Definition
Overabsorbed overhead refers to a situation in absorption costing where the overhead costs allocated to products based on a predetermined rate exceed the actual overhead costs incurred during a specific period. This creates a favorable variance, leading to an increase in the budgeted profits of the organization.
Examples
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Example 1: Manufacturing Scenario
- A manufacturing company estimates its overhead costs to be $10,000 for a given period and uses a predetermined overhead rate to allocate $12,000 to its products. The actual overhead incurred is $9,000. Therefore, the company has overabsorbed overhead by $3,000 ($12,000 - $9,000).
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Example 2: Service Industry
- A consulting firm predicts overhead costs of $50,000 for the year and allocates $52,000 to client projects based on billable hours. The actual overhead incurred is $48,000, resulting in overabsorbed overhead of $4,000 ($52,000 - $48,000).
Frequently Asked Questions (FAQs)
Q1: What causes overabsorbed overhead?
- Overabsorbed overhead can occur if the predetermined overhead rate is higher than the actual overhead costs, or if production levels exceed expectations.
Q2: How is overabsorbed overhead accounted for?
- Overabsorbed overhead is typically adjusted by crediting cost of goods sold or other relevant expense accounts, thereby reflecting the excess in financial statements.
Q3: What is the impact of overabsorbed overhead on profitability?
- Overabsorbed overhead results in a favorable variance, which means that the company will report higher than budgeted profits due to lower actual overhead costs.
Q4: What is the difference between overabsorbed and underabsorbed overhead?
- Overabsorbed overhead occurs when allocated overhead costs exceed actual costs, while underabsorbed overhead occurs when allocated costs are less than actual costs.
Q5: Can overabsorbed overhead lead to overly optimistic financial reports?
- Yes, if not properly managed, overabsorbed overhead can give a misleading impression of an organization’s profitability and operational efficiency.
Related Terms
- Absorption Costing: An accounting method that includes all manufacturing costs—both fixed and variable—in the cost of a product.
- Absorbed Overhead: The portion of overhead costs assigned to products or services based on a predetermined rate.
- Favorable Variance: A variance where actual financial performance is better than budgeted/forecasted figures, leading to increased profitability.
- Underabsorbed Overhead: The situation where the amount of overhead absorbed into production is less than the actual overhead incurred.
- Overhead Total Variance: The difference between the total actual overhead incurred and the total overhead absorbed during a period.
Online References
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
- “Management and Cost Accounting” by Alnoor Bhimani, Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
- “Accounting for Decision Making and Control” by Jerold L. Zimmerman.
Accounting Basics: “Overabsorbed Overhead” Fundamentals Quiz
### What defines overabsorbed overhead?
- [x] When the absorbed overhead exceeds the actual overhead costs.
- [ ] When the actual overhead costs exceed the absorbed overhead.
- [ ] The difference between variable and fixed overheads.
- [ ] None of the above.
> **Explanation:** Overabsorbed overhead occurs when the absorbed overhead, based on the predetermined rate, exceeds the actual overhead costs incurred during the period.
### Which costing method utilizes the concept of overabsorbed overhead?
- [ ] Variable Costing
- [x] Absorption Costing
- [ ] Direct Costing
- [ ] Marginal Costing
> **Explanation:** Absorption costing includes all manufacturing costs in product cost, therefore, it considers overabsorbed and underabsorbed overhead scenarios.
### What is the financial impact of overabsorbed overhead?
- [ ] It decreases budgeted profits.
- [x] It increases budgeted profits.
- [ ] It has no impact on profits.
- [ ] It leads to inventory valuation changes only.
> **Explanation:** Overabsorbed overhead results in a favorable variance, meaning that the organization will report higher than budgeted profits.
### How is overabsorbed overhead typically adjusted in financial statements?
- [ ] By debiting cost of goods sold.
- [ ] By increasing administrative expenses.
- [x] By crediting cost of goods sold.
- [ ] By adjusting wages.
> **Explanation:** Overabsorbed overhead is adjusted by crediting the cost of goods sold account to reflect the excess in absorbed costs over actual costs.
### What can be a primary reason for overhead being overabsorbed?
- [ ] Increased labor hours.
- [ ] Decreased material costs.
- [x] Higher production levels.
- [ ] Decreased utility expenses.
> **Explanation:** Overabsorbed overhead may result from production levels being higher than initially expected, leading to more overhead being allocated than actually incurred.
### In what scenario might a company face overabsorbed overhead?
- [ ] When estimated overhead rate is lower than actual costs.
- [ ] During a period of reduced output.
- [x] When actual overhead costs are lower than anticipated.
- [ ] Under conditions of variable costing.
> **Explanation:** Overabsorbed overhead typically occurs when the actual overhead costs incurred are lower than the anticipated costs.
### What variance category does overabsorbed overhead fall into?
- [ ] Unfavorable variance
- [ ] Neutral variance
- [x] Favorable variance
- [ ] Indeterminate variance
> **Explanation:** Overabsorbed overhead creates a favorable variance, as it represents savings in overhead costs relative to what was absorbed.
### Which term is closely related to overabsorbed overhead?
- [x] Absorbed Overhead
- [ ] Direct Materials
- [ ] Fixed Costs
- [ ] Depreciation
> **Explanation:** Absorbed overhead is closely related as it refers to the overhead costs assigned to products based on a predetermined rate.
### Which aspect of accounting is positively affected by overabsorbed overhead?
- [ ] Audit Accuracy
- [ ] Cost of Capital
- [ ] Financial Statement Transparency
- [x] Profitability
> **Explanation:** Overabsorbed overhead positively affects profitability as it indicates that actual costs were less than the absorbed overhead, leading to higher profits.
### Overabsorbed overhead is a result of what type of overhead rate?
- [ ] Actual Overhead Rate
- [ ] Average Overhead Rate
- [x] Predetermined Overhead Rate
- [ ] Variable Overhead Rate
> **Explanation:** Overabsorbed overhead arises when overhead is allocated based on a predetermined overhead rate, which may differ from actual incurred costs.
Thank you for exploring the intricate concepts of overabsorbed overhead in accounting and taking our illustrative quiz. Keep honing your financial acumen!
