Absorption Costing: Over and Under-absorption

• As has been said before overhead absorption rates are calculated in advance
• The formula for getting an overhead absorption rate is:
• \text{OAR=}\dfrac{\text{Budgeted Production Overhead}}{\text{Budgeted Level of Activity}}
• The budgeted level of activity can be units,labour hours, machine hours etc
• It is very unlikely however that budget overheads or/and the budgeted level of activity will be equal to the overheads/bases that will be actually realised during the year/period
• If estimates for the budgeted overheads and/or the budgeted level of activity are different from the actual results for the year then this will lead to either:
  1. under-absorption (recovery) of overheads or
  2. over-absorption (recovery) of overheads
• Under-absorption is when the total absorbed overheads that were absorbed using predetermined rates are less than the actual overheads during the period
• Under-absorption occurs because the actual level of activity was less than the budgeted level of activity and/or the budgeted overheads were less than actual overheads
• Over-absorption is when the total absorbed overheads that were absorbed using predetermined OARs exceed the actual overheads during the period
• Over-absorption occurs when the actual level of activity is more the budgeted level of activity or/and the budgeted overheads are less than the actual overheads

Calculating Under or Over-Absorption

• This involves three steps:
  1. Calculate the OAR based on the budget
  2. Calculate the overheads absorbed based on the actual level of activity i.e. \text{Overheads absorbed = predetermined OAR x actual level of activity}
  3. Compare absorbed overheads to actual overheads
• If at the end of this period the overheads are greater than the actual overheads then there has been over-absorption of overheads
• If on the other hand the overheads absorbed are less that the actual overheads it means that there has been under-absorption of overheads
• Over and under-absorption for the period are transferred to the income statement (statement of profit) for that period as either income or an expense respectively

Example

The following data relates to Benzi Ltd for period ended 31 December 20×8

Required:

1. Calculate the under or over-absorption

Solution

• The first step is to calculate the OAR using the formula above
• \text{OAR=}\dfrac{\text{\$80 000}}{\text{20 000}}
• This gives an OAR of $4 per each hour worked
• The second step is to determine how much of these overheads were absorbed (recovered)
• \text{Overhead absorbed=22 000x\$4}
• That means overheads totalling $88 000 were absorbed
• Actual overheads were $90 000
• The difference between absorbed and actual is:
• \text{\$88 000-\$90 000=-\$2 000}
• This means total absorbed overheads were $2 000 less than actual overheads
• This means there was an under-absorption of $2 000

To access more topics go the ZIMSEC Advanced Level Accounting page

To access more topics go to the Cambridge AS/A level page