Absorption of overheads

According to CIMA, absorption of overhead means “the process of absorbing all overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”. In other words, apportion of overhead means the process of apportionment of overhead to cost centre.

In order to find out the total cost per unit, each unit of production is charged with its respective share of overhead. So, absorption of overhead is the charge made on each job for recording indirect cost. After careful consideration of all relevant factors a suitable basis is to be selected, e.g., direct labour hours, machine hours, direct wages, production units, etc.

The absorption rate is, thus, obtained by dividing the total departmental overhead by the basis which is applied to various production units for calculating cost of each unit of production, the so-called calculated rate is multiplied to the base unit of each product.

It can be written as:

Overhead Rate = overhead Expenses/ Total quantum (quantity or Value) of basis

Absorption of Overhead = Overhead Rate x Units of the base contained in the product.

Rate of Determination:

(a) Actual Rate:

Actual overhead rate/historical overhead rate is determined by dividing actual cost of overhead by the actual base of a certain period. It is calculated as

Actual Rate = Actual overhead Cost/ Actual Base

It is needless to say that actual rate may be computed monthly, quarterly, or annually.

(b) Predetermined Overhead Rate:

This rate can be computed as:

Pre-determined Overhead Rate = Budgeted overhead cost for the Year/Budgeted base for the Year