Absorbed Overhead: Definition, Calculation, and Methods

Absorbed overhead refers to the manufacturing overhead costs allocated to a specific product, cost center, or department within an organization. It is a crucial component of absorption costing, a method that assigns all direct and indirect manufacturing costs to the production of goods or services.

Indirect Costs Included in Absorbed Overhead

Absorbed overhead encompasses a wide range of indirect costs incurred during the production process. These costs are not directly tied to a particular product or service but are necessary for the overall manufacturing process. Examples of such costs include:

• Factory rent or property taxes
• Utilities such as electricity, water, and gas
• Depreciation on manufacturing equipment
• Indirect labor costs, such as salaries of factory supervisors
• Insurance and maintenance expenses for the factory

Methods for Calculating Absorbed Overhead

There are several methods for calculating absorbed overhead, each with its own advantages and disadvantages. The choice of method depends on the specific circumstances and the organization’s preferences.

Production Unit Method

The production unit method allocates overhead costs based on the number of units produced. The overhead absorption rate is calculated by dividing the total overhead costs by the number of units produced. This method is straightforward and easy to apply, but it may not accurately reflect the actual overhead costs associated with each unit, especially if the production process is complex or involves multiple products.

Percentage Methods

Percentage methods allocate overhead costs based on a percentage of direct costs, such as direct labor costs, direct material costs, or prime cost (the sum of direct labor and direct material costs). The overhead absorption rate is calculated by dividing the total overhead costs by the total direct costs.

• Percentage of Direct Wages

  This method calculates the overhead absorption rate as a percentage of the direct labor costs incurred during production.

• Percentage of Direct Material Costs

  Similar to the previous method, this method uses direct material costs as the basis for calculating the overhead absorption rate.

• Percentage of Prime Cost

  This method considers both direct labor and direct material costs when calculating the overhead absorption rate.

Percentage methods are relatively simple to apply and provide a more accurate allocation of overhead costs compared to the production unit method, especially when the production process involves multiple products with varying costs.

Hourly Rate Methods

Hourly rate methods allocate overhead costs based on the amount of time spent on production. The overhead absorption rate is calculated by dividing the total overhead costs by the total machine hours or direct labor hours incurred during production.

• Direct Labor Hour Rate

  This method uses direct labor hours as the basis for calculating the overhead absorption rate.

• Machine Hour Rate

  This method uses machine hours as the basis for calculating the overhead absorption rate.

Hourly rate methods are particularly useful when the production process is highly automated or involves significant machine usage. They provide a more accurate allocation of overhead costs compared to the production unit method, especially when the production process involves multiple products with varying production times.

Overabsorption and Underabsorption of Manufacturing Costs

In practice, the amount of overhead assigned to products may not always match the actual overhead costs incurred. This can lead to overabsorption or underabsorption of manufacturing costs.

• Overabsorption

  Occurs when the amount of overhead assigned to products is more than the actual overhead costs incurred. This can result in inflated product costs and potentially lead to overpricing.

• Underabsorption

  Occurs when the amount of overhead assigned to products is less than the actual overhead costs incurred. This can result in understated product costs and potentially lead to underpricing.

Overabsorption and underabsorption can occur due to variations in production levels, changes in actual overhead costs, or inaccurate overhead allocation methods. It is important for organizations to regularly review and adjust their overhead allocation methods to minimize the occurrence of overabsorption or underabsorption.

Conclusion

Absorbed overhead plays a crucial role in absorption costing, providing a comprehensive view of the total cost of producing goods or services. By accurately calculating and allocating absorbed overhead, organizations can make informed decisions regarding product pricing, profitability analysis, and resource allocation. The choice of overhead allocation method depends on various factors, and organizations should select the method that best suits their specific circumstances and objectives.

References

• https://www.superfastcpa.com/what-is-absorbed-overhead-in-accounting/
• https://debitoor.com/dictionary/absorbed-overhead
• https://www.investopedia.com/terms/a/absorptioncosting.asp

FAQs

What is absorbed overhead?

Absorbed overhead refers to the manufacturing overhead costs that are allocated to a specific product, cost center, or department within an organization. It is a key component of absorption costing, a method that assigns all direct and indirect manufacturing costs to the production of goods or services.

What are some examples of indirect costs included in absorbed overhead?

Examples of indirect costs included in absorbed overhead include factory rent or property taxes, utilities, depreciation on manufacturing equipment, indirect labor costs, and insurance and maintenance expenses for the factory.

What are the different methods for calculating absorbed overhead?

There are several methods for calculating absorbed overhead, including the production unit method, percentage methods (percentage of direct wages, percentage of direct material costs, and percentage of prime cost), and hourly rate methods (direct labor hour rate and machine hour rate).

What is the difference between overabsorption and underabsorption of manufacturing costs?

Overabsorption occurs when the amount of overhead assigned to products is more than the actual overhead costs incurred, while underabsorption occurs when the amount of overhead assigned to products is less than the actual overhead costs incurred.

What are the potential consequences of overabsorption and underabsorption?

Overabsorption can lead to inflated product costs and potentially result in overpricing, while underabsorption can lead to understated product costs and potentially result in underpricing.

How can organizations minimize the occurrence of overabsorption and underabsorption?

Organizations can minimize the occurrence of overabsorption and underabsorption by regularly reviewing and adjusting their overhead allocation methods, accurately estimating overhead costs, and monitoring production levels and actual overhead costs.

When is absorption costing used?

Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements, as it complies with generally accepted accounting principles (GAAP).

What are the advantages of absorption costing?

Advantages of absorption costing include providing a more complete picture of the total cost of a product by including both direct and indirect costs, helping to determine the total actual cost of goods sold and the cost of inventory on the balance sheet, and allowing a company to understand the full cost of each product or service it provides.