Under-absorbed fixed overhead occurs when the fixed overhead costs allocated to products are less than the actual fixed overhead costs incurred during a period. This situation typically arises when a business uses a predetermined overhead rate based on estimated production levels, but the actual production is lower than expected. Under-absorption can lead to under-reporting of costs and distorted profit margins. In this article, we explore the concept of under-absorbed fixed overhead, its causes, consequences, and how businesses can address it effectively to ensure accurate financial reporting and decision-making.
1. What is Under-Absorbed Fixed Overhead?
Under-absorbed fixed overhead occurs when the amount of fixed overhead allocated to products or services is less than the actual fixed overhead costs incurred. Fixed overhead costs, such as rent, utilities, and depreciation, are often spread across units produced using a predetermined overhead rate based on estimated production levels. If actual production falls short of expectations, the fixed overhead absorbed by the products will be lower than the actual overhead incurred, leading to under-absorption.
A. Key Features of Under-Absorbed Fixed Overhead
- Predetermined Overhead Rate: Under-absorption typically occurs when a business applies a predetermined overhead rate based on estimated production, and actual production is lower than expected.
- Excess of Actual Fixed Costs: Under-absorbed fixed overhead happens when the actual fixed overhead costs exceed the amount allocated to products based on the predetermined rate.
- Temporary Issue: Under-absorption is generally a short-term issue that can be adjusted at the end of the period or in the following period through adjustments to the financial statements.
2. Causes of Under-Absorbed Fixed Overhead
A. Lower Than Expected Production
- Cause: Under-absorption often occurs when actual production is lower than estimated, leading to fewer units absorbing fixed overhead costs. This can happen due to lower demand, production delays, or operational inefficiencies.
- Example: If a business expects to produce 10,000 units but only produces 8,000 units, the fixed overheads are absorbed by fewer units, resulting in under-absorption.
B. Over-Estimation of Production Hours
- Cause: If the company overestimates the number of labor hours or machine hours required to produce goods, it will allocate fewer overhead costs to the products than the actual fixed costs incurred.
- Example: A company estimates using 5,000 machine hours but only uses 4,000 hours. The fixed costs will be allocated to fewer hours, causing under-absorption.
C. Under-Estimation of Fixed Overhead Costs
- Cause: If the company underestimates its fixed overhead costs in the budget, the allocation of overhead costs to products may be lower than the actual costs incurred.
- Example: A company might underestimate its total fixed overheads in its budget but still use the same allocation rate. The fixed overheads allocated to products will be lower than the actual costs incurred.
3. Consequences of Under-Absorbed Fixed Overhead
A. Impact on Profitability
- Effect: Under-absorbed fixed overhead can lead to an understatement of total production costs, which in turn may inflate reported profits. Since less overhead is absorbed by products, the cost of goods sold (COGS) may appear lower than the actual costs, resulting in higher reported profits than the business is truly earning.
- Example: If under-absorption is $30,000, the business might report a higher profit than it should, leading to misleading financial statements and potentially incorrect business decisions.
B. Misleading Product Costing
- Effect: Under-absorbed fixed overhead can cause products to be underpriced. Since fewer overhead costs are assigned to each unit, the product cost will appear lower, potentially leading to underpricing and reduced profitability.
- Example: A company that under-absorbs fixed overheads might inadvertently set prices too low, believing the cost of production is lower than it actually is, which could lead to unsustainable pricing.
C. Impact on Budgeting and Cost Control
- Effect: Under-absorption can distort budget forecasts and make it difficult for management to control costs accurately. If overhead costs are under-absorbed, the business may not realize that actual overheads are higher than expected, leading to poor cost management decisions.
- Example: A business might allocate fewer funds to fixed overhead cost control, believing that costs are lower than they are, which can lead to budget overruns or a failure to address inefficiencies.
4. How to Address Under-Absorbed Fixed Overhead
A. Adjusting the Predetermined Overhead Rate
- Solution: A business can adjust its predetermined overhead rate to align more closely with actual production levels. By recalculating the rate based on more accurate production estimates, the business can reduce the likelihood of under-absorption in future periods.
- Example: If a company repeatedly under-absorbs overheads due to inaccurate production estimates, it can adjust its overhead rate for the next period based on actual production levels to prevent further under-absorption.
B. Allocating Under-Absorbed Overheads
- Solution: Under-absorbed fixed overheads can be allocated at the end of the period. This process involves adjusting the cost of goods sold (COGS) and allocating the under-absorbed costs to the relevant accounting periods to correct financial reporting.
- Example: At the end of the period, a business can review its actual fixed costs and adjust its financial statements to reflect the true overhead costs, thereby reducing the under-absorption in the accounting records.
C. Reviewing Production and Budgeting Assumptions
- Solution: A business should regularly review its production assumptions and budget forecasts to ensure they align with actual production levels. By adjusting estimates more frequently, a company can avoid under-absorbing fixed overhead costs in future periods.
- Example: If a company regularly experiences under-absorption, it may need to revise its production forecasts and the basis for its overhead rate calculation to reflect real-world conditions more accurately.
5. Managing Under-Absorbed Fixed Overhead
Under-absorbed fixed overhead is a common issue that occurs when fixed overhead costs are allocated to products at a rate that is lower than the actual costs incurred. While it may result in understated product costs and inflated profits in the short term, businesses can effectively manage under-absorption by adjusting their predetermined overhead rates, allocating under-absorbed costs, and regularly reviewing production and budgeting assumptions. By taking these corrective measures, businesses can ensure more accurate financial reporting, better cost control, and improved decision-making, ultimately supporting sustainable growth and profitability.