Overabsorbed definition
/What is Meant by Overabsorbed?
The overabsorbed concept applies to factory overhead costs. These costs are not directly associated with the production of specific goods, so they must be allocated to goods instead, using a standard overhead rate. This rate is typically calculated at the beginning of a firm’s fiscal year, based on the expected amount of factory overhead costs that will be incurred and the expected number of units to be produced. If either of these numbers turns out to be different from the actual numbers, then the standard overhead rate may be too high; if so, the result is that more factory overhead costs are charged to units produced than were actually incurred, resulting in overabsorbed overhead costs. Thus, more costs were capitalized into produced units than should have been the case.
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How to Account for Overabsorbed Overhead
At the end of the organization’s fiscal year, the amount of any overabsorbed overhead is flushed out by charging the excess to the firm’s cost of goods sold. In cases where the amount of cost overabsorption is significant, the excess is allocated between the ending inventory account and the cost of goods sold, depending on where the costs are residing at year-end. No matter which approach is used, the result is a drop in the reported profit percentage in the final month of the year, which could come as a surprise to the users of the reporting entity’s financial statements.
Example of Overabsorbed
Newt Corporation manufactures potion brewing kits for the stay-at-home witch crowd. The company’s controller estimated at the beginning of the year that the firm would have $500,000 of overhead costs. Since it typically ships 10,000 home brewing kits per year, this results in a predetermined overhead rate of $50 per kit. Accordingly, the controller applies this overhead rate to all sales of the home brewing kits.
At year-end, Newt’s controller funds that the company did indeed ship 10,000 kits to its customers, but only incurred $400,000 in overhead costs. Thus, the firm applied $100,000 of excess overhead costs to its shipped products. This is an overabsorption of $100,000.