Overhead Absorption
The allocation of indirect manufacturing costs to products using a predetermined overhead rate.
What is Overhead Absorption?
Overhead absorption is a cost accounting method that assigns indirect manufacturing costs — such as factory rent, utilities, and supervisor salaries — to individual products using a predetermined overhead absorption rate. The rate is typically calculated by dividing budgeted overhead costs by a budgeted activity base, such as direct labor hours or machine hours. When the overhead absorbed exceeds actual overhead incurred, the difference is termed over-absorption; when less, it is under-absorption. Both variances are typically written off to the income statement at period end. Accurate overhead absorption is essential for product costing, pricing decisions, and inventory valuation under absorption costing methods required by GAAP.
Example
A factory budgets $500,000 in overhead for 100,000 direct labor hours, giving an absorption rate of $5 per hour. If a product requires 2 direct labor hours, $10 of overhead is absorbed into its unit cost. If actual overhead is $480,000 at 100,000 hours, the $20,000 difference is over-absorption — credited to the income statement as it indicates costs were over-allocated to inventory.