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 costIndirect CostIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc., 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 objectsCost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. are various attributes for which cost is generally calculated, like customers, products, product lines, distribution channels, etc.
Absorption of overhead costOverhead CostOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. 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.
Fixed Absorbed Overhead Rate = Fixed Overheads / (Output * Machine Hours)
Variable Absorbed Overhead Rate = Variable Overheads / (Output * Machine Hours)
Let’s take an example.
Let us assume a company manufactures only a single type of product. The company follows a standard absorption costingAbsorption CostingAbsorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period. 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
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 costDirect Material CostDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company. 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 direct labor costDirect Labor CostDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services. 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
Advantages of Absorbed Overhead
- It is in line with GAAP GAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors. 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 statementsIncome StatementsThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements..
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 budgetFlexible BudgetA flexible budget refers to an estimate which varies with the change in production activity or volume. Such a budget is more realistic and flares the managerial efficiency and effectiveness as it sets a benchmark for the actual corporate performance..
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 –