Absorption of overheads: introduction; definitions; examples; overhead absorption rate; procedures; importance and examples

1.1 Introduction

Once allotment and apportionment of overhead cost to the production department is completed, the next level is to carry out overhead cost absorption process.

1.2 Definitions

Definition-1: The term absorption in cost accounting refers to the process of estimating the amount of overhead cost to be incurred in production through budgeting. The estimation is done using absorption formula where a rate is computed as follows;

The general formula to estimate the expected overheads to be incurred is as given below;

OR

Definition-2; Absorption: The term absorption in Cost Accounting means estimation of the overhead cost to be incurred by a business or department in the future. It is a process that involves use of a predetermined or budgeted overhead absorption rate to compute or set empirically the total overhead cost expected to be incurred by a production department (see previous definition).

OR

Definition -3: Overhead absorption is the charging of the overhead to cost unit. Once overhead costs are allocated, apportioned and re-apportioned to the particular production departments, then the next step is to know how much overhead cost specifically is ascertainable to the actual products (i.e., goods and services) produced. For example, if the estimated total overhead cost charged to a certain production department such as “P” was $1,000,000 which had produced 100,000 units, then the amount of overhead absorbed/or budgeted for individual unit of the product in question will be; (Working-1)

As a learner or producer or an entrepreneur, you should know that the overhead cost per unit is added to the already known direct raw material cost per unit, direct cost per unit and direct expenses to determine the total cost per unit. So, like in this case here, the cost statement per unit will be expressed as;

Therefore, in this case the cost per unit is $25. Now again take note of this that the unit being expressed here refers to the standard of measure being used such as a kilometer, a meter of cloth material, a Liter of milk or a kilogram of sugar or salt.

NB1: The total budgeted overhead represents either fixed or variable overhead

NB2: The denominator can assume other aspects depending on the correlation the denominator has with the overhead in question.

This means that once the rate of absorption is established, it will be used to determine the estimated overhead cost to be affiliated to the cost unit or cost product which is compared with the actual overhead incurred at the end of it all.

1.3 Example 1

The following estimates relate to Deluxe co.  Ltd for the year ending on 31st/05/2021

Note the following, that experience portrays that overhead is highly correlated with material cost, direct labor cost and direct labor hours.

Required

Determine the overhead absorption rate based on the three aspects aforementioned apportionment bases, namely; material cost, direct labor cost and direct labor hours.

Determine the overhead cost to be absorbed in producing the 30 units produced on 7th/Nov 2020 

Solution

Overhead absorption rate (oar)

2.1 Introduction

From the aforementioned discussion of overhead absorption, it is clear that there is need of considering the various rate of absorbing overhead costs. These rates are a ratio or quotient which portrays the level at which overhead costs are consumed in production as the various bases change in terms of units which can assume diverse aspects of measurement.

2.2 Procedure of determining overhead absorption rates (oar)

The following are simple step by step procedures of establishing overhead absorption rates;

Step 1: Categorization of overhead costs.

Based on the agreed upon criterion by the management, the indirect costs are fitted in their most sensible or logical classes so as to be well guided of the base to use to compute the rate. The benefit derived by a product or department is key in this case. 

Step 2: Summation of costs:

The essence of this stage is to gather all similar cost which is related to a particular base of benefit. 

Step 3: Base Formation:

Link up the relevant bases with the respective nature of cost which are highly correlated. This procedure is guided by the respective cost driver directly responsible to the changes occurring on the product of concern. For example, the labor driven indirect costs will use total labor cost as the base etc.

Step 4: Provide the appropriate Overhead Absorption Rate (OAR)

Empirically express the relationship between the total overhead cost with the identified base. This can be expressed in ratio/quotient/ratio or percentage form.

Importance of overhead absorption rate (oar)

Determination or computation of Overhead Absorption Rate (OAR)is very key in business. The following are some of the advantages of OAR.

1). Control measure

OAR is a tool that is useful in estimating the possible consumption rate of overhead in a department or cost unit which act as a basis of comparison with the actual consumption. This in turn help in correcting unfavorable variances of such costs

2). Optimal utilization of cost resources

Setting of OAR prior to actual consumption of overhead cost is important for it provides the producer with an approximation which can be used as historical data in guiding how best these resources can be utilized to give optimal results.

3). Reduction or resource wastage by workers

With already pre-determined guideline on how overhead resources will be utilized helps in ensuring that the employees don’t misuse resources for they have a guide on average how much of overhead resources to use in a department or product.

4). Pricing policy

Setting of selling price of the final product requires that all factors be incorporated to avoid over or under pricing. The aspect or OAR helps in capturing the exact total production cost so as to determine the correct selling price.

5). Increasing competitive edge

By setting the correct overhead absorption rate helps in correct estimation of the sales value of the final products of the firm. This helps in ensuring that the risk of losing market share due to customer price threats des not arise.