Definition of Overabsorbed and Underabsorbed
In cost accounting , overabsorbed and underabsorbed pertain to a manufacturer's manufacturing overhead costs . The manufacturing overhead costs are the indirect product and production costs. (These are in addition to the other product and production costs of direct materials and direct labor.)
Since the fixed manufacturing overhead costs (such as depreciation, salaries of manufacturing personnel, etc.) are indirect costs that occur in large amounts, they must be assigned or allocated to the products manufactured. This is often done by using a predetermined overhead rate . The predetermined rate is likely based on the amount from the annual manufacturing overhead budget divided by some activity such as the expected number of machine hours.
The assigning of fixed and variable manufacturing overhead costs are part of the cost accounting method known as absorption costing , which is required by U.S. GAAP and U.S. income tax regulations. Absorption costing means that fixed manufacturing costs must be assigned to the products manufactured. In other words, the products must absorb the fixed manufacturing overhead .
If the amount of overhead assigned to the products manufactured is greater than the amount of overhead actually incurred, the products have overabsorbed the overhead costs. If the amount of overhead assigned to the products is less than the amount of overhead actually incurred, the products have underabsorbed the overhead costs.
Example of Overabsorbed and Underabsorbed Overhead Costs
Assume a manufacturer has an annual budget of $1,000,000 for its fixed manufacturing overhead and expects its production machines to run 40,000 hours. It's predetermined fixed overhead rate will be $25 per machine hour. If the actual costs end up being $1,000,000 but the machines ran 41,000 hours to produce good products, the products overabsorbed the fixed overhead by $25,000 ($1,025,000 absorbed - $1,000,000 of actual costs). If the machines ran 39,400 hours to produce good units, the products underabsorbed the fixed overhead by $15,000 ($985,000 absorbed - $1,000,000 of actual costs).