Under absorbed overhead

@learner10

It seems your understanding regarding the Overhead Absorption isn’t clear. Let me explain it here.

Overheads are the expenses incurred in course of making the product. Hence, these MUST be deducted from the revenue earned by those products in order to find a profit.

Overheads are normally ‘absorbed’ into units produced (i.e included in their cost) through some Absorption Rate. This absorption rate is multiplied with the actual activity (which may be in no. of units produced, hours worked, etc) to find Absorbed Overheads.

These Absorbed Overheads are compared with the ACTUAL Overheads incurred and calculated whether these are more or less than the actual ones. If these are more, then we suggest that we’ve over-absorbed overheads than the actual ones, and if those are less than actual, then we suggest we’ve under-absorbed than the actual ones.

The word ‘absorb’ simply means that we include these costs in the Cost of Goods Sold (or Cost of Sales) and deduct from the sales revenue to get a Gross Profit. If there’s an ‘over-absorption’ of overheads, then it will mean ‘over-deduction’ of overheads, meaning that overheads amount deducted is more than what should’ve been (which is the actual overhead amount). Similarly, ‘under-absorption’ of overheads means ‘under-deduction’ of overheads, meaning overheads amount deducted is less than what should’ve been (the actual one).

In order to deduct correct amount for overheads (which is the actual one), we take these steps:

1) In case of over-absorption, we simply remove the ‘excess’ amount deducted from the revenue. This is done by adding the excess amount back to profits.
2) In case of under-absorption, we deduct the ‘remaining’ amount (which is yet to be deducted) from the revenue. This is done by deducting the remaining amount from profits.

After above treatments, the amount deducted from revenues equals the Actual Overheads amount.