Absorption

Absorption of overheads refers to the process of charging or recovering overhead costs to cost units such as products, jobs, or processes. After overheads are estimated, collected, allocated, and apportioned to cost centers, they are finally absorbed into the cost of production using suitable absorption rates. This step ensures that each unit of output bears a fair share of indirect costs.

Absorption is essential because overheads cannot be directly traced to individual products. By applying predetermined absorption rates, organizations can include overheads in product costs during the production period without waiting for actual expenses to be known. This leads to timely cost ascertainment and better cost control.

Overhead absorption rates may be based on various factors such as direct labor hours, machine hours, direct wages, units produced, or percentage of prime cost. The choice of a suitable base depends on the nature of production and the relationship between overheads and the selected base.

Proper absorption of overheads helps in accurate product costing, pricing decisions, profit determination, and inventory valuation. It also facilitates comparison between estimated and actual overheads, enabling management to identify under-absorption or over-absorption and take corrective actions.

In cost accounting, effective absorption of overheads ensures fair distribution of indirect costs, supports managerial decision-making, and contributes to overall cost efficiency and profitability.

Need for Absorption of Overheads

Absorption of overheads is essential in cost accounting to ensure that indirect costs are fairly included in product costs. Since overheads cannot be directly traced to individual units, absorption helps distribute them systematically. The need for absorption of overheads can be explained under the following eight points, each explained in detail.

• Accurate Cost Determination

Absorption of overheads ensures that indirect costs such as rent, power, supervision, and depreciation are included in the total cost of production. Without absorption, product costs would be understated. Accurate cost determination is essential for knowing the real cost per unit and for maintaining reliable cost records in cost accounting.

• Fixation of Selling Price

Correct absorption of overheads helps management fix appropriate selling prices. When overheads are properly absorbed into product costs, prices can be set to cover total costs and earn desired profits. Under-absorption may lead to losses, while over-absorption may result in uncompetitive pricing in the market.

• Valuation of Inventory

Absorption of overheads is necessary for correct valuation of work-in-progress and finished goods. Inventories must include a fair share of overhead costs to reflect true value. Proper valuation ensures accurate profit measurement and compliance with accounting principles and cost accounting standards.

• Cost Control and Efficiency

By absorbing overheads using predetermined rates, management can compare absorbed overheads with actual overheads. This comparison helps identify over-absorption or under-absorption, enabling management to take corrective actions and improve cost control and operational efficiency.

• Profit Measurement

Absorption of overheads ensures correct calculation of profit. If overheads are not absorbed, profits may be overstated or understated. Including overheads in product costs provides a realistic picture of business performance and helps management assess profitability accurately.

• Uniform Costing and Comparison

Absorption allows uniform costing by applying consistent overhead rates across periods or departments. This uniformity enables meaningful comparison of costs between products, departments, or time periods, helping management analyze trends and take informed decisions.

• Facilitates Budgetary Control

Overhead absorption is closely linked with budgetary control. Predetermined absorption rates are based on estimated overheads and activity levels. This helps in monitoring actual performance against budgets and detecting variances related to overhead expenses.

• Supports Managerial Decision-Making

Absorbed overhead data supports important managerial decisions such as make-or-buy, product selection, expansion, and capacity utilization. Reliable cost information including overheads enables management to make sound strategic and operational decisions.

Methods of Absorption of Overheads

Absorption of overheads refers to the process of charging indirect costs to products, jobs, or processes using suitable bases. Different methods are used depending on the nature of production and the relationship between overheads and the chosen base. The important methods of absorption of overheads are explained below.

1. Unit of Output Method

Under this method, overheads are absorbed on the basis of units produced. Total overheads are divided by total units of output to calculate overhead cost per unit. This method is simple and suitable where production is uniform and continuous. However, it is not appropriate when products differ in size or complexity.

2. Direct Labour Cost Method

In this method, overheads are absorbed as a percentage of direct labour cost. The overhead rate is calculated by dividing total overheads by total direct wages. This method is suitable where labour plays a significant role in production. However, it becomes ineffective when wage rates vary widely.

3. Direct Labour Hour Method

Here, overheads are absorbed based on the number of direct labour hours worked. The overhead rate per labour hour is calculated by dividing total overheads by total labour hours. This method is more accurate than the wage-based method and is suitable for labour-intensive industries.

4. Machine Hour Method

Under this method, overheads are absorbed based on machine hours worked. Total overheads are divided by total machine hours to determine the rate per machine hour. This method is most suitable for machine-intensive industries where machines play a major role in production.

5. Prime Cost Percentage Method

In this method, overheads are absorbed as a percentage of prime cost, which includes direct material and direct labour. The method is simple but less accurate, as overheads may not have a direct relationship with prime cost components.

6. Direct Material Cost Method

Overheads are absorbed as a percentage of direct material cost under this method. It is suitable when material cost is a dominant factor in production. However, it ignores the role of labour and machines, making it less reliable.

7. Sales Value Method

This method absorbs overheads as a percentage of sales value. It is mainly used for selling and distribution overheads. However, it is influenced by market prices and does not reflect actual production effort.