What is Absorbed Overhead?
Absorbed overhead is the amount of overhead cost that is allocated to the production of goods in a particular accounting period, using the absorption costing technique. This method distributes indirect costs (such as utilities, rent, and administrative costs) proportionately to each unit or batch of production, based on an absorption rate that is predetermined. This cost allocation helps in estimating the actual cost of production more accurately and ensures that all overhead costs are accounted for in the valuation of the inventory and cost of goods sold.
Calculation of Absorbed Overhead:
\[ \text{Absorbed Overhead} = \text{Actual Production} \times \text{Absorption Rate} \]
The absorption rate is often determined at the beginning of an accounting period and may be based on estimated or historical data.
Examples of Absorbed Overhead
Example 1: A factory has decided its annual overhead costs (e.g., salaries of supervisors, factory rent, machinery depreciation) are approximately $120,000. If the factory expects to produce 10,000 units in the year, the absorption rate would be:
\[ \text{Absorption Rate} = \frac{$120,000}{10,000 \text{ units}} = $12 \text{ per unit} \]
If the factory produces 800 units in a month, the absorbed overhead for that month would be calculated as:
\[ \text{Absorbed Overhead} = 800 \text{ units} \times $12 \text{ per unit} = $9,600 \]
Example 2: A service company projects its overhead costs to be $200,000 annually, and it is expected to work for 20,000 billable hours. The absorption rate per billable hour is:
\[ \text{Absorption Rate} = \frac{$200,000}{20,000 \text{ hours}} = $10 \text{ per hour} \]
For a project demanding 250 hours, the absorbed overhead will be:
\[ \text{Absorbed Overhead} = 250 \text{ hours} \times $10 \text{ per hour} = $2,500 \]
Frequently Asked Questions (FAQs)
What is the difference between absorbed overhead and actual overhead?
Absorbed overhead is the estimated allocation of overhead costs to products, while actual overhead refers to the real indirect costs incurred during production.
Why is absorption costing important?
Absorption costing ensures that all overhead costs are captured in product costing, which aids in accurate pricing, inventory valuation, and financial reporting.
How is the absorption rate determined?
The absorption rate is typically calculated based on historical data, estimated overhead costs, and expected production volumes for a future period.
Can absorption costing result in under/over absorption of overhead?
Yes, if there is a difference between the actual overhead incurred and the absorbed overhead, it can lead to under-absorption (actual overhead > absorbed overhead) or over-absorption (actual overhead < absorbed overhead).
What is an overhead absorption rate?
The overhead absorption rate is the predetermined rate used to allocate overhead costs to products, based on a cost driver such as machine hours, labor hours, or units produced.
Related Terms
- Overhead Costs: Indirect costs associated with production that cannot be directly traced to specific units like utilities, rent, and administrative salaries.
- Absorption Costing: A costing method that assigns all manufacturing costs to products, including both variable and fixed overhead costs.
- Production Costs: Total costs incurred during the process of producing goods or services, including direct materials, direct labor, and overhead.
- Absorption Rate: The rate used to assign overhead costs to products, often based on estimates or historical data.
Online References
- Investopedia on Absorption Costing
- AccountingTools - Absorbed Overhead
- Corporate Finance Institute - Absorption Overhead
Suggested Books for Further Studies
- “Managerial Accounting” by Ray H. Garrison, Eric Noreen, and Peter Brewer - A comprehensive book providing in-depth insights into managerial accounting principles, including absorption costing.
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan - An essential book that covers various costing methods, including overhead absorption and estimation of production costs.
- “Horngren’s Cost Accounting: A Managerial Emphasis” by Charles T. Horngren - A detailed exploration of cost accounting techniques and methodologies with real-world examples and applications.
Accounting Basics: “Absorbed Overhead” Fundamentals Quiz
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
