Over and under absorption of production overhead costs

This may be analysed under

  1. Activity

Level of the business or cost center. Expenditure on some items of production overhead costs will vary directly with activity whereas others will be fixed irrespective of the changes in activity level. For example in a machine orientated cost center, power cost will vary in proportion to machine hours whereas salary of the cost center manager will be fixed.

  1. Level of expenditure on production overhead

Expenditure level may change from the budgeted level because of a change in the price of an overhead item or a change in the usage of the overhead item

  1. Activity level and the absorption of production overhead cost

In the table below the variable overhead absorbed per machine hour is constant (Shs.3) irrespective of the activity level. The fixed overhead cost per machine hour depends on the activity level used as the base. If 100 machine hours are used, Shs.5 per machine hour must be charged in order to absorb the fixed overhead cost of Shs.500. if 300 machine hours are used, Shs.1.67 per machine hour is a sufficient charge in order to absorb the total fixed overhead cost.

Figure 5.0 Machining cost center

Activity levelMachine hrs  Total fixedOverhead costs Total variable Overhead costs Total overhead cost  Average Machine   Overhead Hour  Cost per

Shs. Shs. Shs. Shs. Shs. Shs. Shs.
100 500 300 800 5.00 3.00 8.00
150 500 450 950 3.33 3.00 6.33
200 500 600 1100 2.50 3.00 5.50
250 500 750 1250 2.00 3.00 5.00
300 500 900 1400 1.67 3.00 4.67

Production overheads will be absorbed by jobs or products at the pre-determined rater per machine hour.

If the actual number of machine hours used differs from the number used in the calculation of the overhead absorption rate, an over or under absorption will occur.

Note that this problem does not occur with variable overheads since the incidence of the cost (such as power cost) varies with changes in activity.