Definition
Absorbed overhead refers to the portion of the fixed manufacturing costs that are assigned to the production of a specific product or service. It forms part of the total cost of the product or service, which is then used for cost control and pricing decisions. This allocation method seeks to accurately reflect the true cost of producing or providing each good or service.
Key Takeaways
- Absorbed Overhead refers to the portion of the total manufacturing costs that a business allocates to its produced goods or services. This is crucial for an accurate measure of the product cost, and subsequently, pricing the products or services competitively.
- The process of overhead absorption is done using a predetermined overhead absorption rate, calculated at the start of an accounting period. This rate is typically based on an activity level such as direct labor hours, machine hours, or the direct labor cost.
- Over or under absorption of overheads can occur, due to inaccuracies in estimation. Both situations can have potential impacts on a company’s profitability and pricing strategy. Hence, businesses regularly monitor to rectify any significant differences swiftly.
Importance
Absorbed overhead is a crucial term in finance because it refers to the total indirect costs or overheads that a company allocates to its produced goods or services.
It is essential in determining the true cost of either producing a product or delivering a service, thereby supporting pricing decisions and profitability analysis.
By accurately absorbing overhead costs onto individual products or services, businesses can ensure cost efficiency, avoid underpricing or overpricing their offerings, and maintain a competitive edge in the market.
Furthermore, understanding absorbed overhead helps in budgeting and provides valuable insight into how overhead costs impact overall business profitability.
Therefore, failure to properly account for absorbed overhead can lead to financial misjudgments, affecting the company’s sustainability and growth.
Explanation
Investors and managers use Absorbed Overhead as a mechanism for analyzing and managing the totality of costs associated with the production of goods or services. The purpose of this financial term is to account for all indirect expenses related to production, such as utilities, wages for staff not directly involved in the manufacturing process, and equipment maintenance.
By including these costs, organizations can achieve a more accurate and comprehensive analysis of total production costs. Absorbed overhead is primarily used in costing strategies such as standard costing or activity-based costing.
By including absorbed overhead costs in their calculations, businesses are better able to set their prices appropriately to ensure profitability. Additionally, understanding absorbed overhead indicates the level of efficiency an organization has in using its resources.
If overhead costs are high, the company may look for ways to lower these costs, improve efficiency, and ultimately, increase profitability.
Examples of Absorbed Overhead
Manufacturing Companies: A clothing manufacturing company considers its overhead costs which include rent, utility bills, and salaries of non-production employees. These costs are then allocated or absorbed into the cost of each unit of clothes produced. Once the clothes are sold, revenue generated covers not only the direct costs of materials and labour but also the absorbed overhead costs.
Food and Beverage Industry: In a restaurant, costs such as rent, utilities, kitchen equipment depreciation, and management salaries are spread out over each dish served. When a customer pays for their meal, they’re also contributing to these overhead costs. This is an example of absorbed overhead.
Healthcare institutions: A hospital will absorb overhead costs like administrative salaries, building maintenance, and equipment repair into the cost of each patient’s treatment or stay. This means the overall cost a patient is charged not only consists of direct costs related to their medical care but also a portion of the hospital’s overhead costs.
FAQs on Absorbed Overhead
1. What is Absorbed Overhead?
Absorbed overhead refers to the percentage of total overhead costs that are covered by a company’s production process. In other words, it is the overhead cost that has been assigned to the production activities or output for a certain period.
2. How is Absorbed Overhead calculated?
Absorbed Overhead is calculated by multiplying the overhead absorption rate with the actual level of activity.
3. What is meant by Overhead Absorption?
Overhead absorption, also known as overhead allocation, is the process of spreading the cost of the manufacturing overhead across the units produced. Essentially, it is the assignment of all indirect costs, everywhere possible, to the produced goods or services.
4. What is the difference between Absorbed Overhead and Unabsorbed Overhead?
Absorbed overheads are the overheads which are allocated to the particular cost centre or cost unit, while unabsorbed overheads are those overheads which can’t be allocated to the particular cost centre or cost unit. The reason for the unabsorbtion may be due to excess budgeted overheads or due to ineffective utilisation of resources.
5. What impact does Absorbed Overhead have on financial statements?
Absorbing overhead costs can have a significant impact on a company’s financial statements. By allocating overhead costs, it can more accurately reflect the cost of producing each good or service, and as such provide a more accurate view of profitability for each individual product.
Related Entrepreneurship Terms
- Allocation Base: This is the measure used to assign overhead costs to products or services. It is closely linked with absorbed overhead as companies have to decide how they will allocate their overheads.
- Fixed Overhead: This is an overhead expense that remains constant, regardless of the volume of production or sales. When discussing absorbed overhead, fixed overheads are often a part of the picture.
- Variable Overhead: These are costs that fluctuate in direct proportion to production volume. Variable overheads also play a part in the total absorbed overhead.
- Overhead Recovery Rate: A rate used to apply manufacturing overhead costs to units produced. This is key to the concept of absorbed overhead as it involves the process of charging overhead costs to cost objects.
- Under-absorbed Overhead: This occurs when a business doesn’t charge enough for its overhead costs and results in a business not covering its total overhead costs.
Sources for More Information
- Investopedia: A reliable source with a vast collection of financial news, terms, and definitions, including ‘Absorbed Overhead’.
- Accounting Tools: Provides detailed explanations on various accounting terminologies, including ‘Absorbed Overhead’.
- Corporate Finance Institute: Offers finance courses and resources including explanations of key financial terms and concepts like ‘Absorbed Overhead’.
- Finance Formulas: An extensive collection of finance formulas, explanations, and definitions, including ‘Absorbed Overhead’.
