all!

The question is about over- (under-) absorption.

Osborne Textbook Q.5.6 - - - c)__??????????

Accounting firm with two partners.
Estimated overhead cost for next year: £59,900.
Partners are planned to work for 47 weeks next year. They will be in the office for 40 hours but willbe working on behalf of their clients for 35 hours per week.
Questions:
a)What's OAR per partner hour:

35 x 47 = 3290
59,900/3290 = £18.21

b)If partners want each £30,000 salary a year, what's combined hourly rate per partner, which includes overheads and salary?

(59,900 + 60,000) / 3290 = £36.44

c) If both partners actually work on their clients' behalf for 37 hours per week, what will be the total over-absorption of overheads for the year?

Here's where I have a problem. Without even calculation I can say that there will be no over-absorption but under-absorption. If absorbed cost is less that actual cost then we get under-absorption.
Why they asking about over-absorption? Or is it just a tricky question??? Why did they not ask what over-absorption OR under-absorption will be?

Am I getting this wrong or something?

• Registered Posts: 782
It will be an over absorption. You've calculated the OAR on a basis of 35 hours per week, so every week, once you've charged for 35 hours you will have covered all the overheads. In effect, for those extra 2 hours, you are still charging the same price but as there are no more overheads left to pay, you have over absorbed them.
• Registered, Moderator Posts: 2,034 mod

Before the accounting period starts
You produce a budget of the various overhead costs a department will incur
And if you are going to absorb on a direct labour hour basis, you produce a budget of the direct labour hours.
Then by dividing the Budgeted Overhead cost by the Budgeted Direct Labour Hours, you produce the overhead absorption rate as say £18.21 per hour

During the accounting period
Charge the department account with the overhead at the rate of £18.21 per hour worked. In this case the charge would be made to each client, and a control account used for the totals. This involves debiting the client control account (in manufacturing work-in-progress) and the individual client accounts in a subsidiary ledger and crediting the overhead control account.

At the end of the accounting period
If more overheads were incurred than absorbed, the overhead account will have a debit total that is greater than the credit total. This is under absorption. If more has been absorbed than the actual overhead cost incurred, this is over-absorption.

*This question doesn't specify the actual overhead incurred.

Note
Two things can cause the overhead absorbed to be under or over the overhead incurred.
1. The hours worked are different from the budget.
For example 2 lots of 37 hours are worked and overhead charged at £18.21: ccc. Overhead absorbed £1,347.54
And (amazingly the overhead cost for the week was 1/52th of £59,000 estimated: Overhead incurred £1,151.92
In this case we have an over-absorbed overhead of ccccccccccccccccccccccccccccccccccccccccc£195.62
2. The actual overhead cost was different from the budget
For example the overheads in the week in question were £1500.
The overhead absorbed would be exactly as above (2 x 37 hrs x £18.21) Overhead absorbedccccccc £1,347.54
The actual overhead incurred is cccccccccccccccccccccccccccccc.cccccccccccccccccccccccccc £1,500.00
In this case we have an under-absorbed overhead of cccccc.ccccccccccccccccccccccccccccccccc £152.46
Sandy
sandy@sandyhood.com
www.sandyhood.com
• Registered Posts: 41 Epic contributor 🐘
But I just want to say we're all right here. What is wrong in my opinion is how they presented the question.
It is all about 37 hours here.

1).If they meant: What if they planned to work 37 hours at the beginning of the period? Then yes, it is over-absorption. Because OAR will be different. They absorbed overheads based on planned hours which is 37 but they actually worked 35 so they over-absorbed 2 hours towards overheads. They actually spent less than they planned to spend.

2) But I got it as: What if they actually work 37 hours at the end of the period? Then it will be under-absorption. Because OAR will still be based on 35 hours but they actually worked 37 hours. They spent more money on their overheads than they absorbed.

Do I make sense here?
The question is not very clear.
It says: If both partners actually work on their clients' behalf for 37 hours per week, what will be the total over-absorption of overheads for the year?

Please correct me if I am wrong...:glare:
• Registered Posts: 782
If I understand you right (apologies if I haven't), it sounds like you are getting the purpose of OAR the wrong way round. OAR is used to calculate how to cover the expected overheads, not to calculate the actual overheads.

In point 1, if they work less hours than the OAR is based on, you are likely to have an under absorption, not an over absorption (assuming actual overheads are same as budgeted, which in absence of any further info, you have to assume is the case).

In point 2, I think you are thinking that OAR affects the actual overheads incurred - it doesn't.

Does that make sense?
• Registered Posts: 41 Epic contributor 🐘
I think I am getting it the wrong way around.
Here's the quick example, let me know whether I am right or wrong:

£1200 - total budgeted overheads for the year
20 hours a week - planned hours to work a week X 52 = 1040 hours a year

Now: OAR = 1200/1040 = 1.15

Budgeted overheads for one week = £1200/52weeks = £23 OR 1.15 X 20hours/week = same £23.

So we thought we gonna work 20 hours a week, but we actually worked more, we worked 22 hours a week.

Actual overheads for one week = 1.15 X 22hours/week = £25.3

I am saying that we have under-absorption.
• Registered Posts: 41 Epic contributor 🐘
Nps1976: I thing I am wrong. It is over-absorption, isn't it?

Overheads absorbed(at the end of the period) - Overheads (estimated at the beginning of the period) = if positive - over-absorption / if negative - under-absorption.

Is that correct?
• Registered Posts: 782
OAR has no effect on actual overheads, it only shows what you have absorbed. So working extra hours will absorb (ie. cover the costs of) more overheads but it won't actually generate more overheads. (Yes of course, in the real world, working more hours probably will mean you pay more in gas/electricity, but in these questions that's not what is being asked)

In your above but one post, your OAR is correct but then you go on to say that actual overheads are £25.30 - this is the amount absorbed not the actual overheads incurred. The actual overheads may be as budgeted, or may be more or less, but you need to be told that figure, you can't work it out with the information given in this level of question. In the absence of any further info, use the budgeted overheads of £23 per week, but you have generated £25.30 to cover those overheads, so you have £2.30 spare (or in other words, over absorption).

You've also inadvertently confirmed that you've calculated your OAR correctly, by showing that your OAR multiplied by the budgeted number of hours equals the budgeted overheads.

And yes, reading your second post, I think it's just clicked for you!
• Registered Posts: 782
Of course, you will now start getting questions where confirmed actual overheads at the end of the year/month/week are different to the budgeted overheads (but you will be told the actual cost). In these cases, you may well get an under absorption even if extra hours are worked, if overheads end up being much more than expected. But for now, just make sure you fully understand the theory if actual overheads are the same as budgeted overheads.

Think of it as an OAR being a best guess to try and cover overheads as best you can. The reality is that you can't predict final overheads with 100% certainty but you can make a sensible plan to try and cover them as best you can with the information available at the start of the year.
• Registered Posts: 41 Epic contributor 🐘
Nps1976

Thank you very much!:thumbup1:
You pointed just exactly where I was wrong.
In my head more hours worked would generate more overheads and that's where I am wrong.
I get it now. OAR basically is the perfect amount we need to cover our overheads and if we worked more that would only mean that we have more money to cover the same amount of overheads, then we have money left - which is over-absorption.
The thing is I have already passed my exam last Friday.
I exceeded every question apart from this only one. I got borderline for it. And I was wondering why that is. Now I know. I did not want to leave it but get my head around it as quick as possible so I can move on to Level 4 with confidence.

I have to say I was so blindly sure I was right. And I would argue with anyone. I would let to chop my arm off if I was wrong. As turned out I WAS wrong.

Big THANK YOU again for your time and help. This is perfect. You couldn't be more helpful.
• Registered Posts: 782
Well done for passing, but wise to get this bit clear in your head, as it will crop up again but with more complications.

My first post on here was asking about valuing inventory. I was so sure that my calculation was right (despite being able to recite the method, which clearly showed I was wrong), that I just couldn't see how my answer was wrong. It was such a simple mistake but I was so sure I was right, my brain just could not see the blinding error.

Glad I could help, sometimes you just need someone to rephrase something a bit differently for it to click.