What is Absorption of Overhead?
Overhead absorption is the process of spread over the overhead to the production for a specific period. This is otherwise called as overhead application, overhead costing, levy of overhead, recovery of overhead, burden application or burden absorption.
The production departments through the process of secondary distribution only absorb overhead. A suitable basis for secondary distribution should be find out so that each job or product gets due share of overhead when it passes through that department.
Thus, absorption of overhead involves the apportionment of production department overhead among the units produced in that department for a specific period.
The basis for the absorption of overhead should be reasonable one. The reason is that pricing policies, tenders and other managerial decisions are based on the unit cost arrived after the absorption of overhead. Overhead rate is used for the overhead absorption.
What is Overhead absorption rate?
Overhead absorption rate is a rate charged to cost unit intended to account for the overhead at a predetermined level of activity. On the basis of direct labour hours, direct labour cost or machine hours, overhead is attributed to a product or service. If the number of units is a basis for determining overhead rate, the following formula is used.
Overhead Rate = Amount of Overhead for the period / Total number of units to be produced for the period
The overhead absorbed in a period will be found out by multiplying overhead rate by total number of units produced for the period.
Objectives for determining overhead absorption rate
The followings are the objectives for determining Overhead Absorption Rate.
1. To include the overhead in the cost of production of goods and services.
2. To calculate the cost of unit soon after the completion of production.
3. To determine the amount to be debited to work in progress account for indirect material, indirect labour and indirect expenses for production.
4. To estimate the overhead to be included in the cost of job order.
5. To help in the application of overhead over the production on an equitable basis.