Absorption Costing | Sahithyan's Notes

Overhead absorption is a systematic process of distributing overhead, allocated, apportioned, and reapportioned to production departments, among the units produced.

The absorption rate is the rate at which overheads are charged to the cost units.

Overhead Absorption Rate

Computed as either an actual rate or a predetermined rate.

Predetermined OAR

\text{Predetermined OAR} = \frac{\text{Budgeted Overhead Expenses for the Period}}{\text{Budgeted Basis}}

Used for planning, control, and pricing purposes.

Actual OAR

\text{Actual OAR} = \frac{\text{Actual Overhead Expenses for the Period}}{\text{Actual Basis}}

Methods of Overhead Absorption

Production Unit Method

\text{OHAR} = \frac{\text{Production Overhead for the Period}}{\text{Number of Units of Output}}

Percentage Methods

\text{OHAR} = \frac{\text{Production Overhead for the Period}}{\text{Base}} \times 100

Where the base is one of:

Direct labour cost.
Direct material cost.
Prime cost.

Hourly Rate Methods

\text{OHAR} = \frac{\text{Production Overhead for the Period}}{\text{Hours}}

Where hours is one of:

Direct labour hours.
Machine hours.

Blanket Overhead Absorption

Total production overheads of the organization are absorbed on a single absorption basis, giving only one rate for the entire unit, plant, or department.

Under and Over Absorbed Overhead

Arises for 1 of the following reasons:

Actual overhead costs differ from budgeted overheads.
The activity level differs from the budgeted activity level.
Both actual overhead and activity level differ from budget.