Question

Explain your personal view on over and under-absorption :its good or bad effect to biz and customer :the reasons to support your belief

Answer 1

The over and under absorption of overhead arises to the difference in actual cost driver activities and estimated cost driver activities. The predetermined overhead rate is calculated based on estimated cost driver activities at the beginning for the year. For example Labor hours or machine hours. The pre-determined overhead rate is applied to the actual usage of cost drivers to apply manufacturing overheads to the job. At the end of the period the difference is calculated between actual overheads and applied overheads. The excess or shortfall is under or application of overheads

The over or under absorption is not good for the business if the difference is significant. Some amount of overheads under or over absorption is inevitable since the estimation cannot be 100% accurate. But too much of over or under absorption reflects the lack of application of skills. It will have an adverse impact on the product cost and product pricing to the customers. The product may not have competitive advantage in market or customers might be overpriced due to inaccuracy in application manufacturing overheads to products. Hence a firm should take effective steps to minimise adverse affects to business and customers.

· The difference between estimated activity level and actual activity level should be minimal

· The overheads should be estimated on a reasonable level in line with past trend

· Monthly analysis and periodical review should be conducted for over or under absorption to ensure no surprises at the end of the period.