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Absorption of Overheads & Overhead Rates

Imagine your factory runs all month — machines humming, supervisors supervising, lights blazing — even when production is slow. Those indirect costs (rent, depreciation, factory salaries) don't disappear. Absorption of overheads is the process of charging these costs to individual products or jobs so every unit of output carries its fair share of the burden. Without absorption, your cost sheet is incomplete and your profit figures are wrong.

The engine of absorption is the Overhead Absorption Rate (OAR), calculated at the start of the year using budgeted figures — not actual:

OAR = Budgeted Overheads ÷ Budgeted Activity Level

The 'activity level' is your chosen absorption base — and picking the right one matters enormously:

  • Machine Hour Rate: best when machines dominate production (capital-intensive)
  • Labour Hour Rate: best when workers dominate (labour-intensive)
  • Direct Wages %: OAR as a % of direct labour cost
  • Prime Cost %: OAR as a % of (direct material + direct labour)
  • Unit of Output: only works for single-product factories

Once production runs, each unit is charged: Absorbed OH = OAR × Actual Activity. But the real world rarely matches budgets. When absorbed overheads ≠ actual overheads, you get under or over absorption — one of the most exam-heavy areas in Paper 4.

  • Over absorption (Absorbed > Actual): you've charged too much to products → credit back to Costing P&L (profit increases)
  • Under absorption (Absorbed < Actual): you've charged too little → debit Costing P&L (profit decreases)

Both are written off to the Costing P&L Account at year-end. The two root causes: (1) actual overheads differ from budget (expenditure variance), or (2) actual activity differs from budget (volume variance).

Activity-Based Costing (ABC) takes this further — instead of one blanket OAR, overheads are pooled by activity (e.g., machine setups, purchase orders, quality inspections) and each pool gets its own cost driver. ABC is more accurate when a factory makes diverse products with very different overhead demands. The ICAI exam often pairs ABC with a comparison to traditional absorption, so understand why ABC gives different product costs.

This topic is asked frequently as a 6–10 mark problem — either OAR calculation + under/over absorption treatment, or an ABC cost sheet comparison.

📊 Worked example

Example 1: OAR Calculation and Under/Over Absorption

Rajesh & Co. Pvt. Ltd. provides the following data for its machine department:

  • Budgeted factory overheads: ₹6,00,000
  • Budgeted machine hours: 20,000 hours
  • Actual machine hours worked: 18,500 hours
  • Actual factory overheads incurred: ₹5,80,000

Step 1 — Calculate OAR:

OAR = ₹6,00,000 ÷ 20,000 = ₹30 per machine hour

Step 2 — Calculate Overheads Absorbed:

Absorbed OH = 18,500 hours × ₹30 = ₹5,55,000

Step 3 — Under/Over Absorption:

Actual OH incurred = ₹5,80,000

Absorbed OH = ₹5,55,000

Difference = ₹5,80,000 − ₹5,55,000 = ₹25,000 (Under Absorbed)

Treatment: Debit ₹25,000 to Costing P&L Account (reduces profit).

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Example 2: ABC vs Traditional Absorption

Ms. Iyer's factory makes two products — Product A (high volume, simple) and Product B (low volume, complex). Overhead data:

| Activity Pool | Cost | Driver | Product A | Product B |

|---|---|---|---|---|

| Machine setup | ₹1,20,000 | No. of setups | 10 | 30 |

| Quality inspection | ₹80,000 | No. of inspections | 20 | 60 |

Total setups = 40; Total inspections = 80

ABC Rates:

  • Setup rate = ₹1,20,000 ÷ 40 = ₹3,000 per setup
  • Inspection rate = ₹80,000 ÷ 80 = ₹1,000 per inspection

OH charged to Product B:

  • Setups: 30 × ₹3,000 = ₹90,000
  • Inspections: 60 × ₹1,000 = ₹60,000
  • Total ABC overhead for Product B = ₹1,50,000

Under traditional absorption (single OAR based on units), Product A would cross-subsidise Product B. ABC reveals Product B's true cost — a classic exam discussion point.

⚠️ Common exam mistakes

  • Confusing allocation, apportionment, and absorption: Students mix these up. Allocation = directly assigning an overhead to one cost centre. Apportionment = sharing overheads across multiple cost centres. Absorption = charging overheads from cost centres to products. These are three separate steps.
  • Using actual figures to calculate OAR: Don't use actual overheads or actual activity in the OAR formula — always use budgeted figures. OAR is a predetermined rate set before the year begins.
  • Getting under/over absorption treatment backwards: If absorbed > actual → over absorption → credit to P&L (good, profit goes up). Students often reverse this. Remember: over = excess charged = give it back.
  • Picking the wrong absorption base: In a question about a mechanised factory, don't use Labour Hour Rate — use Machine Hour Rate. The exam question usually signals which base is appropriate through context clues (% of machine usage, labour as minor cost, etc.).
  • In ABC problems, confusing cost pool with cost driver: A cost pool is the overhead bucket (e.g., setup costs ₹1,20,000). A cost driver is the measure used to allocate it (e.g., number of setups). The rate = pool ÷ total driver quantity. Don't divide by rupees or units of output unless that's explicitly the driver.
📖 Reference: Absorption — Institute of Chartered Accountants of India
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