Usually overheads are absorbed on the basis of predetermined rates. Since predetermined overhead rates are based on budgeted overheads and budgeted production, invariably the overheads absorbed by this process do not agree with the actual overheads incurred for the period.
If the absorbed overheads at predetermined rates are greater than actual overheads, this is known as over-absorption. Conversely, if absorbed overheads ae less than the actual overheads, this is known as under-absorption.
The amount of overhead absorption in costs is the total amount of the overhead costs allotted to individual cost units by application of overhead rate. Overhead costs are fully recovered from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overheads incurred. But when a predetermined rate is used on the basis of budgeted overheads and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses.
If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and/or the output or hours worked being less than the estimates, the difference is known as under-absorption. Under-absorption of overheads thus means the amount by which the absorbed overheads fall short of the actual amount of overheads incurred. It represents understating the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, processes etc.
On the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and/or the output or hours worked exceeding the estimates, it would mean over-absorption of overheads and will inflate the costs. Over-absorption of overheads thus means the excess of overheads absorbed over the actual amount of overheads incurred.
Causes of Under or Over-Absorption of Overheads:
Under or over-absorption of overheads may arise due to any of the following reasons:
(i) Error in estimating overheads: The total overheads actually incurred for a department may be more or less than the amount estimated because of error in estimating. This may be due to deliberate decision in this regard or lack of proper control.
(ii) Error in estimating of proper volume: The actual volume of output may be more or less than the output anticipated because of error in estimating the level of production.
(iii) The actual hours worked may be more or less than hours anticipated.
(iv) The basis upon which the factory overheads are recovered from production may no longer be correct on account of changes in the prices of material or wages rates.
(v) Work-in-progress might not have been charged with its share of overhead in cost accounts.
(vi) Major unanticipated changes in method of production might have occurred due to which an expense of a non-recurring nature might have been incurred during the year.
(vii) Seasonal fluctuations in the overhead expenses from period to period. Overhead rate is calculated by averaging the peaks and troughs. This results in under-absorption of overheads if the rate is calculated with reference to full capacity and under-absorption of overhead cost represents the overheads pertaining to the unutilized capacity.
(viii) There may be some important changes in the work situation such as heavy overtime, introduction of another shift, substitution of manual labour by equipment etc.