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
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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.
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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.
Related Terms with Definitions
-
Absorption Costing:
- A costing method that allocates all manufacture-related costs, both fixed and variable, to the production of goods or services.
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Absorbed Overhead:
- The portion of overhead costs allocated to a specific product, job, or service based on a predetermined rate.
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Adverse Variance:
- A variance indicating that actual costs have exceeded budgeted or standard costs, negatively impacting profitability.
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Overabsorbed Overhead:
- A situation where the absorbed overhead exceeds the actual overhead incurred, leading to a favorable variance.
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Overhead Total Variance:
- The difference between the total actual overhead costs and the total absorbed overhead costs for a period.
Online References
- Investopedia: Absorption Costing
- Accounting Coach: Overhead Costs
- CIMA: Under/Over Absorption of Overhead
Suggested Books for Further Studies
- Cost Accounting: A Managerial Emphasis by Charles T. Horngren
- Principles of Cost Accounting by Edward J. Vanderbeck and Maria R. Mitchell
- Managerial Accounting by Ray H. Garrison, Eric Noreen, and Peter Brewer
Accounting Basics: “Underabsorbed Overhead” Fundamentals Quiz
### What does underabsorbed overhead indicate?
- [x] Actual overhead costs exceed absorbed overhead costs.
- [ ] Absorbed overhead costs exceed actual overhead costs.
- [ ] There is an equal balance between actual and absorbed overhead costs.
- [ ] Overhead costs are not considered in the costing method.
> **Explanation:** Underabsorbed overhead indicates that the actual overhead costs are greater than the absorbed overhead costs, reflecting an adverse variance.
### In which costing method is underabsorbed overhead typically identified?
- [x] Absorption costing
- [ ] Variable costing
- [ ] Activity-based costing
- [ ] Marginal costing
> **Explanation:** Underabsorbed overhead is typically identified in absorption costing, where all manufacturing costs, including overheads, are assigned to products.
### What is the financial implication of underabsorbed overhead?
- [ ] Increased profitability
- [x] Reduced profitability
- [ ] Neutral effect on profits
- [ ] Overstated profits
> **Explanation:** The financial implication of underabsorbed overhead is reduced profitability, as actual expenses exceeded the absorbed costs, reflecting an adverse variance.
### How can a company address underabsorbed overhead?
- [ ] By ignoring it in financial statements.
- [x] By adjusting production volume or absorption rates.
- [ ] By increasing marketing expenses.
- [ ] By reducing wages.
> **Explanation:** A company can address underabsorbed overhead by adjusting production volumes or reevaluating and recalculating the overhead absorption rates to ensure more accurate cost allocation.
### When actual overhead exceeds absorbed overhead, what type of variance results?
- [x] Adverse variance
- [ ] Favorable variance
- [ ] Neutral variance
- [ ] Undefined variance
> **Explanation:** When actual overhead exceeds absorbed overhead, it results in an adverse variance, indicating a negative impact on profitability.
### Which statement is true regarding underabsorbed overhead?
- [x] It results when overhead costs incurred are higher than what was absorbed.
- [ ] It indicates an overestimation of overhead absorption rates.
- [ ] It suggests higher profit margins.
- [ ] It is not factored into financial decisions.
> **Explanation:** Underabsorbed overhead occurs when the incurred overhead costs are higher than absorbed, suggesting inaccuracies in the initial overhead absorption rate or lower-than-expected production volumes.
### What type of overhead costs are allocated to products in absorption costing?
- [x] Both fixed and variable overhead costs
- [ ] Only fixed overhead costs
- [ ] Only variable overhead costs
- [ ] No overhead costs
> **Explanation:** In absorption costing, both fixed and variable overhead costs are allocated to the production of goods or services.
### What might indicate the need to reassess the overhead absorption rate?
- [x] Consistently recurring underabsorbed overhead
- [ ] Seasonal production spikes
- [ ] Decreased marketing expenditures
- [ ] High product demand
> **Explanation:** Consistently recurring underabsorbed overhead indicates the need to reassess the overhead absorption rate to more accurately reflect actual cost behaviors.
### What happens to overhead costs that are unabsorbed?
- [x] They represent an adverse variance.
- [ ] They are added to profits.
- [ ] They are ignored in financial reporting.
- [ ] They reduce costs of goods sold.
> **Explanation:** Overhead costs that are unabsorbed represent an adverse variance, signaling a negative effect on budgeted profits.
### Which industry scenario might result in underabsorbed overhead?
- [x] A manufacturing plant producing fewer units than expected.
- [ ] A retail store with increased seasonal sales.
- [ ] A service provider with stable costing structures.
- [ ] A tech company with rapid development cycles.
> **Explanation:** A manufacturing plant producing fewer units than expected might result in underabsorbed overhead, as there would be fewer units to absorb the fixed overhead costs, leading to an adverse variance.
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!
