Absorbed Overhead

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Absorbed Overhead?

Absorbed overhead, a frequently used terminology in cost accounting, is the sum of the entire manufacturing overhead implemented to comparable products or other cost objects. This overhead is generally considered in the calculation using a predetermined overhead allocation rate.

Explanation

AAbsorbed overhead means the total amount ofIndirect 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.read more 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.read more, which has been assigned to various cost objects. Indirect cost is the type of cost we cannot directly trace to a product or an activity. A cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. read moreCost objectsCost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. read more are various attributes for which cost is generally calculated, like customers, products, product lines, distribution channelsDistribution ChannelsA distribution channel is a network of intermediaries that facilitates product delivery from the manufacturer to the end consumer and transfers payments from the buyer to the producer. In other words, it is the route through which a product travels from the production end to the point of consumption. read more, 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.read more is a set requirement by both GAAP and IFRS. It is done to include the entire cost of overheads in the inventory details shown in the books of accounts of the business.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Formula

Absorbed Overhead

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Absorbed Overhead (wallstreetmojo.com)

The formula of absorbed overhead is as follows:

We can have 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.

You can download this Absorbed Overhead Excel Template here – Absorbed Overhead Excel Template

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.read more 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

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:

Example 1

Fixed absorbed overhead rate = $8000/1000 = $8 per machine hour

Absorbed Overhead Example 1.1

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:

Methods

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Absorbed Overhead (wallstreetmojo.com)

#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.read more serves as the basis of absorption. It is calculated by the formula given below. This method is suitable when the material price 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.read more serves as the basis of absorption. It is calculated by the formula given below. This method is suitable when wages do not vary significantly or where direct wages form the major cost component. Also, this method is applied when there is 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 department’s direct material and direct labor costs. 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. This method is best for cases when production is carried out manually or even for cases where production is not uniform. The formula is as follows:

Labor Hour Rate = Factory Overhead / Labor Hours

#5 – Machine Hour Rate Method

This applies 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 budgetOverhead BudgetOverhead Budget is prepared to forecast and present all the expected costs concerning manufacturing the goods that the company expects to incur in the next year. It excludes the direct material and the direct labor cost and the information of which becomes part of the cost of the goods sold in the master budget.read more is divided by the sales price per production unit. The formula for the same is as follows:

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

Advantages of Absorbed Overhead

Disadvantages of Absorbed Overhead

Recommended Articles

This has been a guide to Absorbed Overhead and its definition. Here we discuss the formula to calculate fixed, variable absorbed overhead rate along with its example and methods. You can learn more about it from the following articles –