  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.

### Explanation

Absorbed overhead simply means the total amount of , 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. are various attributes for which cost is generally calculated, like customers, products, product lines, distribution channels, etc.

Absorption of 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.

### Formula

For eg:

The formula of absorbed overhead is as follows:

We can have namely two broad types – Fixed and variable absorbed overhead rate.

Fixed Absorbed Overhead Rate = Fixed Overheads / (Output * Machine Hours)

Variable Absorbed Overhead Rate = Variable Overheads / (Output * Machine Hours)

### Example

Let’s take an example.

Let us assume a company manufactures only a single type of product. The company follows a standard 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
• Machine hours = 0.20 hours per unit

Solution:

The total budgeted hours we can calculate as 5000 units * 0.20 hours per unit = 1000 hours

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

There are a total of seven methods of overhead absorption, which are as follows:

For eg:

#### #1 – Direct Material Cost Method

Here the 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.

Direct Material Percentage Rate = (Factory Overhead / Direct Material Cost) * 100

#### #2 – Direct Labor Cost Method

Here the 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.

Direct Labor Percentage Rate = (Factory Overhead /Direct Wages) * 100

#### #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:

Prime Cost Percentage Rate = (Factory Overhead / Prime Cost) * 100

#### #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:

Labor Hour Rate = Factory Overhead / Labor Hours

#### #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:

Machine Hour Rate = Factory Overhead / Machine Hours

#### #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:

Overhead Absorption Rate per Unit = Factory Overhead / Units of Production

#### #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:

Sales Price Recovery Rate = (Factory Overhead / Sales Value Unit of Production) * 100

• It is in line with 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 .