Every factory incurs indirect costs — rent, power, supervisor salaries — and these must be included in product costs. But you can't wait until year-end to know the exact total. So at the start of the year, you calculate a Predetermined Overhead Absorption Rate (OAR):
OAR = Budgeted Overheads ÷ Budgeted Activity Level
The activity level is usually machine hours, labour hours, or units — whichever best drives overhead costs in that factory. Once OAR is set, every unit produced is charged: Absorbed Overhead = OAR × Actual Activity. The problem? Actual overheads and actual activity almost never match the budget perfectly. That gap is called under-absorption or over-absorption.
Under-absorption happens when Absorbed Overhead < Actual Overhead incurred. You recovered less from production than you actually spent — product costs are understated, so it's effectively a loss. Over-absorption is the opposite: Absorbed > Actual, meaning you charged production more than you spent — a gain. Two things cause this gap: (1) actual overheads differing from budget (expenditure variance), and (2) actual activity differing from budget (volume variance). Both can operate simultaneously.
How to treat the difference — ICAI recognises three methods. First, the Supplementary Rate Method: calculate an additional OAR to adjust job costs. Use this when the difference is large and affects closing stock significantly. Second, Transfer to Costing Profit & Loss Account: write off the difference directly. This is the exam default — use it unless the question says otherwise. Third, Carry Forward to Next Period: only acceptable when the difference is due to seasonal fluctuations. For journal entries, remember: under-absorption → debit Costing P&L (loss, you under-recovered). Over-absorption → credit Costing P&L (gain, you over-recovered). This topic is asked frequently as a 5–8 mark numerical or theory question — examiners love asking you to calculate under/over-absorption and state its treatment in the same question. Quick memory hook: Under = Under-recovered = Loss = Dr. Costing P&L. Over = Over-recovered = Gain = Cr. Costing P&L.