Overhead absorption is the name given to the process of absorbing the overhead of a business into the cost of its products. The process allows the total product cost to be used by the business in making decisions about pricing, profitability and inventory valuations.
Difference Between Overhead Absorption, Allocation and Apportionment
In order to understand cost absorption, it is necessary to distinguish it from overhead allocation, and apportionment. Overhead allocation is used to allocate overhead that is specifically identified with a cost center to that cost center, apportionment is used to apportion overhead costs between cost centers, and absorption is used to absorb the overhead into the total cost of its products.
In the diagram, the overhead cost which has previously been allocated to the general overhead cost center, is apportioned between the two production departments shown as the manufacturing and finishing departments. The overheads from the manufacturing and finishing departments are then absorbed into the production units.
How to Calculate Absorption Cost
The process of overhead absorption involves four steps.
- Estimate overhead using a budget for the accounting period.
- Choose an appropriate absorption base. An overhead absorption base is the basis used by a business to absorb its overhead costs into the cost of its products.
The absorption base is usually a quantity such as direct labor hours, direct labor cost, machine hours or material cost. The base used should be appropriate for the overhead cost to ensure that the cost is fairly absorbed between products.
- Determine the overhead rate using the absorption rate formula. Having decided on an appropriate base, using the budgeted overhead, a predetermined overhead rate can be calculated using the absorption rate formula below.
Overhead rate = Overhead cost / Total base quantity
- Apply the overhead Finally, the overhead is applied to the product cost by multiplying the base quantity used to manufacture the product by the calculated overhead rate.
Overhead absorbed = Product base quantity x Overhead rate
Overhead Absorption Example
Suppose a business budgets its annual overhead at 75,000 for the accounting period. The business applies overhead to its products using direct labor hours as the absorption base, and budgets for 30,000 direct labor hours for the same accounting period.
The business makes two products A and B. Product A uses 3.50 direct labor hours and product B uses 8.50 direct labor hours during manufacture.
- Estimate overhead
The overhead to be allocated is estimated using the budget as 75,000
- Choose an appropriate absorption base
The absorption base in this case is direct labor hours. For the accounting period the total base quantity is 30,000 direct labor hours.
- Determine the overhead rate
Using the overhead rate formula, the overhead rate is calculated as follows.
Overhead rate = Overhead cost / Total base quantity Overhead rate = 75,000 / 30,000 Overhead rate = 2.50
The overhead rate calculation shows that the overhead should be allocated to the products at the rate of 2.50 for each direct labor hour used in the manufacture of the product.
- Apply the overhead
Using the predetermined overhead absorption rate, the overhead can be now be applied to each of the products based on direct labor hours.
Overhead absorption = Product base quantity x Overhead rate Product A Overhead absorption = 3.50 x 2.50 = 8.75 Product B Overhead absorption = 8.50 x 2.50 = 21.25
For each unit of product A, overhead of 8.75 is included in the total cost of the product, and for each unit of product B, overhead of 21.25 is included in the total cost.
Advantages and Disadvantages of Absorption
The advantage of overhead absorption is that it allows the total cost of manufacturing a product to be used to make decisions about pricing, and assessment of the profitability of different products. In addition, as the product cost now includes absorbed overhead, any products not sold at the end of the accounting period and included in inventory, also include a proportion of the overhead cost allowing it to be matched against the revenue from future sales.
The main disadvantage of overhead absorption is that the mechanism used to apply it (the absorption base) is a matter of judgment and arbitrary in nature.
Suppose in the above example the absorption base was machine hours instead of direct labor hours used in manufacture of the product, the absorbed overhead per unit of product would change. If product A with its lower labor cost, used a larger number of machine hours than product B, then more overhead would have been absorbed into product A than product B, giving the opposite result to that shown above. Clearly, the absorption base must be reviewed regularly and be appropriate for the type of product and overhead involved.
Overhead Absorption Rate Calculator
Our overhead recovery rate calculator can be used to determine the amount of overhead to be absorbed by a product based on details of the budgeted overhead and the absorption base units.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.