3.2 Overhead Absorption Rates (OAR) & Under/Over-Absorption

Once factory overheads have been allocated, apportioned, and reapportioned, the entire overhead burden of the manufacturing plant resides within the production cost centres. The final stage in traditional absorption costing is overhead absorption (also known as overhead recovery)—the systematic charging of production overheads into individual cost units (products or customer jobs).

Calculating, applying and adjusting absorption rates is a core BA2 skill (syllabus area B2(b): overhead absorption rates and under- or over-absorbed overheads).

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1. The Predetermined Overhead Absorption Rate (OAR)

Why do organizations use predetermined absorption rates calculated in advance, rather than waiting for actual overhead costs at the end of the year?

In commercial practice, companies cannot wait until the financial year closes to know what a product costs. Quotations must be provided to customers daily, selling prices must be established, inventory must be valued at monthly reporting dates, and cost control benchmarks must be maintained.

Because actual overheads and actual production volumes fluctuate continuously, management calculates a Predetermined Overhead Absorption Rate (OAR) prior to the start of the accounting period based on budgeted estimates:

$$\text{Predetermined OAR} = \frac{\text{Budgeted Production Overheads}}{\text{Budgeted Activity Level}}$$

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2. Selecting an Appropriate Absorption Base

The choice of the activity base in the denominator is critical. The base chosen should be the primary factor that drives overhead expenditure within that specific production department:

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3. Calculating Absorbed Overhead and Under/Over-Absorption

During the accounting period, overhead is charged into production based on the actual activity achieved:

$$\text{Absorbed Overheads} = \text{Actual Activity Level} \times \text{Predetermined OAR}$$

At the end of the accounting period, the actual overhead costs incurred are tallied and compared against the overheads absorbed into production:

$$\text{Under/Over-Absorption} = \text{Absorbed Overheads} - \text{Actual Overheads}$$

• Under-Absorption (Absorbed < Actual): Insufficient overhead was charged to products during the period. The predetermined rate was too low, or actual spending was unexpectedly high, or factory volume fell short. The unrecovered overhead represents an adverse variance that reduces operating profit.
• Over-Absorption (Absorbed > Actual): Excessive overhead was charged to products during the period. The predetermined rate was too high, or spending was lower than planned, or production volume exceeded capacity. The surplus overhead recovered represents a favorable variance that increases operating profit.

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4. Comprehensive Numerical Case: Valence Precision Engineering

To master the mechanics of overhead absorption and variance analysis, examine Valence Precision Engineering, which operates an automated Machining Department.

Budgeted Baseline (Start of Year):

• Budgeted production overheads: $480,000
• Budgeted machine hours: 24,000 hours
• Budgeted direct labour hours: 8,000 hours

Because the department is capital-intensive, the company selects machine hours as the absorption base:

$$\text{Predetermined OAR} = \frac{\text{\textdollar}480,000}{24,000 \text{ machine hours}} = \mathbf{\text{\textdollar}20.00 \text{ per machine hour}}$$

Actual Operating Results (End of Year):

• Actual machine hours worked: 22,500 hours
• Actual production overheads incurred: $492,000

Step 1: Compute Overhead Absorbed into WIP

$$\text{Absorbed Overheads} = 22,500 \text{ actual hours} \times \text{\textdollar}20.00 = \mathbf{\text{\textdollar}450,000}$$

Step 2: Determine Under- or Over-Absorption

$$\text{Net Difference} = \text{Absorbed Overheads } (\text{\textdollar}450,000) - \text{Actual Overheads } (\text{\textdollar}492,000) = -\mathbf{\text{\textdollar}42,000}$$

Because absorbed overheads ($450,000) fall short of actual overheads incurred ($492,000), there is an Under-Absorption of $42,000.

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5. Decomposing the Discrepancy: Root Causes

Why did the $42,000 under-absorption occur? Management accountants isolate two distinct operational drivers:

1. Overhead Expenditure Variance

Measures the spending discrepancy between what management budgeted to spend and what was actually spent:

$$\text{Expenditure Variance} = \text{Budgeted Overheads} - \text{Actual Overheads}$$ $$\text{Expenditure Variance} = \text{\textdollar}480,000 - \text{\textdollar}492,000 = -\mathbf{\text{\textdollar}12,000 \text{ (Adverse)}}$$

The department overspent its overhead budget by $12,000 (e.g., due to rising utility rates or unanticipated equipment maintenance).

2. Overhead Volume Variance

Measures the absorption impact of working at a different activity level than planned:

$$\text{Volume Variance} = (\text{Actual Activity} - \text{Budgeted Activity}) \times \text{Predetermined OAR}$$ $$\text{Volume Variance} = (22,500 \text{ hrs} - 24,000 \text{ hrs}) \times \text{\textdollar}20.00 = -1,500 \text{ hrs} \times \text{\textdollar}20.00 = -\mathbf{\text{\textdollar}30,000 \text{ (Adverse)}}$$

The plant operated 1,500 machine hours below budgeted capacity, failing to absorb $30,000 of fixed manufacturing overhead into production.

Reconciliation Check:

$$\text{Total Under-Absorption} = \text{Expenditure Variance } (-\text{\textdollar}12,000) + \text{Volume Variance } (-\text{\textdollar}30,000) = -\mathbf{\text{\textdollar}42,000}$$

This identity holds here because the department's overhead is treated as fixed: total under- or over-absorption is the sum of the expenditure and volume variances. Where overheads are partly variable, spending should be compared with a flexed budget, and Chapter 7 analyses variable and fixed overhead variances separately.

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6. Financial Ledger Accounts and Journal Entries

The flow of overheads through standard cost ledger accounts follows a clear double-entry sequence:

1. Recording Actual Overheads Incurred:

As actual overhead costs are paid or accrued throughout the period, they are debited to the Production Overhead Control Account:

• Debit: Production Overhead Control Account: $492,000
• Credit: Bank / Accounts Payable / Accumulated Depreciation: $492,000

2. Absorbing Overhead into Production:

As products are manufactured, overhead is absorbed into Work-in-Progress (WIP) at the predetermined OAR:

• Debit: Work-in-Progress Account: $450,000
• Credit: Production Overhead Control Account: $450,000

3. Closing the Production Overhead Control Account at Period End:

Inspecting the T-account of the Production Overhead Control Account:

• Total Debits (Actual costs): $492,000
• Total Credits (Absorbed costs): $450,000
• Remaining Debit Balance: $42,000

To close this balance at the end of the financial period:

• Debit: Statement of Profit or Loss (Under-absorbed overhead expense): $42,000
• Credit: Production Overhead Control Account: $42,000