What is Absorbed Overhead?
Absorbed overhead, a frequently used terminology in cost accounting, is defined as the the sum of the entire manufacturing overhead that has been implemented to the relative products or other cost objects and this overhead is generally considered into the calculation by using a predetermined overhead allocation rate.
Absorbed overhead simply means the total amount of indirect cost, which has been assigned to various cost objects. Indirect cost is the type of cost that we cannot directly trace to a product or an activity. Cost objects are various attributes for which cost is generally calculated, like customers, products, product lines, distribution channels, etc.
Absorption of overhead cost is a set requirement by both GAAP and IFRS. This is done to include the entire cost of overheads in the inventory details shown in the books of accounts of the business.
The formula of absorbed overhead is as follows:
We can have namely two broad types – Fixed and variable absorbed overhead rate.
Let’s take an example.
Let us assume a company manufactures only a single type of product. The company follows a standard absorption costing system and goes for the absorption of production overhead based on its machine-hours utilized. The budgeted details from the last year are mentioned as follows:
- Output generated = 5000 units
- Variable overheads = $10,000
- Fixed overheads = $8,000
- Machine hours = 0.20 hours per unit
The total budgeted hours we can calculate as 5000 units * 0.20 hours per unit = 1000 hours
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To calculate the absorption rates now let us use the fixed and variable absorption overhead formulas which are as follows:
Fixed absorbed overhead rate = $8000/1000 = $8 per machine hour
Variable absorbed overhead rate = $10,000/1000 = $10 per machine hour
Thus, to arrive at a standard cost per unit:
- Fixed overhead = 0.2 *8 = $1.6 / unit
- Variable overhead = 0.2*10 = $2 / unit
Methods of Absorbed Overhead
There are a total of seven methods of overhead absorption, which are as follows:
#1 – Direct Material Cost Method
Here the direct material cost serves as the basis of absorption. This is calculated by the formula given below. This method is suitable when the price of material does not vary a lot or where material cost forms the major cost component.
#2 – Direct Labor Cost Method
Here the direct labor cost serves as the basis of absorption. This is calculated by the formula given below. This method is suitable when wages do not vary a lot or where direct wages form the major cost component. Also, this method is applied when there are efficiency and productivity in the workforce.
#3 – Prime Cost Percentage Method
Here the overhead is divided by the sum of the direct material and direct labor cost of the department. This method is simple and easy to calculate. The formula for the same is as below:
#4 – Direct Labor Hour Method
This is calculated by dividing the factory overhead by direct labor hours, and this method is best for cases when production is carried manually or even for then cases where production is not uniform. The formula is as follows:
#5 – Machine Hour Rate Method
This is applicable to those industries where the manual job is negligible, and machines are extensively used for production. The formula goes as follows:
#6 – Rate per Unit Production Method
This is used in industries where the output is measured in physical units like weight or some numbers. This is applicable in cases where only one type of product is being produced, and production is uniform. The formula for the same is as follows:
#7 – Sales Price Method
Under this method, the overhead budget is divided by the sales price per unit of production. The formula for the same is as follows:
Advantages of Absorbed Overhead
- It is in line with GAAP and gives more accurate results than the variable costing method.
- It considers all production costs and not like the variable costing methods where only variable cost is considered.
- When production is done to have sales in the future, it will show better results than variable costing.
- It eradicates the separation of cost into fixed and variable elements.
- It helps to calculate gross and net profit separately in income statements.
Disadvantages of Absorbed Overhead
- It is difficult to compare and to control the cost.
- It is not helpful in managerial decisions where decisions related to the selection of product mix or decision to buy or manufacture need to be taken.
- Some criticize this method because of the inclusion of fixed cost, too, which is not justified.
- Here the fixed overheads are apportioned by arbitrary methods.
- It is not helpful in the preparation of a flexible budget.
This has been a guide to Absorbed Overhead and its definition. Here we discuss formula to calculate fixed and variable absorbed overhead rate along with its example and methods. You can learn more about from the following articles –