Overheads and absorption - Under- and over-absorption of ove...

Learning Outcomes

By the end of this article, you will be able to explain how production overheads are absorbed, identify causes of under- and over-absorption, and calculate adjustments using overhead absorption rates. You will also understand the implications of under- and over-absorption for financial statements and be able to recognise and correct common exam pitfalls.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand the allocation, absorption, and adjustment of overheads within cost accounting. This article is relevant to:

• Defining direct and indirect costs, and explaining the treatment of production overheads
• Describing the calculation and use of overhead absorption rates (OAR)
• Identifying and computing under- and over-absorption of overheads
• Explaining how under- or over-absorbed overheads impact product costing and profit reporting
• Preparing journal and ledger entries for incurred and absorbed overheads, including adjustments for under- or over-absorption

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the formula for calculating an overhead absorption rate (OAR)?
2. A company’s budgeted overheads are $120,000 and budgeted activity is 30,000 machine hours. Actual overhead incurred is $125,000, and actual machine hours worked are 32,000. Was overhead under- or over-absorbed, and by how much?
3. Why does under- or over-absorption of overheads occur in practice?
4. How is under-absorbed overhead usually dealt with at period-end in financial statements?

Introduction

Production overheads are indirect costs incurred in the manufacturing process that cannot be directly traced to a product, such as factory rent, supervisors’ salaries, or factory depreciation. These overhead costs must be fairly distributed (absorbed) into product costs using a consistent basis.

When estimating the cost per unit, businesses use budgeted overheads and budgeted production levels to calculate an overhead absorption rate (OAR). In reality, actual overheads and actual activity levels are usually different, creating either under-absorption or over-absorption. Adjustments for these differences are important for accurate profit reporting and effective cost control.

Key Term: Overhead Absorption Rate (OAR)
A predetermined rate used to charge production overheads to products, calculated by dividing budgeted overheads by the budgeted activity level.

CALCULATING THE OVERHEAD ABSORPTION RATE (OAR)

The OAR allows indirect production costs to be allocated in a systematic way to products or services.

OAR formula

The chosen basis for absorption should reflect the cost behaviour of the overhead. For example, use:

• Machine hours in a machine-intensive environment
• Direct labour hours in a labour-intensive environment
• Units produced in simple processes

Worked Example 1.1

A manufacturing firm estimates budgeted production overheads of $80,000 and plans to produce 10,000 units next month. What is the OAR per unit?

Answer:
OAR = $80,000 / 10,000 = $8 per unit

ABSORPTION OF OVERHEADS IN PRACTICE

Once the OAR has been determined, products or jobs are charged with overheads according to the actual activity (units produced or hours worked).

However, rarely do actual figures match the budget. This gives rise to under-absorption (less overhead charged to production than incurred) or over-absorption (more overhead charged to production than incurred).

Key Term: Under-absorption of Overheads
The amount by which the absorbed overheads (using the OAR) are less than the actual overheads incurred in a period.

Key Term: Over-absorption of Overheads
The amount by which the absorbed overheads (using the OAR) are more than the actual overheads incurred in a period.

CAUSES OF UNDER- AND OVER-ABSORPTION

Differences between overheads absorbed and overheads incurred usually arise due to:

• Actual activity levels (machine/labour hours, output) being different from budget
• Actual overhead incurred being different from budgeted overhead
• Inefficiency, waste, unexpected costs, or fluctuations in production

These differences must be identified and corrected to ensure accurate cost and profit reporting.

Worked Example 1.2

Budgeted overheads: $60,000
Budgeted production: 15,000 machine hours
OAR: $4 per machine hour

Actual overhead incurred: $62,000
Actual machine hours: 16,000

Calculate the under-/over-absorption.

Step 1: Overhead absorbed = OAR × actual activity = $4 × 16,000 = $64,000
Step 2: Overhead absorbed ($64,000) vs. overhead incurred ($62,000):
$64,000 − $62,000 = $2,000 over-absorbed

Answer:
Overhead was over-absorbed by $2,000.

ACCOUNTING FOR UNDER- AND OVER-ABSORBED OVERHEADS

At the end of the period, any balance between absorbed and actual overheads must be adjusted in the accounts.

• Under-absorbed overheads: added to cost of sales (deducts from profit)
• Over-absorbed overheads: deducted from cost of sales (adds to profit)

This ensures reported profits reflect all actual overheads incurred.

Worked Example 1.3

If a company over-absorbed overheads by $4,000 for the year, how should this be reflected in the financial statements?

Answer:
The $4,000 over-absorbed overhead is deducted from cost of sales, thereby increasing the reported net profit.

COMMON REASONS FOR MISMATCHES BETWEEN ABSORBED AND ACTUAL OVERHEADS

• Actual activity higher than expected, but overhead spending unchanged (leads to over-absorption)
• Actual overhead spending higher than expected, but activity unchanged (leads to under-absorption)
• Simultaneous changes in both activity and actual spending (direction depends on size of changes)

Exam Warning

Calculating the OAR using actual rather than budgeted activity is a common exam error. The OAR must always be based on budgeted figures to avoid circular reasoning.

JOURNAL ENTRIES AND OVERHEAD CONTROL ACCOUNTS

Businesses systematically record overhead incurred, overhead absorbed, and the period-end adjustment using control accounts.

Illustrative entries for a manufacturing business:

• Debit Production Overheads Account with actual overheads incurred
• Credit Production Overheads Account with overheads absorbed (OAR × actual activity)
• Balance represents under- or over-absorbed overhead
• At period end:
  • Under-absorbed: Debit Cost of Sales, Credit Overheads Account
  • Over-absorbed: Debit Overheads Account, Credit Cost of Sales

DEALING WITH UNDER- OR OVER-ABSORPTION

There are several possible approaches:

• Write off the amount to the statement of profit or loss (common with small variances)
• Carry forward the balance in the overhead account to adjust absorption in future periods (less common, may be used for large projects)
• Allocate between cost of sales, closing inventory, and work in progress if the variance is significant and inventories are material

IMPACT ON PROFIT

Under-absorbed overheads reduce reported profit, whereas over-absorbed overheads increase it. Failure to correct these variances misstates inventory values and profits, potentially misleading stakeholders.

Worked Example 1.4

A company has:

• Under-absorbed production overheads of $6,000
• Closing inventory valued at $10,000 before adjustment

Management decides to split the under-absorbed overhead between cost of sales ($90,000 sold) and inventory ($10,000 remaining). Adjust the accounts.

Answer:
Total production: $100,000. Inventory = 10% of production. Allocate 10% of $6,000 ($600) to inventory (increase closing inventory), and $5,400 to cost of sales (increase expense).

SUMMARY TABLE: UNDER- VS OVER-ABSORPTION

Key Point Checklist

This article has covered the following key knowledge points:

• Calculation and application of overhead absorption rates (OAR) based on budgeted overheads and activity
• Reasons for differences between absorbed and actual overheads
• Definition and calculation of under- and over-absorption of overheads
• Accounting entries to adjust for over- and under-absorbed overheads
• Impact on cost of sales, closing inventory, and profit
• Exam tips for correct calculation and reporting of overhead variances

Key Terms and Concepts

• Overhead Absorption Rate (OAR)
• Under-absorption of Overheads
• Over-absorption of Overheads