Prepare absorption costs and explain overhead differences
Use absorbed fixed production overhead in unit and profit statements, calculate under- or over-absorption, and interpret the results with their limitations.
Section 2.2 · Traditional costing methods
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. These original lessons cover Topic 2.2.1–2.2.4: unit, job and batch costing; absorption costing and overheads; marginal costing, contribution and break-even analysis; and cost–volume–profit decisions. Practice is self-checked, not an official Cambridge grade; full timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Know the difference between direct and indirect costs and between fixed and variable cost behaviour. Keep units, production volume, overhead rates and relevant ranges visible in calculations.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
What is the absorption-costing unit cost if direct production cost is $14 and overhead absorbed per unit is $6?
What you will learn
- Calculate under- and over-absorption from actual and absorbed overhead
- Prepare an absorption-costing profit statement
- Explain uses, limitations and relevant non-financial factors
Compare overhead incurred with overhead absorbed
Overhead absorbed = OAR × actual activity. If actual production overhead is greater than the amount absorbed, the difference is under-absorption; if actual overhead is lower, the difference is over-absorption. The difference may arise because activity, spending or the absorption estimate differs from budget.
A costing statement adds production overhead to direct production cost. An absorption-costing profit statement includes fixed production overhead in inventory cost and cost of sales. Use the rate and capacity basis specified; do not confuse absorbed overhead with actual cash paid in the period.
Interpret full production cost with context
Absorption costing can support inventory valuation for internal costing, longer-term pricing and understanding the resources required to make a product. A full unit cost can be useful where fixed production resources need to be recovered over normal output.
A full average cost can hide unused capacity, cost drivers or demand. An overhead rate based on a different activity level changes the apparent unit cost. Consider relevant output, product quality, delivery reliability, waste, staff capacity and customer service alongside the statement; a higher cost does not by itself prove inefficiency.
Pause and explain
Which can cause actual overhead and absorbed overhead to differ?
Worked example
Budgeted overhead is $48,000 for 4,000 machine hours. Actual activity is 4,600 hours and actual overhead is $56,000. Calculate absorbed overhead and under- or over-absorption. Then calculate the absorption unit cost if direct production cost is $12 per unit and one machine hour is used per unit.
Show the worked solution
- OAR = $48,000 ÷ 4,000 = $12 per machine hour.
- Absorbed overhead = 4,600 × $12 = $55,200; actual overhead exceeds absorption by $800, so overhead is under-absorbed by $800.
- With one machine hour per unit, overhead absorbed per unit is $12; absorption unit cost = $12 direct cost + $12 overhead = $24.
Answer OAR $12 per machine hour; absorbed overhead $55,200; under-absorption $800; absorption unit cost $24.
Try a topic test
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Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
Actual overhead is $72,600 and absorbed overhead is $68,000. State the amount and direction of the difference. Then give two possible causes to investigate.
Give me a hint
Compare actual cost with absorbed cost, then distinguish spending from activity effects.
Compare my reasoning
- Difference = 72,600 − 68,000 = $4,600 under-absorbed.
- Actual overhead spending may have exceeded budget because of prices, maintenance or energy use.
- Actual activity may differ from the budgeted level; the rate or cost driver may also be inappropriate.
Under-absorption is $4,600. Investigate spending changes, actual activity and whether the chosen absorption basis reflects overhead use.
Look for these in your work
- Difference magnitude correct
- Direction correct
- More than one cause considered
A company makes 5,000 units and sells 4,400. Fixed production overhead is $30,000, variable manufacturing cost is $12 per unit, selling price is $30, variable selling cost is $2 per unit, fixed selling cost is $8,000 and administration is $20,000. There is no opening inventory. Prepare the absorption-costing profit and calculate the closing inventory value.
Give me a hint
Absorb production overhead over units made; cost of sales uses units sold.
Compare my reasoning
- Fixed overhead per unit = 30,000 ÷ 5,000 = $6; absorption production cost = $12 + $6 = $18 per unit.
- Sales = 4,400 × $30 = $132,000; cost of sales = 4,400 × $18 = $79,200; gross profit = $52,800.
- Variable selling = $8,800; profit = 52,800 − 8,800 − 8,000 − 20,000 = $16,000. Closing stock = 600 × $18 = $10,800.
Absorption profit $16,000; closing inventory 600 units valued at $10,800.
Look for these in your work
- Fixed production overhead absorbed per unit
- Cost of sales based on sales quantity
- Closing stock valued at full production cost
A product manager reports that a unit's absorption cost rose after output fell, while total fixed factory overhead stayed unchanged. Explain the likely reason and give one risk of using the higher unit cost alone to set a price.
Give me a hint
Consider the denominator used to spread fixed overhead.
Compare my reasoning
- Lower output spreads the same fixed production overhead across fewer units.
- The average unit cost rises even though total fixed overhead did not; variable cost or efficiency may not have changed.
- A price based only on the higher average may exceed customer willingness to pay or ignore the contribution and spare-capacity context.
The higher cost may be a fixed-overhead allocation effect from lower output. Check demand, variable costs, spare capacity and competitor prices before changing the selling price; the average cost alone does not determine a viable price.
Look for these in your work
- Denominator effect explained
- Total fixed cost separated from unit cost
- Pricing context considered
Common mistakes
- Calling overhead under-absorbed when absorbed overhead is greater than actual overhead
- Adding the entire period's fixed overhead to each unit
- Treating an estimated full cost as the only relevant cost for every decision
What can you explain now?
Actual overhead is $38,000 and absorbed overhead is $41,000. What is the difference?
Compare with the explanation
Over-absorbed by $3,000
More overhead was charged to output than was incurred.
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Make it stick
How do you identify under-absorption, and what production costs are included in absorption unit cost?
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.