Overhead absorption is defined as the allotment of overheads to cost units. When the amount of overheads has been determined on the predetermined basis for each cost center, the next step is to charge it to production. This involves taking each cost center and applying its overheads to all the products that pass through it. This application of overheads is called absorption, which can be defined as the charging of overheads to production. All products, jobs, or services pass through one or more producing cost centers. Therefore, it becomes necessary to charge overheads to the cost of products, jobs, and processes according to certain well-established norms and scientific reasoning. This ensures that the cost pertaining to a cost center must be absorbed as per the set norms. The process of such charging to or recovering of the overheads in the cost of production is called overhead absorption. After overheads have been allocated and apportioned to various production departments, the total overhead cost of a production department comprises the following: (i) Expenses allocated to the production department (e.g., salary for department head, salary for departmental foremen, and the cost of indirect materials issued to the department) (ii) Share of the common expenses apportioned to the production department (e.g., factory rent, salary of works manager, and factory utility bills) (iii) Share of the expenses of the personnel department, storehouse, time-keeping department, and others The total amount of overhead accumulated for a production department is ultimately charged to the various cost units of that department. The distribution of the accumulated overhead cost of a production department amongst its cost units is known as overhead absorption. Thus, the absorption of overheads is the function of apportioning overhead costs to individual units, jobs, production lots, processes, work-orders, or such other convenient cost units. It is also known as the recovery or application of overhead expenses to cost units. There are three essential steps for overhead absorption. These are: Various methods exist to calculate overhead absorption. Using these methods, overheads are recovered, charged to, or absorbed in the factory cost. This is the simplest method of overhead absorption. It refers to the application of overheads based on the number of units of output manufactured during the period. This is said to be a direct method of overhead absorption and it is the most convenient method. The overhead rate can be determined by dividing the total estimated overheads of the cost center or job by the total estimated units of output. This method is suitable when the output is uniform in size and quality. The overhead absorption rate is calculated as follows: Overhead absorption rate per unit = Total estimated overheads / Total estimated units of output If the total units produced are 3,000 and the total production overhead on these units is $15,000, then: Rate per unit = Amount of production overhead / Number of units produced Rate per unit = 15,000 / 3,000 = $5 Here, according to this method of overhead absorption, $5 per unit will be taken as factory overhead. Under this method, the total direct material cost for all production is taken as the basis of the overhead absorption rate. This method is suitable when: Usually, the amount of the overheads and the value of direct materials are determined from past experience, and the overhead rate is calculated in advance. The overhead rate is applied to determine the amount of overhead to be charged to a job. The rate is calculated as follows: Overhead absorption rate = (Total estimated overheads / Total direct material cost for all production ) x 100 If the total production overhead is $15,000 and the cost of direct materials is $60,000, then: Rate = (15,000 x 100) / 60,000 = 25% Here, according to this method, the absorption rate will be 25%. If, for example, the direct materials cost of a product is $2,000, then the overhead of (2,000 x 25) / 100 = $500 per unit will be charged to factory cost. This methods benefits from its ease and simplicity. It gives reasonably accurate results when the quality and prices of raw materials do not differ substantially. Ideally, the quantity and cost of materials in each product are uniform, and processing is also uniform. This method of overhead absorption refers to the application of overheads as a percentage of direct labor. This is one of the oldest methods of cost absorption and it is widely regarded as one of the best. The percentage is obtained by dividing the overhead cost by the amount of direct labor. The overhead here is applied by multiplying the obtained percentage by the direct labor cost associated with each product, job, or process. Under this method, the total direct labor cost forms the basis of the overhead absorption rate. This method is suitable when: The rate is calculated as follows: Overhead absorption rate (%) = (Total estimated overhead / Total estimated direct wages) x 100 If the production overhead is $15,000 and the direct labor cost is $30,000, then: Rate (%) = (15,000 x 100) / 30,000 = 50% If a job involves direct wages of $1,000, the overhead to be absorbed amounts to $500 (i.e., 50% of $1,000). This method is usually applied in cases where labor is the main factor in production. It is also applied when the quality, skill, and gender of employees do not differ significantly. This is a simple, easy, and efficient method of overhead absorption. Salaries, rent, insurance, and taxes are examples of the overheads that are related to the time factor. Therefore, using this method for these items yields satisfactory results. The percentage of direct labor cost method of overhead absorption is also useful due to the simple fact that the labor rate, as compared to other rates in the elements of cost, is more stable. Hence, it yields a favorable result. Under this method, prime cost is used as the basis for determining the overhead absorption rate. We know that both direct materials and direct labor determine the nature of overheads. The prime cost, comprising direct materials, direct labor, and direct expenses, is significant in every type of organization. This method is suitable to apply when: The rate is calculated as follows: Overhead absorption rate (%) = (Total estimated overhead / Estimated prime cost) x100 If the production overhead is $1,000 and the prime cost is $4,000, the rate will be: Rate (%) = (1,000 x 100) / 4,000 = 25% If the prime cost of a unit is $200, the absorption rate per unit will be $50. That's to say, it will equal ($200 x 25) / 100, which is $50. This is a simple and easy method. No additional record is required to calculate it. It also considers all direct costs (i.e. materials, labor, and expenses). It is best suited to those units of production where overheads depend on both direct materials and direct labor. Under this method, total direct labor hours are used to determine the overhead absorption rate. This method is suitable for labor-intensive industries in which manual labor is a dominant factor in production. The rate is calculated as follows: Overhead absorption rate per direct labor hour = Total estimated overheads / Total estimated direct labor hours for all production If the overheads amount to $4,000 and labor spent comes to 20,000 hours, then: Rate = 4,000 / 20,000 = $0.2 per hour If 25 hours are spent on a job, then the absorption on the job will be of $0.2 x 25 hours (i.e., $5). This method should be applied when labor is the main factor of production. Total machine hours are used to determine the overhead absorption rate in this method. This is an excellent method for the absorption of overhead costs in industries where much of the work is performed with the help of machines. The rate is calculated as follows: Overhead rate per machine hour = Total estimated overhead / Total estimated machine hours for all production A factory uses 10 machines, each of which runs for 20 hours per day. Also, the total production overhead comes to $20,000. In this case, the machine hour rate is calculated as follows: Machine hour rate = 20,000 / (10 x 20) = $200 Importantly, machine hour rate is always calculated per machine (i.e., not for all machines). Therefore, the correct formula and calculation are as follows: Machine hour rate = Production overhead of one machine / Machine hour of one machine = (20,000 / 10) / 20 = $2,000 / 20 = $10 per hour per machine To apply predetermined absorption rates, the actual value (i.e., the actual number of units or any other actual base data such as direct labor hours or machine hours) is multiplied by the predetermined rate. The product of this calculation will indicate the amount of overhead to be applied (or charged) to production for the period. It is rare for applied overheads to agree with actual overheads; a difference is always likely to exist. If the absorbed amount exceeds the actual overhead, the difference is termed overapplied overhead. If, however, it falls short of the actual overhead, the difference is known as under-applied overhead.Overhead Absorption: Definition
Overhead Absorption: Explanation
Steps Involved in Overhead Absorption
Methods to Calculate the Overhead Absorption Rate
1. Rate Per Unit of Output
Formula
Example
2. Percentage of Direct Material Cost
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Example
3. Percentage of Direct Labor Cost
Formula
Example
4. Percentage of Prime Cost
Formula
Example
5. Direct Labor Hour Rate
Formula
Example
6. Machine Hour Rate
Formula
Example
Application of Overhead Absorption Rates
Overhead Absorption FAQs
Overhead absorption is defined as the allotment of overheads to cost units. When the amount of overheads has been determined on the predetermined basis for each cost center, the next step is to charge it to production.
There are three essential steps for overhead absorption. These are: determination of absorption bases, working out the overhead absorption rate, and application of overhead to products at this worked-out rate.
To apply predetermined absorption rates, the actual value (i.E., The actual number of units or any other actual base data such as direct labor hours or machine hours) is multiplied by the predetermined rate.
1. Rate per unit of output, 2. Percentage of direct Material Cost, 3. Percentage of direct labor cost, 4. Percentage of prime cost, 5. Direct labor hour rate, 6. Machine hour rate
It is rare for applied overheads to agree with actual overheads; a difference is always likely to exist. If the absorbed amount exceeds the actual overhead, the difference is termed overapplied overhead.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
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