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Companies must allocate indirect costs to products or services to determine their costs accurately. It involves considering expenses not directly tied to specific products or services, such as rent, utilities, and overhead labour. Consequently, this allocation process helps companies include these indirect costs to use in several areas. This process occurs through overhead absorption.
What is Overhead Absorption?
Overhead absorption is a managerial accounting method to distribute indirect or overhead costs to products or services based on predetermined rates. Overhead costs are indirect costs not directly tied to a specific product or service. However, they support the overall operation of a company. These may include several items, for example, rent, utilities, depreciation, and administrative expenses.
Companies can absorb overheads using various methods, such as job costing, process costing, or activity-based costing. The use of these methods depends on the nature of the company and the level of accuracy desired. Therefore, companies must determine the most appropriate approach for their specific situation. It ensures overhead costs get allocated and reflected accurately in the cost of their products or services.
How does Overhead Absorption work?
Overhead absorption allocates indirect or overhead costs to products or services using a predetermined rate or factor. Usually, companies go through several steps to absorb these overheads. These steps are as follows.
- Identify and gather indirect costs: Identify and collect costs not directly tied to a specific product or service but still support the overall operation of the company, such as rent, utilities, depreciation, and administrative expenses.
- Select a cost driver: Choose a measurable activity or resource having a cause-and-effect relationship with the incurrence of overhead costs, such as direct labour hours, machine hours, or material costs. It is crucial in allocating overhead costs.
- Determine the overhead absorption rate or factor: Calculate the overhead absorption rate or factor by dividing the total indirect costs by the overall usage of the selected cost driver during a specific period.
- Apply the overhead absorption rate or factor: Multiply the overhead absorption rate or factor by the actual usage of the cost driver for each product or service to allocate overhead costs to them.
- Calculate the total cost per product or service: Add the allocated overhead costs to the direct costs, such as direct materials and labour, to determine the total cost per product used for pricing, financial reporting, and profitability analysis.
What is the importance of Overhead Absorption?
The importance of overhead absorption in cost accounting lies in its ability to allocate indirect costs to products or services, facilitating accurate cost determination and decision-making. Overhead absorption helps companies include indirect costs in inventory, leading to more comprehensive financial reporting. It also aids in better pricing decisions, cost management, and profitability analysis, supporting informed strategic decisions.
Overhead absorption also provides a relatively simple and efficient method for cost allocation, making it accessible to companies of different sizes and accounting expertise. However, it’s crucial to consider the specific context of a company and use overhead absorption in conjunction with other cost accounting methods and managerial judgment to ensure accurate and reliable cost allocation.
Overhead absorption helps assign indirect costs to products or services in cost accounting. It has advantages, for example, being simple to use, helping with accurate product costing and pricing decisions, and improving financial reporting. However, it’s critical to consider the specific context of the business and use it alongside other methods for accurate cost allocation.
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