Overview§
Overhead absorption is the process of allocating overhead costs, which are indirect costs, to specific cost units or products. Indirect costs, unlike direct costs, cannot be directly traced to a specific cost unit. Examples include utilities, rent, and administrative salaries. The goal is to ensure that all production costs (direct and indirect) are included when calculating the total cost of a product or service.
Examples of Overhead Absorption§
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Manufacturing Industry:
- Indirect costs like factory rent, electricity, and supervisor salaries are absorbed into the cost of production units based on labor hours, machine hours, or production volume.
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Service Sector:
- A consulting firm’s overhead costs, such as office rent, utilities, and administrative salaries, might be absorbed into client projects based on billable hours or direct costs.
Frequently Asked Questions (FAQs)§
What is the difference between overhead absorption and overhead allocation?§
Overhead absorption and overhead allocation are often used interchangeably. However, absorption specifically refers to the inclusion of overhead costs in the cost of production, ensuring all costs are covered. Allocation is the broader process of distributing costs across different cost centers or units.
Why is overhead absorption important?§
Overhead absorption is critical as it provides a more accurate costing of products/services, helping in pricing decisions, cost control, and profitability analysis.
How is the overhead absorption rate calculated?§
The overhead absorption rate can be calculated using various bases like labor hours, machine hours, or production units. For example, if total overheads are $50,000 and total labor hours are 10,000, the overhead absorption rate is $5 per labor hour.
What happens if overheads are over-absorbed or under-absorbed?§
Over-absorption occurs when overheads allocated exceed actual overheads incurred, resulting in higher cost estimates. Under-absorption is the opposite, leading to underestimations. Both scenarios require adjustments in accounting records and financial statements.
Related Terms§
- Absorption Costing: A method of costing that includes all manufacturing costs, both variable and fixed, in the cost of a product.
- Activity-Based Costing (ABC): A costing method that alloculates overhead to products based on the activities that drive costs, providing more accurate cost information.
- Marginal Costing: A costing technique that includes only variable costs as product costs, treating fixed costs as period costs.
Online References§
- Investopedia - Absorption Costing
- Accounting Coach - Overhead Allocation
- Managerial Accounting – Open Textbooks
Suggested Books for Further Studies§
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan: This book offers an in-depth look at cost accounting principles, including overhead absorption.
- “Managerial Accounting” by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer: A comprehensive guide exploring various costing methods, including activity-based costing and absorption costing.
- “Accounting for Dummies” by John A. Tracy: A beginner-friendly resource that covers the fundamentals of accounting, including cost and managerial accounting concepts.
Accounting Basics: “Overhead Absorption” Fundamentals Quiz§
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