When a company uses standard costing, it derives a standard amount of overhead cost that should be incurred in an accounting period, and applies this standard amount of overhead to cost objects (usually produced goods). If the actual amount of overhead turns out to be different from the standard amount of overhead, then the overhead is said to either under absorbed or over absorbed.
If overhead is under absorbed, this means that more actual overhead costs were incurred than expected, with the difference being charged to expense as incurred. This usually means that the recognition of expense is accelerated into the current period, so that the amount of profit recognized declines.
If overhead is over absorbed, this means that fewer actual overhead costs were incurred than expected, so that more cost is applied to cost objects than were actually incurred. This means that the recognition of expense is reduced in the current period, which increases profits. For example, if the overhead rate is predetermined to be $20 per direct labor hour consumed, but the actual amount should have been $18 per hour, then the $2 difference is considered to be over absorbed overhead.
There can be several reasons for overhead under absorption or over absorption, including:
- The amount of overhead incurred is not the same as the amount expected.
- The basis upon which overhead is applied is in an amount different than expected. For example, if there are $100,000 of standard overhead to be applied and 2,000 hours of direct labor are expected to be incurred in the period, then the overhead application rate is set at $50 per hour. However, if the number of hours actually incurred is only 1,900 hours, then the $5,000 of overhead associated with the missing 100 hours will not be applied.
- There may be seasonal differences in the amount of overhead actually incurred or in the basis of application, versus a standard rate that is based on a longer-term average.
- The basis of allocation may be incorrect, perhaps due to a data entry or calculation error.
When under or over absorption is encountered, it is normally dealt with in one of the following ways:
- The difference (either positive or negative) is charged to the cost of goods sold at once.
- The difference (either positive or negative) is applied to the relevant cost objects.
The first approach is easier to accomplish, but less precise. Consequently, an immediate write-off is usually limited to smaller variances, while the latter method is used for larger variances.
The entire issue of overhead absorption can be reduced by using just-in-time systems to reduce the amount of inventory on hand at the end of a reporting period. By doing so, a case can be made to charge all overhead costs to expense as incurred.