Sunrise Engineering: Under-Absorbed Overhead and a Cut-Price Enquiry
Sunrise Engineering makes custom machine guards to order. For the year just ended it budgeted factory overhead of ₹9,00,000 and 30,000 machine hours, and set its overhead absorption rate on that basis. Actual overhead was ₹9,60,000 on 28,000 machine hours. The plant is rated at 32,000 machine hours; a large export order was cancelled in the third quarter and 4,000 hours went unused. Enquiry 214 needs direct material of ₹4,500 and 160 direct labour hours at ₹20 an hour (the workforce is on daily wages and is retained through slack periods); it will occupy 90 machine hours. The firm's pricing rule is full factory cost plus 15 per cent. The customer has said a competitor will do the job for ₹10,800 and has offered ₹10,500. The works manager wants to know whether the firm should match the price and whether the absorption rate itself needs revisiting.
1. Compute the predetermined overhead rate, the overhead absorbed and the under- or over-absorption for the year. Split the variance into its volume and spending components.
Read the worked answer
Rate and absorption
- Predetermined rate = ₹9,00,000 ÷ 30,000 machine hours = ₹30 per machine hour
- Overhead absorbed = 28,000 × ₹30 = ₹8,40,000
- Actual overhead = ₹9,60,000
- Under-absorbed = ₹1,20,000 (actual exceeds absorbed, so cost of sales is short by this amount)
Decomposition
| Component | Calculation | ₹ |
|---|---|---|
| Volume (idle capacity) | 2,000 hours short of budget × ₹30 | 60,000 |
| Spending (over budget) | 9,60,000 − 9,00,000 | 60,000 |
| Total under-absorption | 1,20,000 |
Why each arose. The volume element is the cancelled export order: fixed overhead is incurred whether or not the hours are worked, so 2,000 unrecovered hours leave ₹60,000 unabsorbed. The spending element is genuine overspending - higher power tariffs, overtime on maintenance or price rises on consumables - and is not a volume story at all.
Judgement. The rate was also set on 30,000 hours when the plant is rated at 32,000 and demand is running at 28,000, so a systematic under-recovery was built in before the year began. A rate based on practical capacity or on normal long-run demand would have been less volatile.
2. Cost Job 214 under the current rule and compute the quoted price. Should the firm accept ₹10,500? Show your reasoning with relevant (incremental) cost.
Read the worked answer
Full cost and quote
| Element | Calculation | ₹ |
|---|---|---|
| Direct material | given | 4,500 |
| Direct labour | 160 hrs × ₹20 | 3,200 |
| Overhead | 90 machine hrs × ₹30 | 2,700 |
| Full factory cost | 10,400 | |
| Mark-up 15% | 10,400 × 0.15 | 1,560 |
| Quoted price | 11,960 |
At ₹10,500 the job shows a shortfall of ₹1,460 against full cost - which is why the works manager hesitates.
Relevant cost analysis. The plant has 4,000 idle machine hours and the workforce is retained through slack periods, so both labour and fixed overhead will be incurred whether or not Job 214 is taken. The only cost the firm avoids by refusing the job is the material (and any genuinely variable overhead such as power, ignored here for simplicity).
Contribution at ₹10,500 = 10,500 − 4,500 = ₹6,000 towards labour and fixed overhead that are already committed.
Decision: accept, subject to three safeguards:
- No better-paying enquiry is displaced - the 90 hours would otherwise sit idle.
- The price is documented as a one-off spot price for a specific customer, so it does not become the reference price for other buyers.
- The customer does not receive the drawings or the design free of charge, which would allow repeat buying at cost.
Refusing would leave 90 hours idle and lose ₹6,000 of contribution in order to protect a cost figure that includes costs already sunk.
3. Advise on two linked issues: how the ₹1,20,000 under-absorption should be treated in the accounts, and whether the absorption base or the pricing rule should change.
Read the worked answer
Treatment of the under-absorption. Two methods exist:
- Write off to cost of sales as a period charge.
- Prorate between work in progress, finished goods and cost of sales in proportion to overhead absorbed.
Write-off is preferable here because roughly half the variance (₹60,000) is spending, which relates to the period's actual costs rather than to particular jobs, and much of the volume element is the cost of idle capacity - the cancelled export order - which should not be carried in inventory as if it were a product cost. Prorating would push part of an abnormal idle-capacity cost into closing stock and into next year's profit.
The absorption base. The rate is set on 30,000 hours while the plant is rated at 32,000 and actual demand is 28,000. That base is neither practical capacity nor realistic normal demand, so the firm reliably under-recovers and sees a large variance each year. Rebase on practical capacity or on a normal-capacity average of recent years, and review the rate annually.
The pricing rule. Because jobs are under-costed by the under-recovery, a 15 per cent mark-up on full cost does not actually recover overhead plus 15 per cent of profit - the firm is quietly under-pricing every job. The real question about the ₹10,500 offer is therefore not whether it covers overhead, but whether the firm knows its true cost at all. Fix the rate first, then judge future enquiries against a cost figure that is defensible.