Jai Narayan Vyas University

Jodhpur
Faculty of law

SESSION = 2020-21
SUBJECT = COST ACCOUNTING
TOPIC = ABSORPTION OF OVERHEAD: OVER AND
UNDER

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Under-Absorption and Over-Absorption of Overheads

Meaning:
According to the terminology of Cost Accountancy, CIMA, London, overhead is defined as
“the aggregate of indirect material cost, indirect wages and indirect expenses”.

In the words of Wheldon, overhead may be defined as “the cost of indirect materials, indirect
labour and such other expenses including services that cannot conveniently be charged direct
to specific cost units”.

Therefore, overhead includes:

. Indirect costs, which cannot be, by their nature, traced to specific units of production.

2. Direct costs, which are so small in amount that it is inexpedient to trace them to specific
units of production.

Overhead = Indirect material + Indirect labour + Indirect expenses

Overheads – Meaning
Overheads are any expenditure over and above the prime cost. Overheads may be defined as
all indirect costs incurred for the production of goods or services. Overheads are also known
in cost accounting terminology as ‘On Cost’, ‘Burden’, Indirect Expenses, etc.

Indirect cost or overheads are those expenses which cannot be identified or related to a
specific or particular product or service. These overheads are not ‘Allocated’ but are
apportioned (divided) among various products or cost centres like rent, insurance, repairs,
telephone charges, etc.

As the production these days is involving capital intensive industries and on the mass scale
with automatic machines and computerised system. All this has resulted into heavy
expenditure on indirect cost which means increase in overheads. Overhead expenses these
days are very significant in the total cost of production.

So these overhead needs careful analysis for cost calculation and control of cost. The
overhead analysis, classification and apportionment to a cost centre plays a significant role in
various types of managerial decision-making. Minimisation of overheads (control on
wastage) is very important to keep a watch on the cost of production and production
planning.
Overheads – Definitions
“Any cost of doing business other than a direct cost of an output of product or service”.

– Eric L. Kohler

“Overheads are cost of an which do not result solely from the existence of individual cost
units”. – W. M. Harper

“Overhead represents the cost of indirect material, indirect labour and such other expenses
including services as cannot conveniently be charged to a specific unit”.

According to CIMA, overhead costs are defined as, ‘the total cost of indirect materials,
indirect labour and indirect expenses’. Thus all indirect costs like indirect materials, indirect
labour and indirect expenses are called as ‘overheads’.

Meaning of Accounting of Overheads

Accounting of overheads means the method adopted by the organization to accurately include
the overhead costs in the total production cost of the finished goods. Accounting of overheads
is a much more complex matter than that of accounting of direct costs.

Objectives of Costing for Overheads

The objectives of costing for overheads are:
1. For determining the actual cost of a product, overheads are to be charged indirectly to the
product.

2. For identifying overheads with cost centres, or for the purpose of cost control, overheads
have to be identified and charged to the final output.

Important Features of Overhead Expenses

The features of overhead are as follows:
They are identified below:
 1. Overhead Expenses are indirect costs.
2. They are common costs.
3. They include both escapable and inescapable. Because, discontinuance of a Cost Centre or
Cost Unit results in the avoidance of incurrence of certain items of Overhead Expenses.

Therefore, they are called escapable. Other Overhead Expenses (i.e., which cannot be
avoided) are inescapable.
4. They comprise of both cash expenses (e.g., insurance, rent, etc.,) and book expenses (i.e.,
depreciation).

5. They consist of both production expenses and non-production expenses (i.e.,

administrative, and selling and distribution expenses).

6. They are both variable and fixed.

Overheads Elements – Indirect Material Cost, Indirect Labour Cost and Indirect
Services Cost
he elements of overhead are discussed below:
Element # 1. Indirect Material Cost:
Indirect material cost is that material cost which cannot be assigned to specific units of
production. Indirect material cost is common to several units of production. A few examples
for the same are consumable stores, lubricating oil, cotton waste and small tools for general
use.

Sometimes indirect material cost includes direct material cost, which is so small or complex
that direct tracing to specific units is inexpedient, for example, glue, thread, rivets and chalks
etc.

Element # 2. Indirect Labour Cost:

Indirect labour cost is that portion of labour cost, which cannot be assigned to any specific
units of production. Indirect labour cost is common to several units.

Salaries of foreman, supervisory staff and works manager, wages for maintenance workers,
idle time, and workmen compensation are some of the examples of indirect labour cost,
which like some direct material cost, are not assigned to the specific units of production for
the sake of expediency.

Element # 3. Indirect Services Cost:

A few examples of indirect services are –

(i) repair and maintenance of plant and machinery,

(ii) factory rent,

(iii) expenses of keeping and handling of stores, and

(iv) first aid expenses.

Overheads Classifications – According to Elements, Function, Variability and
Controllability
Overheads may be classified on various basis such as:
1. According to Nature/element

2. According to Function or Functional classification

3. According to Variability

4. According to Controllability.

1. According to Elements:
Overheads are divided into 3 categories:
i. Indirect material

ii. Indirect labour

iii. Indirect expenses

2. Functional Classification:
i. Production Overhead:
Production Overhead mean and include all indirect cost involved in the production process. It
includes indirect material, indirect labour and other indirect expenses of the factory.
Production overhead are also termed as factory overhead or works overhead etc.

The examples include Factory’s power & lighting, factory rent, depreciation on factory
building, repairs & maintenance etc.

ii. Administrative Overhead:

All those costs which are of general natural and spent for administrative purposes will from
part of administrative overhead. For example office staff salaries, manager salary, office
stationary, rent of office building, insurances of office building etc.

It is to remember here that the purpose for which amount is spent will constitute the basis for
its allocation. For instance if stationary is purchased for office use, it will be administrative
overhead but if the stationary is used in factory, it will be part of production overhead.

Similarity lighting expenditure of office building is administrative overhead while lighting

expenditure of factory building will be production overhead. Therefore, the place and the
purpose of money spent is the key to know the category of overhead cost.
iii. Selling & Distribution Overhead:
Selling and distribution overhead include all indirect costs incurred to enhance and maintain
sales level. For example – godown expenses, packing expenses, salesman’s salary &
advertising, travelling expenditure etc.

3. According to Variability:
Overheads can be classified into three categories according to variability viz.:
i. Fixed overheads,

ii. Variable overheads and

iii. Semi-variable overheads.

These are explained below:

i. Fixed Overhead:
Costs are those cost which do not change because of change in the particular production
level. It means the fixed overhead is independent of production process. Some examples are
rent of building, salaries to staff, insurance of the building, manager’s salary etc.

It should be remembered here that concept of fixed cost is applicable only in the short run.
All costs are variable in the long run.

ii. Variable Overhead:

This is the most confusing word. If we are talking about overhead, it has to be indirect cost
and it is generally believed that all indirect cost are fixed cost. But this is not true. There are
certain cost which are indirect costs but are variable in nature.

For instance, oil & lubricant expenditure of the machine. It is indirect cost because it cannot
easily be identified with the product but variable in nature as the use of oil and lubricant
depends on the level of production. Other examples are store, power, lighting expenditure,
indirect labour etc.

iii. Semi-Variable Overhead:

Semi variable Overhead costs are those costs which do not vary in the same proportion as the
level of production.

Example of semi variable cost are:

a. Depreciation of P & M

b. Inspection cost
c. Supervisors salaries

d. Repairs & maintenance

4. According to Controllability:
All those overhead cost which can be influenced by the decision of the management are
called controllable overhead cost. Generally variable and semi variable cost are covered in
this category.

Uncontrollable Overhead –
Those overhead costs which are not controllable at the discretion of the management are
called uncontrollable overhead cost. Generally fixed overhead cost is covered in
uncontrollable overhead e.g., rent of office, salaries of staff etc.

Advantages of Classifying the Cost into Fixed and Variable Component:

Variable cost are controllable costs, therefore total costs has to be divided into variable &
fixed cost so that effective cost control is possible.

Segregation of cost into fixed & variable component helps in following ways:
(i) Cost Control and Decision Making:
Cost control can be exercised only if the cost is divided into fixed and variable cost as only
variables cost can be controlled and reduced easily. Fixed costs are considered to be
uncontrollable costs and therefore are left while taking decisions.

But is does not mean that all fixed costs are redundant. The fixed cost which is relevant in a
particular decision making situation is known as controllable cost.

Therefore, costs are divided into relevant and irrelevant cost in decision making process.
Relevant costs may include variable as well as fixed costs.

(ii) Budget Preparation:

Cost classification helps in budget preparation for various levels of production. Variable cost
generally increases or decreases according to the level of production while fixes cost remains
same. So, all semi fixed cost need to be divided into fixed & variable components so that a
comparative budget can be prepared.

(iii) Helps in Marginal Costing:

Division of cost into fixed and variable component helps in marginal costing. In marginal
costing, only variable costs are considered to calculate cost of production and valuation of
closing/opening stocks.
Marginal costing also helps in fixation of the price in depressions or slowdown. Marginal
costing also helps in various other decisions like make of buy, shut down, product mix etc.

(iv) Helps in Determining Overhead Absorption Rate:

Separation of cost into fixed and variable cost helps in determination of overhead rate
separately for fixed and variable overhead cost without the use of predetermined overhead
rate. The cost cannot be absorbed without the use of overhead absorption rate.

Collection of Overheads from Various Sources

In cost accounting collection of the overheads from various sources is very important, so that
these may be properly allocated, apportioned and codified.

The sources of these overheads can be:

(i) Purchase Journal and Invoices

(ii) Store requisitions

(iii) Wages Analysis Book

(iv) Cash book

(v) Journal

(vi) Different Reports and Registers.

Overheads Codification – Methods and Objects

When the collected overheads are grouped according to their class it is known as
classification of overheads. Each group or class is given a code number to help in maintaining
mechanised accounting and secrecy in the system. This code allotment procedure is known as
codification.

Codification may be done by any of the following methods:

(i) Numbers

(ii) Alphabets

(iii) Combination of numbers and alphabets

(iv) Symbols.
Objects of Codification:
(i) To collect the overheads of similar nature into one group.

(ii) To help the allocation and apportionment of overheads to products, process, jobs or cost
centres.

(iii) To help in planning and control of cost of products.

(iv) To make possible to prepare accounts by mechanised and computerised system.

(v) To make the accounting system more economical and useful through reducing the number
of the ledgers and accounts.

Codification is associated with allotment of standing order, numbers to the different groups
and items of overheads.

(i) Standing Order Number – The numbers provided to production overheads are known as
standing order numbers.

(ii) Cost Accounts Number – The numbers provided to office overheads and selling and
distribution overheads are known as cost accounts numbers.

The orders in which these numbers are allotted remain fixed. These are known as standing
orders. These standing order numbers as adopted by an organisation are to be listed in a
schedule or manual.

Under-Absorption and Over-Absorption of Overheads (With Reasons and

Accounting Treatment)
Overheads to the cost of production may be absorbed on the basis of the actual or on the basis
of estimated or pre-determined basis. If actual rate is applied then there is no question of
under or over absorption of overheads.

But in case of predetermined rate, it may result into either under-absorption or over-
absorption. If the amount of overhead (on the basis of predetermined rate) absorbed is less
than the actual overhead incurred, it is a case of under-absorption (short absorption).

It represents the amount by which the absorbed overheads fall short of the actual amount of
overhead incurred. If the amount absorbed is more than the expenditure incurred actually it is
over-absorption of overheads.
Over-absorption will inflate the cost. It means over-absorption (means the excess of
overheads absorbed over the actual amount of overhead incurred.)

(1) Under absorption – Where the amount absorbed is less than the actual amount of
overheads incurred is known as under absorption.

Under-absorption = Actual Overheads – Absorbed Overheads

(2) Over-absorption – Where the amount absorbed is more than the amount of overhead
actually incurred it is a case of over-absorption of overheads.

Over-absorption = Absorbed Overheads – Actual Overheads

Reasons for Under-Absorption or Over-Absorption of Overheads:

(i) Error in estimating overheads.

(ii) Error in estimating the level of production.
(iii) Error in estimating the machine hour or labour hours to be worked.
(iv) Seasonal variation in the overhead expenses from period to period.
(v) Unanticipated changes in the method or techniques of production.
(vi) Unforeseen changes in the production capacity.
(vii) Under or over-utilisation of productive capacity.
Treatment of under absorption or over absorption of overheads may be disposed off in any of
the following manners:

Accounting Treatment of Under-Absorbed or Over-Absorbed Overheads:

A. Transfer to Costing Profit and Loss Account;

B. Carry forward to Next Year;
C. Use of Supplementary Overhead Rate
A. Transfer to Costing Profit and Loss Account:

Under this method the amount of under-absorbed or over-absorbed overheads is written off
by transferring to costing profit and loss account.

The main problem in this method is that the value of stock is distorted. Under-absorption or
over absorption will also give false figure of profit or loss of the organisation by the same
amount for the period. Journal entry to be passed in case of under absorption
General Principles for Items of Overhead Expenditure:

Following general principles should be kept in view while considering whether an item of

expenditure is to be treated as overhead:

1. Overhead comprises of indirect costs, i.e. the costs which cannot be directly charged or

allocated to any particular job, process or product. Thus, the relationship of the items of

expenditure to product, job etc., must be seen.

2. Direct costs are not to be treated as overheads. But in certain cases even direct expenses

may be treated as overheads; for example, when the cost of a particular item like screws,

nuts, bolts etc. though incurred for a particular job or product is so small that it is not

convenient to charge them as direct costs, is to be apportioned as overheads over the jobs or

products.

3. Overheads may be attached to a cost centre in accordance with the principles of benefit and

I or responsibilities. The benefit principle implies that if a cost centre occupies a proportion

of a larger unit of space for which standing charges such as rent and rates are exactly

ascertainable, it should be charged with a due proportion of such costs. The responsibility

principle implies that as the departmental head has no control over the amount of rent and

rates paid, these being fixed by decisions of others, his department should not bear any
allocation of them.

4. All expenditures of capital nature should be excluded from costs and shall not be treated as

overheads.

5. All expenditures which do not relate to cost, such as penal rates of interest on loans,

donations, subscriptions, income-tax etc., are excluded from costs and shall not be treated as

overheads.
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