Management Accounting · Module 3: Types of product costing
The $2,500 Overhead Gap
Chapters
- Case
- Rate
- Wrong rates
- Year end
- Recap
In short
A predetermined overhead absorption rate is budgeted overhead divided by budgeted activity on the chosen base, set before the year starts. With $540,000 of budgeted overhead and 36,000 machine hours the rate is $15 an hour. If absorbed overhead is below actual overhead at year end, the shortfall is under-absorbed and charged to cost of sales.
- Rate = budgeted overhead ÷ budgeted activity.
- Use the base the business absorbs on, e.g. machine hours.
- Under-absorbed overhead reduces profit; over-absorbed increases it.
Transcript
Case
Galah Castings has to price its jobs today. But it won't know its real overhead until the year ends. So it sets a rate in advance.
Rate
Galah absorbs overhead on machine hours. The budget says $540,000 of overhead, over 36,000 machine hours. Divide one by the other: $15 per machine hour. The rate is set before the year starts, so it uses budget figures only.
Wrong rates
The exam offers three other rates, and each one breaks a rule. $12 divides by labor hours. But Galah absorbs on machine hours. $15.07 uses actual overhead and actual hours. Nobody knows those yet. $14.40 mixes the two: budget overhead over actual hours.
Year end
Now the year ends. The machines actually ran 37,500 hours. At $15 an hour, the jobs absorbed $562,500 of overhead. But the overhead actually spent was $565,000. Pause. Was overhead over-absorbed, or under-absorbed? Under. The jobs carried $2,500 less than was really spent. So $2,500 more goes to cost of sales at year end. Absorb more than you spend, and it is over-absorbed: profit goes up.
Recap
Budget figures make the rate. Actual figures settle the gap. Next: practice Module 3 in the CPA dashboard while it is fresh. Subscribe so you catch the next lesson.
Try a question on this lesson
From the EstatePass Management Accounting bank. Answer it, then read the explanation.
Galah Castings Pty Ltd absorbs production overhead on machine hours. Budgeted overhead is $540,000, budgeted machine hours 36,000 and budgeted labor hours 45,000. Actual overhead was $565,000 and actual machine hours were 37,500. What is the predetermined overhead absorption rate per machine hour?
Sources
- Absorption costing: predetermined overhead absorption rate
- CPA question bank: cpa-ma-0023, 0025
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