Unlike in variable cost or marginal costing, interestingly in absorption costing environment, under or over absorption of overheads generally occurs when overheads incurred do not equal the overheads absorbed. The rate of overhead absorption is based on estimates and it is quite likely that either one or both (nominator and denominator) of the estimates will not agree with what actually happens.
Actual overheads incurred during a period possibly be either greater than or less than overheads absorbed into the cost of production and so it is almost inescapable that at the completion of the accounting year there will have been an over absorption or under absorption of the overhead actually incurred. Under or over absorption of overheads depends on the volume of activities.
Why Under or over absorption of overheads happens?
• Over absorption signifies that the overheads charged to the cost of sales are higher than the overheads actually incurred.
• Under absorption represents that insufficient overheads have been included in the cost of sales.
The reasons for under or over-absorbed overhead:
The overhead absorption rate is predetermined from budget estimates of overhead cost and activity level. It is aligned with the budget of a given period.
Under or over recovery of overhead may happen in the following circumstances.
• Actual overhead and actual activity level or operations differ from those budgeted.
• Actual overhead are different from budgeted overheads.
• The actual activity level or operation level is different from the budgeted activity level.
The rate of overhead absorption is dependent on estimates and it is quite likely that either one or both (numerator and denominator) of the estimates will not agree with what actually happens. Under or over absorption of overheads depends on the volume of activities. We will publish more contents on this subject in future.