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Overhead absorption rates and over- or under-absorption
Edexcel IAL Accounting · WAC11 The Accounting System and Costing
An overhead absorption rate (OAR) charges each department's overheads to products. Because it is set from budgets, actual overheads absorbed rarely equal actual overheads incurred (spec 1.4.10 and 1.4.11).
Machine hour and labour hour rates
OAR = budgeted overheads / budgeted activity, set at the start of the period.
- Machine hour rate: for machine-intensive departments, where overheads (power, depreciation, maintenance) depend on machine time.
- Direct labour hour rate: for labour-intensive departments.
Each department has its own rate. The 2024 examiners' report noted some candidates added labour hours and machine hours together as one divisor: never do this; use the one basis that suits each department.
| Machining | Assembly | |
|---|---|---|
| Budgeted overheads | £96,000 | £72,000 |
| Budgeted activity | 12,000 machine hours | 18,000 labour hours |
| OAR | £8.00 per machine hour | £4.00 per labour hour |
Over- and under-absorption
Overheads absorbed = OAR x actual activity. Compare with actual overheads:
- Absorbed > actual: over-absorbed (over-recovered). Products were charged too much; the difference is added to profit at the period end.
- Absorbed < actual: under-absorbed. The difference is an extra expense reducing profit.
Causes: actual overheads different from budget, and/or actual activity different from budget.
| Machining £ | Assembly £ | |
|---|---|---|
| Overheads absorbed | 102,400 (12,800 x £8) | 68,800 (17,200 x £4) |
| Actual overheads | 99,500 | 70,100 |
| Over / (under) absorbed | 2,900 | (1,300) |
Using absorption rates
OARs let a business cost a job or product as soon as it is made, without waiting for actual overhead totals at the year end; this supports pricing and quotes. Limitations: rates are based on estimates, the choice of basis is a judgement, and fixed overheads absorbed per unit change if activity changes. The June 2024 examiners' report noted that over- or under-recovery was often not attempted: practise it.
Worked example
Find the over- or under-absorption in each department.
- Machining: absorbed 102,400, actual 99,500: over-absorbed by 2,900.
- Assembly: absorbed 68,800, actual 70,100: under-absorbed by 1,300.
Answer: Machining over-absorbed £2,900 (add to profit); Assembly under-absorbed £1,300 (extra expense).
Check yourself
- A department's budgeted overheads are £135,000 and budgeted machine hours are 9,000. Calculate the machine hour rate.
Show answer
£15.00. 135,000 / 9,000 = £15.00 per machine hour.
- The OAR is £6.50 per direct labour hour. Actual direct labour hours were 14,200. Calculate the overheads absorbed.
Show answer
£92300. 6.50 x 14,200 = 92,300.
- Overheads absorbed were £92,300 and actual overheads were £88,750. By how much were overheads over-absorbed?
Show answer
£3550. 92,300 - 88,750 = 3,550, added to profit.
- Budgeted overheads £60,000; budgeted labour hours 15,000. Actual hours 13,800; actual overheads £61,200. Calculate the under-absorption.
Show answer
£6000. OAR £4; absorbed 4 x 13,800 = 55,200; under-absorbed = 61,200 - 55,200 = 6,000.
- A department is highly automated, with a few staff supervising many machines. Which absorption basis is most suitable?
- Machine hours
- Direct labour hours
- Machine hours plus labour hours added together
- Number of employees
Show answer
Machine hours. Overheads are driven by machine time.
- Overheads have been under-absorbed. How is this treated at the end of the period?
- As extra income, increasing profit
- Added to closing inventory
- As an additional expense, reducing profit
- Ignored, as it is only an estimate
Show answer
As an additional expense, reducing profit. Products were undercharged, so the shortfall is charged against profit.
Sources
Last updated 8 November 2026. Spotted a mistake? Tell us.