Overabsorbed Overhead

In absorption costing, overabsorbed overhead occurs when the absorbed overhead is greater than the incurred overhead costs for a period, representing an addition to the budgeted profits of the organization.
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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

  1. 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).

  2. 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.
  • 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

  1. Investopedia - Absorption Costing
  2. AccountingCoach - Overhead Variance

Suggested Books for Further Studies

  1. “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
  2. “Management and Cost Accounting” by Alnoor Bhimani, Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
  3. “Accounting for Decision Making and Control” by Jerold L. Zimmerman.

Accounting Basics: “Overabsorbed Overhead” Fundamentals Quiz

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