Definition
Overhead absorption is the method of charging indirect production costs, such as factory rent, supervision and machine depreciation, to products using a predetermined rate per unit of activity, for example per direct labour hour or machine hour. The rate is set from budgets so that product costs are known as production happens, not months later.
How it works
The predetermined rate is budgeted overhead divided by budgeted activity. Each job or batch is then charged the rate times the actual activity it used. Choose the base that best drives the overhead: machine hours in an automated plant, labour hours in a workshop.
Because budgets are never exact, absorbed overhead differs from actual overhead at period end. If more was absorbed than spent, overhead is over-absorbed; if less, under-absorbed. The difference is usually charged to cost of goods sold, or prorated across WIP, finished goods and cost of sales when it is material.
In Ledgeriano production orders absorb overhead at predetermined rates based on labour hours, machine hours, labour cost or units, and overhead closing moves the under- or over-applied balance to cost of goods sold or prorates it. When products use support activities very differently, consider activity-based costing.
Formula
Absorption rate = Budgeted overhead ÷ Budgeted activity
Absorbed overhead = Rate × Actual activity
Under/(over) absorbed = Actual overhead - Absorbed overhead
Example: a labour-hour rate
A factory budgets overhead of 480,000 and 24,000 direct labour hours, so the rate is 20 per hour. During the year it works 25,000 hours and spends 490,000 on overhead.
Absorbed overhead is 25,000 × 20 = 500,000. Overhead is over-absorbed by 10,000, which reduces cost of goods sold at year end.