Study tips: Fixed overheads – part 2 actual overheads and under/over absorption

In a previous article, we considered overheads; what they are, how they are budgeted, and how they are absorbed.

Now we are going to focus on actual overheads and how they differ from the overheads recovered via overhead absorption rates (OAR’s), including what that means for over and under absorption.

At the end of the last article we had covered the following key points:

• overheads can be absorbed into the cost of production on either a unit, machine hour or labour hour basis
• OAR’s are calculated as part of planning a budget and are based on estimates of both production and non-production overheads and expected production level

In our scenario, we had allocated and apportioned the estimated overheads for Charlie’s Chocolates Ltd, a company that makes premium quality hand-finished chocolates, and reapportioned the support department costs to the production and finishing departments:

Expected production levels resulted in budgeted machine hours of 600,000 in the production department and budgeted labour hours of 18,000 in the finishing department.  So we had calculated the OAR’s to be £0.53 per machine hour for production (£317,951 ÷ 600,000 hours) and £7.17 per labour hour for finishing (£129,049 ÷ 18,000 hours).

That took us to the end of the planning phase.  Now let’s imagine we’re in the first quarter of the new financial year, the one we’ve budgeted for and to which the OAR’s relate. 

Throughout the quarter we will apply the OAR’s to the actual hours worked.  So, for example, if 52,500 machine hours were used in the first week then £27,825 will have been included in the cost of production (52,500 machine hours x £0.53 per machine hour) and charged to customers. 

If staff in the finishing department worked for 1,480 hours then £10,612 (1,480 labour hours x £7.17 per labour hour) will have been included as well.  Once the chocolates are sold and customers pay their invoices, these amounts will be recovered and available to pay overhead costs.

Now we need to do a bit of time travelling and skip forward to the end of the quarter.  The OAR’s, based on budgeted costs and estimated hours, have been applied to the actual hours worked and, in that way, money has been recovered.

Let’s remind ourselves of the budgeted figures:

• Total budgeted overheads amounted to £447,000 which were divided between the production and finishing departments; £317,951 and £129,049 respectively.
• Estimated hours were 600,000 machine hours in production and 18,000 labour hours in finishing.

Now we’re at the end of the quarter we have the actual figures:

• Actual overheads incurred amounted to £445,792 which were allocated and apportioned to the production and finishing departments as £318,542 and £127,250 respectively.
• Actual hours were 600,560 machine hours in production and 17,800 labour hours in finishing.

It is important to note that actual overheads are often different to budgeted overheads because prices change and more, or less, resources such as power are used.  Additionally, the amounts that have been recovered are likely to be different from planned because they are the result of the combination of both budgeted and actual elements.  

In the quarter, the amounts actually recovered were:

• £318,297 in production (600,560 actual machine hours x £0.53 per hour)
• £127,626 in finishing (17,800 actual labour hours x £7.17 per hour)

In comparison to the actual overheads incurred the differences are:

• -£245 in production (£318,297 overheads recovered less £318,542 actual overheads)
• £376 in finishing (£127,626 overheads recovered less £127,250 actual overheads)

In production, insufficient overheads were recovered in order to pay the actual overheads incurred.  Overheads were under-absorbed by £245.

In finishing, £376 more than is needed to pay the actual overheads was recovered.  This means that overheads were over-absorbed.

In this scenario the values are only small, however, budgeting always involves a degree of educated guesswork so over and under-absorption is a regular occurrence and it’s important to know what each means and how to account for them correctly.

Overheads recovered are recorded in the production and overheads control accounts:

Overheads incurred are paid out of the bank and posted to the overheads control account:

The over or under absorption is the balance on the control account and may be posted to an over/under absorption account:

Under absorption is an expense and will be transferred to the profit or loss account at period end, (either through the over/under absorption account or directly from overheads control account), increasing the expenses and decreasing profit:

Try entering the overheads recovered and paid in relation to the finishing department into some T accounts.  Then make the required adjustments to account for the over absorption.  Check your answers against mine to see if you got it right!

Further reading:

• Study tips: Understanding fixed overhead variances
• Budgeting using standard costing and the labour variance analysis
• Material variance analysis when budgeting

Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.