Overhead Absorption

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on August 26, 2021

Overhead Absorption: Definition

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.

Overhead Absorption: Explanation

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.

Steps Involved in Overhead Absorption

There are three essential steps for overhead absorption. These are:

  • Determination of absorption bases
  • Working out the overhead absorption rate
  • Application of overhead to products at this worked-out rate

Methods to Calculate the Overhead Absorption Rate

Various methods exist to calculate overhead absorption. Using these methods, overheads are recovered, charged to, or absorbed in the factory cost.

1. Rate Per Unit of Output

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.

Formula

The overhead absorption rate is calculated as follows:
Overhead absorption rate per unit = Total estimated overheads / Total estimated units of output

Example

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.

2. Percentage of Direct Material Cost

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:

  • Prices of materials don’t fluctuate
  • The product is uniform in all respects
  • Material cost constitutes a significant proportion of the total cost

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.

Formula

The rate is calculated as follows:
Overhead absorption rate = (Total estimated overheads / Total direct material cost for all production ) x 100

Example

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.

3. Percentage of Direct Labor Cost

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 direct labor cost constitutes a major proportion of the total cost
  • Labor rates do not fluctuate widely
  • Workers have the same efficiency
  • Production is uniform

Formula

The rate is calculated as follows:
Overhead absorption rate (%) = (Total estimated overhead / Total estimated direct wages) x 100

Example

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.

4. Percentage of Prime Cost

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 products are uniform
  • The quantities of direct materials and direct labor are constant

Formula

The rate is calculated as follows:
Overhead absorption rate (%) = (Total estimated overhead / Estimated prime cost) x100

Example

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.

5. Direct Labor Hour Rate

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.

Formula

The rate is calculated as follows:
Overhead absorption rate per direct labor hour = Total estimated overheads / Total estimated direct labor hours for all production

Example

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.

6. Machine Hour Rate

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.

Formula

The rate is calculated as follows:
Overhead rate per machine hour = Total estimated overhead / Total estimated machine hours for all production

Example

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

Application of Overhead Absorption Rates

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.

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