Underabsorbed Overhead

In absorption costing, the circumstance in which the absorbed overhead is less than the overhead costs incurred for a period. This adverse variance represents a reduction of the budgeted profits of the organization.
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Definition

Underabsorbed Overhead, also known as Underapplied Overhead, occurs in absorption costing when the overhead costs allocated to products or services (absorbed overhead) are less than the actual overhead costs incurred during a specific period. This situation results in an adverse variance, indicating a reduction in the expected or budgeted profits of an organization.

Examples

  1. Manufacturing Scenario:

    • A manufacturing company estimated $50,000 in overhead costs for the month but only absorbed $40,000 based on actual production. Therefore, the underabsorbed overhead is $10,000.

  2. Service Industry Scenario:

    • A consulting firm budgeted $30,000 for their overheads but absorbed only $25,000 for the month due to lower than expected billable hours. The underabsorbed overhead in this case amounts to $5,000.

Frequently Asked Questions (FAQs)

What is absorption costing?

Absorption costing is a method where all manufacturing costs, including both fixed and variable overheads, are allocated to the cost of a product. It contrasts with variable costing, where only variable production costs are considered.

How is underabsorbed overhead identified?

Underabsorbed overhead is identified by comparing the actual overhead costs incurred with the absorbed overhead costs. If actual costs surpass absorbed costs, the difference is termed underabsorbed overhead.

What are the implications of underabsorbed overhead?

Underabsorbed overhead can lead to reduced profitability as it indicates that the company did not absorb enough overhead costs relative to what was actually incurred. This might suggest inefficiencies or inaccuracies in the overhead absorption rate.

Can underabsorbed overhead be corrected?

Yes, underabsorbed overhead can be adjusted by:

  • Increasing production volume.
  • Reevaluating overhead absorption rates.
  • Enhancing operational efficiency to reduce actual overhead costs.

  • Absorption Costing:

    • A costing method that allocates all manufacture-related costs, both fixed and variable, to the production of goods or services.

  • Absorbed Overhead:

    • The portion of overhead costs allocated to a specific product, job, or service based on a predetermined rate.

  • Adverse Variance:

    • A variance indicating that actual costs have exceeded budgeted or standard costs, negatively impacting profitability.

  • Overabsorbed Overhead:

    • A situation where the absorbed overhead exceeds the actual overhead incurred, leading to a favorable variance.

  • Overhead Total Variance:

    • The difference between the total actual overhead costs and the total absorbed overhead costs for a period.

Online References

  1. Investopedia: Absorption Costing
  2. Accounting Coach: Overhead Costs
  3. CIMA: Under/Over Absorption of Overhead

Suggested Books for Further Studies

  1. Cost Accounting: A Managerial Emphasis by Charles T. Horngren
  2. Principles of Cost Accounting by Edward J. Vanderbeck and Maria R. Mitchell
  3. Managerial Accounting by Ray H. Garrison, Eric Noreen, and Peter Brewer

Accounting Basics: “Underabsorbed Overhead” Fundamentals Quiz

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Thank you for delving into this comprehensive explanation of underabsorbed overhead. By understanding and managing these variances, businesses can better control costs and maintain financial health!

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Under-Withholding