If the applied overhead exceeds the actual overhead, the difference is termed an over absorption variance. Additionally, adopting more modern costing methodologies, such as Activity-Based Costing (ABC), can mitigate the risk.
How Activity Based Costing Prevents Over Absorption in Detail
If the inventory is eventually sold, the excessive overhead previously absorbed will have been released to the income statement all at once, causing future periods to show abnormally low costs and potentially masking future inefficiencies. This involves implementing flexible budgeting that allows overhead rates to be adjusted based on actual activity levels.
Finally, unexpected improvements in operational efficiency, while generally positive, can contribute if the reduction in labor or machine hours leads to less overhead being incurred than was allocated. This creates a misleading picture of operational efficiency and can result in higher reported earnings.
Activity Based Costing to Prevent Over Absorption
This misvaluation violates the accounting principle of prudence, which requires assets to be stated at no more than their net realizable value. Over absorption represents a critical yet often misunderstood concept within the realms of accounting and financial management, describing a scenario where the allocated overhead costs to a product or service exceed the actual incurred expenses.
More About Over absorption
Looking at Over absorption from another angle can help expand the discussion and give readers a second clear paragraph under the same section.
More perspective on Over absorption can make the topic easier to follow by connecting earlier points with a few simple takeaways.
