Overhead absorption and normal capacity

Overhead absorption at different levels of output

A plant has fixed production overheads of 1,200,000 a year and a normal capacity, the production it expects to achieve on average over a number of periods under normal circumstances, of 100,000 units. The fixed overhead rate is therefore 12 per unit.

In the low-output year, the factory still incurs 1,200,000 of fixed costs but makes only 75,000 units. Charging 16 per unit would load the cost of idle capacity onto the stock and defer it to a future period when the goods are sold. IAS 2 prevents this: the rate stays at 12 and 300,000 is expensed now. In the high-output year, the rate falls to 10 so the total absorbed does not exceed the overheads actually incurred.

How is normal capacity set?

As the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the capacity lost through planned maintenance. Actual production may be used if it approximates normal capacity. Normal capacity is not the plant's maximum theoretical output, which is never achieved, nor simply this year's output, which would defeat the purpose in a downturn.

What if the plant shuts down unexpectedly?

If a plant stops for a month because of a fire or a supply failure, the fixed overheads of that month are abnormal idle-capacity costs, expensed as incurred. Planned maintenance shutdowns are different: they are part of normal operations and already reflected in normal capacity, so overheads continue to be absorbed through the year's normal output.

How does this work in interim reports?

IAS 34 applies the same principles at interim dates as at the year end, so a seasonal manufacturer with low output in one quarter expenses that quarter's unabsorbed overheads; deferring variances expected to be absorbed later in the year is not appropriate. US GAAP differs: planned variances expected to be absorbed by year end are usually deferred at interim dates.

How are variable overheads treated?

Variable production overheads, such as power used by machines and indirect materials, vary with output, so they are allocated on the basis of the actual use of the production facilities. There is no unabsorbed variable overhead problem: if the plant makes fewer units, it incurs less variable overhead.

Which overheads are production overheads?

• Included: factory depreciation and maintenance, factory management and supervision, factory rent and rates, quality control, production planning.
• Excluded: general administration, selling and distribution, storage of finished goods unless necessary in the production process, and abnormal waste.

Shared costs, such as a site's IT or HR, are split between production and administration on a reasonable basis.

Why does this matter most in a downturn?

Because output falls below normal capacity, unabsorbed overheads hit profit immediately rather than being carried in inventory. A manufacturer that kept its overhead rate fixed but ignored lower output, or quietly lowered its normal capacity, would overstate inventory and profit. A sustained fall in demand may justify revising normal capacity, but only when the lower level is expected to persist.

Where to go next

See standard costing and variances, IAS 2 explained and manufacturing accounting.

This guide is general information. It is not tax or legal advice for your situation.