Overhead expenses are usually applied to production on the basis of predetermined rates. The predetermined rates may represent estimated, actual or normal costs. In either case, the amount of expenses actually incurred and the amount of overheads applied to production will seldom be the same. Some difference is inevitable. If the actual expenses fall short of the amount applied, there is said to be over-absorption of overheads, and, conversely, if the actual expenses exceed the amount applied to production, it is a case of under-absorption. Such over or under-absorption may also be termed as overhead variance, the amount of over-absorption being represented by the credit balance on the variance account, and, conversely, the amount of under- absorption by a debit balance.
Treatment of under-absorption and over-absorption of overheads: The treatment will depend on the causes that led to under or over-absorption. The amount ascribable to abnormal factors should be charged off to costing profit and loss account, otherwise costs previously arrived at should be adjusted. The following are the main methods of disposal of under or over-absorption of overheads.
Writing off to costing profit and loss account: Where the difference between actual or absorbed overheads is not large, the simple method is to write it off to the costing profit and loss account. When there is under absorption due to idle facility, the concerned amount is also written off in this manner, likewise, when there was wasteful expenditure due to lack of control also.
Carrying of overheads: The balance of under/over-absorbed overheads at the end of the year is transferred to an overhead reserve or suspense account and is carried forward to the next year account for absorption This method is preferably applied when the normal business cycle is more than one year and in the case of new projects and schemes when the output is low in the initial stages of production and cannot bear the entire share of overhead.
