Under/Over-Absorption

Hi everyone,

I have a quick question regarding absorption costing which I felt I had understood when doing Level 3, but now that I'm working on Level 4 is confusing me again.

Whenever you calculate Overhead Aborption Rates (OAR) you use budgeted overheads / budgeted activity level. Now, when calculating over/under-absorption you use the OAR x actual activity and then compare this figure against Actual Overheads. The part I'm not understanding is why is it that we multiple OAR by actual activity and not simply use budgeted activity instead (which would simply yield Budgeted Overheads). I don't understand why continue to use the OAR and not simply Budgeted Fixed Overheads to then calculate under/over-absorbed overheads. After all, wouldn't the budgeted figures be used on the P&L if one was drawn up before the end of the period? At that point in time, I wouldn't even know what is the actual activity level.

If someone could help me out that'd be appreciated.

Answers

  • SandyHood
    SandyHood Registered, Moderator Posts: 2,034
    Dear BU982T
    You have made a lot of points. I'll address as many as I can.
    1. Under an absorption costing system a company sets an overhead absorption rate before the accounting period starts. If I use a garage as an example, we need to have an idea of the full cost of the jobs we do when we fix the cars. The customer will be quoted an hourly rate plus parts. That hourly rate needs to include our overheads.
      We make some forecasts and they give us the budgeted overhead cost for the period and the budgeted mechanics' hours. We calculate a budgeted overhead absorption rate.

    2. As the period progresses, each hour a mechanic works we absorb an hour of overhead. This is a credit entry in the production overhead account and a debit in the "Cars Repaired" account [effectively our cost of sales]
    3. At the same time every overhead cost we actually incur is debited to our production overhead account.
    4. At the end of the accounting period we look at the debits and credits in the production overhead account. If the total cost actually incurred [the debit entries] are more than the amount charged to cost of cars repaired [credit entries] we didn't absorb all the overhead. We have under absorbed. If the credits are more than the debits we have over absorbed.
    5. Why don't we use the budgeted overhead in the profit or loss? The p or l is our record of the costs we had during the period, it doesn't have budgeted values. At the beginning of the accounting period we needed to know how much overhead to charge per hour worked, so we used our budget to set an absorption rate. That became the actual cost we charged Cost of Sales [or cost of cars repaired] every time an hour was worked.

    I hope this helps
    If I've missed any aspect which has been troubling you, please let me know.
    Yours
    Sandy
    [email protected]
    www.sandyhood.com
    http://www.amazon.co.uk/Management-Cost-Accounting-For-Dummies/dp/1118650492
    Sandy
    [email protected]
    www.sandyhood.com
    KarenMustardTutor
  • BU982T
    BU982T Registered Posts: 40
    Hi Sandy,

    Thank you very much for your answer. I really needed someone to break it down to actually *when* things happen. I'm glad you spotted that this is what I needed even though I wasn't necessarily explicit about it.

    I have one last thing I would appreciate if you could clarify. Do the absorbed POHs arrive at the P or L via the COGS account? In your example, you credited POH and debited Cars Repaired which you say is COGS, but how does it work with a WIP/Finished Goods account? I ask this because there could potentially be a balance remaining in the WIP account which isn't transferred over to Finished Goods (we use this account to calculate COGS) and therefore leaving some absorbed POH behind which would then not have POH on the P or L not balance to *actual* POH incurred after under-over absorption.
  • SandyHood
    SandyHood Registered, Moderator Posts: 2,034
    BU982T
    This question is fine.
    I think it is a shame your textbook hasn't addressed this.

    The T accounts for this can show this visually.
    There could be a manufacturing scenario with 2 departments: cutting and finishing

    Each department would have its own WIP and its own Production Overhead Control account.

    The Cutting department might have completed 1000 units and have 300 units closing work in progress. The 1000 completed units may have had 2 hours of labour each and the 300 closing WIP may have 1 hour each of labour. This will mean that the cutting department has absorbed 2,300 x the hourly overhead absorption rate. If the rate was £20 per hour then £46,000. The production overhead incurred for cutting may have been £50,000.
    This means there is an under absorbed cutting department production overhead of £4,000.
    The value credited to the Cutting WIP will include 2,000 x £20 [£40,000] of production overhead.
    This value will be the same as the value debited to Finishing WIP.

    The Finishing department might have taken the 1000 units from cutting and added material, labour and production overhead and at the end of the period have 800 to transfer to finish goods and 200 work in progress. The 800 finished goods may have had 3 hrs of direct labour time each and the 200 WIP may have had 2.5 hrs direct labour hours each. If the overhead absorption rate is £30 per labour hour then Finishing will have absorbed 2900 hours x £30/hr = £87,000
    If the Finishing dept incurred £90,000 for production overheads there will be £3,000 under absorbed finishing dept production overhead.

    The WIP in both the Cutting Dept and the Finishing Dept are part of the inventory at the end of the accounting period. They will include the overhead incurred to date: £6,000 in Cutting £15,000 in Finishing

    The 800 units transferred to finished goods will be recorded as a debit to finished goods and a credit to Finishing Dept. The value will be the total cost incurred including the overheads absorbed.

    If say 600 of the finished goods are sold, these will be a debit to cost of sales and a credit to finished goods. The other 200 would be the closing stock of finished goods.

    There will also be two under absorbed overhead debit entries in cost of sales. The £4,000 under absorbed in the cutting department and £3,000 under absorbed in the finishing department.

    I hope this helps.
    I recommend that you draw up a series of T accounts and see how the value moves through the various processes into cost of sales.

    Yours

    Sandy
    [email protected]
    www.sandyhood.com
    http://www.amazon.co.uk/Management-Cost-Accounting-For-Dummies/dp/1118650492
    Sandy
    [email protected]
    www.sandyhood.com
    KarenMustardTutor
  • SandyHood
    SandyHood Registered, Moderator Posts: 2,034
    BU982T
    I've taken this from a sentence in your posting
    which isn't transferred over to Finished Goods (we use this account to calculate COGS)

    I might be telling you something you know. If so, I apologise.
    When you calculate cost of goods sold in a manufacturing scenario where products are costed including production overheads, you don't apply the opening inventory + production - closing inventory approach.
    The cost of goods sold [cost of sales] comes from the accounting system.
    As in my previous posting, the debit for cost of sales only takes place when the sale takes place.

    See chapter 2
    http://www.amazon.co.uk/Management-Cost-Accounting-For-Dummies/dp/1118650492
    Sandy
    [email protected]
    www.sandyhood.com
    BU982TKarenMustardTutor
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