Overhead incurred is the indirect costs that an entity actually experiences during a reporting period. These costs are accumulated in an overhead cost pool.
Overhead absorbed is the amount of overhead allocated to products and services. Overhead incurred does not necessarily match the amount of overhead absorbed. There are two scenarios for allocating overhead, which are:
- Allocate actual costs. If an entity allocates all of the contents of its overhead cost pool, the amount of overhead incurred always matches the amount of overhead absorbed.
- Allocate standard costs. An entity may attempt to smooth out the allocation rate from period to period by adopting a standard allocation rate that is based on a standard amount of overhead costs that probably has some basis in recent historical experience. This allocation almost certainly will vary from the actual amount of overhead incurred in a reporting period.
In the latter case, if the variance is small, you can charge the difference to the cost of goods sold. If the variance is larger, it is more correct to allocate the difference between inventory and the cost of goods sold.
For example, Lumens Lighting experiences overhead incurred of $15,000, which it stores in an overhead cost pool. Lumens uses a standard overhead rate of $0.30 per unit, which approximates its long-term experience with the relationship between overhead costs and production volumes. In March, it produces 45,000 units, to which it allocates $13,500 (allocation rate of $0.30 x 45,000 units). This leaves a difference between overhead incurred and overhead absorbed of $1,500. Given the small size of the variance, Lumens charges the $1,500 difference to the cost of goods sold, thereby clearing out the overhead cost pool.