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Overhead Recovery: Under & Over Explained

Under- and over-recovery of overheads occurs when the actual overhead costs incurred differ from the standard overhead costs allocated using budgeted overhead rates. If actual overhead is higher than standard, overhead is under-absorbed and expenses are accelerated. If actual overhead is lower, overhead is over-recovered and more cost is applied to products than actually incurred, through variances. Non-manufacturing overhead includes costs like marketing, administration, and R&D that are not directly tied to production. These costs still need to be assigned for decision making like setting prices, though not for external reporting where allocation is unnecessary. Indirect costs are assigned through identifying production and support departments, reallocating support department costs, and calculating predetermined

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22 views6 pages

Overhead Recovery: Under & Over Explained

Under- and over-recovery of overheads occurs when the actual overhead costs incurred differ from the standard overhead costs allocated using budgeted overhead rates. If actual overhead is higher than standard, overhead is under-absorbed and expenses are accelerated. If actual overhead is lower, overhead is over-recovered and more cost is applied to products than actually incurred, through variances. Non-manufacturing overhead includes costs like marketing, administration, and R&D that are not directly tied to production. These costs still need to be assigned for decision making like setting prices, though not for external reporting where allocation is unnecessary. Indirect costs are assigned through identifying production and support departments, reallocating support department costs, and calculating predetermined

Uploaded by

sagung anindya
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

UNDER- AND OVER-RECOVERY OF OVERHEADS

When a company uses standard costing, it derives a standard amount of


overhead cost that should be incurred in an accounting period, and applies it to
cost objects (usually produced goods. The effect of calculating overhead rates based
on budgeted annual overhead expenditure and activity is that it will be most unlikely
that the overhead allocated to products manufactured during the period will be the
same as the actual overhead incurred. If the actual amount of overhead turns out to
be different from the standard amount of overhead, then the overhead is said to be
either under absorbed or over absorbed. If overhead is under absorbed, this means
that more actual overhead costs were incurred than expected, with the difference
being charged to expense as incurred. This usually means that the recognition of
expense is accelerated into the current period, so that the amount of profit
recognized declines. If overhead is over recovery, this means that fewer actual
overhead costs were incurred than expected, so that more cost is applied to cost
objects than were actually incurred.

For example, if the overhead rate is predetermined to be $20 per direct


labor hour consumed, but the actual amount should have been $18 per hour, then
the $2 difference is considered to be over absorbed overhead
Consider a situation where the estimated annual fixed overheads are
£2,000,000 and the estimated annual activity is 1,000,000 direct labour hours. The
estimated fixed overhead rate will be £2 per hour. Assume that actual overheads are
£2,000,000 and are therefore identical with the estimate, but that actual activity is
900,000 direct labour hours instead of the estimated 1,000,000 hours. In this situation,
only £1,800,000 will be charged to production. This calculation is based on 900,000
direct labour hours at £2 per hour, giving an under-recovery of overheads of
£200,000.
Consider an alternative situation where the actual overheads are £1,950,000
instead of the estimated £2,000,000, and actual activity is 1,000,000 direct labour
hours, which is identical to the original estimate. In this situation, 1,000,000 direct
labour hours at £2 per hour will be charged to production giving an over-recovery of
£50,000. This example illustrates that there will be an under- or over-recovery of
overheads whenever actual activity or overhead expenditure is different from the
budgeted overheads and activity used to estimate the budgeted overhead rate. This
under- or over-recovery of fixed overheads arising from actual activity differing from
budgeted activity is also called a volume variance and any under- or over-recovery
arising from actual fixed overhead expenditure differing from budget is also called a
fixed overhead expenditure variance.

NON-MANUFACTURING OVERHEAD
Non-manufacturing overhead costs, also known as administrative or operating
expenses, refer to the costs that are not directly tied to the manufacturing or
production process in a business. Unlike manufacturing overheads, which include
costs like raw materials, direct labor, and factory overheads, non-manufacturing
overhead costs are not associated with the creation or production of goods or services.
For external reporting, it is therefore unnecessary to allocate non-manufacturing
overheads to products. However, for decision-making, it may be necessary to assign
non-manufacturing costs to products.
For example, in many organizations, it is not uncommon for selling prices to
be based on estimates of total cost or even actual cost. Housing contractors and
garages often charge for their services by adding a percentage profit margin to actual
cost. Some non-manufacturing costs may be a direct cost of the product. Delivery
costs, sales people’s salaries, commission and travelling expenses may be directly
identifiable with the product, but it is likely that many non-manufacturing overheads
cannot be allocated directly to specific products

Example of Non-Manufacturing Overhead Costs

TechX produces and sells a variety of technological devices. Aside from the
costs associated directly with producing these devices (like the cost of materials, labor
costs for assembly, costs to run the factory, etc.), they also have a number of non-
manufacturing overhead costs.
 Marketing and Sales Expenses: TechX spends $500,000 on a marketing
campaign for their new smartphone. This includes TV commercials, online ads,
and hiring a marketing agency to run the campaign. They also pay their sales
team a total of $200,000 in salaries.
 General and Administrative Expenses (G&A): TechX’s headquarters in a
city office costs $300,000 in annual rent. They pay $100,000 for utilities for
this office building. They also have an administrative staff that manages the
office, human resources, legal, and finance, costing $400,000 in salaries.
 Research and Development (R&D): TechX is also developing a new AI
technology that they plan to implement into their future devices. They have a
team of engineers and AI specialists working on this project, with salaries
totaling $600,000. They also spend $200,000 on testing and other research
materials.

COST ASSIGNMENT IN NON-MANUFACTURING ORGANIZATIONS


For profit reporting, The primarily focused on cost assignment for allocating
65 costs between inventory costs and cost of goods sold. A job-order costing system
is also used by many service organizations. Accounting, legal, printing, automotive,
and appliance repair businesses, for instance, provide distinct services to customers,
necessitating cost tracking for each customer.
The prices of the services that have been provided are frequently determined
using the costs that have been assigned to each customer. At the conclusion of
the accounting period, these businesses may also have inventories that consist
of work that has only been partially completed (WIP).For profit reporting, we have
primarily focused on cost assignment for allocating 65 costs between inventory costs
and cost of goods sold.
A job-order costing system is also used by many service organizations.
Accounting, legal, printing, automotive, and appliance repair businesses, for instance,
providedistinct services to customers, necessitating cost tracking for each customer.
The prices of the services that have been provided are frequently determined using the
costs that have been assigned to each customer. At the conclusion of the accounting
period, these businesses may also have inventories that consist of work that has only
been partially completed (WIP).

However, a job-order costing system as described above is inappropriate for many


non-manufacturing
organizations for the following reasons:
1. They do not provide unique services for specific customers. Instead, they provide
similar
services for a large number of customers. Consider a bank whose principal activities
include mortgage lending, personal lending, variable interest and fixed interest
savings accounts, insurance, foreign currency, etc. It is not feasible or useful to track
the costs of undertaking these activities to individual customers. Instead, costs are
assigned to each activity so that the total costs incurred can be deducted from sales
revenue to periodically determine the profits/losses of each activity.
2. They do not need to assign costs to individual customers to determine prices of
the services provided because prices are determined by market forces rather than
cost.
3. They do not convert purchased materials into finished products or have work in
progress. Therefore, there is no legal requirement to assign indirect costs to cost
objects for inventory valuation

THE INDIRECT COST ASSIGNMENT PROCESS


This directive establishes the proper methods of assigning indirect
costs. Uniform Guidance 2 CFR 200 defines indirect costs as those that are incurred
for common or joint objectives and therefore cannot be identified readily and
specifically with a particular sponsored project, and instructional activity or any other
institutional activity. These costs are usually classified and accumulated in the
following indirect cost categories:

 depreciation/use allowances
 operations and maintenance
 general administration/general expenses
 department administration
 sponsored projects administration, library, and student administration/services
The following is a summary of the process of assigning indirect costs to cost objects
for a job-order
traditional costing system:
1. Identify the production departments (or their equivalent in service organizations)
that are responsible for creating the products of services that are sold.
2. Identify the support departments that provide essential support services for the
production departments.
3. Assign all indirect (overhead) costs in the firm to a producing (or customer-
facing) or support department.
4. Reallocate the support department costs to the production departments.
5. Calculate predetermined overhead rates for each producing department.
6. Allocate the departmental overhead costs to the units of the individual products
or services using the predetermined overhead rates

Where a job-order costing system is not used the process may end at stage 4.
For example, in the preceding section, the costs of the merchandising departmental
store were assigned to departments and not to the individual products sold within the
departments.
Therefore, the costs assigned to the departments are equivalent to the costs of
undertaking the activities. Thus for profitability analysis purposes the assignment of
costs can end at the fourth stage since the costs assigned to the departments also
represents the costs of undertaking the principal activities. We can conclude that the
nature of the business, the organization structure, its strategy, etc.
References
Understanding SAP Modules: SAP FI, SAP CO, SAP SD, SAP
HCM and more. Available at [Link]/
sap-modules-sap-fi-sap-co-sap-sd-sap-hcm-and-more
rar111-article (accessed 28 April 2020)

Common questions

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Manufacturing overhead costs are directly tied to the production process, including raw materials, direct labor, and factory overhead. These costs are typically allocated to products for external reporting. Non-manufacturing overhead costs, such as administrative and operating expenses, are not tied to production and do not need to be allocated to products for external reports, though they may be for internal decision-making. This distinction influences cost allocation strategies since manufacturing costs must be matched with production, whereas non-manufacturing costs may be allocated based on decision-making needs .

Indirect cost assignment in non-manufacturing organizations is crucial for profitability analysis as it helps attribute costs to distinct activities rather than individual customers, given the often broad nature of services provided, like in banks or insurance companies. This process allows managers to allocate costs more accurately to activities, thereby determining the true profitability of each activity separately. Accurate cost allocation helps in evaluating which activities are most profitable and which require improvement or restructuring .

The main challenge of using job-order costing systems in non-manufacturing enterprises is the lack of directly traceable activities to individual outputs or customers, unlike in manufacturing environments. For example, banks with activities like lending or insurance providers offering policies face difficulty in assigning specific costs to each client's service, as these services are uniform and market-priced rather than cost-driven. This complication often results in a more generalized allocation of costs to activities rather than specific jobs, which can obscure detailed cost analysis .

Under- and over-recovery of overheads impact a company's financial reporting by affecting the reported profit. If overhead is under absorbed, the company incurs more actual overhead costs than expected, leading to an accelerated recognition of expense in the current period, thereby reducing the recognized profit. Conversely, if overhead is over absorbed, fewer actual overhead costs are incurred than expected, resulting in a slower recognition of expenses and potentially inflating profit .

Reallocating support department costs to production departments ensures that all costs contributing to production are accurately reflected in each department's budget, thus helping in effective financial planning and management. This process aligns financial targets with operational capabilities, facilitating better resource allocation and efficiency improvement strategies. By understanding the actual cost contributions of support services, management can make informed decisions about resource optimization and cost-reduction initiatives .

Volume variance occurs when the actual activity level differs from the budgeted activity, leading to under- or over-recovery of overhead costs, while fixed overhead expenditure variance arises when actual overhead expenses differ from budgeted figures. These variances affect financial management by influencing cost control measures and budget adjustments, as they highlight discrepancies between expected and actual performance, and necessitate managerial actions to realign operational efficiency and financial projections .

In service organizations providing non-unique services, a job-order costing system is often impractical because these organizations provide similar services to a large number of customers, making individual cost tracking inefficient and unnecessary. For example, a bank offering mortgage lending and personal loans doesn't individually track costs for each customer but assigns costs to activities or services instead. This helps determine overall profitability per activity rather than per customer, as pricing is more market-driven than cost-driven .

For external reporting, allocating non-manufacturing overhead to products is unnecessary because such costs are not directly associated with product creation and do not affect product inventory valuation. However, for internal decision-making, allocating these costs to products helps understand the full cost structure and assists in internal strategic decisions such as setting prices or assessing product line profitability, as it provides a comprehensive view of incurred costs .

Imagine a manufacturing firm with budgeted overhead costs based on expected activity levels that consistently reports an overhead rate variance, revealing significant under-absorption due to reduced production hours. This consistent variance may lead management to decide on strategic measures such as revising the production schedule, reorganizing workforce allocation, or adjusting overhead application rates, all intended to improve alignment between planned activities and actual production levels, thereby optimizing cost control and enhancing profitability .

Non-manufacturing costs impact pricing strategies in sectors like housing and automotive by being integrated into the total cost estimates on which prices are based. Companies in these sectors often add a percentage profit margin to the actual costs incurred, which may include delivery costs, sales salaries, and other direct non-manufacturing expenses. This ensures that all incurred expenses are covered in the pricing strategy, thereby maintaining profitability .

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