Methods of Overhead Absorption

What is overhead absorption?

Overhead absorption is the amount of indirect costs assigned to cost objects. Indirect costs are costs that are not directly traceable to an activity or product. Overhead absorption is a necessary part of the requirement by both the GAAP and IFRS accounting frameworks to include overhead costs in the recorded amount of inventory that is shown in a company's financial statements.

Examples of indirect costs are:

• Selling and marketing costs
• Administrative costs
• Production costs

Selling, marketing, and administrative costs are usually charged to expense in the period incurred. However, indirect production costs are classified as overhead and then charged to products through overhead absorption.
Cost objects are items for which costs are compiled, such as products, product lines, customers, retail stores, and distribution channels.
Overhead absorption involves the following steps:

1. Classify indirect costs. Depending on the type of allocation desired, some costs may be included in overhead and others may not. For example, overhead absorption for a product would not include marketing costs, but marketing costs might be included in an internal cost report for a distribution channel.
2. Aggregate costs. Shift the identified costs into cost pools. Each cost pool should have a different allocation base. Thus, the indirect costs related to a facility might be aggregated into a cost pool that is allocated based on square footage used.
3. Determine allocation base. This is the basis upon which overhead is assigned to a cost object. For example, facility costs may be assigned based on square footage used, while labor-related indirect costs may be assigned based on direct labor used.
4. Assign overhead. Divide the allocation base into the total amount of overhead included in a cost pool to arrive at the overhead rate.

Overhead absorption is based on a combination of the overhead rate and the usage of the allocation base by the cost object. Thus, the allocation of overhead to a product may be based on an overhead rate of $5.00 per direct labor hour used, which can be altered by changing the number of hours used or the amount of overhead cost in the cost pool.
Overhead absorption does not necessarily reflect the exact amount of overhead cost actually incurred during an accounting period, since the overhead rate may be a long-term one that was based on information derived at some point in the past. If so, the amount of overhead absorbed may differ from the amount of overhead actually incurred.

Methods of Overhead Absorption

After allocation and apportionment of overheads to their departments, we have to include it in the cost of production. The process of this is called absorption of overheads. For calculating the total cost of production, overhead is its main part. For including overhead in each unit of production, we have to study the methods of overhead absorption.


Following are the main methods of Overhead Absorption


1. Direct Material Cost Method 

According to the material cost method, we calculate the rate of overhead on the basis of past actual direct material and past actual overheads. For example, past actual direct material's cost is Rs. 10,000 and past actual overhead cost is Rs. 2000. So, Overhead rate will be 20%. If we have obtained any specific order for producing any product, we will include the 20% cost of overhead. For example, we have produced one unit for our customer for this, we have used our Rs. 1000 material. Our overhead cost in it will be Rs. 1000 X 20% = Rs. 200. We this, we need not to go to deep study of calculating each overhead like electricity consumption in this one unit, depreciation for this one unit, salary cost for this one unit and other overhead cost for producing this one unit. Ok.

2. Direct Labour Cost Method 

According to the Direct Labour Cost method, we calculate the rate of overhead on the basis of past actual cost of direct wages and past actual overheads

following is the formula

= Actual Overhead Cost / Direct Labour Cost X 100 

For example, past actual direct wage's cost is Rs. 10,000 and past actual overhead cost is Rs. 2000. So, Overhead rate will be 20%. If we have obtained any specific order for producing any product, we will include the 20% cost of overhead. For example, we have produced one unit for our customer for this, we have paid Rs. 1000 to our laborers for their labour. Our overhead cost in it will be Rs. 1000 X 20% = Rs. 200.

3. Prime Cost Method 

Under prime cost method, we calculate the actual or estimated prime cost in which direct material cost and direct labour cost will be added. We also calculate the budgeted Overhead Cost. After this, we calculate the rate of overhead. On this rate, we absorb our overhead cost on any new production.

Following is the formula of overhead rate

= Budgeted Overhead Expenses / Anticipated Prime Cost 

4. Direct Labour Hour Method 

Under this method of overhead absorption, we calculate the total direct labour hours by using our accounting information. We also see the total cost of overhead in these labour hours. After dividing this overhead cost with direct labour hours, we can easily calculate the rate of overhead. On this rate, we can absorb the estimated amount of overhead in any unit or units of production.

Following is the formula

= Overhead Cost / Direct labour Hours 

For example, total direct labour hours are 10,000. Total overhead cost in these hours are Rs. 5,000. Our overhead rate is the 50% of labour hours in any production.

5.Machine Hour Rate Method 

This is very good method of absorption of overhead cost in the industry where we do all works with the help of machines. We just have to calculate the machine hour rate and same rate will be the overhead rate and on this basis, we can absorb the estimated cost of overhead when we produce any unit of production. Following is the formula of calculating the machine hour rate

= Total Overhead Cost / Total Machine Hours

We have to apportion all the overhead cost on the basis of our machines.

a) Rent Expense

It is divided on the basis of area for each machine.

b) Lighting Expenses 

It is divided on the basis of No. of Points for Each Machine

c) Supervision Cost 

It is divided on the basis of time spent on each machine.

d) Insurance 

It is divided on the basis of value of each machine.

e) Depreciation

It is divided on the basis of cost of each machine.

f) Power

It is divided on the basis of consumption by each machine.

g) Repair

It is divided on the basis of working life of each machine.

Learn more about Machine Hour Rate at
Rate Per Unit of Production Method 

In this method, we calculated estimated overhead rate on the basis of units output and same is used for absorption of actual units of production.

Formula of Rate of Overhead

=Budgeted Overhead Cost / Budgeted Units of Production 


7. Sales Price Method 

Under this method of absorption of overhead, we calculate the rate of overhead on the basis of sales of units and budgeted overhead cost.Same rate is used for absorption.

Formula

= Budgeted Overhead Expenses / Sales of Units of Production