ASCMS02 — Over/Under Absorption & Absorption Costing Applications

Absorption costing is used to determine the full cost of producing a product or providing a service by including an appropriate share of production overheads.

This supplementary resource focuses on the areas that often cause difficulty:

- - - - Cost centres and cost units
        Allocation and apportionment of overheads
        Overhead absorption rates
        Absorption of overheads
        Under-absorption
        Over-absorption
        Costing and profit statements
        Interpretation and management applications
        Limitations of absorption costing

Learn the calculation. Understand the reason. Interpret the result.

Learning Objectives

By the end of this supplementary topic, students should be able to:

1. Distinguish between a cost centre and a cost unit.
2. Explain allocation and apportionment of overheads.
3. Calculate an overhead absorption rate using an appropriate basis.
4. Calculate overheads absorbed by production.
5. Calculate under-absorption and over-absorption.
6. Prepare costing and profit statements using absorption costing.
7. Explain why under- or over-absorption occurs.
8. Interpret absorption-costing information.
9. Evaluate the usefulness and limitations of absorption costing.
10. Apply absorption-costing information to management decisions.

Concept Framework

What is absorption costing

Absorption costing is a costing method in which production overheads are absorbed into the cost of products or services.

The basic idea is:

Direct costs + absorbed production overhead = full production cost

Production overheads cannot always be traced directly to one product.

Examples include:

Factory rent
Factory electricity
Depreciation of factory machinery
Factory supervision
Indirect materials
Indirect labour

Absorption costing provides a systematic method of assigning these costs to production.

Cost Centre

A cost centre is a department, location or area of the business where costs are collected.

Examples:

Machining department
Assembly department
Finishing department
Maintenance department

A cost centre helps the business identify where overhead costs are incurred.

Cost Unit

A cost unit is a unit of product or service for which a cost is calculated.

Examples:

One table
One machine
One batch of products
One hotel room-night
One service provided

Key distinction

Cost centre = where costs are collected

Cost unit = what the cost is calculated for

Allocation

Allocation means charging an overhead directly to a particular cost centre when the cost clearly belongs to that centre.

Example

The machining department uses a particular machine.

The depreciation of that machine can be allocated directly to the machining department.

Apportionment

Apportionment is used when an overhead is shared by more than one cost centre.

The total cost is divided between the cost centres using an appropriate basis.

Example

Factory rent is shared by three departments.

Possible basis:

Floor area occupied

Choosing an appropriate basis

Overhead	Possible basis
Factory rent	Floor area
Electricity	Machine hours / usage
Canteen costs	Number of employees
Depreciation of machinery	Machine value / usage
Staff welfare	Number of employees
Insurance	Asset value

The basis should reflect the relationship between the overhead and the cost centre.

OVERHEAD ABSORPTION RATE

Once production overheads have been assigned and apportioned to production departments, an overhead absorption rate (OAR) can be calculated.

Formula

OAR = Budgeted production overhead ÷ Budgeted activity

The activity measure may be:

Units produced
Labour hours
Machine hours
Labour cost
Other appropriate measures

The most appropriate basis should be selected according to the nature of the production process.

Worked Example 1 — Labour Hours

A production department expects:

Production overhead = £60,000
Labour hours = 12,000

OAR

£60,000 ÷ 12,000

= £5 per labour hour

If a product requires 4 labour hours:

Overhead absorbed:

4 × £5

= £20

MACHINE-HOUR ABSORPTION

Where production depends heavily on machinery, machine hours may be more appropriate.

Worked Example 2

Budgeted factory overhead = £90,000

Budgeted machine hours = 15,000

OAR = £90,000 ÷ 15,000

= £6 per machine hour

A product uses 8 machine hours.

Overhead absorbed:

8 × £6

= £48

ABSORBED OVERHEAD

Absorbed overhead represents the amount of production overhead charged to products based on the predetermined absorption rate.

Formula

Overhead absorbed = Actual activity × OAR

For example:

Actual machine hours = 18,000

OAR = £6 per machine hour

Overhead absorbed:

18,000 × £6

= £108,000

UNDER-ABSORPTION

Under-absorption occurs when:

Actual production overhead > Overhead absorbed

Formula

Under-absorption = Actual overhead − Absorbed overhead

Worked Example 3

Actual overhead = £120,000

Absorbed overhead = £108,000

Under-absorption:

£120,000 − £108,000

= £12,000

The business has absorbed £12,000 less overhead than it actually incurred.

Why can under-absorption occur?

Possible reasons include:

Actual overhead costs were higher than expected.
Actual production was lower than expected.
Actual activity was lower than budgeted.
Input prices increased.
Production inefficiencies increased costs.
The absorption rate was based on unrealistic assumptions.

OVER-ABSORPTION

Over-absorption occurs when:

Overhead absorbed > Actual production overhead

Formula

Over-absorption = Absorbed overhead − Actual overhead

Worked Example 4

Absorbed overhead = £135,000

Actual overhead = £120,000

Over-absorption:

£135,000 − £120,000

= £15,000

The business has absorbed £15,000 more overhead than it actually incurred.

COSTING STATEMENT

An absorption-costing statement may include:

Direct materials

Direct labour
Direct expenses

= Prime cost

Production overhead absorbed

= Production cost

Other appropriate costs where relevant

= Total cost

Profit

= Selling price

The exact presentation can vary depending on the information provided.

WORKED EXAMPLE — FULL COST

A business produces Product X.

For one unit:

Direct materials = £18
Direct labour = £12
Machine hours = 3
OAR = £4 per machine hour

Step 1 — Prime cost

£18 + £12

= £30

Step 2 — Production overhead

3 × £4

= £12

Step 3 — Full production cost

£30 + £12

= £42

Therefore:

Full production cost per unit = £42

APPLYING ABSORPTION COSTING

Absorption costing can help management:

Calculate product costs
Determine selling prices
Compare product profitability
Monitor overhead costs
Assess departmental performance
Support longer-term planning
Understand the resources consumed by production

However, absorption costing should not automatically be treated as the only basis for a decision.

Management should also consider:

Demand
Competition
Capacity
Quality
Customer requirements
Cash-flow implications
Other relevant financial information
Non-financial factors

LIMITATIONS OF ABSORPTION COSTING

Overhead allocation can be subjective

Some overheads cannot be traced directly to a product.

The choice of apportionment basis may affect the calculated cost.

Fixed costs may be spread using estimates

The absorption rate often depends on budgeted activity.

If actual activity differs significantly from the budget, under- or over-absorption may occur.

Product costs may be distorted

An inappropriate absorption basis may assign too much or too little overhead to a product.

Not every decision requires full cost

For some short-term decisions, management may need to focus on relevant costs and contribution rather than allocated fixed overheads.

Therefore, absorption-cost information should be interpreted alongside other information.

WORKED EXAMPLE — UNDER/OVER ABSORPTION

A department has:

Budgeted overhead = £80,000

Budgeted labour hours = 20,000

Actual overhead = £84,000

Actual labour hours = 19,000

Step 1 — Calculate OAR

£80,000 ÷ 20,000

= £4 per labour hour

Step 2 — Calculate absorbed overhead

19,000 × £4

= £76,000

Step 3 — Compare

Actual overhead = £84,000

Absorbed overhead = £76,000

Therefore:

£84,000 − £76,000

= £8,000 under-absorption

Interpretation

The department incurred £84,000 of overhead but only absorbed £76,000 into production.

The difference of £8,000 needs to be considered when determining the final result.

EXAMINATION THINKING

When solving absorption-costing questions:

Step 1

Identify the cost centre.

Step 2

Identify the relevant overheads.

Step 3

Allocate or apportion overheads where required.

Step 4

Identify the appropriate activity basis.

Step 5

Calculate the OAR.

Step 6

Calculate absorbed overhead.

Step 7

Compare actual and absorbed overhead.

Step 8

Identify under- or over-absorption.

Step 9

Prepare the required costing/profit statement.

Step 10

Interpret the result if required.

COMMON EXAMINATION ERRORS

Error 1 — Confusing cost centre and cost unit

Remember:

Centre = where

Unit = what

Error 2 — Reversing under and over absorption

Always compare:

Actual overhead with absorbed overhead.

Error 3 — Using the wrong activity basis

Do not automatically use labour hours.

Consider whether:

Labour hours
Machine hours
Units
Labour cost

or another basis is more appropriate.

Error 4 — Forgetting units

If the OAR is £5 per machine hour, show the unit.

Error 5 — Giving a calculation without interpretation

When evaluation is required, explain what the result means for the business.

Structured Practice

Question 1 — OAR

A production department has budgeted overhead of £72,000 and budgeted machine hours of 18,000.

Calculate the overhead absorption rate.

(2 marks)

Question 2 — Absorbed Overhead

The OAR is £6 per machine hour.

Product A requires 7 machine hours.

Calculate the production overhead absorbed by Product A.

(2 marks)

Question 3 — Under-Absorption

Actual production overhead is £95,000.

Overhead absorbed is £88,000.

Calculate the amount of under- or over-absorption.

(2 marks)

Question 4 — Full Cost

A product has:

Direct materials: £25
Direct labour: £15
Production overhead absorbed: £10

Calculate the full production cost per unit.

(2 marks)

Question 5 — Evaluation

Explain one reason why absorption costing may not provide a perfectly accurate product cost.

(3 marks)

Proficiency Check

LEARN → UNLEARN → RELEARN

LEARN

Complete these statements:

A cost centre is __________.
A cost unit is __________.
OAR = __________.
Under-absorption occurs when __________.
Over-absorption occurs when __________.

UNLEARN

Correct the following statements:

Statement A

“Under-absorption occurs when absorbed overhead is greater than actual overhead.”

Statement B

“A cost unit is the department where overheads are collected.”

Statement C

“The OAR is always calculated using labour hours.”

RELEARN

Explain in your own words:

Why does a business need an overhead absorption rate?
Why can actual overhead differ from absorbed overhead?
Why might a business choose machine hours instead of labour hours?
Why should management consider non-financial information as well as absorption-cost data?

Detailed Activity Solutions

Question 1, 2, 3, 4, 5

Question 1

OAR:

£72,000 ÷ 18,000

= £4 per machine hour

Question 2

Overhead absorbed:

7 × £6

= £42

Question 3

Actual overhead = £95,000

Absorbed overhead = £88,000

Actual > absorbed.

Therefore:

£95,000 − £88,000

= £7,000 under-absorption

Question 4

Full production cost:

£25 + £15 + £10

= £50 per unit

Question 5

Absorption costing may not provide a perfectly accurate product cost because some overheads cannot be traced directly to individual products. They must be apportioned using an appropriate basis, and the selected basis may not perfectly represent the resources consumed by each product.

How This Topic Appears in the Examination

Questions may require you to:

identify cost centres and cost units;
allocate and apportion overheads;
calculate an overhead absorption rate;
calculate absorbed overhead;
calculate under- or over-absorption;
prepare costing statements;
calculate product costs;
explain causes of under/over absorption;
evaluate absorption costing;
apply costing information to business decisions;
consider relevant non-financial factors.

Cambridge’s 2026–2028 syllabus specifically includes these areas under 2.2.2 Absorption costing.

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Self-Assessment Checklist

Before leaving this topic, I can:

☐ Explain absorption costing.

☐ Distinguish between a cost centre and cost unit.

☐ Explain allocation.

☐ Explain apportionment.

☐ Select an appropriate apportionment basis.

☐ Calculate an OAR.

☐ Calculate absorbed overhead.

☐ Calculate under-absorption.

☐ Calculate over-absorption.

☐ Prepare a costing statement.

☐ Explain why under/over absorption occurs.

☐ Evaluate the usefulness of absorption costing.

☐ Explain its limitations.

☐ Apply costing information to management decisions.

☐ Consider non-financial factors.

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