Companies calculate a predetermined overhead rate at the beginning of a period by dividing the total estimated overhead costs by a chosen allocation base, such as direct labor hours or machine hours. The accuracy of this process hinges on the initial estimate; if the estimate is flawed or actual production volume deviates significantly, the stage is set for either under or over absorption to occur.
Over Absorption Leading To Future Period Issues
Strategies for Identification and Correction Accounting systems are designed with mechanisms to detect and rectify the variance caused by over absorption. ABC assigns overhead based on the actual activities that drive costs, providing a more accurate and dynamic cost allocation that is less susceptible to volume fluctuations.
When actual production falls below these initial estimates, the fixed overhead costs, which remain constant regardless of output, become spread over fewer units, leading to a higher cost burden per unit than originally planned. Because more cost is attached to each unit of inventory, the cost of goods sold on the income statement is initially lower, leading to an inflated gross profit.
Over Absorption Leading To Future Period Issues
This process, known as writing off the variance, removes the excess amount from the inventory valuation and adjusts the profit figure to reflect the true economic performance of the period. 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.
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.
