Overhead Absorption: How to Calculate and Apply Overhead Rates
Allocation, apportionment and absorption explained step by step, with worked examples.
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The three steps: allocate, apportion, absorb
Overhead cannot be traced to one product, yet every product should carry a fair share. Cost accountants do this in stages.
- Allocation. Assign overhead that clearly belongs to one department, such as the wages of a cutting-department supervisor, directly to that department.
- Apportionment. Share overhead that benefits several departments using a fair basis: rent by floor area, power by machine hours, canteen costs by number of employees.
- Absorption. Divide each department’s overhead by its budgeted activity to get a rate, then charge products at that rate.
Where service departments (such as maintenance) support production departments, their costs are also reapportioned to production before absorption. See overhead for the definition.
Choosing an absorption basis
| Basis | Best when |
|---|---|
| Machine hours | Production is machine-intensive and machine time drives overhead |
| Direct labour hours | Production is labour-intensive |
| Percentage of direct labour cost | Labour rates are similar across products (simple, but less accurate) |
| Rate per unit | The business makes one identical product |
The aim is to choose the basis that best reflects what really causes the overhead.
Worked example: two departments
A factory has a Cutting department (machine-intensive) and an Assembly department (labour-intensive). Budgeted overheads are factory rent 24,000, shared by floor area, and power 8,000, shared by machine hours.
| Item | Basis | Cutting | Assembly | Total |
|---|---|---|---|---|
| Floor area (m²) | 300 | 100 | 400 | |
| Machine hours | 3,000 | 1,000 | 4,000 | |
| Rent 24,000 | Floor area | 18,000 | 6,000 | 24,000 |
| Power 8,000 | Machine hours | 6,000 | 2,000 | 8,000 |
| Total overhead | 24,000 | 8,000 | 32,000 |
Rates. Cutting is machine-intensive: 24,000 ÷ 3,000 budgeted machine hours = 8.00 per machine hour. Assembly is labour-intensive: 8,000 ÷ 2,000 budgeted labour hours = 4.00 per labour hour.
Charging a job. Job 7 uses 10 machine hours in Cutting and 6 labour hours in Assembly.
| Cutting overhead (10 × 8.00) | 80.00 |
| Assembly overhead (6 × 4.00) | 24.00 |
| Overhead absorbed by Job 7 | 104.00 |
|---|
Under- and over-absorbed overhead
The rate is set in advance using budgeted figures, so actual results rarely match. The difference is called under- or over-absorption.
Example. Budgeted overhead is 60,000 and budgeted hours are 20,000, so the rate is 3 per hour. Actual overhead was 58,000 and actual hours were 19,000.
| Overhead absorbed (19,000 × 3) | 57,000 |
| Actual overhead incurred | 58,000 |
| Under-absorbed overhead | 1,000 |
|---|
- Under-absorbed (absorbed < actual): too little was charged to products. The shortfall is an extra cost in the income statement.
- Over-absorbed (absorbed > actual): too much was charged. The excess reduces cost in the income statement.
Common mistakes
- Using actual overhead to set the rate. The rate is based on budgeted overhead and activity, so products can be costed during the year.
- Choosing a basis that does not drive the cost. Using labour hours in a highly automated department gives a distorted product cost.
- Mixing up the direction. Absorbed less than actual means under-absorbed.
Quick check
1. Budgeted overhead is 48,000 and budgeted machine hours are 12,000. What is the rate, and how much does a job using 30 machine hours absorb?
Rate = 48,000 ÷ 12,000 = 4 per machine hour. The job absorbs 30 × 4 = 120.
2. Overhead absorbed was 90,000 and actual overhead was 95,000. What is the difference called?
Under-absorbed by 5,000, because the amount absorbed is less than the amount incurred.
Practise further with Problem 4 (under- and over-absorption) and Problem 5 (job costing).
Frequently asked questions
What is the difference between allocation and apportionment?
Allocation assigns a cost that belongs wholly to one department. Apportionment shares a cost that benefits several departments using a fair basis.
Why is the absorption rate based on budgeted figures?
So that products can be costed throughout the year, before actual overhead and activity are known.
What happens to under-absorbed overhead?
It is normally written off to the income statement as an additional cost for the period.
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