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How does absorption costing attach fixed production overhead to each unit, and how is the overhead absorption rate applied?

Prepare an absorption costing statement and explain how fixed production overhead is absorbed into unit cost

A focused answer to the H2 Principles of Accounting outcome on absorption costing. The full production cost per unit, the overhead absorption rate, valuing inventory at full cost, and the absorption costing profit statement.

Generated by Claude Opus 4.810 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to prepare an absorption costing profit statement and to explain how fixed production overhead is absorbed into the cost of each unit. Absorption costing is the method used for external financial reporting, because it values inventory at full production cost. The central insight is that absorption costing spreads fixed production overhead across units using a predetermined rate, so each unit carries a share of fixed cost and unsold units carry that share into inventory.

The answer

Full production cost

Absorption costing builds a full production cost per unit by adding a share of fixed production overhead to the variable cost:

\text{Full cost per unit} = \text{variable production cost} + \text{absorbed fixed overhead per unit}

Inventory is valued at this full cost, so some fixed overhead is carried forward in unsold units rather than expensed in the period.

The overhead absorption rate

Fixed overhead is shared out using a predetermined absorption rate, set in advance from the budget:

\text{Absorption rate} = \frac{\text{budgeted fixed production overhead}}{\text{budgeted activity}}

Activity may be units, labour hours or machine hours, whichever best reflects how overhead is incurred. The overhead absorbed into production is then the rate times the actual activity.

Over- and under-absorption

Because the rate is predetermined, the overhead absorbed rarely matches the actual overhead incurred:

Over-absorbed (absorbed more than actual): the excess is credited to the income statement, raising profit.
Under-absorbed (absorbed less than actual): the shortfall is debited to the income statement, lowering profit.

This adjustment ensures the actual overhead is ultimately charged, correcting the estimate built into the predetermined rate.

The profit statement layout

An absorption costing statement deducts the full cost of sales from sales to give gross profit, then adjusts for any over- or under-absorption, then deducts non-production costs:

Line
Sales	$X$
Less cost of sales (at full cost)	$(X)$
Gross profit	$X$
Adjust over/(under) absorption	$\pm$
Less non-production costs	$(X)$
Profit	$X$

Worked example

Budgeted fixed production overhead is $\$ 300,000 $for budgeted output of$ 25,000 $units. Variable production cost is$ \ $20$ per unit. The firm produces $25\,000$ units and sells $22\,000$ at $\$ 45 $. Actual fixed overhead was$ \ $310\,000$ . Prepare the absorption costing result.

Step 1: Absorption rate and full cost

Rate $= \dfrac{300\,000}{25\,000} = \$ 12 $per unit. Full cost$ = 20 + 12 = \ $32$ per unit.

Step 2: Overhead absorbed and the adjustment

Overhead absorbed $= 25\,000 \times 12 = \$ 300,000 $. Actual overhead$ = \ $310\,000$ , so $\$ 10,000$ is under-absorbed (debit to income statement, reducing profit).

Step 3: Gross profit on units sold

Sales $= 22\,000 \times 45 = \$ 990,000 $. Cost of sales$ = 22,000 \times 32 = \ $704\,000$ . Gross profit $= 990\,000 - 704\,000 = \$ 286,000$.

Step 4: Adjust and state profit

Less under-absorption $\$ 10,000 $: profit$ = 286,000 - 10,000 = \ $276\,000$ . The $3\,000$ unsold units carry $3\,000 \times 12 = \$ 36,000$ of fixed overhead into closing inventory, so not all fixed overhead hits this period's cost of sales, the defining feature of absorption costing.

Examples in context

Example 1. Why absorption costing is used for reporting. Accounting standards require inventory to be valued at full production cost, including a fair share of fixed production overhead, so that the cost carried forward reflects all the costs of getting the goods ready. Absorption costing meets this requirement, which is why it, rather than marginal costing, is used in the published financial statements, even though marginal costing is preferred for internal decisions.

Example 2. Under-absorption in a quiet period. A factory budgets overhead absorption assuming $30\,000$ units, but a downturn means only $24\,000$ are made. Less overhead is absorbed than incurred, so overhead is under-absorbed and profit is reduced by the shortfall. The adjustment warns management that the fixed cost base was not fully recovered because output fell below plan, a useful signal that capacity was underused.

Try this

Q1. Budgeted overhead is $\$ 180,000 $for$ 15,000$ units. Find the absorption rate per unit. [2 marks]

Cue. $\dfrac{180\,000}{15\,000} = \$ 12$ per unit.

Q2. Overhead absorbed is $\$ 200,000 $but actual overhead is$ \ $190\,000$ . State the over/under-absorption and its effect on profit. [2 marks]

Cue. Over-absorbed by $\$ 10,000 $; credited to the income statement, increasing profit by$ \ $10\,000$ .

Q3. Explain why some fixed overhead is carried in closing inventory under absorption costing. [3 marks]

Cue. Each unit absorbs a share of fixed overhead in its full cost, so unsold units carry that absorbed overhead forward in inventory rather than charging it to this period's cost of sales.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original7 marksBudgeted fixed production overhead is

\

240\,000

and budgeted output is

20\,000

units. A unit uses variable cost of

30

. (a) Calculate the overhead absorption rate per unit. (b) Calculate the full production cost per unit. (c) If

18\,000

units are sold at

\

each (with

20\,000$ produced), prepare the absorption costing profit statement.

Show worked answer →

(a) Overhead absorption rate $= \dfrac{\text{budgeted fixed overhead}}{\text{budgeted output}} = \dfrac{240\,000}{20\,000} = \$ 12 \text{ per unit}$.

(b) Full production cost per unit $=$ variable cost $+$ absorbed fixed overhead $= 30 + 12 = \$ 42$.

Absorption costing statement	$\$ $
Sales ( $18\,000 \times 60$ )	1,080,000
Less cost of sales ( $18\,000 \times 42$ )	(756,000)
Gross profit	324,000
(Over/under absorption: none, actual = budget)	0
Profit	324,000

Closing inventory $= 2\,000$ units at full cost $\$ 42 = \ $84\,000$ is carried forward, so $\$ 24,000 $of fixed overhead ($ 2,000 \times 12$) is held in inventory rather than expensed.

Markers reward the $\$ 12 $absorption rate, full cost of$ \ $42$ , cost of sales on units sold, and a profit of $\$ 324,000$ with fixed overhead carried in inventory.

Original5 marksExplain what is meant by over-absorption and under-absorption of fixed overhead and how each is treated in the income statement.

Show worked answer →

Overhead is absorbed using a predetermined rate based on budgeted overhead and budgeted activity. Because the rate is set in advance, the overhead absorbed (rate times actual units) rarely equals the actual overhead incurred.

Over-absorption occurs when the overhead absorbed exceeds the actual overhead (for example actual output was higher than budgeted, so too much overhead was charged to units). The excess is credited to the income statement, increasing profit.

Under-absorption occurs when the overhead absorbed is less than the actual overhead (for example output was lower than budgeted). The shortfall is debited to the income statement, reducing profit.

In both cases an adjustment corrects profit so that the actual overhead incurred is ultimately charged. Markers reward the predetermined-rate cause, the direction of each adjustment, and that over-absorption increases profit while under-absorption decreases it.