On the other hand, indirect costs refer to costs that are not direct costs or are the opposite of direct costs. These are expenses unrelated to producing a product. Indirect costs, unlike direct costs, are not traceable to a single unit of product, cost centre or project. Similarly, indirect costs are also costs that a company incurs regardless of its level of activity. Some indirect costs may depend on the level of activity of the company, such as electricity but, they also have a fixed element or may be shared by different departments at the same time.
When deciding on the price of a product, companies need to know its cost. It’s easy to derive the direct cost of a product. However, companies also need to account for indirect costs. While indirect costs are not easily traceable to a specific unit, there is technique companies use known as Absorption of Overheads or Overheads Absorption.
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Definition of Absorption of Overheads in Cost Accounting
Absorption of overheads in cost accounting refers to the process in which companies charge their overheads to individual products, jobs or batches. The process consists of a distribution of overheads attributable to a particular department or cost centre in a company over the total units produced. In this process, companies assign their indirect costs to specific units of products, cost centres or projects. This is a requirement under common accounting standards such as GAAP or IFRS.
The process consists of establishing an overhead absorption rate and then applying the rate to the total units produced. These costs are said to be absorbed into the products. Companies must calculate this rate for each cost centre. Usually, they must calculate the rate before the production begins. Therefore, it requires them to forecast their costs and units produced to determine the rate.
Formula of Overhead Absorption Rate
The formula to calculate the overhead absorption rate is below.
Overhead absorption rate = Total estimated overheads / Total estimated units of production
As mentioned above, this rate becomes part of the cost of a product. Ideally, companies need to know their overheads and units of production beforehand to use an accurate rate. However, companies need to know the overhead absorption rate at the start of the period to determine the cost of the units produced. It requires them to calculate this rate beforehand and estimate both the overheads and units of production.
Bases of Absorption of Overheads
While some companies use total units produced as a basis to calculate the overhead absorption rate, there are many other bases they can use as well. In the above formula, the basis used to calculate this rate is units produced. For other bases, companies must alter the denominator in the formula. The other bases companies use to calculate this rate are as follows.
Direct labour hours
Under this method, companies calculate their overhead absorption rate by dividing the total overheads by the estimated number of direct labour hours for an estimated level of activity. There are different ways to calculate the estimated direct labour hours. For example, under standard costing, companies can calculate estimated direct labour hours by multiplying the standard labour hours with the expected units of production. Similarly, they may calculate it by taking the number of hours which would relate to working at normal capacity. Using direct labour hours is an appropriate basis for companies that heavily rely on labour hours for production.
The formula to calculate the rate based on direct labour hours is as follows.
Overhead absorption rate = Total estimated overheads / Total estimated direct labour hours
Direct machine hours
Direct machine hours are also a basis companies use to calculate their overhead absorption rate. Under this basis, they calculate the rate by dividing the total estimated overheads by the estimated number of direct machine hours for an estimated level of activity. As with direct labour hours, companies can use different methods to calculate their estimated direct machine hours. Companies that rely heavily on machine hours use this as a basis when calculating this rate.
The formula for this basis is as follows.
Overhead absorption rate = Total estimated overheads / Total estimated direct machine hours
Percentage basis
Companies can also use a percentage of their costs as a basis when calculating their overhead absorption rates. There are three main types of costs they may use. These include direct material costs, direct wages or labour costs and prime costs. When using a percentage basis, the rate derived is in the form of a percentage, rather than a monetary rate.
The formula to calculate the rate using a percentage basis is as below.
Overhead absorption rate (%) = Total estimated overheads / (Direct Material / Direct Labor / Prime costs) x 100
How to Select Absorption Bases?
Selecting an appropriate base for overhead absorption in cost accounting is crucial for companies. It is because it can significantly impact the cost, and in turn, the price of the product. Many factors determine which basis a company should use when calculating the overhead absorption rate. As mentioned above, these factors depend on the activity of the company.
For cost centres that are labour intensive, labour hours are a more appropriate basis. However, nowadays, most companies use machinery for their tasks. Therefore, for cost centres that heavily rely on machinery hours, machine hour is a better basis for calculating this rate. Direct materials are also a basis that companies may use. However, direct material can cause some irregularities in the cost of products. Therefore, the usage of direct material as a basis is less common.
Method of Absorption of Overheads—Choice of Method
Once companies select an appropriate basis, selection of the proper method of calculating overhead absorption rate is also a requirement. Most companies use the hourly method of calculating overhead absorption as it produces the most accurate results. It is because most companies and their cost centres incur costs that are period costs and relate to time.
Some companies may also use costs instead of hours when calculating this rate. In these companies, the costs of labour and machine are not directly proportional to the hours worked. Therefore, in these circumstances, using costs instead of hours may be more appropriate. It can happen in cost centres where companies use a different class of workers, for example, skilled and unskilled, at the same time.
Example and Explanation
A company, ABC Co., wants to calculate its overhead absorption rate. It estimates its total overheads to be $10,000. It also estimates its total units of production to be 1,000 units. Furthermore, it predicts the labour hour for each product to be 2 hours. Therefore, its total estimated labour hours are 2,000 labour hours. To calculate this rate, ABC Co. must decide which basis to use for calculation. If ABC Co. uses total units produced, this rate can be calculated using the following formula.
Overhead absorption rate = Total estimated overheads / Total estimated units of production
Overhead absorption rate = $10,000 / 1,000 units
Hence, Overhead absorption rate = $10 per unit
On the other hand, using labour hours as a basis, the formula to calculate the overhead absorption rate is as follows.
Overhead absorption rate = Total estimated overheads / Total estimated direct labour hours
Overhead absorption rate = $10,000 / 2,000 labour hours
Hence, Overhead absorption rate = $5 per unit
While both the rates are different, the cost of a product will not change regardless of which basis the company uses. That is because each unit requires 2 hours of labour. That means the company will still charge $10 ($5 overheads absorption rate x 2 labour hours per product) overhead absorption rate to products even if it uses the labour hours basis. If the company has different products that take require different labour hours, the overhead absorption for each product will significantly differ for each product based on which basis it uses.
Conclusion
Companies have two types of costs, direct and indirect costs. Direct costs are directly attributable to a single unit of product. Indirect costs need to be allocated to each product separately. In cost accounting, to allocate indirect costs to products, companies must calculate an overhead absorption rate. The process of allocating indirect costs to products using the overhead absorption rate is known as the absorption of overheads. There are different bases that companies may use to calculate the overhead absorption rate. Which basis is appropriate for a specific company depends on several factors.