Is it better to be under or over absorbed?

Is it better to be under or over absorbed?

September 01, 20247 min read

Let's talk about being under or over absorbed. It's not about your skin and a pool party. We're diving into the world of business finances.

In general, overhead costs in a company are better when over absorbed than under absorbed. Over absorption means you've collected more money than you spent on overhead. That's like finding an extra 20 bucks in your jacket pocket.

But don't get too excited. Both situations have their pros and cons. It's all about finding that sweet spot where your numbers line up just right. Like Goldilocks, but with spreadsheets instead of porridge.

Key Takeaways

  • Over absorption usually means more profit for your business

  • Accurate predictions help avoid both under and over absorption

  • Regular monitoring and adjustments are key to maintaining balance

What is Overhead Absorption?

Overhead absorption is a way to deal with those pesky indirect costs in your business. It's like spreading peanut butter on toast - you want it evenly distributed.

Defining Absorbed Overhead

Absorbed overhead is the amount of indirect costs you assign to your products or services. It's not the easy-to-track stuff like materials or direct labor.

Think of it as the behind-the-scenes costs. Rent, utilities, management salaries - all that jazz. You can't directly tie these to a specific product, but they're crucial for your business.

Overhead absorption is how you spread these costs across what you produce. It's like giving each product its fair share of the overhead burden.

Digging into Absorption Costing

Absorption costing is the method you use to figure out the total cost of your products. It's like making a sandwich - you need to account for everything that goes into it.

You start with the obvious stuff: direct materials and labor. Then you add a slice of overhead costs. This gives you the full picture of what it takes to make your product.

It's super helpful for pricing and inventory valuation. You'll know exactly what each item costs you, all-in.

But here's the kicker: your actual production might not match your budget. That's where under or over absorption comes into play. It's like ordering too much or too little food for a party - you've got to deal with the difference.

The Tale of Two Extremes

Absorption can swing too far in either direction. Let's look at what happens when things get out of whack.

The Issues with Under Absorption

You know that feeling when you're short on cash? That's under absorption in a nutshell. It's when your actual overhead costs are higher than what you planned for.

This can mess with your pricing. You might end up selling stuff too cheap because you didn't factor in all the costs.

It's like trying to fill a bucket with a hole in it. No matter how much you pour in, you're always coming up short.

Under absorption can make your profits look better than they really are. But don't be fooled. It's just hiding the true cost of doing business.

You need to keep a close eye on this. If you don't, you might make decisions based on bad info. And that's a recipe for trouble.

The Drama of Over Absorption

Now, over absorption is like finding extra cash in your pocket. Sounds great, right? Well, not so fast.

Over absorption happens when you've set aside more money for overheads than you actually needed. It's like budgeting $100 for dinner and only spending $50.

This can make your profits look worse than they really are. You might think you're losing money when you're actually doing fine.

It can lead to some weird decisions. You might raise prices when you don't need to. Or cut costs that didn't need cutting.

Over absorption can also mess with your future planning. You might set aside too much money again, creating a cycle of over absorption.

Remember, in business, accuracy is key. Too much of a good thing can be just as bad as not enough.

Mastering the Math

Let's dive into the numbers game. You're about to become a pro at crunching those overhead figures. Trust me, it's not as scary as it sounds.

Calculating Overhead Rate

You know those pesky overhead costs? They're like that clingy ex who won't let go. But don't worry, we've got a formula for that.

Here's the deal: Overhead Rate = Total Overhead Costs / Allocation Base

Simple, right? Your allocation base could be direct labor hours, machine hours, or even units produced. Pick what makes sense for your biz.

Let's say your total overhead is $100,000 and you've got 10,000 labor hours. Plug it in:

$100,000 / 10,000 hours = $10 per hour

Boom! That's your overhead rate. You're now speaking accountant-ese.

Decoding the Overhead Absorption Rate

Ready to level up? Let's talk overhead absorption rate. It's like a financial crystal ball, helping you predict future costs.

Here's the magic formula: Overhead Absorption Rate = Budgeted Overhead / Budgeted Activity Level

Say you've budgeted $150,000 for overhead and expect 15,000 labor hours. Let's do this:

$150,000 / 15,000 hours = $10 per hour

That's your overhead absorption rate. Use it to figure out how much overhead to apply to each job or product.

Remember, this is all about estimates. Your actual results might differ. But hey, that's business for you - always keeping us on our toes!

Impact on the Books

Being under or over absorbed affects your financial statements. It can mess with your profits and change how your balance sheet looks. Let's break it down.

Consequences on Costing Profit and Loss Account

When you're over absorbed, you're in for a treat. Your profits look better than they really are. Why? Because you've applied more overhead costs to your products than you actually spent.

It's like finding extra cash in your pocket. But don't get too excited. This isn't real money. It's just an accounting quirk.

On the flip side, being under absorbed is a downer. Your profits take a hit. You've spent more on overhead than you accounted for in your product costs.

It's like getting a surprise bill. Not fun. This affects your costing profit and loss account directly.

Effect on Balance Sheet

Your balance sheet gets a makeover too. If you're over absorbed, your inventory value goes up. Sounds good, right? Well, not so fast.

This inflated inventory can bite you later. When you sell these products, your profit margins might shrink.

Under absorption does the opposite. Your inventory value drops. This might look bad now, but it could mean better profits later when you sell.

Either way, your balance sheet changes. It's like a financial costume change. Sometimes you look richer, sometimes poorer. But it's all about the numbers game.

Navigating Absorption in Practice

Balancing absorption isn't always easy. You'll face ups and downs, but with the right moves, you can keep things on track.

Dealing with Seasonal Fluctuations

Ever notice how some businesses go nuts during certain times of the year? That's seasonal fluctuation, baby. It's like a rollercoaster for your budget.

You've got to be ready for those peaks and valleys. During slow seasons, you might under-absorb overhead. That means less production, but the same fixed costs. Ouch.

But when things heat up, you could over-absorb. More production, same fixed costs. Cha-ching!

Your best bet? Use a flexible budget. It adjusts based on your actual activity levels. This way, you're not caught with your pants down when seasons change.

Adjusting Production Activity

Here's the deal: your budgeted activity might not match reality. When that happens, you've got to pivot.

If you're under-absorbing, consider ramping up production. More units mean spreading those fixed costs thinner. It's like making your dollar stretch further.

Over-absorbing? You might want to slow down a bit. Don't overproduce and end up with dead stock.

Use supplementary rates to fine-tune your absorption. These rates help you adjust for the difference between budgeted and actual activity.

When to be Wary of Overhead Absorption

You gotta keep your eyes peeled when it comes to overhead absorption. It's like a seesaw - too much on either side, and you're in for a bumpy ride.

Over-absorption happens when you apply more costs to your products than you actually spent. Sounds great, right? Not so fast. It can inflate your profits in the short term, but it's a ticking time bomb.

On the flip side, under-absorption means you're not covering all your costs. Your products look cheaper than they really are. That's a recipe for disaster.

Watch out for big swings in your variable costs or direct labor hours. These can throw your absorption rate way off.

Keep an eye on your fixed production overhead absorption rate too. If it's not matching reality, you're in for a world of hurt.

Remember, your gross profit isn't real until you've accounted for all your costs. Don't let absorption tricks fool you into thinking you're rolling in dough when you're not.

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Janez Sebenik - Business Coach, Marketing consultant

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