Under-absorption and Over-absorption of Overheads

Overhead is usually charged to products not at the actual rate (which is known only after the period ends) but at a predetermined (estimated) overhead rate fixed at the start of the period, so that product costs can be worked out promptly without waiting for the accounts to close. A predetermined rate is calculated as:

Predetermined overhead rate = Estimated (budgeted) overhead ÷ Estimated base (units / hours)

Because this rate rests on estimates of both the overhead and the activity level, the overhead actually absorbed (recovered) during the period rarely equals the overhead actually incurred. The difference is called under- or over-absorption.

• Under-absorption (under-recovery) arises when the overhead absorbed is less than the overhead actually incurred. Under-absorption = Actual overhead − Overhead absorbed (a positive figure). Part of the real overhead has not been charged to products, so product costs are understated.
• Over-absorption (over-recovery) arises when the overhead absorbed is more than the overhead actually incurred. Over-absorption = Overhead absorbed − Actual overhead (a positive figure). More overhead has been charged than was really incurred, so product costs are overstated.

where Overhead absorbed = predetermined rate × actual base (actual units or actual hours).

Causes of under- or over-absorption:

• Error in estimating overhead — actual overhead turned out higher or lower than the budgeted figure.
• Error in estimating the activity level — actual output, machine hours or labour hours differed from the level assumed when fixing the rate.
• Unexpected changes in methods, prices, or capacity used during the period.
• Seasonal fluctuations in production, where a single annual rate is applied to uneven monthly output.
• Abnormal circumstances — a strike, a breakdown, or unusually high idle capacity.

Treatment (how the difference is disposed of):

• If the amount is small / normal, it is transferred to the Costing Profit and Loss Account (under-absorption reduces profit; over-absorption increases it).
• If the amount is large and due to normal causes (a genuine mis-estimate), it may be adjusted by a supplementary rate — spreading it over the cost units, work-in-progress and finished goods of the period so that costs are corrected. …