Q.What is meant by under-absorption and over-absorption of overheads? State the causes and how the difference is treated.

Because overhead is charged at a predetermined rate based on estimates, the overhead absorbed rarely matches the overhead actually incurred, and the gap is called under- or over-absorption.

Overhead is usually charged to products at a predetermined (estimated) rate — estimated overhead ÷ estimated base — fixed at the start of the period so that product costs can be found promptly. Because both the overhead and the activity level are estimates, the overhead absorbed (predetermined rate × actual base) rarely equals the overhead actually incurred. The difference is under- or over-absorption.

Meaning:

• Under-absorption — the overhead absorbed is less than the actual overhead. Under-absorption = actual overhead − overhead absorbed. Part of the real overhead has not been charged to products, so product costs are understated.
• Over-absorption — the overhead absorbed is more than the actual overhead. Over-absorption = overhead absorbed − actual overhead. More overhead has been charged than incurred, so product costs are overstated.

Causes:

1. Error in estimating the overhead (actual higher or lower than budgeted).
2. Error in estimating the activity level (actual output/hours differ from the level assumed).
3. Unexpected changes in methods, prices or capacity used.
4. Seasonal fluctuations in output when a single annual rate is applied to uneven monthly production.
5. Abnormal circumstances — a strike, a breakdown, unusually high idle capacity.

Treatment:

• If the amount is small / normal, transfer it to the Costing Profit and Loss Account (under-absorption reduces profit; over-absorption increases it). …

Students frequently reverse the definitions — remember 'absorbed less than actual = under-absorption'. They also often give only the causes and forge …