Over-absorbed fixed overhead occurs when the fixed overhead costs allocated to products exceed the actual fixed overhead costs incurred during a period. This situation typically arises when a business applies a predetermined overhead rate to products based on estimated production levels, but the actual production is higher than anticipated. Over-absorption of fixed overheads can lead to inflated profit margins and requires careful analysis to ensure that financial statements accurately reflect the true costs of production. This article explores the concept of over-absorbed fixed overhead, its causes, and how businesses can handle it effectively.
1. What is Over-Absorbed Fixed Overhead?
Over-absorbed fixed overhead refers to the situation where the applied fixed overhead cost, calculated using a predetermined overhead rate, exceeds the actual fixed overhead costs incurred. Fixed overheads are typically allocated to products based on a pre-determined rate, often related to direct labor hours, machine hours, or units produced. If the actual production exceeds the estimated production, more fixed costs are absorbed by the products, leading to over-absorption.
A. Key Features of Over-Absorbed Fixed Overhead
- Predetermined Overhead Rate: Over-absorption typically occurs when a company uses a predetermined overhead rate, which is based on estimated costs and production levels for a given period.
- Excess Absorption: The actual costs incurred for fixed overhead are lower than the amount absorbed by the products, leading to an over-absorption of fixed overheads.
- Temporary Impact: Over-absorption is often a short-term issue that can be adjusted during the next period or through year-end adjustments.
2. Causes of Over-Absorbed Fixed Overhead
A. Higher Than Expected Production
- Cause: If actual production levels are higher than estimated, more units will absorb the allocated fixed overheads, leading to over-absorption. This can occur if sales or production demand exceeds initial forecasts.
- Example: A manufacturer estimates the production of 10,000 units for the period but actually produces 12,000 units. The fixed overhead costs will be absorbed by a larger number of units, causing over-absorption.
B. Over-Estimation of Production Hours
- Cause: Over-absorption can also occur if the company overestimates the number of labor hours or machine hours required to produce the goods. If actual hours are lower than expected, the absorbed fixed overhead costs will exceed the actual costs.
- Example: A company estimates it will use 5,000 machine hours in production but only uses 4,000 hours. The fixed costs absorbed by the products based on the estimated machine hours will be higher than the actual overhead incurred.
C. Under-Estimation of Fixed Overhead Costs
- Cause: If the company underestimates the fixed overhead costs in its budget or cost allocation plan, it may lead to over-absorption if the actual production is higher than anticipated.
- Example: If a company underestimates its total fixed overhead costs but still uses the same allocation rate, the fixed overhead absorption will be higher than the actual fixed costs incurred.
3. Consequences of Over-Absorbed Fixed Overhead
A. Impact on Profitability
- Effect: Over-absorbed fixed overhead can artificially inflate the profitability of a business. Since more overhead costs are allocated to products than are actually incurred, it may make the business appear more profitable than it is. This distortion can lead to misleading financial reporting.
- Example: If a business over-absorbs fixed overhead by $50,000, its reported profit will be higher than the actual profit, which may cause problems when preparing financial statements or making business decisions.
B. Misleading Product Costing
- Effect: Over-absorbed fixed overhead can lead to inaccurate product costing. Products may be priced higher than necessary, which could result in lost sales or reduced competitiveness in the market. Businesses may also make poor pricing decisions based on distorted cost data.
- Example: A company that over-absorbs overheads may set its product prices too high, thinking it has a higher cost of production than it actually does.
C. Challenges in Cost Control
- Effect: Over-absorption may mask inefficiencies in production or other operational areas, making it harder for management to control costs. Since fixed overheads are absorbed regardless of actual production levels, companies might not realize that cost-saving measures are necessary until the over-absorption is corrected.
- Example: A company that continuously over-absorbs fixed overhead may fail to notice that fixed costs are increasing due to inefficiencies, leading to missed opportunities for cost control.
4. How to Address Over-Absorbed Fixed Overhead
A. Adjusting the Predetermined Overhead Rate
- Solution: Businesses can adjust their predetermined overhead rate to reflect actual production levels more accurately. This helps prevent future over-absorption by aligning the estimated fixed overhead rate with the real production experience.
- Example: If over-absorption is a recurring issue, the business might recalculate the overhead rate based on actual production volumes and more accurate cost estimates for the next period.
B. Allocating Over-Absorbed Overheads
- Solution: Over-absorbed fixed overhead can be allocated to the products or services produced during the period. This process involves adjusting the cost of goods sold (COGS) to reflect the actual overhead costs incurred.
- Example: A business can correct its over-absorption by reducing the fixed overhead costs allocated to inventory or sales and adjusting its financial statements to reflect the actual fixed costs.
C. Reviewing Production Estimates
- Solution: A business should regularly review its production estimates and budget assumptions to ensure they align with actual performance. By refining these estimates, a company can avoid over-absorbing overhead costs in future periods.
- Example: A company might review its estimated production levels, labor hours, and machine hours more frequently to ensure that the predetermined overhead rate reflects actual production conditions.
5. Managing Over-Absorbed Fixed Overhead
Over-absorbed fixed overhead is a common issue in cost accounting that arises when the allocated fixed overhead costs exceed the actual overhead incurred. While it can distort profitability and product costing, businesses can manage over-absorption by adjusting their predetermined overhead rates, reallocating over-absorbed costs, and reviewing production estimates. By addressing this issue promptly and accurately, companies can ensure more accurate financial reporting, better pricing decisions, and improved cost control, ultimately enhancing their overall profitability and competitiveness in the market.