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Absorbed overhead

Absorbed overhead – What is absorbed overhead?

‘Absorbed overhead’ refers to manufacturing overhead that’s been applied to a manufactured product or other cost object.

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When you talk about ‘manufacturing overhead’, it refers to all of the indirect costs that are incurred during the production process. They are usually calculated and assigned to a product at a predetermined rate. This is likely to be based on an annual overhead budget for manufacturing and then divided by certain factors, for example, how long a machine is expected to run to produce the product in question. We can talk about the manufacturing overhead as being assigned to a product, or rather, that the product has absorbed the overhead.

Methods for calculating absorbed overhead

There are several different methods that you can use to calculate the manufacturing overhead of a product. They fall into 3 categories:

  1. Production unit method
  2. Percentage methods
  3. Hourly rate methods.

1. Production unit method for calculating absorbed overhead

To work out the overhead absorption rate using the production unit method, you need to divide the overhead cost by the number of units you’re going to produce (or expect to produce).

The production unit method calculation is represented as:

Overhead absorption rate = Overhead (budgeted or expected) ÷ Number of units produced

2. Percentage methods for calculating absorbed overhead

Alternatively, you may want to work out the overhead absorption rate using a percentage method. There are 3 different percentage methods that may be used:

  • Percentage of direct wages
  • Percentage of direct material costs
  • Percentage of prime cost.

2a. Percentage of direct wages

This method calculates the overhead absorption rate by giving the overhead expense that needs to be absorbed as a percentage of the cost of direct labour for the same period.

The method for calculating the absorbed overhead in this way can be represented as:

Overhead absorption rate (%) = (Actual or expected overhead costs ÷ Actual or expected cost of wages to produce the product) x 100

Example of calculating absorbed overhead using the percentage of direct wages method

For example, suppose that budgeted overhead for Product X is £15,000, and budgeted direct labour cost for the same period is £45,000. The direct wage percentage can then be calculated as:

Percentage of direct wages = (15,000 ÷ 45,000) x 100 = 33.3·%

So, what this means is that if the direct wages to produce one Product X are £300, then it means that 33.3·% of £300 (i.e. £100) should be charged to the manufacturing of this Product X as production overhead.

2b. Percentage of direct material cost

Here, rather than working out the absorption rate using the cost of direct wages needed to produce the product, you use the cost of direct materials. The cost of the materials that you use to manufacture your product is therefore the basis of charging overhead to your product units. To work out the percentage of direct material costs, you need to divide the total overhead cost by the total cost of the materials used. Like before, you’re again working out a percentage.

The calculation can be represented in this way:

Overhead absorption rate (%) = (Total overhead cost (budgeted or expected) ÷ Total cost of direct materials) x 100

Example of calculating absorbed overhead using the percentage of direct material cost method

So, in an example where the budgeted overhead for Product X is £15,000 and budgeted direct material cost is £25,000, you can calculate the direct material cost as:

Direct material cost = (£15,000 ÷ £25,000) x 100 = 60 %

So, what this means is that if the cost of direct material to produce one Product X is £300, the production overhead that’s to be absorbed is simply £300 x 60% = £180.

2c. Percentage of prime cost method

This method assumes that both the materials you use and the labour (i.e the wages) it takes to produce the product jointly lead to factory overheads. Therefore, the total cost of both material and labour should be accounted for when calculating the absorption of factory overheads.

The percentage of prime costs finds the overhead absorption rate by dividing the total overhead by the total prime cost. The calculation is:

Overhead absorption rate = (Budgeted or actual overhead ÷ Prime cost) x 100

Example of calculating absorbed overhead using the percentage of prime cost method

For example, we could say that the production overhead to be absorbed is £10,000 and the prime cost is £40,000. To calculate the percentage of prime cost, we then need to do this calculation:

Percentage of prime cost = (£10,000 ÷ £40,000) x 100 = 25 %

What this then means is if the prime cost to produce Product X is £50, the production overhead that needs to be absorbed per unit of Product X is 25% of 50 = £12.50.

3. Hourly rate methods for calculating absorbed overhead

It’s also possible to work out absorption overhead by using hourly rate methods, i.e. the amount of time (and therefore the cost of this time) it takes to manufacture a product. There are 2 different hourly rate methods that you can use:

  • Direct labour hour rate
  • Machine hour rate.

3a. Direct labour hour rate

This method may be used to calculate overhead absorption when you’re manufacturing a product that is labour intensive (and therefore costly in labour), but there is little machine involvement, and therefore low machine-related expenses.

With this method, an overhead absorption rate is calculated by dividing the expected overhead attributable to the production by the appropriate number of direct labour hours. What this means is that the overheads are calculated by the number of labour hours used. It’s common for this rate to be calculated for each type of worker involved in the manufacturing. To find the direct labour hour rate you calculate:

Direct labour hour rate = Overhead for the specific period ÷ Direct labour hours for the same period

Example of calculating absorbed overhead using the direct labour hour rate method

For example, when we’re manufacturing Product X, the total overhead cost may be £30,000 and the total amount of direct labour hours is 50,000 hours. To find the direct labour hourly rate you do this:

£30,000 ÷ 50,000 = Direct labour hour rate of £0.60 per hour

3b. Machine hour rate

If you’re talking about a machine hour rate, this refers to the expenses that accumulate whilst you’re running the machine for one hour. You calculate overheads with this method when machinery is predominantly used to manufacture a product.

To work out the overheads you need to calculate the expenses that are incurred from running the machine. This will include things like the machine’s depreciation, how much power it uses, how much the insurance costs, and how much maintenance is needed.

To calculate the machine hour rate, you need to perform this calculation:

Machine hour rate = Estimated production overhead during specific time period ÷ Machine hours during that time period

Example of calculating absorbed overhead using the machine hour rate method

For example, suppose that the estimated production time using the machinery is 250 hours and the estimated overhead cost for this period is £28,000. To get the overhead absorption rate using the machine hour rate method, you simply calculate:

£28,000 ÷ 250 = Machine hour rate of £112 per hour

Overabsorption and underabsorption of manufacturing costs

If the amount of overhead that is assigned to the products manufactured is more than the amount of overhead that is actually incurred, then the products have overabsorbed the overhead costs. Equally, if the amount of overhead that is assigned to the product is less than the actual amount of overhead that incurred, then the products have been underabsorbed.

Overabsorption and underabsorption will usually be caused by the following factors:

  • How much of the product is manufactured
  • The actual overhead costs incurred during production.

With time, the overhead allocation rate for the production of a product should be adjusted so it matches the actual amount of overhead it incurs. This means that eventually the amount of overabsorbed and underabsorbed overhead should balance each other out.