Absorption Costing

Over- and Under-Absorption

Why Over/Under Absorption Occurs

The OAR is calculated using budgeted data before the period starts. When actual results differ from budget, the overheads absorbed will not equal actual overheads incurred.

Two causes:

• Actual activity (hours/units) differs from budgeted activity
• Actual overhead costs differ from budgeted overhead costs

Formulae

$$\text{Overhead absorbed} = \text{OAR} \times \text{Actual activity}$$

$$\text{Over/under absorption} = \text{Overhead absorbed} - \text{Actual overheads}$$

Worked Example

• OAR = £168 000 ÷ 14 000 = £12.00 per machine hour
• Overhead absorbed = 13 500 × £12 = £162 000
• Under-absorption = £162 000 − £172 000 = £10 000 under-absorbed

Both causes operated here: fewer hours worked (13 500 vs 14 000) AND higher actual overheads (£172 000 vs £168 000).

Treatment in the Income Statement

• Over-absorption → credit to the income statement (reduces cost of sales / increases profit)
• Under-absorption → debit to the income statement (increases cost of sales / reduces profit)