Q5. How does over/under absorption arise? Overhead absorption rates are usually predetermined.

Tthey are calculated in advance of the period over which they will be used. The problem with using predetermined overhead absorption rates is that the actual figures for overhead and for the absorption base are likely to be different from the estimates used in calculating the absorption rate. When this happens, the overhead will be either under- or over-absorbed. If the actual overhead incurred is higher than the overhead absorbed, then overhead is under-absorbed. If the reverse is true then the overhead is over-absorbed. There are two possible causes of this. (a) The actual number of hours (machine or direct labour) was different from the number contained in the budget data. If this happens, then we would expect the variable element of the overhead to vary in direct proportion to the change in hours, so this part of the absorption rate would still be accurate. However, the fi xed overhead would not alter with the hours worked and this means that the actual overhead per hour would be different from the predetermined rate. (b) The actual production overhead incurred may be different from the estimate contained in the predetermined rate. Apart from the expected change in variable overhead referred to in (a), this would also cause an under- or over-absorption of overhead.

Reasons of under / Over-absorption of overheads The under or over-absorption of overheads may arise due to any one or more of the following reasons: (i) Wrong estimation of overhead expenses: The actual overhead expenses may be substantially less or more than the estimated amount. When actual fixed overhead expenditure exceeds the budget, there is an adverse variance, and this will result in some under absorption of fixed overheads. When actual fixed overhead expenditure is less than budget, there is a favourable variance and this will result in over-absorption of fixed overhead. The reason might be excessive spending on overhead items or under-estimating fixed overhead expenditure in the budget. (ii) Wrong estimation of work done: The amount of work done may greatly exceed or may be substantially less than the estimated work. For example if actual work is 8,000 working hours against estimated working hours of 10,000, then the expenses charged to job will be 20% less. (iii) Error in using method of absorption: Sometimes the method of absorption may not be suitable. If the percentage of direct material method is used, fluctuation in prices of material may lead to under or over-absorption of overheads. (iv) Seasonal fluctuation in overhead: Due to seasonal nature of work, overhead may fluctuate from one period to another period.

(v) Under or over utilisation of capacity: There may be under or over-absorption of overhead due to under or over utilisation of productive capacity. When overheads are absorbed on the basis of direct labour hours or machine hours, the actual hours worked might be higher or lower than budgeted. The reasons might be: ~ working more hours than budgeted might be caused by working overtime, or taking on additional direct labour employees. ~ working fewer hours than budgeted might be caused by staff shortages (due to employees leaving or absence from work), hold-ups in production or lack of customer orders. (vi) Wrong estimation of output: When the actual output substantially differs from the anticipated output, it leads to under or over-absorption of overheads.
The debit balance indicates that the factory overhead costs were underapplied or underabsorbed. In other words, the work in process account and the individual jobs worked on were undercharged for the costs of factory overhead incurred in the accounting period. Probable causes for the underapplication could include: (1) a lower level of operating capacity was achieved than was budgeted for when the predetermined rate was established or (2) the actual factory overhead expenses were more than budgeted for the operating level achieved. If, on the other hand, a credit balance remains in Factory Overhead after the applied factory overhead account is closed to the control account, the credit balance would represent overapplied or overabsorbed factory overhead. This means that more overhead was applied to production than was actually incurred in the period. The section on Under- and over-recovery of fixed overheads in Chapter 4 indicates that an under- or over-recovery will arise whenever actual activity or expenditure differs from budgeted activity or expenditure. Actual activity was 1700 hours in excess of budget and this will result in an over-recovery of fixed overheads of 30 940. Actual overheads incurred were 94 039 (2 317 461 2 411 500) less than budget and this is the second factor explaining the overabsorption of fixed overheads.

Under- or overapplication is caused by two factors that can work independently or jointly. Th ese two factors are cost diff erences and utilization diff erences. For example, if actual fi xed overhead (FOH) cost diff ers from expected FOH cost, a fi xed manufacturing overhead spending variance is created. If actual capacity utilization diff ers from expected utilization, a volume variance arises